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 December 31, 1998
Securities and Exchange Commission File Number 0-25722
HF BANCORP, INC.
(Exact name of registrant as specified in its charter)
DELAWARE 33-0576146
(State or other jurisdiction (I.R.S. Employer 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
Registrant's Internet site: www.hemetfed.com
Registrant's electronic mail address: corpinfo@hemetfed.com
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 6,409,733 shares of the Registrant's common stock, par value
$0.01 per share, outstanding as of February 9, 1999.
2
HF BANCORP, INC. AND SUBSIDIARY
FORM 10-Q
INDEX
PART I - FINANCIAL INFORMATION PAGE
--------------------- ----
ITEM 1. FINANCIAL STATEMENTS
Consolidated Statements Of Financial Condition As Of
December 31, 1998 (unaudited) and June 30, 1998 3 - 4
Consolidated Statements Of Operations (unaudited) For The
Three And Six Months Ended December 31, 1998 and 1997 5 - 6
Consolidated Statement Of Changes In Stockholders' Equity (unaudited)
For The Six Months Ended December 31, 1998 7
Consolidated Statements Of Cash Flows (unaudited) For The
Six Months Ended December 31, 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 - 37
ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK 37
PART II - OTHER INFORMATION
-----------------
Item 1. Legal Proceedings 38
Item 2. Changes In Securities 38
Item 3. Defaults Upon Senior Securities 38
Item 4. Submission Of Matters To A Vote Of Security Holders 38
Item 5. Other Information 39
Item 6. Exhibits And Reports On Form 8-K 39
Signature Page 40
2
3
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
December 31, June 30,
1998 1998
---- ----
(Unaudited)
(Dollars In Thousands)
ASSETS
Cash and cash equivalents $ 51,028 $ 27,720
Securities available-for-sale, at estimated fair value:
Investment securities (amortized cost of $108,992 and $98,792 at
December 31, 1998 and June 30, 1998 respectively) 109,426 98,573
Mortgage-backed securities (amortized cost of $211,780 and $164,400 at
December 31,1998 and June 30,1998, respectively) 211,165 165,004
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 $6,496
and $6,271 at December 31, 1998 and June 30, 1998, respectively) 611,327 581,153
Loans held-for-sale 5,294 3,763
Accrued interest receivable 5,513 6,038
Investment in capital stock of the Federal Home Loan Bank, at cost 8,269 8,048
Premises and equipment, net 6,386 7,145
Real estate acquired through foreclosure, net 991 1,674
Gross intangible assets 10,941 12,118
Other assets 1,259 1,358
--------- ---------
Total assets $ 1,021,599 $ 1,045,837
=========== ===========
See Notes to Consolidated Financial Statements
3
4
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (CONTINUED)
December 31, June 30,
1998 1998
---- ----
(Unaudited)
(Dollars In Thousands)
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Checking deposits $ 95,352 $ 88,231
Savings deposits 78,932 88,008
Money market deposits 110,253 82,249
Certificates of deposit 599,654 608,236
------- -------
Total deposits 884,191 866,724
Advances from the Federal Home Loan Bank 45,000 85,000
Accounts payable and other liabilities 5,871 7,030
Income taxes 2,155 3,305
---------- ----------
Total liabilities 937,217 962,059
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 December 31, 1998 and June 30, 1998; 6,398,923 outstanding at
December 31, 1998 and 6,369,103 outstanding at June 30, 1998 66 66
Additional paid-in capital 51,720 51,557
Retained earnings, substantially restricted 38,851 38,552
Accumulated other comprehensive income (124) 226
Deferred stock compensation (3,969) (4,159)
Treasury stock, 213,577 shares at December 31, 1998 and 243,397 shares
at June 30, 1998 (2,162) (2,464)
------------ ------------
Total stockholders' equity 84,382 83,778
---------- ----------
Total liabilities and stockholders' equity $ 1,021,599 $ 1,045,837
=========== ===========
See Notes to Consolidated Financial Statements
4
5
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS
(UNAUDITED)
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED DECEMBER 31, ENDED DECEMBER 31,
------------------ ------------------
1998 1997 1998 1997
---- ---- ---- ----
(Dollars In Thousands)
INTEREST INCOME:
Interest on loans $ 12,113 $ 10,647 $ 23,627 $ 20,476
Interest on mortgage-backed securities 3,395 4,865 7,530 9,483
Interest and dividends on investment securities 1,869 3,247 4,445 7,036
-------- -------- -------- --------
Total interest income 17,377 18,759 35,602 36,995
INTEREST EXPENSE:
Interest on deposit accounts 10,166 10,370 20,431 20,753
Interest on advances from the Federal Home Loan
Bank and other borrowings 733 1,830 2,307 3,076
Net interest expense of hedging transactions 347 462 813 948
------- ------- ------ ------
Total interest expense 11,246 12,662 23,551 24,777
NET INTEREST INCOME BEFORE PROVISION
FOR ESTIMATED LOAN LOSSES 6,131 6,097 12,051 12,218
PROVISION FOR ESTIMATED LOAN LOSSES 600 300 1,200 400
------- ------- ------- -------
NET INTEREST INCOME AFTER PROVISION
FOR ESTIMATED LOAN LOSSES 5,531 5,797 10,851 11,818
OTHER INCOME (EXPENSE):
Loan and other fees 117 99 222 197
Net gain on sales of mortgage-backed securities available-for-sale 159 6 159 62
Net gain on sales of loans held for sale 161 44 251 70
Income (expense) from real estate operations, net 16 (198) 198 (641)
Amortization of intangible assets (588) (588) (1,177) (1,177)
Branch and deposit related fees 662 620 1,252 1,071
Other income 305 30 667 91
------- -------- ------- --------
Total other income (expense) 832 13 1,572 (327)
See Notes to Consolidated Financial Statements
5
6
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED)
(UNAUDITED)
FOR THE THREE MONTHS FOR THE SIX MONTHS
ENDED DECEMBER 31, ENDED DECEMBER 31,
------------------ ------------------
1998 1997 1998 1997
---- ---- ---- ----
(Dollars In Thousands)
GENERAL AND ADMINISTRATIVE EXPENSES:
Salaries and employee benefits $ 3,075 $ 2,065 $ 6,029 $ 4,610
Occupancy and equipment expense 964 926 2,059 1,908
FDIC insurance and other assessments 178 181 362 362
Legal and professional services 283 222 524 346
Data and item processing service costs 601 579 1,164 1,050
Marketing expense 194 157 444 245
