1
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
FORM 10-Q
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 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 Identification No.)
of incorporation or organization)
445 East Florida Avenue, Hemet, California 92543
(Address of principal executive offices)(Zip Code)
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 6,395,303 shares of the Registrant's common stock, par value
$0.01 per share, outstanding as of November 9, 1998.
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HF BANCORP, INC. AND SUBSIDIARY
FORM 10-Q
INDEX
PAGE
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PART I - FINANCIAL INFORMATION
ITEM 1. FINANCIAL STATEMENTS
Consolidated Statements Of Financial Condition As Of
September 30, 1998 (unaudited) and June 30, 1998 3 - 4
Consolidated Statements Of Operations (unaudited) For The
Three Months Ended September 30, 1998 and 1997 5 - 6
Consolidated Statements Of Changes In Stockholders' Equity (unaudited)
For The Three Months Ended September 30, 1998 7
Consolidated Statements Of Cash Flows (unaudited) For The
Three Months ended September, 1998 and 1997 8 - 9
Notes To Consolidated Financial Statements (unaudited) 10 - 12
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF
FINANCIAL CONDITION AND RESULTS OF OPERATIONS 13 - 33
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK 33
PART II - OTHER INFORMATION
Item 1. Legal Proceedings 34
Item 2. Changes In Securities 34
Item 3. Defaults Upon Senior Securities 34
Item 4. Submission Of Matters To A Vote Of Security Holders 34
Item 5. Other Information 35
Item 6. Exhibits And Reports On Form 8-K 35
Signature Page 36
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3
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
September 30, June 30,
1998 1998
------------- --------
(Unaudited)
(Dollars In Thousands)
ASSETS
Cash and cash equivalents $ 47,214 $ 27,720
Securities available-for-sale, at estimated fair value:
Investment securities (amortized cost of $104,701 and $98,792 at
September 30, 1998 and June 30, 1998 respectively) 104,992 98,573
Mortgage-backed securities (amortized cost of $263,438 and $164,400 at
September 30,1998 and June 30,1998, respectively) 263,052 165,004
Securities held-to-maturity, at cost:
Investment securities (estimated fair value of $9,753 at June 30, 1998) -- 9,647
Mortgage-backed securities (estimated fair value of $123,281 at June 30, 1998) -- 123,596
Loans receivable (net of allowance for estimated loan losses of $6,357
and $6,271 at September 30, 1998 and June 30, 1998, respectively) 603,979 581,153
Loans held-for-sale 6,622 3,763
Accrued interest receivable 6,063 6,038
Investment in capital stock of the Federal Home Loan Bank, at cost 8,165 8,048
Premises and equipment, net 5,753 7,145
Assets held pending disposition, net of impairment allowances 207 --
Real estate acquired through foreclosure, net 972 1,674
Gross intangible assets 11,530 12,118
Other assets 1,051 1,358
--------- ---------
Total assets $ 1,059,600 $ 1,045,837
=========== ===========
See Notes to Consolidated Financial Statements
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4
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (CONTINUED)
September 30, June 30,
1998 1998
------------- --------
(Unaudited)
(Dollars In Thousands)
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Checking deposits $ 85,643 $ 88,231
Savings deposits 82,175 88,008
Money market deposits 92,508 82,249
Certificates of deposit 621,471 608,236
------- -------
Total deposits 881,797 866,724
Advances from the Federal Home Loan Bank 85,000 85,000
Accounts payable and other liabilities 6,520 7,030
Income taxes 2,356 3,305
---------- ----------
Total liabilities 975,673 962,059
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
at September 30, 1998 and June 30, 1998; 6,391,303 outstanding at
September 30, 1998 and 6,369,103 outstanding at June 30, 1998 66 66
Additional paid-in capital 51,659 51,557
Retained earnings, substantially restricted 38,733 38,552
Accumulated other comprehensive income (279) 226
Deferred stock compensation (4,012) (4,159)
Treasury stock, 221,197 shares at September 30, 1998 and 243,397 shares
at June 30, 1998 (2,240) (2,464)
------------ ------------
Total stockholders' equity 83,927 83,778
---------- ----------
Total liabilities and stockholders' equity $ 1,059,600 $ 1,045,837
=========== ===========
See Notes to Consolidated Financial Statements
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HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE THREE MONTHS
ENDED SEPTEMBER 30,
-------------------------
1998 1997
-------- --------
(Dollars In Thousands)
INTEREST INCOME:
Interest on loans $ 11,514 $ 9,829
Interest on mortgage-backed securities 4,135 4,617
Interest and dividends on investment securities 2,575 3,789
-------- --------
Total interest income 18,224 18,235
INTEREST EXPENSE:
Interest on deposit accounts 10,265 10,383
Interest on advances from the Federal Home Loan
Bank and other borrowings 1,573 1,246
Net interest expense of hedging transactions 466 486
------- -------
Total interest expense 12,304 12,115
NET INTEREST INCOME BEFORE PROVISION
FOR ESTIMATED LOAN LOSSES 5,920 6,120
PROVISION FOR ESTIMATED LOAN LOSSES 600 100
------- -------
NET INTEREST INCOME AFTER PROVISION
FOR ESTIMATED LOAN LOSSES 5,320 6,020
OTHER INCOME (EXPENSE):
Loan and other fees 104 97
Net gain on sales of mortgage-backed securities available-for-sale -- 56
Net gain on sales of loans held for sale 90 27
Income (expense) from real estate operations, net 182 (443)
Amortization of intangible assets (588) (588)
Branch and deposit related fees 590 450
Other income 362 61
------- --------
Total other income (expense) 740 (340)
See Notes to Consolidated Financial Statements
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HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(UNAUDITED)
FOR THE THREE MONTHS
ENDED SEPTEMBER 30,
--------------------------
1998 1997
--------- ---------
(Dollars In Thousands)
GENERAL AND ADMINISTRATIVE EXPENSES:
Salaries and employee benefits $ 2,954 $ 2,545
Occupancy and equipment expense 1,095 982
FDIC insurance and other assessments 185 181
Legal and professional services 241 124
Data and item processing service costs 562 471
Marketing expense 250 89
Supplies expense 88 65
Other operating expenses 399 366
-------- --------
Total general and administrative expenses 5,774 4,823
EARNINGS BEFORE INCOME
TAX EXPENSE 286 857
INCOME TAX EXPENSE 105 355
-------- -------
NET EARNINGS $ 181 $ 502
======== ========
SHARES APPLICABLE TO BASIC EARNINGS PER SHARE 6,385,090 6,281,875
BASIC EARNINGS PER SHARE $ 0.03 $ 0.08
====== ======
SHARES APPLICABLE TO DILUTED EARNINGS PER SHARE 6,501,665 6,453,841
DILUTED EARNINGS PER SHARE $ 0.03 $ 0.08
====== ======
See Notes to Consolidated Financial Statements
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HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
THREE MONTHS ENDED SEPTEMBER 30, 1998
(UNAUDITED)
(DOLLARS AND SHARES IN THOUSANDS)
Additional Deferred
Common stock paid-in Retained stock- Treasury
Shares Amount capital earnings compensation stock
------ ------ ---------- -------- ------------ --------
Balance at June 30, 1998 6,613 $ 66 $ 51,557 $ 38,552 $ (4,159) $ (2,464)
Amortization of deferred stock compensation -- -- 104 -- 147 --
Sale of treasury stock -- -- (2) -- -- 224
Comprehensive income:
Net earnings -- -- -- 181 -- --
Other comprehensive income:
Change in net unrealized gain on available- -- -- -- -- -- --
for-sale securities, net of $198 in taxes -- -- -- -- -- --
Recognition of net unrealized loss on interest
rate swaps designated as cash flow
hedges, net of $156 in taxes -- -- -- -- -- --
Comprehensive income
Balance at September 30, 1998 6,613 $ 66 $ 51,659 $ 38,733 $ (4,012) $ (2,240)
===== ==== ======== ======== ========= =========
Accumulated
other Total
comprehensive stockholders'
income equity
------------- -------------
Balance at June 30, 1998 $ 226 $ 83,778
Amortization of deferred stock compensation -- 251
Sale of treasury stock -- 222
Comprehensive income:
Net earnings -- 181
Other comprehensive income:
Change in net unrealized gain on available-
for-sale securities, net of $198 in taxes (282)
Recognition of net unrealized loss on interest
rate swaps designated as cash flow
hedges, net of $156 in taxes (223) (505)
-----
Comprehensive income (324)
Balance at September 30, 1998 $ (279) $ 83,927
======= ========
See Notes to Consolidated Financial Statements
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HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE THREE MONTHS
----------------------
ENDED SEPTEMBER 30,
1998 1997
---- ----
(Dollars In Thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings $ 181 $ 502
Adjustments to reconcile net earnings to net cash provided by (used in)
operating activities:
Origination of loans held-for-sale (10,656) (4,133)
Proceeds of sale of loans held-for-sale 7,888 2,275
Provisions for estimated loan and real estate losses 609 526
Depreciation and amortization 262 350
Amortization of deferred loan fees (250) (214)
Amortization (accretion) of premiums (discounts) on loans
and investment and mortgage-backed securities, net 425 98
Amortization of intangible assets 588 588
Federal Home Loan Bank stock dividend (117) (94)
Gain on sales of mortgage backed and investment securities available-for-sale -- (56)
Gain on sales of loans held-for-sale (90) (27)
Gain on sales of foreclosed real estate, net (190) (2)
(Gain) loss on sale of premises and equipment (78) 1
(Increase) decrease in accrued interest receivable (25) 300
Decrease in accounts payable and other liabilities (510) (152)
(Increase) decrease in other assets (72) 396
Other, net (120) 205
-------------- -----------
(2,155) 563
Net cash (used in) provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans receivable (23,700) (42,544)
Purchases of mortgage-backed securities available-for-sale -- (53,754)
Principal repayments on mortgage-backed securities held-to-maturity -- 6,833
Principal repayments on mortgage-backed securities available-for-sale 24,130 6,596
Purchases of investment securities available-for-sale (27,226) --
Principal repayments on investment securities held-to-maturity -- 272
Principal repayments on investment securities available-for-sale 20,086 1,415
Proceeds from sales of mortgage-backed and investment securities available-for-sale -- 15,609
Matured / called investment and mortgage backed securities held-to-maturity -- 8,000
Matured / called investment and mortgage backed securities available-for-sale 10,800 --
Proceeds from sales of real estate acquired by foreclosure 1,485 1,565
Proceeds from sales of real estate held for investment -- 278
Proceeds from sale of premises and equipment 1,228 41
Acquisitions of premises and equipment (227) (35)
----------- ----------
Net cash provided by (used in) investing activities 6,576 (55,724)
See Notes to Consolidated Financial Statements
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HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)
FOR THE THREE MONTHS
ENDED SEPTEMBER 30,
1998 1997
---- ----
(Dollars In Thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Advances received from Federal Home Loan Bank $ 57,000 $ 45,000
Proceeds from other borrowings -- 50,000
Increase in deposit accounts 15,073 17,374
Repayment of advances from Federal Home Loan Bank (57,000) --
Repayment of other borrowings -- (50,000)
---------- --------
Net cash provided by financing activities 15,073 62,374
------ ------
NET INCREASE IN CASH AND CASH EQUIVALENTS 19,494 7,213
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 27,720 18,411
------ ------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 47,214 $ 25,624
========== ==========
SUPPLEMENTAL CASH FLOW DISCLOSURES:
Cash paid during the period for:
Interest on deposit accounts and other borrowings $ 3,229 $ 2,298
========== ==========
SUPPLEMENTAL DISCLOSURES OF NON CASH
INVESTING AND FINANCING ACTIVITIES:
Real estate acquired through foreclosure $ 941 $ 2,289
========== ==========
Loans to facilitate the sale of real estate acquired through foreclosure $ 92 $ 227
========== ==========
Transfer of mortgage-backed securities held-to-maturity to available-for-sale classification $ 123,596 $ --
========== ==========
Transfer of investment securities held-to-maturity to available-for-sale classification $ 9,647 $ --
---------- ==========
See Notes to Consolidated Financial Statements
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NOTE 1: 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 three month
period ended September 30, 1998, are not necessarily indicative of the results
that may be expected for the entire fiscal year or any other interim period.
HF Bancorp Inc. ("HFB") is the holding company for Hemet Federal Savings
& Loan ("Bank") and the Bank's subsidiary, First Hemet Corporation ("FHC"). 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 unaudited consolidated financial statements and the information
under the heading "Item 2. Management's Discussion And Analysis Of Financial
Condition And Results Of Operations" have been prepared with the presumption
that the users of this interim financial information have read, or have access
to, the most recent audited consolidated financial statements and notes thereto
of HF Bancorp, Inc. for the fiscal year ended June 30, 1998 included in the
Company's Annual Report on Form 10-K for the fiscal year ended June 30, 1998.
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.
NOTE 2: Computation Of Earnings Per Share
The Company calculates earnings per share ("EPS") in accordance with
Statement Of Financial Accounting Standards ("SFAS") No. 128 "Earnings Per
Share". All of the Company's net income has been available to common
shareholders during the periods covered in this Form 10-Q. Basic and diluted EPS
were calculated based upon the following information:
PLUS: PLUS:
EQUALS: Treasury Treasury EQUALS: Shares Shares *
LESS: Shares Stock Stock Shares * For For
Average Average For Method: Method: For Quarterly Fiscal Fiscal
Total Shares Quarterly Shares For Shares 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
------ --------- -------- --------- ---------- ---------- --------- --------- --------- ---------
09/30/97 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
06/30/98 6,612,500 280,391 6,332,109 148,744 17,672 6,498,525 $16.98 6,301,358 6,490,881
09/30/98 6,612,500 227,410 6,385,090 103,878 12,697 6,501,665 $16.14 6,385,090 6,501,665
*Share counts for diluted EPS are applicable only in the event of positive
earnings.
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NOTE 3: Derivative Financial Instruments
Effective July 1, 1998, the Company adopted SFAS No. 133 "Accounting For
Derivative Instruments And Hedging Activities". At that date, the Company
maintained $35.0 million (notional amount) in active interest rate exchange
agreements which had previously been designated as "cash flow hedges" within the
meaning defined in the Statement. The $35.0 million is comprised of two separate
swaps, both of which will contractually mature in January 1999; and both of
which place the Company in a "net payment" position based upon the current
market interest rates applicable to the swap agreements. Also at July 1, 1998,
the Company maintained one deferred loss with a remaining book value of $272
thousand associated with a terminated swap previously designated as a "cash flow
hedge". These derivative positions were established many years ago in order to
stabilize the effective cost of short term deposits. Prior to the adoption of
SFAS No. 133, these positions were accounted for on an accrual basis, with the
net periodic amount payable (receivable) debited (credited) to interest expense.
Due to the historic hedging relationship and accounting treatment for
these derivatives, and per the applicable requirements of SFAS No. 133,
effective July 1, 1998, the active interest rate swaps were marked to fair value
and recorded as liabilities on the Company's balance sheet. A corresponding
adjustment, net of tax effect, was posted to a separate component of
shareholders' equity through Other Comprehensive Income as defined in SFAS No.
130. For the terminated swap, the related deferred loss was reclassified, net of
tax effect, to a separate component of stockholders' equity, through a charge to
Other Comprehensive Income. Also per SFAS No. 133, no restatement was recorded
for periods prior to the adoption of the Statement.
Also effective July 1, 1998, the Company evaluated the effectiveness of
the cash flow hedges and determined them to be ineffective as defined in SFAS
No. 133. As a result, future changes in the fair values of the active interest
rate swaps due to changes in interest rates will be reflected in current
earnings, whereas changes in fair value due to the passage of time will be
amortized from Other Comprehensive Income into earnings over the remaining terms
of the interest rate swaps. The amount charged to Other Comprehensive Income
associated with the terminated swap will also be amortized into income over the
remaining life of the original agreement, which had an expiration date of
November 21, 1998.
Because the two active swaps mature during fiscal 1999 and because the
original amortization period for the deferred loss associated with the
terminated swap concludes in fiscal 1999, the adoption of SFAS No. 133 will
therefore present no net impact upon fiscal 1999 aggregate earnings or
shareholders' equity. Results within each quarter of fiscal 1999, however, will
be impacted by the adoption of the Statement. During the quarter ended September
30, 1998, interest expense increased $37 thousand above what would have been
recorded had SFAS No. 133 not been adopted at July 1, 1998. This increase is due
to the charge to earnings for the change in fair value of the active interest
rate swaps attributable to changes in interest rates, as described above.
In conjunction with the adoption of SFAS No. 133, the Company
reclassified 100% of its securities to "available-for- sale" as defined under
SFAS No. 115. A total of $133.2 million (amortized cost) in mortgage-backed and
investment securities were reclassified from "held-to-maturity" on July 1, 1998.
The Company reclassified these securities in order to provide additional
flexibility in future balance sheet and interest rate risk management, and due
to the clarification of regulatory capital treatment for unrealized gains and
losses accounted for under SFAS No. 115 since the initial adoption of that
Statement.