Supplies expense 114 71 202 135
Expenses for pending acquisition 225 0 225 0
Other operating expenses 562 367 961 735
-------- -------- -------- --------
Total general and administrative expenses 6,196 4,568 11,970 9,391
EARNINGS BEFORE INCOME
TAX EXPENSE 167 1,242 453 2,100
INCOME TAX EXPENSE 49 515 154 871
--------- -------- -------- --------
NET EARNINGS $ 118 $ 727 $ 299 $ 1,229
======== ======== ======== ========
SHARES APPLICABLE TO BASIC EARNINGS PER SHARE 6,395,922 6,286,157 6,390,506 6,284,016
BASIC EARNINGS PER SHARE $ 0.02 $ 0.12 $ 0.05 $ 0.20
====== ====== ====== ======
SHARES APPLICABLE TO DILUTED EARNINGS PER SHARE 6,507,628 6,501,870 6,504,647 6,477,856
DILUTED EARNINGS PER SHARE $ 0.02 $ 0.11 $ 0.05 $ 0.19
====== ====== ====== ======
See Notes to Consolidated Financial Statements
6
7
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENT OF CHANGES IN STOCKHOLDERS' EQUITY
SIX MONTHS ENDED DECEMBER 31, 1998
(UNAUDITED)
(DOLLARS AND SHARES IN THOUSANDS)
Accumulated Total
Common stock Additional Deferred other stock-
----------------- paid-in Retained stock- Treasury comprehensive holders'
Shares Amount capital earnings compensation stock income equity
------ ------ ------- -------- ------------ -------- ------------- ------
Balance at June 30, 1998 6,613 $ 66 $ 51,557 $ 38,552 $ (4,159) $ (2,464) $ 226 $ 83,778
Amortization of deferred stock
compensation -- -- 165 -- 190 -- -- 355
Sale of treasury stock -- -- (2) -- -- 302 -- 300
Comprehensive income:
Net earnings -- -- -- 299 -- -- -- 299
Other comprehensive income:
Change in net unrealized gain
on available-for-sale
securities, net of
$233 in taxes -- -- -- -- -- -- (333)
Recognition of net unrealized
loss on interest rate swaps
designated as cash flow
hedges, net of $12 in taxes -- -- -- -- -- -- (17) (350)
--------
Comprehensive income (51)
------ ------ -------- -------- -------- -------- -------- --------
Balance at December 31, 1998 6,613 $ 66 $ 51,720 $ 38,851 $ (3,969) $ (2,162) $ (124) $ 84,382
====== ====== ======== ======== ======== ======== ======== ========
See Notes to Consolidated Financial Statements
7
8
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)
FOR THE SIX MONTHS
ENDED DECEMBER 31,
1998 1997
---- ----
(Dollars In Thousands)
CASH FLOWS FROM OPERATING ACTIVITIES:
Net earnings $ 299 $ 1,229
Adjustments to reconcile net earnings to net cash provided by (used in)
operating activities:
Origination of loans held-for-sale (23,265) (9,298)
Proceeds of sale of loans held-for-sale 21,985 5,507
Provisions for estimated loan and real estate losses 1,213 960
Depreciation and amortization 547 651
Amortization of deferred loan fees (467) (421)
Amortization (accretion) of premiums (discounts) on loans
and investment and mortgage-backed securities, net 1,428 161
Amortization of intangible assets 1,177 1,177
Federal Home Loan Bank stock dividend (221) (200)
Gain on sales of mortgage backed and investment securities available-for-sale (159) (62)
Gain on sales of loans held-for-sale (251) (70)
Gain on sales of foreclosed real estate, net (193) (25)
(Gain) loss on sale of premises and equipment (78) 19
Decrease in accrued interest receivable 525 551
Decrease in accounts payable and other liabilities (1,140) (1,149)
Decrease in other assets 43 1,440
Other, net (243) 83
-------------- -----------
1,200 553
Net cash provided by operating activities
CASH FLOWS FROM INVESTING ACTIVITIES:
Net increase in loans receivable (31,812) (108,610)
Purchases of mortgage-backed securities available-for-sale -- (80,163)
Principal repayments on mortgage-backed securities held-to-maturity -- 13,131
Principal repayments on mortgage-backed securities available-for-sale 47,021 16,198
Purchases of investment securities available-for-sale (62,441) --
Principal repayments on investment securities held-to-maturity -- 485
Principal repayments on investment securities available-for-sale 49,749 2,614
Proceeds from sales of mortgage-backed and investment securities available-for-sale 28,157 58,254
Matured / called investment and mortgage backed securities held-to-maturity -- 16,000
Matured / called investment and mortgage backed securities available-for-sale 11,741 3,032
Proceeds from sales of real estate acquired by foreclosure 1,936 3,063
Proceeds from sales of real estate held for investment -- 427
Proceeds from sale of premises and equipment 1,360 43
Acquisitions of premises and equipment (1,070) (148)
----------- -----------
Net cash provided by (used in) investing activities 44,641 (75,674)
See Notes to Consolidated Financial Statements
8
9
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(UNAUDITED)
FOR THE SIX MONTHS
ENDED DECEMBER 31,
1998 1997
---- ----
(Dollars In Thousands)
CASH FLOWS FROM FINANCING ACTIVITIES:
Advances received from Federal Home Loan Bank $ 107,000 $ 60,000
Proceeds from other borrowings -- 182,000
Increase in deposit accounts 17,467 15,909
Repayment of advances from Federal Home Loan Bank (147,000) --
Repayment of other borrowings -- (182,000)
----------- -----------
Net cash (used in) provided by financing activities (22,533) 75,909
----------- -----------
NET INCREASE IN CASH AND CASH EQUIVALENTS 23,308 788
CASH AND CASH EQUIVALENTS AT BEGINNING OF PERIOD 27,720 18,411
----------- -----------
CASH AND CASH EQUIVALENTS AT END OF PERIOD $ 51,028 $ 19,199
=========== ==========
SUPPLEMENTAL CASH FLOW DISCLOSURES:
Cash paid during the period for:
Interest on deposit accounts and other borrowings $ 5,219 $ 4,857
============ ==========
SUPPLEMENTAL DISCLOSURES OF NON CASH
INVESTING AND FINANCING ACTIVITIES:
Real estate acquired through foreclosure $ 1,964 $ 3,823
=========== ==========
Loans to facilitate the sale of real estate acquired through foreclosure $ 338 $ $ 358
============ ============
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
9
10
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 six month
period ended December 31, 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 year's 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
12/31/98 6,612,500 216,578 6,395,922 98,921 12,785 6,507,628 $15.98 6,390,506 6,504,647
*Share counts for diluted EPS are applicable only in the event of positive
earnings.
10
11
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 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 was 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 six months ended
December 31, 1998, interest expense increased $7 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 Plans
During the six months ended December 31, 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. In addition, the one participant in the
non-qualified Retirement Restoration Plan has elected to receive a cash
distribution during the fiscal third quarter in lieu of future monthly benefits
under that plan.
11
12
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. All outstanding
stock options and awards under the plan vest in the event of a change in
control, such as the Company's planned acquisition by Temple-Inland, Inc. 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
12/31/98 811,250 580,890 160,008 117,048 113,312 $11.17
Activity during the six months ended December 31, 1998 included:
Granted 47,250
Canceled 2,500
Exercised 29,820
The exercise price of individual vested stock options ranged from a low
of $9.50 per share to a high of $17.50 per share as of December 31, 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
12/31/98 198,375 107,565 74,917 15,893
Activity during the six months ended December 31, 1998 included:
Granted 11,300
Canceled 0
Vested 6,660
NOTE 6: Commitments And Contingencies
At December 31, 1998, the Company maintained commitments to sell $8.1
million in residential fixed rate mortgage loans on a servicing released basis,
to originate $5.9 million in various types of loans, and to purchase $2.2
million in loans secured by multifamily real estate. The Company maintained no
commitments to assume borrowings, purchase securities, or sell securities at
December 31, 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". The Company does not believe this Statement will have a material
effect upon its financial condition or results of operations, as the Company has
not historically securitized its mortgage loans held for sale. In addition, at
this time, the Company has no plans to commence securitizing such loans.
12
13
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 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, the nature and timing of the planned acquisition by Temple-Inland, Inc.,
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 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 extent to which the Company's operations and results are
impacted by its pending acquisition, regulatory and shareholder response to the
planned acquisition, the general business environment, the California real
estate market, competitive conditions among bank and non-bank financial services
providers, changes in laws or regulations, 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. The Company's common stock is listed on the Nasdaq
National Market ("NASDAQ") under the symbol "HEMT".
At December 31, 1998, the Company had $1,021.6 million in assets,
$611.3 million in net loans receivable, and $884.2 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, a transaction capable Internet site, and ATM access through an array of
networks including STAR, CIRRUS, PLUS, and NOVUS. Through its 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, issuing debit
cards, and supplying various forms of electronic funds transfer. In addition,
the Bank, through third party relationships and its First Hemet Corporation
("FHC") subsidiary, makes various non FDIC insured investment products available
to its customers, including mutual funds and selected insurance related
products.
13
14
Recent Developments
Acquisition By Temple-Inland, Inc.
As previously announced, on November 14, 1998, the Company entered into
an Agreement and Plan of Merger with Temple Inland, Inc. ("TI"), pursuant to
which the Company will be merged with and into TI. Upon consummation of the
transaction, shareholders of Registrant will receive cash, stock, or a
combination thereof, valued at $18.50 per share, subject to certain limitations
on the amount of stock to be issued in the transaction. Shareholders will have
the opportunity to indicate a preference for the form of consideration to be
received in the merger. The merger is subject to regulatory and shareholder
approvals. An application for regulatory approval has been filed with the OTS
and is pending. A Form S-4 registration statement regarding the proposed merger
was filed with the SEC on February 3, 1999. The Company's special shareholders'
meeting, previously announced for March 25, 1999, will be postponed to
accommodate SEC review of TI's registration statement.
Check Kite
During the fourth quarter of calendar 1998, the Company announced that
it had identified a $2.9 million check kite by a customer. The customer has
continued to cooperate with the Bank, and has now repaid all of the outstanding
overdraft balance, the cost of collection, and interest.
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.
"99" for "1999"). 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 three phases of its Year 2000 plan
and is currently working internally and with external vendors on the final two
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 and telecommunications hardware
throughout the organization as Year 2000 compliant.
o Those ATM's requiring new hardware and / or software to achieve Year
2000 compliance have been upgraded, and all new ATM's acquired have
been Year 2000 certified. In addition, Year 2000 testing for the third
party which drives the Company's ATM's was recently completed by the
Bank's primary data processor. The Bank anticipates receiving the
results of this testing during the quarter ended March 31, 1999.
o The Company introduced debit cards and a transaction capable Internet
site during the quarter ended December 31, 1998. Prior to implementing
these new services, Year 2000 testing was conducted with no
shortcomings identified.
o In conjunction with the Federal Reserve, the Bank has scheduled testing
of its FedWire wire transfer system for Year 2000 compliance during
March, 1999.
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 $500 thousand to the Company. No responses received to date have
highlighted the likelihood of significant financial loss to the
Company. However, only approximately 40% of those loan customers
contacted have responded. The Company is continuing to pursue 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 it 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. This replacement is part of
the Company's contingency planning. The Company intends to complete
substantially all of its contingency planning and testing no later than June 30,
1999. Year 2000 contingency planning involves four phases:
1. establishing organizational planning guidelines
2. completing a business impact analysis
3. developing a business resumption contingency plan
4. validating the business resumption contingency plan
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 $75 thousand. This range of costs does not include normal
ongoing costs for computer hardware and software that would be replaced 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.
Overview Of Business Activity And Results
Results for the six months ended December 31, 1998 were significantly
influenced by four primary factors:
1. Expenses associated with the implementation of the Company's strategic
plan of evolving an almost 80 year old savings & loan into a community
based financial services firm.
2. The November 14, 1998 signing of a definitive agreement to sell the
Company to Temple-Inland, Inc., which triggered various events,
including the liability for significant merger related expenses,
restrictions on the Company's operations, a modification in the
Company's strategic plan, and a redirection of various internal
resources towards facilitating a timely and effective close to the
transaction.
3. A continuation of the historically low and flat status of the Treasury
security yield curve, thereby fostering high prepayments on a variety
of mortgage related assets, which in turn affected net interest income
and the composition of the Company's balance sheet.
4. Provisions for estimated loan losses up from the first six months of
the prior fiscal year, although down from levels recorded during the
latter half of fiscal 1998.
The confluence of the above factors resulted in depressed earnings versus
comparable periods during the prior fiscal year and an efficiency ratio above
the Company's peer average.