NOTE 4: Non-qualified Pension Plan
During the quarter ended September 30, 1998, the Company commenced cash
distributions of accumulated participant benefits under the non-qualified
Directors Retirement Plan. All but three participants have elected to receive
cash payments prior to the end of the Company's current fiscal year in lieu of
future monthly benefits under this plan. The substantial liquidation of this
plan will reduce Company administrative costs in future periods, while also
constraining a potential source of volatility in future general & administrative
expenses stemming from changes in Director fees and / or general market interest
rates. The cash distributions also accelerate the deductibility of these
expenses by the Company, thereby reducing associated deferred tax assets as
accounted for under SFAS No. 109.
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NOTE 5: Stock Plan
The Company maintains the HF Bancorp, Inc. Stock Based Incentive Plan,
which includes both a stock option and a stock award component. The following
tables summarize the status of this plan:
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
- ---- ---------- ----------- ------------ ------------ ---------- --------
06/30/98 811,250 565,960 163,528 87,228 158,062 $10.47
09/30/98 811,250 587,010 165,328 109,428 114,812 $11.10
Activity during the quarter ended September 30, 1998 included:
Granted 43,250
Canceled 0
Exercised 22,200
The exercise price of individual vested stock options ranged from a low
of $9.50 per share to a high of $15.00 per share as of September 30, 1998.
HF BANCORP, INC. STOCK BASED INCENTIVE PLAN: STOCK AWARD INFORMATION
Stock
Stock Awards
Stock Stock Awards Available
Awards Awards Cumulatively For Future
Date Authorized Outstanding Vested Grants
- ---- ---------- ----------- ------------ ----------
06/30/98 198,375 102,925 68,257 27,193
09/30/98 198,375 99,565 74,917 23,893
Activity during the quarter ended September 30, 1998 included:
Granted 3,300
Canceled 0
Vested 6,660
NOTE 6: Commitments And Contingencies
At September 30, 1998, the Company maintained commitments to sell $958
thousand in residential fixed rate mortgage loans on a servicing released basis,
to originate $14.6 million in various types of loans, to purchase $11.9 million
in loans secured by multifamily real estate, and to purchase $5.0 million in
investment securities. The Company maintained no commitments to assume
borrowings at September 30, 1998.
NOTE 7: Recent Accounting Pronouncements
In October 1998, the Financial Accounting Standards Board ("FASB")
issued SFAS No. 134 "Accounting For Mortgage-Backed Securities Retained After
The Securitization Of Mortgage Loans Held For Sale By A Mortgage Banking
Enterprise". This Statement is effective for the first fiscal quarter beginning
after December 15, 1998. Management has not yet evaluated the potential impact
of this Statement upon the Company's financial condition or results of
operations.
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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, 1998. The Company does not undertake, and specifically disclaims any
obligation, to update any forward looking statements to reflect occurrences or
unanticipated events or circumstances after the date of such statements.
General
HF 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 September 30, 1998, the Company had $1,059.6 million in assets,
$604.0 million in net loans receivable, and $881.8 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, electronic mail address CORPINFO@HEMETFED.COM. 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.
The Company conducts business from eighteen full service branch
offices, one loan production office, 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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Recent Developments
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 extensive presence of
dates in 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:
1. awareness
2. assessment
3. renovation
4. validation
5. implementation
The Company has 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 loan customers whose
possible lack of Year 2000 preparedness might expose the Bank to financial loss,
and to highlight any servicers of purchased loans or securities which might
present Year 2000 related operating problems.
The Board Of Directors has established a Year 2000 subcommittee to
monitor progress with achieving and certifying Year 2000 compliance. In
addition, the Company has utilized an external consulting firm to assist with
its Year 2000 program.
The Company has no significant internally generated software coding to
correct, as substantially all of the software utilized by the Company is
purchased or licensed from external providers. The Company believes that it has
relatively little exposure to contingencies related to the Year 2000 Issue for
products it has sold due to the nature of its business.
14
15
The Company has recently conducted the following Year 2000 related activities:
o Validation testing with the Company's primary data processor was
performed. No significant shortcomings or issues arose as a result of
the testing. However, several additional areas were identified that
would benefit from further testing, primarily in regards to processing
for December 31, 2000 and January 1, 2001. This further testing is
planned to occur prior to March 31, 1999.
o The Company has communicated with servicers and trustees for a majority
of its securities portfolio. These entities (primarily government
sponsored enterprises such as the Federal National Mortgage
Association) have provided information in regards to their Year 2000
readiness. No significant risk to the Company has been identified
through this process. However, the Company maintains little opportunity
to independently verify the responses from most servicers, including
the government sponsored enterprises.
o Due to the age of much of the hardware and software utilized by the
Company at the beginning of calendar year 1998, and in conjunction with
its strategic plan, the Company has installed a new branch computer
environment. The new PC hardware associated with this upgrade completed
the Company's certification of all PC hardware throughout the
organization as Year 2000 compliant.
o Those ATM's requiring new hardware and / or software to achieve Year
2000 compliance were upgraded. In addition, testing information from
the third party which drives the Company's ATM's indicates that Year
2000 compliance should be validated by December 31, 1998.
o The Company has corresponded with those loan customers whose business
or cash flow might be interrupted by a lack of Year 2000 compliance in
some aspect of their operation and who present a credit exposure of at
least $650 thousand to the Company. No responses received to date have
highlighted the likelihood of significant financial loss to the
Company. However, only approximately 50% of those loan customers
contacted have responded. The Company is pursuing personal contact for
those customers who have not yet responded.
The Company is prepared to curtail credit availability to customers
identified as having material exposure to the Year 2000 Issue. However, the
Company's ability to exercise such curtailment may be limited by various
factors, including existing legal agreements and potential concerns regarding
lender liability.
The Company has conducted formal communications with all of its
significant suppliers to determine the extent to which the Company is vulnerable
to those third parties' failure to remediate their own Year 2000 issues. The
Company is requesting that third party vendors represent their products and
services to be Year 2000 compliant and that they have a program to test for that
compliance. The Company plans to replace any significant vendor which does not
supply a sufficient and favorable response to the Company by December 31, 1998.
This replacement is part of the Company's contingency planning. The Company
intends to complete substantially all of its contingency planning no later than
March 31, 1999. At this time, the Company cannot estimate the additional cost,
if any, that might develop from such contingency plans.
15
16
The Company's total Year 2000 estimated project cost, which is based
upon currently available information, includes expenses for the review and
testing of third parties, including government entities. However, there can be
no guarantee that the hardware, software, and systems of such third parties will
be without unfavorable Year 2000 issues and therefore not present a material
adverse impact upon the Company.
Year 2000 compliance costs incurred during fiscal 1999 totaled
approximately $9 thousand. This figure does not include the implicit costs
associated with the reallocation of internal staff hours to Year 2000 project
related efforts. At this time, management currently estimates additional Year
2000 compliance costs, which are expensed on a current period basis, at between
$25 thousand and $175 thousand. This range of costs does not include normal
ongoing costs for computer hardware 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 and service
infrastructure. The Company anticipates spending approximately $1.2 million in
fiscal 1999 in conjunction with changes to the technological aspects of its
delivery structure. The aforementioned Year 2000 project 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. At this time, no significant projects have been delayed as a result of
the Company's Year 2000 effort.
Despite the Company's activities in regards to the Year 2000 Issue,
there can be no assurance that partial or total systems interruptions or the
costs necessary to update hardware and software would not have a material
adverse effect upon the Company's business, financial condition, results of
operations, and business prospects.
16
17
Consolidation In The Financial Services Industry
The significant consolidation which has occurred in the financial
services industry during the past several years continued during recent months.
Washington Mutual has completed the acquisition of HF Ahmanson, the
parent company for Home Savings. This acquisition follows the purchase of the
former American Savings and Great Western franchises. Washington Mutual is now
the largest thrift in the country and maintains a substantial presence in the
Company's market areas.
Golden State Bancorp Inc. now constitutes the former franchises of
California Federal, Glendale Federal, CenFed, and Redlands Federal, forming a
thrift with assets over $50 billion that also maintains a significant market
share in many of the communities served by the Company.
Bank Of America has merged with NationsBank to produce the largest
commercial bank in the country, while continuing its leading market share
California.
Wells Fargo & Company is scheduled to merge with Norwest Corporation
late in calendar 1998 to form the seventh largest US commercial bank. Wells
Fargo is the second largest commercial bank in California, and Norwest has a
strategic focus which includes residential mortgage lending, servicing, and
secondary market activity.
As a result of these mergers, the Company is now challenged by a number
of much larger competitors who benefit from more extensive branch networks, more
advanced technology, and financial resources well beyond the capacity of the
Company. However, 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. For example,
Washington Mutual has recently announced the planned closure of dozens of
branches in conjunction with its integration of the former Home Savings
franchise.
Potential Federal Legislation
Over the past year, the US Congress has continued debating a
potentially significant reform of the federal laws governing the financial
services industry. The recent merger between Travelers Corporation and Citicorp,
which melds 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 financial industry reform legislation 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. Recent news from Washington, D.C. indicates that
financial industry reform legislation will be postponed until the next Congress.