16
17
Significant steps in implementing the Company's strategic plan achieved during
fiscal 1999 included:
o The completion of the branch restructuring announced during the summer
of 1998.
o The introduction of debit cards and a transaction capable Internet site.
o A shift in balance sheet mix away from the historical predominance of
residential mortgage assets funded by retail certificates of deposit.
o A large expansion in the Company's alternative investment sales
program.
o Increased non-interest income, fueled by the imposition of a new fee
and service charge schedule, the offering of an expanded roster of
services, and ongoing growth in mortgage banking activity.
o The establishment of a separate commercial lending unit and a loan
production office in Orange County.
o A major upgrade in technology utilized by the Bank's branch network,
supporting enhanced customer service while also providing Year 2000
certification.
A number of the above initiatives and achievements, however, generated operating
costs in advance of and / or in excess of associated revenues during fiscal
1999, due to the requirement to establish new operating foundations prior to the
generation of new business.
With the signing of the definitive agreement, the Company became liable
to pay its investment banking firm 1.25% of the market value of the
consideration paid to the shareholders of the Company, with such fee segmented
into a series of payments based upon the progress of the sale. Additional costs
were incurred, and will be incurred through the close of the sale, for legal and
accountant services. These additional expenses reduced fiscal 1999 year to date
earnings and will continue to impact results through to the close of the
transaction. The definitive agreement to sell the Company presents various
operating restrictions, including limitations on investment security purchases
and lending activity. These restrictions unfavorably affected earnings during
the most recent quarter. With the announcement of the Company's sale, certain
strategic projects, including a new loan origination system and the migration to
a "proof of deposit" ("POD") branch operations environment, were placed on hold.
Internal resources previously assigned to these projects were reallocated toward
facilitating the legal and operational (including systems conversion) aspects of
timely concluding the transaction with Temple-Inland, Inc.
Earnings during fiscal 1999 were also unfavorably affected by the
impacts stemming from the particularly flat and low state of the Treasury
security yield curve, 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, 2 basis points at September 30, 1998, and 13 basis points at
December 31, 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 six months ended December 31, 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 fiscal 1999 reduced
the spread derived from the Company's net liability sensitive position,
pressuring net interest income. Management responded to this environment by
augmenting its mortgage banking activity, bolstering fee income, and focusing
upon reducing the Company's cost of funds.
Additional information concerning the above factors and events is
presented in the pages which follow.
17
18
Changes In Financial Condition From June 30, 1998 to December 31, 1998
Total assets decreased $24.2 million, or 2.3%, from $1,045.8 million at
June 30, 1998 to $1,021.6 million at December 31, 1998. Total assets declined by
$38.0 million during the three months ended December 31, 1998 primarily due to
the redirection of cash flows from security prepayments and security sales to
reducing borrowings.
Cash and cash equivalents rose from $27.7 million at June 30, 1998 to
$51.0 million at December 31, 1998, as the Company built up a balance of short
term funds in preparation for a planned wholesale loan purchase during the third
fiscal quarter. The objectives of the planned wholesale loan purchase are to
bolster net interest income and better deploy the Bank's strong regulatory
capital position. If the Bank is not successful in accomplishing the planned
loan acquisition, alternative investments providing lesser yields will most
likely be pursued.
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 effective July 1, 1998 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
$320.6 million at December 31, 1998 due to amortization, prepayments, sales, and
calls being only partially offset by new purchases. Funds from the reduction in
mortgage-backed security balances were reinvested into the loan portfolio, used
to repay maturing borrowings, and retained in short term cash equivalents, as
described above. The Company experienced historically high prepayment speeds for
mortgage related securities during the most recent quarter in conjunction with
the availability of new fixed rate mortgages with rates below 7.00% and because
of the historically flat and low shape of the Treasury yield curve.
Securities purchases during the six months ended December 31, 1998 were
concentrated in private label, AAA rated, relatively low duration, fixed rate
collateralized mortgage obligations ("CMO's"). However, security purchases
following the signing of the definitive agreement to sell the Company were
solely short term Agency debentures, consistent with the operating restrictions
contained within that document. During fiscal 1999, the Company has 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. A total of $27.9 million in long term, fixed rate
mortgage backed securities were sold in the quarter ended December 31, 1998 in
support of the Company's interest rate risk management program and in order to
better diversify the Bank's investment portfolio. This was the only security
sale during the first six months of fiscal 1999.
Net loans receivable increased 5.2% from $581.2 million at June 30,
1998 to $611.3 million at December 31, 1998. The ratio of loans to deposits rose
from 67.5% at the end of the prior fiscal year to 69.7 % at the conclusion of
the most recent quarter. The nominal and relative increases in the loan
portfolio have been key objectives of management in implementing the Company's
strategic plan.
Credit commitments during the first six months of fiscal 1999 totaled
$155.9 million, down from $183.2 million during the same period during the prior
fiscal year. However, the prior fiscal year total included $107.7 million in
wholesale purchases of residential hybrid loans which are fixed for an extended
initial period (generally three to five years) and then convert to an adjustable
rate mortgage (generally annually adjusting based upon the One Year Treasury
Constant Maturity Index). No such wholesale residential loan purchases occurred
during the first half of fiscal 1999. However, the first six months of fiscal
1999 included the acquisition of $45.0 million in apartment loans sourced
through wholesale conduits, whereas the first half of the prior fiscal year
contained no similar activity.
18
19
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 interest rates at historically low levels.
The Company originated $54.9 million in multifamily real estate loans during the
six months ending December 31, 1998, up significantly from the $8.1 million
funded during the first half of the prior fiscal year. The Company increased its
emphasis upon apartment loans during fiscal 1999 in order to diversify its loan
portfolio away from its historically high concentration in lower yielding single
family mortgages and in order to improve the efficiency of origination in
conjunction with the larger average loan sizes for apartment loans. Construction
lending expanded from $6.6 million to $11.0 million during the three months
ended December 31, 1998 and from $17.3 million to $21.8 million during the six
months ended December 31, 1998. The strength of the real estate markets in many
of the communities in which the Company operates combined with the limited
supply of housing built during the recessionary period from the early to the mid
1990's to create enhanced construction lending opportunities for the Company.
Net loans available for sale increased from $3.8 million at June 30,
1998 to $5.3 million at December 31, 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. During fiscal 1999, the Company has
expanded the number of conduits with whom it conducts its mortgage banking
activity and has 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 at June 30, 1998 to $8.3 million at
December 31, 1998 due to dividends credited.