The most recently drafted primary bill encountered a threatened filibuster in
the US Senate and was effectively tabled.
Congress is also considering a series of other bills which could
present a significant impact upon the Company, including legislation addressing
bankruptcy reform, the potential payment of interest on corporate demand deposit
accounts, and the possible payment of interest on financial institution sterile
balances at the Federal Reserve Banks.
The Company cannot predict what legislation, if any, might eventually
be adopted, and the potential impact of such legislation upon the Company.
17
18
Overview Of Business Activity And Results
During the three months ended September 30, 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 are discussed in the paragraphs which follow.
Steps were taken to prepare for the introduction of new products and
services later this fiscal year:
o debit cards
o a broader range of analyzed business checking products
o foreign cash letter services
o greater scope in non-FDIC insured alternative investment products
o enhanced mortgage banking activity
o expanded income property and multifamily lending
The Company commenced implementing the distribution network changes
which were announced during the prior quarter in conjunction with the posting of
a $1.06 million restructuring charge. During the recently concluded quarter, two
branches were relocated and a new commercial lending office was opened. These
facility changes, plus those still in process, are projected to provide the
Company with a more efficient sales and distribution platform, better able to
provide superior customer service while simultaneously processing a greater
volume of more diverse types of business.
General & administrative expenses expanded during the most recent
quarter, fueled by the costs associated with implementing the structural changes
necessary for the Company to achieve its strategic plan. For example, the Bank
commenced live utilization of a segment of its new frame relay data network,
which is scheduled to be completed by the end of the second fiscal quarter. This
new telecommunications infrastructure will permit all of the Company's locations
to interface electronically among themselves, to key external vendors, and to
current and potential customers.
The Company aggressively worked to liquidate its portfolio of real
estate acquired through foreclosure, with net foreclosed real estate totaling
just $972 thousand at September 30, 1998, comparing favorably to $1.7 million at
the end of the prior fiscal year. Moreover, the Company realized a $190 thousand
pre-tax gain on the sale of foreclosed real estate during the quarter ended
September 30, 1998.
However, the above accomplishments were largely offset by impacts
stemming from the particularly flat and low state of the Treasury security yield
curve throughout the fiscal first quarter, as exhibited by the differential
between the 1 year Treasury security and the 10 year Treasury note totaling just
8 basis points at June 30, 1998 and 2 basis points at September 30, 1998. Flat
(or inverted) and nominally low yield curves present particular challenges to
portfolio lenders such as the Company. 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 September 30, 1998, the Company experienced
historically high loan and security prepayments, fueled by the availability of
residential mortgages at rates below 7.0%.
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. While management responded to this
environment by augmenting its mortgage banking activity, bolstering fee income,
and focusing upon reducing the Company's cost of funds, the speed and magnitude
with which interest rates adjusted and the continuing flat shape of the Treasury
curve proved formidable challenges.
Additional information concerning the above accomplishments and challenges is
presented in the pages which follow.
18
19
Changes In Financial Condition From June 30, 1998 to September 30, 1998
Total assets increased $13.8 million, or 1.3%, from $1,045.8 million at
June 30, 1998 to $1,059.6 million at September 30, 1998. Cash and cash
equivalents rose from $27.7 million at June 30, 1998 to $47.2 million at
September 30, 1998, as the Company built up a balance of short term funds in
order to:
o conclude an investment security purchase scheduled to settle in early
October 1998
o pay off certain FHLB advances with maturity dates in October 1998
o have sufficient funds available to support a historically large loan
pipeline
In conjunction with the Company's adoption of SFAS No. 133 (see Note
3), all investment and mortgage-backed securities were designated as
available-for-sale in order to provide the Company with enhanced flexibility in
balance sheet and interest rate risk management.
Total securities declined from $396.8 million at June 30, 1998 to
$368.0 million at September 30, 1998 due to amortization, prepayments, and
calls. At September 30, 1998, the Company maintained no callable Agency
debentures within its aggregate security portfolio, concluding a significant
shift in portfolio composition over the past two years. Funds from the reduction
in investment and mortgage-backed security balances were reinvested into the
loan portfolio and retained in short term cash equivalents, as described above.
The Company experienced a notable increase in prepayment speeds for mortgage
related securities during the most recent quarter in conjunction with decreases
in general market interest rates and the historically flat and low shape of the
Treasury yield curve. Securities purchases during the three months ended
September 30, 1998 were concentrated in private label, AAA rated, relatively low
duration, fixed rate collateralized mortgage obligations ("CMO's"). The Company
has recently avoided purchasing adjustable rate securities because of concerns
over prepayment exposure and declines in underlying indices, both of which
present the potential for impaired total return. No securities sales were
conducted during the first quarter of fiscal 1999.
Net loans receivable increased 3.9% from $581.2 million at June 30,
1998 to $604.0 million at September 30, 1998. The ratio of loans to deposits
rose from 67.5% at the end of the prior fiscal year to 69.3 % at the conclusion
of the most recent quarter. 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:
o a more effective deployment of the Bank's strong capital position
o a greater return on shareholders' equity
o enhanced support of the communities in which the Company operates
Credit commitments during the quarter totaled $83.3 million, up from
$78.6 million during the same quarter during the prior fiscal year. Expansion in
net loans receivable was constrained by prepayments, particularly on the
Company's portfolio of residential adjustable rate loans, as consumers sought to
refinance with 15 and 30 year fixed mortgage rates available below 7.0%. The
Company originated $30.4 million in multifamily real estate loans during the
three months ending September 30, up significantly from the $4.6 million funded
during the first quarter of the prior fiscal year. The Company has increased its
emphasis upon apartment loans in order to diversify its loan portfolio away from
its historically high concentration in lower yielding single family mortgages
and improve the efficiency of origination in conjunction with the larger average
loan sizes for apartment loans.
Net loans available for sale increased from $3.8 million at June 30,
1998 to $6.6 million at September 30, 1998, as the Company continued building
its mortgage banking operation and due to the higher volume of refinance
activity occurring in the Company's market areas. The Company has recently
expanded the number of conduits with whom it conducts its mortgage banking
activity and broadened the range of products targeted for sale into the
secondary market.
The Company's investment in the capital stock of the Federal Home Loan
Bank ("FHLB") increased from $8.0 million to $8.2 million during the quarter due
to dividends credited.
19
20
Net premises and equipment declined from $7.1 million at June 30, 1998
to $5.8 million at September 30, 1998 due to:
o the sale of the former site of the Bank's Rancho Bernardo branch
o periodic depreciation and amortization
o the reclassification of the Company's investment in the former site of
its Idyllwild branch from premises to assets held pending disposition
as defined under SFAS No. 121.
The $207 thousand value for the assets held pending disposition
represents fair value less estimated costs to sell, and was reduced by a
valuation reserve established in conjunction with the $1.06 million
restructuring charge recorded by the Company during the final quarter of fiscal
1998. The Company is currently actively marketing this property for sale.
The Company's net investment in real estate acquired through
foreclosure dropped from $1.7 million at June 30, 1998 to $972 thousand at
September 30, 1998. The Company sold $1.4 million in foreclosed real estate
during the quarter, including the property with the single greatest book value
($592,000) at June 30, 1998. A continued strengthening of many real estate
markets in Southern California helped accomplish the reduction in foreclosed
property and contributed to a gain on the sale of such property during the three
months ended September 30, 1998.
Gross intangible assets declined from $12.1 million at June 30, 1998 to
$11.5 million at September 30, 1998 due to the continued amortization of the
intangible assets generated in conjunction with the North San Diego County
branch purchase from Hawthorne Savings and the Palm Springs Savings Bank
("PSSB") acquisition. Under OTS regulations, intangible assets net of associated
deferred tax liabilities reduce regulatory capital, resulting in lower capital
ratios than would otherwise be the case. At September 30, 1998, the reduction in
the Bank's regulatory capital resulting from intangible assets was $8.7 million.
Total deposits rose 1.7% from $866.7 million at June 30, 1998 to $881.8
million at September 30, 1998. Key trends within the deposit portfolio included:
o While checking deposits fell $2.6 million, or 2.9%, from June 30, 1998
to September 30, 1998, the number of checking accounts increased by
almost 700 to an all-time high. The Company continues to emphasize
increases in checking balances as a key component of its strategic
plan, and has recently altered its branch incentive program to more
heavily emphasize growth in checking deposits.
o Customers continued their positive response to the Bank's "Platinum"
money market deposit account, which provides competitive, highly tiered
rates for liquid funds. In conjunction with this product, total money
market deposits increased from $82.2 million at June 30, 1998 to $92.5
million three months later. This growth occurred despite repeated
reductions in pricing, as the Company sought to reduce its cost of
funds to offset declines in asset yields.
o Savings deposits fell from $88.0 million at June 30, 1998 to $82.2
million at September 30, 1998, as the Company continued to price its
passbook based 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. The decline in
savings balances during the most recent quarter also stemmed from a
number of higher balance customers moving their savings funds into the
Platinum money market product.
o Certificate of deposit balances rose $13.2 million, or 2.2%, from
$608.2 million at June 30, 1998 to $621.5 million at September 30,
1998. Management believes that a portion of these inflows resulted from
customers reallocating funds from stock and bond investments into the
safe haven of federally insured deposits in response to the recent
volatility in the capital markets.