Net premises and equipment declined from $7.1 million at June 30, 1998
to $6.4 million at December 31, 1998 due to the sale of the former sites for the
Bank's Rancho Bernardo and Idyllwild branches, periodic depreciation and
amortization, and a reduction in capital spending activity following the signing
of the definitive agreement to sell the Company.
The Company's net investment in real estate acquired through
foreclosure dropped from $1.7 million at June 30, 1998 to $991 thousand at
December 31, 1998. The Company sold $1.9 million in foreclosed real estate
during the past six months, highlighting the relatively rapid turnover
experienced in the Company's inventory of foreclosed properties. This has
resulted from a continued strengthening in real estate values in many of the
markets in which the Company lends, which in turn has increased buyer interest
and supported better sales prices. At December 31, 1998, the Company's inventory
of foreclosed properties was comprised of one multifamily building and a number
of residential properties.
Gross intangible assets declined from $12.1 million at June 30, 1998 to
$10.9 million at December 31, 1998 due to the continued amortization of the
intangible assets generated in conjunction with the North San Diego County
branch purchase from Hawthorne Savings 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 December 31, 1998, the reduction in
the Bank's regulatory capital resulting from intangible assets was $8.3 million.
19
20
Total deposits rose 2.0% from $866.7 million at June 30, 1998 to $884.2
million at December 31, 1998. Key trends within the deposit portfolio included:
o Checking account balances expanded from $88.2 million at June 30, 1998
to $95.4 million at December 31, 1998. The Company has continued to
target increases in checking accounts as a source of low cost funds and
non-interest income, with efforts in fiscal 1999 including the
introduction of a transaction capable Internet site, the installation
of additional ATM's, and an alteration in branch staff incentive
program emphasis.
o Customers responded positively 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 $110.3
million six months later. This growth occurred despite repeated
reductions in pricing in response to the three cuts in the federal
funds rate implemented by the Federal Reserve during the six months
ended December 31, 1998.
o Savings deposits fell from $88.0 million at June 30, 1998 to $78.9
million at December 31, 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 fell $8.6 million, or 1.4%, from $608.2
million at June 30, 1998 to $599.7 million at December 31, 1998, with
the decline occurring during the second quarter of fiscal 1999. During
the past three months, the Company priced its certificates of deposit
relatively less aggressively than in prior periods in order to more
quickly reduce the Bank's cost of funds and due to the Company's high
liquidity. This pricing strategy, when combined with the aforementioned
changes in mix and some significant rate rolldowns on maturing longer
term CD's, led to a 20 basis point decline in the Bank's weighted
average cost of deposits during the first half of fiscal 1999.
During the six months ended December 31, 1998, the Bank realized only
minor outflows from the portfolio of deposits relocated from the Diamond Valley
branch, which was consolidated into the nearby and much larger Hemet West branch
in October, 1998. A similar experience was realized for the deposit portfolio
from the San Jacinto branch, which during December 1998 was relocated across the
street to the Company's first supermarket facility. Located in a Stater Bros.
supermarket, this full service branch offers extended hours for customer
convenience and the Bank's first ATM in San Jacinto. New account activity at the
supermarket branch during December was heavily skewed toward checking accounts,
further moderating that branch's already below average cost of deposits.
Customer response to the new locations for the Idyllwild and Rancho
Bernardo branches has also been generally positive. An ATM was installed at the
Sun City branch during the second quarter of fiscal 1999. The Company relocated
its Rancho Mirage branch to an improved facility in nearby Palm Desert in
January, 1999, with the move celebrated in a series of "grand opening" events.
The Palm Desert relocation completed the branch restructuring announced in the
summer of 1998, with a corresponding $1.06 million pre-tax special charge to
fiscal 1998 earnings.
20
21
Advances from the FHLB-SF declined from $85.0 million at June 30, 1998
to $45.0 million at December 31, 1998. $65.0 million of the June 30 inventory of
advances matured during October, 1998. The Company utilized this opportunity to:
o redeploy funds from security prepayments and sales to reduce borrowings
o extend $25.0 million in advances out to between two and three years,
thereby improving the Company's interest rate risk profile
o decrease the weighted average nominal cost of advances from 5.24% to
4.91%
Total stockholders' equity rose from $83.8 million at June 30, 1998 to
$84.4 million at December 31, 1998. Factors contributing to this increase
included:
o net income generated for the fiscal year to date
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
The above factors more than offset:
o depreciation in the portfolios of investments designated as
available-for-sale, with the equity impact of this depreciation
augmented by the realization of $159 thousand in pre-tax gains on the
sale of securities during the second quarter of fiscal 1999
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
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 a regular 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.
21
22
The Company's net liability sensitivity declined during the first six
months of fiscal 1999 due to multiple factors, including:
o The sale of $27.9 million in long term, fixed rate Agency
mortgage-backed securities during the second fiscal quarter.
o The extension of $25.0 million in maturing FHLB advances to terms of
between two and three years.
o A $26.0 million rise in transaction accounts. Checking accounts (and to
a lesser degree savings and money market accounts) are generally less
interest rate sensitive than certificates of deposit and other
alternative funding sources.
o An increase in prepayment speeds on higher duration assets maintained
on the balance sheet. As a result, there are both fewer such remaining
assets and those which do remain present shorter average lives and thus
less volatility in value.
o Associated with the above factor, long term, fixed rate residential
loans held for portfolio declined from $134.9 million at June 30, 1998
to $125.7 million at December 31, 1998.
o An increase in capital. Higher capital levels reduce the percentage
impact or relative exposure from a given volatility in net portfolio
value.
o The call of the final $10.8 million in long term, fixed rate Agency
debentures owned by the Company on June 30, 1998.
The Company's two active interest rate swaps mature in January, 1999.
Management estimates the cost to terminate these two contracts at December 31,
1998 was $37 thousand. The amortization period for the Other Comprehensive
Income adjustment stemming from the Company's final terminated rate swap
concluded 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 December 31, 1998, the Company maintained $51.0 million in cash and
cash equivalents, untapped borrowing capacity of $260.0 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 been granted three
federal funds lines of credit from correspondent financial institutions, with an
aggregate borrowing capacity of $20.0 million. However, there can be no
assurance 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.