20
21
The ongoing consolidation in the financial services industry continues
to leave a large 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 of customer service. Towards the conclusion of
the first fiscal quarter, management noted increased new account activity at
branches near competitor branches scheduled for closure or consolidation.
During the three months ended September 30, 1998, the Bank realized
only minor deposit outflows at the Diamond Valley branch scheduled for
consolidation into the nearby Hemet West office on October 31, 1998. Deposit
balances at the two branches relocated during the first quarter of fiscal 1998
were also little changed.
Advances from the FHLB-SF were unchanged during the most recent
quarter. However, $65.0 million of the $85.0 million in advances at September
30, 1998 were scheduled to mature in October, 1998, thereby providing the Bank
with an opportunity to further restructure its balance sheet.
Total stockholders' equity increased slightly from $83.8 million at
June 30, 1998 to $83.9 million at September 30, 1998, as the following factors
largely offset each other:
o net income generated for the fiscal year to date
o depreciation in the portfolios of investments designated as
available-for-sale, with a particular reduction in value associated
with the Company's inventory of seasoned GNMA adjustable rate
mortgage-backed securities
o the July 1, 1998 adoption of SFAS No. 133, which generated a debit to
shareholders' equity via Other Comprehensive Income stemming from the
fair value of cash flow hedges
o continued amortization of the Company's deferred stock compensation
o the exercise of stock options (funded with Treasury stock) during the
current fiscal year
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,
including participation in the OTS Net Portfolio Value Model and associated
regulatory reporting. 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 in regards to net portfolio value, also referred to as market value
of portfolio equity. This means that the fair value of the Company's assets is
more volatile than that of its liabilities. This net liability sensitivity
primarily arises from the longer term, higher duration mortgage-backed
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 deposits transaction
accounts, certain borrowings, and capital. A net liability sensitive position
typically translates to improved net portfolio value during periods of falling
general market interest rates. Conversely, this position presents the likelihood
of reductions in net portfolio value during increasing rate environments.
Over the longer term and through most likely interest rate cycles,
changes in net portfolio value and changes in net interest income typically
exhibit a positive correlation. Over a shorter term horizon, however, changes in
net portfolio value and net interest income can exhibit little or no
correlation, particularly during periods of structural change in the capital
markets. For example, longer term assets funded with short term liabilities,
while a net liability sensitive position, can generate reductions in net
interest income during periods of flat to inverted yield curves combined with
accelerated prepayment speeds on assets with a basis exceeding par value.
21
22
Despite the Company's net liability sensitive position and a decrease
in most general market interest rates, interest margin during the quarter ended
September 30, 1998 was constrained. This reduction in spread occurred due to a
confluence of factors:
o The multiple impacts stemming from a historically low and flat Treasury
yield curve, exacerbated by the federal funds rate and short term
repurchase agreement rates often exceeding the yield available on 30
year Treasury bonds during the quarter.
o Faster prepayments on mortgage related assets, particularly those
associated with adjustable rate residential loans, many of which the
Company owns at a premium to par value. For example, increased
prepayment speeds on the Company's portfolios of GNMA adjustable rate
mortgage-backed securities ($143.8 million par value at September 30,
1998) and purchased residential hybrid loans resulted in significantly
increased premium amortization during the most recent quarter.
o Rapid declines in Indices underlying adjustable rate assets,
particularly the One Year Treasury Constant Maturities Index. The yield
on the one year Treasury note declined from 5.37% at June 30, 1998 to
4.39% at September 30, 1998. At September 30, 1998, 43.2% of the
Company's loan portfolio repriced based upon various Treasury indices.
o A number of large competitors offering particularly aggressive deposit
rates during the quarter in an attempt to slow deposit outflows as
customers responded negatively to branch closures, account conversions,
and changes in products, services, and personnel stemming from merger
and acquisition activity. While the Company repeatedly cut its deposit
pricing during the most recent quarter, management believes that
further reductions in the cost of funds might have been accomplished if
not for the especially aggressive competitor pricing.
o Increases in non-accrual loans, with the associated reversal of
previously accrued interest and the lack of periodic interest income.
The Company responded to the challenges presented by this environment by:
o expanding sales efforts and employee incentives to acquire low cost
checking accounts and thereby bolster interest margin
o working to constrain non-interest earning assets by selling the former
Rancho Bernardo branch site and reducing net real estate acquired by
foreclosure
o increasing the ratio of loans to deposits
o conducting separate promotional campaigns to attract relatively higher
yielding home equity lines of credit and construction loans
o avoiding further purchases of adjustable rate securities and whole
loans in the secondary market
o repeatedly reducing its deposit rates
o building a liquidity position to provide the potential opportunity to
meaningfully restructure the balance sheet in conjunction with $65.0
million in FHLB advance maturities during October, 1998
o continuing to sell the vast majority of current fixed rate residential
loan production into the secondary market on a servicing released basis
in order to avoid increasing net liability sensitivity and also to
eliminate prepayment risk associated with originated mortgage servicing
rights
22
23
The call of the final $10.8 million in Agency debentures owned by the
Company on June 30, 1998 helped constrain the amount of negative convexity
present in the balance sheet. The term "negative convexity" describes the
financial behavior of assets which depreciate when interest rates rise, yet
appreciate much less (or not at all) when interest rates fall, thereby
presenting an asymmetric pattern of valuation. Callable Agency bonds typically
do not appreciate much above par regardless of the interest rate environment and
are efficiently called by the issuers in conjunction with refinance
opportunities, thereby creating reinvestment risk for the holder. Over the past
two years, the Company has restructured its balance sheet away from callable
securities towards other securities and loans which, while often still
presenting negative convexity, engender a likely less efficient exercise of
embedded options. For example, while AAA rated, private label CMO's generally
prepay with refinance opportunities for the underlying residential mortgages,
the refinancing by hundreds or thousands of individual homeowners is far less
efficient than the call of a security by an Agency, thereby reducing the cost of
the implicit options sold by the Company in purchasing the security and hence
moderating interest rate risk.
The Company's two active interest rate swaps mature in January, 1999.
Management estimates the cost to terminate these two contracts at September 30,
1998 was $318 thousand. The amortization period for the Other Comprehensive
Income adjustment stemming from a terminated rate swap will conclude in
November, 1998.
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.
At September 30, 1998, the Company maintained $47.2 million in cash and
cash equivalents, untapped borrowing capacity of almost $300.0 million at the
FHLB-SF, and 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. In addition, the Bank has recently
commenced seeking its fourth unsecured federal funds line of credit from
correspondent financial institutions. However, there can be no assurance that
the Bank will be successful in this regard, that funds from such lines will be
available at all times, or that such lines will be maintained in future periods.
The Bank's regulatory liquidity ratio under revised guidelines adopted
on January 1, 1998 has exceeded 20.0% since that date, versus a regulatory
requirement of 4.0%. 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 payments associated with its
loan to the ESOP.
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
23
24
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 September 30, 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 Percent Balance Percent Balance Percent
------- ------- ------- ------- ------- -------
(Dollars In Thousands)
Hemet Federal's regulatory capital $ 65,489 6.28% $ 65,489 14.12% $ 69,966 15.09%
Well capitalized requirement 52,124 5.00 27,827 6.00 46,379 10.00
-------- ----- ------ ---- ------ -----
Excess $ 13,365 1.28% $ 37,662 8.12% $ 23,587 5.09%
============= ==== ========= ==== ========= =====
Adjusted assets (1) $ 1,042,482 $ 463,791 $ 463,791
=========== ========= =========
(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.
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. As indicated in the table, Hemet Federal's capital
levels at September 30, 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 $ 65,489 6.28%
Minimum required 15,637 1.50
------ ----
Excess $ 49,852 4.78%
======== =====
Core Capital
Regulatory capital $ 65,489 6.28%
Minimum required 31,274 3.00
------ ----
Excess $ 34,215 3.28%
======== =====
Percent Of
Risk-weighted
Amount Assets
------ ------------
Risk-based Capital
Actual capital $ 69,966 15.09%
Minimum required 37,103 8.00
------ ----
Excess $ 32,863 7.09%
======== =====
24
25
At September 30, 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.