22
23
Regulatory Capital Compliance
The Federal Deposit Insurance Corporation Improvement Act of 1991
("FDICIA") required the OTS to implement a system providing for regulatory
sanctions against institutions that are not adequately capitalized. The severity
of these sanctions increases to the extent that an institution's capital
continues to decline. Under FDICIA, the OTS issued the Prompt Corrective Action
("PCA") regulations with established specific capital ratios for five separate
capital categories as set forth below:
Core Capital To
Adjusted Core Capital To Total Capital
Total Assets Risk-weighted To
(Leverage Ratio) Assets Risk-weighted Assets
---------------- --------------- --------------------
Well capitalized 5% or above 6% or above 10% or above
Adequately capitalized 4% or above 4% or above 8% or above
Undercapitalized Under 4% Under 4% Under 8%
Significantly undercapitalized Under 3% Under 3% Under 6%
Critically undercapitalized Ratio of tangible equity to adjusted total assets of 2% or less
The following table summarizes the capital ratios required by FDICIA
for an institution to be considered well capitalized and the Bank's regulatory
capital at December 31, 1998 as compared to such ratios.
Core Capital To Core Capital To Total Capital To
Adjusted Risk-weighted Risk-weighted
Total Assets Assets Assets
-------------------- ------------------- -------------------
Balance Percent Balance Percent Balance Percent
------- ------- ------- ------- ------- -------
(Dollars In Thousands)
Hemet Federal's regulatory capital $ 66,314 6.59% $ 66,314 14.65% $ 71,281 15.74%
Well capitalized requirement 50,320 5.00 27,164 6.00 45,273 10.00
----------- ---- ------ ------ ---------- -----
Excess $ 15,994 1.59% $ 39,150 8.65% $ 26,008 5.74%
=========== ==== =========== ==== ========== =====
Adjusted assets (1) $ 1,006,393 $ 452,727 $ 452,727
=========== ========== ==========
(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.
23
24
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 December 31, 1998 exceeded all three of the currently applicable
minimum FIRREA capital requirements.
Percent Of
Adjusted
Amount Total Assets
------ ------------
(Dollars In Thousands)
Tangible Capital
Regulatory capital $ 66,314 6.59%
Minimum required 15,096 1.50
------ ----
Excess $ 51,218 5.09%
======== =====
Core Capital
Regulatory capital $ 66,314 6.59%
Minimum required 30,192 3.00
------ ----
Excess $ 36,122 3.59%
======== =====
Percent Of
Risk-weighted
Amount Assets
------ ------
Risk-based Capital
Actual capital $ 71,281 15.74%
Minimum required 36,218 8.00
------ ----
Excess $ 35,063 7.74%
======== =====
At December 31, 1998, the Bank's regulatory capital levels exceeded the
thresholds required to be classified as a "well capitalized" institution. The
Bank's capital ratios detailed above do not reflect the additional capital (and
assets) maintained by the holding company. Management anticipates the Bank to
remain "well capitalized" following the wholesale loan purchase planned for the
third quarter of fiscal 1999.
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.
24
25
Credit Profile
Nonperforming Assets
The following table sets forth information regarding non accrual loans,
real estate acquired through foreclosure, and repossessed consumer assets.
December 31, 1998 June 30, 1998
----------------- -------------
(Dollars In Thousands)
Gross non accrual loans before valuation reserves $ 6,960 $ 4,276
Investment in foreclosed real estate before valuation reserves 1,117 1,853
------- -------
Total nonperforming assets $ 8,077 $ 6,129
======= =======
Non accrual loans to gross loans net of undisbursed loan funds 1.12% 0.72%
Nonperforming assets to total assets 0.79% 0.59%
The following table presents a profile of gross non accrual loans at
December 31, 1998.
Gross Non Accrual Loans December 31, 1998
-----------------
(Dollars In Thousands)
Residential real estate $ 3,716
Multifamily real estate 154
Commercial & industrial real estate 622
Construction 260
Land / Lots 1,952
Consumer 199
Commercial business 57
--------
Total $ 6,960
=========
The increase in non accrual loans during fiscal 1999 primarily resulted
from:
o the placement of a $968 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 $2.9 million of the non accrual loans at December 31,
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
December 31, 1998 $14,813 $17,136 - $1,654 $33,603
The portfolio of loans acquired in conjunction with the PSSB
acquisition, which experienced a disproportionately high charge-off rate
following the acquisition, totaled $86.4 million at December 31, 1998. Of this
total, $67.1 million was composed of residential mortgages and $11.4 million was
comprised of loans secured by commercial & industrial real estate.
Impaired Loans
At December 31, 1998, the Company maintained total gross impaired
loans, before specific reserves, of $9.7 million, constituting 88 credits. This
compares to total gross impaired loans of $10.7 million at June 30, 1998. This
decrease was caused by the Company's continuing to foreclose upon, and generally
subsequently sell, its existing problem credits secured by real estate, the
reinstatement of previously impaired loans combined with evidence of the
capacity for future financial performance, and a limited inflow of new problem
credits due to the strength of the economy, the rebound in Southern California
real estate markets, and the impact of the Company's revised credit management
program implemented toward the end of fiscal 1998. A total of $1.5 million in
specific reserves were established against impaired loans at December 31, 1998,
down from $2.5 million at June 30, 1998. The average recorded investments in
impaired loans during the three and six months ended December 31, 1998 were
$10.7 million and $10.4 million, respectively.
Of the total impaired loans at December 31, 1998, $2.8 million were
either fully current or exhibited 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 six months ended
December 31, 1998, accrued interest on impaired loans was $23 thousand and
interest of $349 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 $399 thousand during the six months ended
December 31, 1998, instead of interest income actually recognized on cash
payments of $232 thousand.
26
27
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.