Credit Profile
Nonperforming Assets
The following table sets forth information regarding non accrual loans,
real estate acquired through foreclosure, and repossessed consumer assets.
September 30, 1998 June 30, 1998
------------------ -------------
(Dollars In Thousands)
Gross non accrual loans before valuation reserves $ 8,256 $ 4,276
Investment in foreclosed real estate before valuation reserves 1,102 1,853
Investment in repossessed consumer assets before valuation reserves 0 0
------- -------
Total nonperforming assets $ 9,358 $ 6,129
======= =======
Non accrual loans to gross loans net of undisbursed loan funds 1.34% 0.72%
Nonperforming assets to total assets 0.88% 0.59%
The following table presents a profile of gross non accrual loans at
September 30, 1998.
Gross Non Accrual Loans September 30, 1998
------------------
(Dollars In Thousands)
Residential real estate $ 3,763
Multifamily real estate 416
Commercial & industrial real estate 1,601
Construction 0
Land / Lots 1,995
Consumer 277
Commercial business 204
-------
Total $ 8,256
========
The increase in non accrual loans during the first quarter of fiscal
1999 primarily resulted from:
o the placement of a $975 thousand loan secured by residential lots onto
non accrual status
o cash flow deterioration for certain income property loans
o retaining reinstated loans on non accrual status pending verification
of collateral values and cash flow adequacy
Approximately $2.6 million of the non accrual loans at September 30,
1998 were paying according to contractual terms. In addition, a continuing
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, contributing to the reduction in foreclosed real estate balances during
fiscal 1999 year to date.
25
26
Criticized And Classified Assets
The following table presents information concerning the Company's
inventory of criticized ("OAEM") and classified ("substandard" and lower)
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
---- ----------- -------- ---- -----
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
June 30, 1998 $20,477 $14,383 -- $2,718 $37,578
September 30, 1998 $16,698 $16,746 -- $2,010 $35,454
The portfolio of loans acquired in conjunction with the PSSB
acquisition, which has generated a disproportionate share of credit related
losses over the past two years, totaled $91.5 million at September 30, 1998. Of
this total, $71.4 million was composed of residential mortgages and $11.5
million was comprised of loans secured by commercial & industrial real estate.
Impaired Loans
At September 30, 1998, the Company maintained total gross impaired
loans, before specific reserves, of $12.3 million, constituting 107 credits.
This compares to total gross impaired loans of $10.7 million at June 30, 1998.
This increase included the identification of the aforementioned $975 thousand
loan secured by residential lots as impaired. A total of $1.9 million in
specific reserves were established against impaired loans at September 30, 1998,
down from $2.5 million at June 30, 1998. The average recorded investment in
impaired loans during the quarter ended September 30, 1998 was $10.1 million.
Of the total impaired loans at September 30, 1998, $4.0 million were
either fully current or with only minor delinquency and were therefore
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 three months ended
September 30, 1998, accrued interest on impaired loans was $57 thousand and
interest of $196 thousand was received in cash. If all non accrual loans had
been performing in accordance with their original loan terms, the Company would
have recorded interest income of $348 thousand during the three months ended
September 30, 1998, instead of interest income actually recognized on cash
payments of $134 thousand.
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.
26
27
The following tables present activity in the Bank's allowances for
estimated loan losses and estimated real estate losses during the three months
ended September 30, 1998 and 1997:
Three Months Ended September 30,
--------------------------------
1998 1997
---- ----
(Dollars In Thousands)
Allowance for Loan Losses:
Balance at June 30 $ 6,271 $ 4,780
Loan chargeoffs:
Residential real estate (151) (235)
Multifamily real estate --- (57)
Commercial & industrial real estate (336) ---
Construction --- ---
Land / Lots --- (246)
Consumer (27) (41)
Commercial business --- ---
------- -------
Total chargeoffs (514) (579)
Loan recoveries --- ---
Provision for estimated loan losses 600 100
------- -------
Balance at September 30 $ 6,357 $ 4,301
======= =======
September 30, 1998 June 30, 1998
------------------ -------------
Allowance for estimated loan losses as a percent of
nonperforming loans 76.99% 146.64%
Allowance for estimated loan losses as a percent of
gross loans receivable net of loans in process 1.03% 1.06%
Three Months Ended September 30,
--------------------------------
1998 1997
---- ----
(Dollars In Thousands)
Valuation Allowances: Real Estate Acquired Through Foreclosure
Balance at June 30 $ 179 $ 1,020
Net chargeoffs (58) (77)
Provision to increase valuation allowances 9 426
---------- ---------
Balance at September 30 $ 130 $ 1,369
Valuation Allowances: Real Estate-Development
Balance at June 30 $ 0 $ 577
Net chargeoffs 0 (287)
Provision to increase valuation allowances 0 0
---------- -----------
Balance at September 30 $ 0 $ 290
TOTAL VALUATION ALLOWANCES FOR REAL ESTATE $ 130 $ 1,659
======= =======
Loan charge-offs during the first quarter of fiscal 1999 included $336
thousand for a commercial real estate loan secured by a retail strip center. The
ratio of allowance for estimated loan losses to non accrual loans decreased from
146.64% at June 30, 1998 to 76.99% at September 30, 1998 due to the $4.0 million
rise in non accrual loans during the quarter. However, specific reserves for
loans declined from $2.5 million at June 30, 1998 to $1.9 million at September
30, 1998. The ratio of allowance for estimated losses to gross loans receivable
net of loans in process declined slightly from 1.06% at June 30, 1998 to 1.03%
at September 30, 1998, as the rate of growth in the loan portfolio exceeded the
rate of expansion in the allowance. At September 30, 1998, 67.5% of the Bank's
gross loan portfolio was comprised of residential real estate loans, while 96.4%
of the gross loan portfolio was composed of loans secured by real estate of
various types.
27
28
The Company exited the real estate development business during the
first half of fiscal 1998. The Company's inventory of foreclosed properties and
repossessed consumer assets is summarized in the following table.
Real Estate Acquired By Foreclosure and Repossessed Consumer Assets
September 30, 1998
(Dollars In Thousands) Gross Valuation Net Percent
Type Of Property Balance Reserves Balance Of Total
- ---------------- ------- -------- ------- --------
Residential 1 - 4 Units $ 558 $ 130 $ 428 44.0%
Multifamily More Than 4 Units 0 0 0 0.0%
Commercial / Industrial 535 0 535 55.1%
Land / Developed Lots 9 0 9 0.9%
Repossessed Consumer Assets 0 0 0 0.0%
------- ------- ------- ------
Total $ 1,102 $ 130 $ 972 100.0%
======= ======= ======= ======
Upon acquisition, the Bank accounts for real estate owned through
foreclosure at fair market value less estimated costs to sell. Management
believes that adequate valuation reserves have been established based upon
current market conditions. At September 30, 1998, approximately $173 thousand in
foreclosed real estate was in escrow under contract for sale. However, no
assurances can be provided regarding whether and when such escrows will close,
and the eventual gain or loss to be realized.
Comparison Of Operating Results For The Three Months Ended September 30, 1998
and September 30, 1997
General
For the fiscal 1999 first quarter ended September 30, 1998, the Company
reported net income of $181 thousand, equivalent to $0.03 basic and diluted
earnings per share. This compares to net income of $502 thousand, or $0.08 basic
and diluted earnings per share, during the same period during the prior fiscal
year.
Three primary factors constrained earnings during the quarter:
1. The various impacts stemming from the historically low and flat shape
of the Treasury yield curve.
2. One-time and continuing operating costs associated with implementing
the Company's strategic plan of transforming an almost 80 year old
savings & loan into a community based financial services firm.
3. Increased provisions for estimated loan losses versus the same quarter
a year ago, although down sequentially from the past two quarters.
Net Interest Income
Net interest income for the quarter ended September 30, 1998 was $5.92
million, down 3.3% from $6.12 million for the same quarter the year before and
$371 thousand below the preceding quarter. The Company's net interest margin on
total assets fell from 2.37% during the quarter ended September 30, 1997 to
2.16% during the three months ended September 30, 1998. This reduction in spread
and net interest income resulted from a series of factors discussed under
"Interest Rate Risk Management And Exposure". The following table presents
certain information relating to net interest income for the three months ended
September 30, 1998 and 1997. The average rates and costs are derived by dividing
annualized interest income or expense by the average balance of assets or
liabilities, respectively, for the periods shown.
28
29
Quarter Ended September 30, 1998 Quarter Ended September 30, 1997
--------------------------------- --------------------------------
(Dollars In Thousands) Average Average Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
ASSETS:
Interest Earning Assets:
Real Estate Loans, Net (1) 569,662 11,051 7.76% 479,075 9,452 7.89%
Non Real Estate Loans, Net (1) 23,407 463 7.91% 15,448 377 9.77%
Mortgage-backed Securities (2) 281,240 4,135 5.88% 284,347 4,617 6.50%
CMO's (3) 101,003 1,439 5.70% 32,410 532 6.57%
FHLB Stock 8,013 118 5.89% 5,451 95 6.94%
Other Interest Earning Assets (4) 65,720 1,018 6.20% 157,065 3,162 8.05%
--------- ------ ---- ------- ------ ----
Total Interest Earning Assets 1,049,045 18,224 6.95% 973,796 18,235 7.49%
Non Interest Earning Assets 45,847 57,411
--------- -------
TOTAL ASSETS 1,094,892 1,031,207
LIABILITIES & SHAREHOLDERS' EQUITY:
Interest Bearing Liabilities:
Deposits 834,479 10,265 4.92% 819,607 10,383 5.07%
Net Hedging Expense (5) 466 486
Borrowings (6) 116,446 1,573 5.40% 83,750 1,246 5.95%
--------- ------ ---- ------- ------ ----
Total Interest Bearing Liabilities 950,925 12,304 5.18% 903,357 12,115 5.36%
Non Interest Bearing Liabilities 59,665 46,100
--------- -------
Total Liabilities 1,010,590 949,457
Shareholders' Equity 84,302 81,750
--------- -------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY 1,094,892 1,031,207
Net Interest Income 5,920 6,120
Interest Rate Spread (7) 1.77% 2.13%
Net Interest Earning Assets 98,120 70,439
Net Interest Margin (8) 2.26% 2.51%
Net Interest Income / Average Total Assets 2.16% 2.37%
Int. Earning Assets / Int. Bearing Liabilities 110.32% 107.80%
- ------------------------------------------
Average balances in the above table were calculated using average daily balances
for fiscal 1999 and month end balances for fiscal 1998.
1) In computing the average balance of loans, non-accrual loans and loans
held-for-sale have been included.
2) Includes both mortgage-backed securities available-for-sale and
held-to-maturity.
3) Includes both collateralized mortgage obligations available-for-sale and
held-to-maturity.
4) Includes federal funds sold, interest earning deposit accounts, securities
purchased under agreement to resell, and US Government and Agency
obligations.
5) Represents the net expense of interest rate swaps, both active and
terminated.
6) Includes advances from the FHLB, securities sold under agreements to
repurchase, and federal funds purchased.
7) Interest rate spread represents the difference between the average rate on
interest earning assets and the average rate on interest bearing liabilities.
8) Net interest margin equals annualized net interest income divided by average
interest earning assets.
29
30
Rate / Volume Analysis
The following table utilizes the figures from the preceding table to
present a comparison of interest income and interest expense resulting from
changes in volumes and the rates on average interest earning assets and average
interest bearing liabilities for the periods indicated. Changes in interest
income or interest expense attributable volume changes are calculated by
multiplying the change in volume by the prior period average interest rate. The
changes in interest income or interest expense attributable to changes in rate
are calculated by multiplying the change in interest rate by the prior period
average volume. The changes in interest income or interest expense attributable
to the combined impact of changes in volume and changes in interest rate are
calculated by multiplying the change in volume by the change in rate.
Quarter Ended September 30, 1998
Compared To
Quarter Ended September 30, 1997
-----------------------------------------------------------------
Increase (Decrease) Due To:
-----------------------------------------------------------------
Volume /
Volume Rate Rate Net
------ ---- ---- ---
INTEREST INCOME:
Real Estate Loans, Net $ 1,787 $ (158) $ (30) $ 1,599
Non Real Estate Loans, Net 194 (71) (37) 86
Mortgage-backed Securities (50) (437) 5 (482)
CMO's 1,126 (70) (149) 907
FHLB Stock 45 (15) (7) 23
Other Interest Earning Assets (1,839) (729) 424 (2,144)
------- ----- --- -------
TOTAL INTEREST INCOME 1,263 (1,480) 206 (11)
INTEREST EXPENSE:
Deposit Accounts 188 (301) (5) (118)
Net Hedging Expense 0 (20) 0 (20)
Borrowings 486 (115) (44) 327
--- ----- ---- ---
TOTAL INTEREST EXPENSE 674 (436) (49) 189
NET CHANGE IN NET INTEREST INCOME $ 589 $ (1,044) $ 255 $ (200)
======= ========= ======= ========
Interest Income
While total interest income was little changed at approximately $18.2
million during the quarters ended September 30, 1998 and 1997, a significant
variation occurred in source.
Interest income on loans rose 17.1% from $9.8 million during the three
months ended September 30, 1997 to $11.5 million during the quarter ending
September 30, 1998. This increase was due to a 19.9% rise in average loans
outstanding, somewhat offset by a decline in average rate. The average rate
realized on loans declined despite a lower concentration in residential
mortgages at September 30, 1998 (67.5%) versus September 30, 1997 (72.6%) due to
lower general market interest rates. Interest income during the most recent
quarter was also unfavorably impacted by increases in non accrual loans.
Interest income on mortgage-backed securities declined from $4.6
million for the three months ended September 30, 1997 to $4.1 million during the
most recent quarter. The Company's effective yield on its mortgage-backed
securities during the most recent quarter was unfavorably impacted by a
significant rise in prepayments on adjustable rate mortgage-backed securities
owned at a premium to par value. The accelerated payoff of these securities
caused a similarly accelerated amortization of the purchase premiums, depressing
yield. The Company experienced this constrained yield despite concentrating its
adjustable rate mortgage backed securities in well seasoned GNMA ARMs, which
historically and recently have exhibited relatively less prepayment volatility
than conventional Agency adjustable rate mortgage-backed securities.
30
31
Interest income on collateralized mortgage obligations ("CMO's")
increased from $532 thousand during the first quarter of fiscal 1998 to $1.4
million during the most recent three months, as an increase in average balances
more than offset a decline in average rate. Over the past six months, the
Company has focused most of its security purchases into low duration, fixed
rate, AAA rated, private label CMO's due to concerns over total return
volatility for adjustable rate securities and because of management's plan to
build a stream of cash flows off of the securities portfolio in order to provide
liquidity for potential increases in credit commitments later in the fiscal
year. The relatively short term of the new CMO purchases therefore constrained
the yield versus what could have been acquired for longer average lives. There
can be no assurance, however, that any increase in credit commitments will occur
or that the CMO's will prepay as forecast.
Interest income on other earning assets fell to $1.0 million during the
most recent three months from $3.2 million during the first quarter of fiscal
1998 due to reductions in both average rate and average volume. These reductions
largely stemmed from the Company's eliminating its portfolio of long term, fixed
rate, callable Agency debentures in conjunction with its interest rate risk
management program.
Interest Expense
Interest expense on deposits declined from $10.4 million during the
quarter ended September 30, 1997 to $10.3 million during the quarter ended
September 30, 1998, as the impact of a reduction in average rate more than
offset the effect of an increase in average volume. Over the past year, the
Company has implemented a series of initiatives to reduce its average cost
of funds, including:
o a greater sales and incentive emphasis upon transaction accounts in
general and checking accounts in particular
o the introduction of new transaction products aimed at reducing the
funding concentration in certificates of deposit
o the development of new certificate products that default to a roll over
into less costly products upon maturity
o reduced the amount of variation in rate from sheet pricing controlled
by the branches
In addition, during the most recent quarter, the Company reduced its sheet rate
pricing repeatedly in response to the declining Treasury yield curve and similar
actions by bank and non bank competitors. Despite these efforts, the Company's
cost of funds failed to decline with the same speed as exhibited by asset
yields, in part because of customer responses to the lower interest rate
environment. These responses included extending CD terms in order to maintain
nominal rate or monthly interest income and internal disintermediation from
lower cost savings accounts to higher yielding money market accounts as
customers again sought to maintain their levels of interest income.
Interest expense on borrowings was $327 thousand higher in the most
recent quarter versus the same quarter during the prior fiscal year primarily
due to expanded balances for short term borrowings matched against short term
investment positions.
Net interest expense of hedging transactions declined from $486
thousand during the three months ended September 30, 1997 to $466 thousand
during the most recent quarter. The prior fiscal year quarter included interest
expense associated with one additional terminated interest rate swap, while the
current fiscal year quarter included an acceleration of $37 thousand in interest
expense in conjunction with the Company's adoption of SFAS No. 133. All of the
Company's interest rate swap positions will mature by the end of January 1999.
The Company's average spread on total assets was constrained by 17 basis points
during the most recent quarter as a result of the swaps.