The following table presents activity in the Bank's allowances for
estimated loan losses during the six months ended December 31, 1998 and 1997:
Six Months Ended December 31,
-----------------------------
1998 1997
---- ----
(Dollars In Thousands)
Allowance for Loan Losses:
Balance at June 30 $6,271 $4,780
Loan chargeoffs:
Residential real estate (351) (402)
Multifamily real estate (125) (121)
Commercial & industrial real estate (336) (313)
Construction --- ---
Land / Lots (12) (265)
Consumer (35) (98)
Commercial business (117) ---
---------- ------------
Total chargeoffs (976) (1,199)
Loan recoveries 1 ---
Provision for estimated loan losses 1,200 400
-------- ----------
Balance at December 31 $ 6,496 $ 3,981
======= =======
December 31, 1998 June 30, 1998
----------------- -------------
Allowance for estimated loan losses as a percent of
nonperforming loans 93.33% 146.64%
Allowance for estimated loan losses as a percent of
gross loans receivable net of loans in process 1.04% 1.06%
27
28
The following table presents activity in the Bank's allowances for
estimated real estate losses during the six months ended December 31, 1998 and
1997:
Six Months Ended December 31,
-----------------------------
1998 1997
---- ----
(Dollars In Thousands)
Valuation Allowances: Real Estate Acquired Through Foreclosure
Balance at June 30 $ 179 $ 1,020
Net chargeoffs (66) (758)
Provision to increase valuation allowances 13 560
------- -------
Balance at December 31 $ 126 $ 822
Valuation Allowances: Real Estate-Development
Balance at June 30 $ 0 $ 577
Net chargeoffs 0 (577)
Provision to increase valuation allowances 0 0
------- -------
Balance at December 31 $ 0 $ 0
TOTAL VALUATION ALLOWANCES FOR REAL ESTATE $ 126 $ 822
======= =======
Loan charge-offs during fiscal 1999 included $336 thousand for a
commercial real estate loan secured by a retail strip center and $125 thousand
for a loan secured by an apartment complex, both of which were located in Hemet.
The ratio of allowance for estimated loan losses to non accrual loans decreased
from 146.64% at June 30, 1998 to 93.33% at December 31, 1998 due to the $2.7
million rise in non accrual loans during the period. However, specific reserves
for loans declined from $2.5 million at June 30, 1998 to $1.5 million at
December 31, 1998, in part because of improved financial performance, property
values, and / or updated cash flow information for certain loans secured by
income properties. 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 1.04% at December 31, 1998, as the rate of growth in the loan portfolio
exceeded the rate of expansion in the allowance. At December 31, 1998, 63.8% of
the Bank's gross loan portfolio was comprised of residential real estate loans.
Multifamily loans constituted the next largest segment, at 15.2% of the gross
loan portfolio. In addition, 96.2% of the gross loan portfolio at December 31,
1998 was composed of loans secured by real estate of various types.
The Company exited the real estate development business during the
first half of fiscal 1998, after the final two development projects were sold.
The Company's inventory of foreclosed properties and repossessed
consumer assets is summarized as follows:
Real Estate Acquired By Foreclosure and Repossessed Consumer Assets
December 31, 1998
(Dollars In Thousands) Gross Valuation Net Percent
Type Of Property Balance Reserves Balance Of Total
- ---------------- ------- -------- ------- --------
Residential 1 - 4 Units $ 979 $ 126 $ 853 86.1%
Multifamily More Than 4 Units 138 0 138 13.9%
Commercial / Industrial 0 0 0 0.0%
Land / Developed Lots 0 0 0 0.0%
Repossessed Consumer Assets 0 0 0 0.0%
---------- ---------- ---------- --------
Total $ 1,117 $ 126 $ 991 100.0%
======= ======== ======== ======
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.
28
29
Comparison Of Operating Results For The Three Months And Six Months Ended
December 31, 1998 and December 31, 1997
General
For the fiscal 1999 second quarter ended December 31, 1998, the Company
reported net income of $118 thousand, equivalent to $0.02 basic and diluted
earnings per share. This compares to earnings of $727 thousand, or $0.12 basic
and $0.11 diluted earnings per share, during the same period during the prior
fiscal year. For the six months ended December 31, 1998, the Company generated
net income of $299 thousand, equivalent to $0.05 basic and diluted earnings per
share. This compares to earnings of $1.2 million, or $0.20 basic and $0.19
diluted earnings per share during the first six months of the prior fiscal year.
Primary factors which constrained earnings during the first half of
fiscal 1999 included:
1. The various impacts stemming from the historically low and flat shape of the
Treasury yield curve.
2. Acquisition related operating costs of $225 thousand, including attorney,
investment banker, and accountant fees.
3. General & administrative expenses above levels experienced in prior quarters.
4. Greater provisions for estimated loan losses than were recorded during the
first half of fiscal 1998.
Net Interest Income
Net interest income increased slightly from $6.10 million during the
quarter ended December 31, 1997 to $6.13 million during the most recent three
months. Net interest income during the most recent three months was bolstered by
the conclusion of the amortization period for the Company's final terminated
interest rate swap. The figures for net hedging expense reported by the Company
reflect the adoption of SFAS No. 133 as of July 1, 1998.
Net interest income for the six months ended December 31, 1998 totaled
$12.05 million, down from $12.22 million during the same period the prior fiscal
year. Net interest income during fiscal 1999 has been constrained by the
unfavorable impacts stemming from the historically low and flat shape of the
Treasury yield curve. As a result of this interest rate environment, the Company
experienced accelerated prepayments, particularly on its portfolios of
adjustable rate mortgage related assets and higher coupon collateralized
mortgage obligations, many of which are owned at a premium to par value, as
customers took advantage of historically low fixed interest rates to refinance.
The Company's average spread on total assets increased from 2.26%
during the second quarter of fiscal 1998 to 2.36% during the most recent three
months. The Company's average spread on total assets during the first half of
the current fiscal year was 2.26%, down from 2.31% for the similar period the
prior fiscal year. During the first half of fiscal 1999, the Company has
achieved a 20 basis point decrease in the weighted average cost of deposits, a
33 basis point fall in the weighted average cost of borrowings, greater ratios
of loans to deposits and average interest earning assets to average interest
bearing liabilities, and a reduced loan portfolio concentration in lower
yielding residential mortgages. These accomplishments were, however, largely
offset by the aforementioned impacts from the general interest rate environment
and by the imposition of balance sheet composition restrictions commencing in
mid-November with the signing of the definitive agreement to sell the Company.
The following tables present certain information relating to net
interest income for the three and six months ended December 31, 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.