Provision For Estimated Loan Losses
The provision for estimated loan losses totaled $600 thousand in the
quarter ended September 30, 1998, up from $100 thousand during the same quarter
the prior fiscal year. However, the $600 thousand was down sequentially from
$2.3 million during the quarter ended March 31, 1998 and $1.05 million during
the quarter ended June 30, 1998. The Company has continued implementing its
revised credit management process over the past six months, whereby all non
homogeneous credits are reviewed at least annually and problem assets are more
quickly identified and aggressively addressed prior to further deterioration. In
addition, real estate trends in most of the market areas served by the Company
remained strong during the most recent quarter, with improvement in collateral
values providing reduced risk of loss to the Bank in a number of instances.
31
32
Other Income & Expense
Other income & expense improved from $340 thousand in expense during
the quarter ended September 30, 1997 to $740 thousand in income during the most
recent quarter, despite a lack of gains on the sale of available-for-sale
securities during the recent period, as:
o Deposit related fee income for the quarter ended September 30, 1998 was
$590 thousand, up 31.0% from $450 thousand for the same quarter a year
earlier. This rise resulted from an expanded roster of fee based
services, the imposition of new fees, the continued expansion in the
number of transaction accounts, and enhanced control over fee waivers.
o Results from real estate operations improved from a loss of $443
thousand for the three months ended September 30, 1997 to income of
$182 thousand during the quarter ended September 30, 1998. During the
most recent three months, the Company carried a comparatively small
inventory of foreclosed properties, thereby moderating operating costs.
In addition, due to the continuing rebound in many of the real estate
markets in which the Company operates, a $190 thousand net gain on the
sale of foreclosed real estate was recorded during the most recent
quarter.
o Net gains on loans held for sale rose to $90 thousand for the quarter
ended September 30, 1998 from $27 thousand for the same period during
the prior fiscal year, as the Company has continued expanding its
mortgage banking program.
o Other income expanded from $61 thousand during the three months ended
September 30, 1997 to $362 thousand during the like period in the
current fiscal year due to improved results from the Company's new
alternative investment (non- FDIC insured) sales program, the operation
of that program on a gross (versus net) basis in the current fiscal
year, and because of an $88 thousand pre-tax gain on the sale of the
former Rancho Bernardo branch site.
General & Administrative Expenses
General & administrative expense rose 19.7% from $4.82 million during
the three months ended September 30, 1997 to $5.77 million during the most
recent quarter. This increase occurred primarily due to costs associated with
implementing the revised distribution system envisioned in the Company's
strategic plan.
During the three months ended September 30, 1998, a commercial loan
production office was established in La Palma, providing the Company with its
first physical presence in populous Orange County. The Company has targeted
commercial lending as part of its strategic plan to diversify its balance sheet
away from its historically high concentration in lower yielding residential
mortgage related assets. General & administrative expenses were increased during
the quarter by the costs associated with leasing the loan production office,
recruiting and installing staff, and preparing the site for operation.
In August, the Rancho Bernardo branch was relocated into a much more
visible site within the city's business district, thereby providing better
accessibility to both consumers and the small business customers central to the
strategic plan. In September, the Company reinforced its commitment to the
Idyllwild community, as the only financial institution with a branch in the
town, by relocating from an 805 square foot facility to a larger site capable of
supporting the Bank's continuing growth in that market. While expenses
associated with closing the old branch sites were accrued as part of the $1.06
million restructuring charge recorded during the quarter ended June 30, 1998,
costs were incurred during the most recent quarter in order to prepare the new
sites for operation.
Also during the quarter, the Company realized expenses for the upcoming
relocation of the San Jacinto branch to the Company's first supermarket
facility. The new site, located in a Stater Bros. supermarket, is planned for an
early December, 1998 opening and will offer customers expanded branch hours and
ATM access. Stater Bros. is a dominant regional supermarket chain holding a
significant market share in most of the communities served by the Company.
Initial costs for the relocation of the Rancho Mirage branch to a new
site in nearby Palm Desert were also expensed during the quarter ended September
30, 1998. The Company plans to open for business in Palm Desert in January,
1999.
32
33
General & administrative expenses for the quarter ended September 30,
1998 were also increased versus the figures for the same quarter the prior
fiscal year by additional costs associated with a major upgrade of the Company's
technology infrastructure. This upgrade, which is integral to the Company's
strategic plan, was mandated by the age of much of the Company's existing
hardware, software, and telecommunications network. More specifically, by
December 31, 1998, the Company plans to have in place:
o a new teller system
o a new branch platform (new accounts) system
o a frame relay WAN connecting all of the Company's sites and also
providing a gateway to key third party vendors
o a new mortgage loan origination system
This significant technology program is planned to provide a foundation for
future gains in operating efficiency, improvements in customer service, and the
delivery of a broader range of financial products and services. This program
also furnishes the Company with a broad base of technology certified as Year
2000 compliant by its manufacturer and / or independent third
parties.
As a result of the above expenses in support of the Company's strategic
plan, the ratio of general & administrative expenses to average assets increased
from 1.87% during the quarter ended September 30, 1997 to 2.11% during the most
recent three months. Similarly, the Company's efficiency ratio increased from
85.94% for the first quarter of fiscal 1997 to 87.47% during the first quarter
of fiscal 1998. Management recognizes that the efficiency ratio is above that of
peer institutions, and has the following plans to improve this performance:
o The upcoming consolidation of the Diamond Valley branch into the nearby
Hemet West branch will result in a savings of four full-time
equivalents, plus lease, insurance, and maintenance costs.
o Potential back office operations and administrative staff reductions
are being examined. The Company intends to leverage off of its
investments in technology to improve efficiency and thereby reduce
headcount, primarily in those areas which present a relatively small
likelihood of an unfavorable impact upon customer service.
o Certain administrative functions are slated for outsourcing to vendors
which specialize in those areas, and can therefore provide better
service at lower cost.
o The former Idyllwild branch site is being actively marketed for sale,
with the objectives of freeing resources for reinvestment into interest
earning assets and decreasing operating costs for maintenance,
insurance, and property taxes.
o Substantially all vendor relationships are planned for review for
opportunities to improve efficiency and reduce expense.
However, 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 $355 thousand during the three months
ended September 30, 1997 to $105 thousand during the most recent quarter due to
a combination of lower pre-tax income and a reduction in the Company's effective
book tax rate. The reduction in the effective book tax rate stems from the
fiscal 1999 recapture of valuation allowances established in prior years for
deferred tax assets associated with California State franchise taxes.
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
For a current discussion of the nature 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". Readers should also
refer to the qualitative and quantitative disclosures (consisting primarily of
interest rate risk) in the Company's Form 10-K for the fiscal year ending June
30, 1998. There has been no significant change in these disclosures since the
filing of that document.
33
34
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
a) The Company's annual meeting of Stockholders was held on October 22,
1998.
b) Not applicable.
c) At such meeting, the Company's stockholders approved the following:
1. The election of the following individuals as Directors for the term
of three years each.
Name For Withheld
---- --- --------
Dr. Robert K. Jabs 5,584,861 37,458
Mr. William D. King 5,584,651 37,668
Ms. Patricia A. Larson 5,581,911 40,408
2. The appointment of Deloitte & Touche LLP as independent auditors
of the Company for the fiscal year ending June 30, 1999.
For Against Abstain
--- ------- -------
5,564,002 26,035 32,282
d) Not applicable.
34
35
Item 5. Other Information
On November 14, 1998, the Company and its subsidiary, Hemet Federal Savings
& Loan Association (the "Bank"), have entered into an Agreement and Plan of
Merger with Temple-Inland inc. ("TI") and its subsidiary Guaranty Federal Bank,
F.S.B. ("Guaranty") pursuant to which the Company will merge with TI (or a
subsidiary) and the Bank will be merged into Guaranty. Company stockholders will
receive $18.50 per share for their stock, in cash, TI stock, or a combination of
the two at the election of the stockholders, subject to a maximum of
approximately 1,216,470 shares of stock in the aggregate to be issued in the
transaction; provided, however, that if the transaction does not qualify as a
tax-deferred reorganization, all Company stockholders will receive cash equal to
$18.50 per share. The transaction, which is subject to regulatory approval and
approval by the stockholders of the Company, is anticipated to close during the
second quarter of calendar 1999.
In connection with the transaction, the Company granted TI an option,
exercisable under certain circumstances, to purchase up to approximately
1,272,665 shares of Company stock, representing about 19.9% of the shares
presently outstanding, at a price of $16.0625 per share.
Item 6. Exhibits and Reports on Form 8-K
A. Exhibits
(27) Financial Data Schedule
(99.1) Press Release Dated November 16, 1998
B. Reports on Form 8-K
The Company filed no reports on Form 8-K during the quarter
ended September 30, 1998.
35
36
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: November 16, 1998 By: /s/ Richard S. Cupp
-------------------
Richard S. Cupp
President
Chief Executive Officer
Date: November 16, 1998 By: /s/ Mark R. Andino
------------------
Mark R. Andino
Senior Vice President
Chief Financial Officer
36