29
30
Three Months Ended December 31, 1998 Three Months Ended December 31, 1997
------------------------------------- ------------------------------------
(Dollars In Thousands) Average Average Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
ASSETS:
Interest Earning Assets:
Real Estate Loans, Net (1) 594,959 11,622 7.81% 538,455 10,268 7.63%
Non Real Estate Loans, Net (1) 24,712 491 7.95% 15,751 379 9.63%
Mortgage-backed Securities (2) 232,153 3,395 5.85% 303,204 4,865 6.42%
CMO's (3) 111,940 1,471 5.26% 29,120 467 6.41%
FHLB Stock 8,134 103 5.07% 6,300 106 6.73%
Other Interest Earning Assets (4) 20,779 295 5.68% 133,897 2,674 7.99%
----------- -------- ----- ---------- ------- -----
Total Interest Earning Assets 992,677 17,377 7.00% 1,026,727 18,759 7.31%
Non Interest Earning Assets 48,465 51,994
----------- -----------
TOTAL ASSETS 1,041,142 1,078,721
LIABILITIES & SHAREHOLDERS' EQUITY:
Interest Bearing Liabilities:
Deposits 841,793 10,166 4.83% 822,556 10,370 5.04%
Net Hedging Expense (5) 347 462
Borrowings (6) 56,386 733 5.20% 121,250 1,830 6.04%
----------- -------- ----- ------- ----- -----
Total Interest Bearing Liabilities 898,179 11,246 5.01% 943,806 12,662 5.37%
Non Interest Bearing Liabilities 58,551 51,370
----------- -----------
Total Liabilities 956,730 995,176
Shareholders' Equity 84,412 83,545
----------- -----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY 1,041,142 1,078,721
Net Interest Income 6,131 6,097
Interest Rate Spread (7) 1.99% 1.94%
Net Interest Earning Assets 94,498 82,921
Net Interest Margin (8) 2.47% 2.38%
Net Interest Income / Average Total Assets 2.36% 2.26%
Int. Earning Assets / Int. Bearing Liabilities 110.52% 108.79%
- ------------------------------------------
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.
30
31
Six Months Ended December 31, 1998 Six Months Ended December 31, 1997
----------------------------------- ----------------------------------
(Dollars In Thousands) Average Average Average Average
Balance Interest Rate Balance Interest Rate
------- -------- ---- ------- -------- ----
ASSETS:
Interest Earning Assets:
Real Estate Loans, Net (1) 583,143 22,674 7.78% 508,367 19,720 7.76%
Non Real Estate Loans, Net (1) 23,228 953 8.21% 15,638 756 9.68%
Mortgage-backed Securities (2) 252,423 7,530 5.97% 292,864 9,483 6.48%
CMO's (3) 106,472 2,910 5.47% 30,683 999 6.51%
FHLB Stock 8,073 221 5.48% 6,254 201 6.42%
Other Interest Earning Assets (4) 43,250 1,314 6.08% 147,234 5,836 7.93%
----------- ------- ----- ---------- ------- -----
Total Interest Earning Assets 1,016,589 35,602 7.00% 1,001,040 36,995 7.39%
Non Interest Earning Assets 51,427 54,579
----------- -----------
TOTAL ASSETS 1,068,016 1,055,619
LIABILITIES & SHAREHOLDERS' EQUITY:
Interest Bearing Liabilities:
Deposits 838,136 20,431 4.88% 820,688 20,753 5.06%
Net Hedging Expense (5) 813 948
Borrowings (6) 86,416 2,307 5.34% 103,572 3,076 5.94%
----------- ------- ----- ------- ------- -----
Total Interest Bearing Liabilities 924,552 23,551 5.09% 924,260 24,777 5.36%
Non Interest Bearing Liabilities 59,084 48,803
----------- -----------
Total Liabilities 983,636 973,063
Shareholders' Equity 84,380 82,556
----------- -----------
TOTAL LIABILITIES & SHAREHOLDERS' EQUITY 1,068,016 1,055,619
Net Interest Income 12,051 12,218
Interest Rate Spread (7) 1.91% 2.03%
Net Interest Earning Assets 92,037 76,780
Net Interest Margin (8) 2.37% 2.44%
Net Interest Income / Average Total Assets 2.26% 2.31%
Int. Earning Assets / Int. Bearing Liabilities 109.95% 108.31%
- ------------------------------------------
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.
31
32
Rate / Volume Analysis
The following tables utilize the figures from the preceding tables 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 to 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.
Three Months Ended December 31, 1998
Compared To
Three Months Ended December 31, 1997
------------------------------------
sands) Increase (Decrease) Due To:
Volume Rate Volume / Rate Net
------ ---- ------------- ---
INTEREST INCOME:
Real Estate Loans, Net $ 1,077 $ 251 $ 26 $ 1,354
Non Real Estate Loans, Net 216 (66) (38) 112
Mortgage-backed Securities (1,140) (431) 101 (1,470)
CMO's 1,328 (84) (240) 1,004
FHLB Stock 31 (26) (8) (3)
Other Interest Earning Assets (2,259) (773) 653 (2,379)
------ ------- ------- ------
TOTAL INTEREST INCOME (747) (1,129) 494 (1,382)
INTEREST EXPENSE:
Deposit Accounts 242 (435) (11) (204)
Net Hedging Expense 0 (115) 0 (115)
Borrowings (979) (254) 136 (1,097)
------- ------- ------- ------
TOTAL INTEREST EXPENSE (737) (804) 125 (1,416)
NET CHANGE IN NET INTEREST INCOME $ (10) $ (325) $ 369 $ 34
======= ======= ======= ========
Six Months Ended December 31, 1998
Compared To
Six Months Ended December 31, 1997
----------------------------------
(Dollars In Thousands) Increase (Decrease) Due To:
---------------------------
Volume Rate Volume / Rate Net
------ ---- ------------- ---
INTEREST INCOME:
Real Estate Loans, Net $ 2,901 $ 47 $ 6 $ 2,954
Non Real Estate Loans, Net 367 (114) (56) 197
Mortgage-backed Securities (1,309) (747) 103 (1,953)
CMO's 2,468 (160) (397) 1,911
FHLB Stock 58 (30) (8) 20
Other Interest Earning Assets (4,122) (1,363) 963 (4,522)
------ ------ ------- -------
TOTAL INTEREST INCOME 363 (2,367) 611 (1,393)
INTEREST EXPENSE:
Deposit Accounts 441 (747) (16) (322)
Net Hedging Expense 0 (135) 0 (135)
Borrowings (510) (311) 52 (769)
------- ------- ------- -------
TOTAL INTEREST EXPENSE (69) (1,193) 36 (1,226)
NET CHANGE IN NET INTEREST INCOME $ 432 $ (1,174) $ 575 $ (167)
======= ======== ======= =======
32
33
Interest Income
Interest income declined from $18.8 million and $37.0 million in the
three and six months ended December 31, 1997 to $17.4 million and $35.6 million
in the three and six months ended December 31, 1998, respectively, as a shift in
asset mix toward loans and away from securities was insufficient to offset both
a generally lower interest rate environment and increased premium amortization
on assets owned with a basis exceeding par. The following table highlights the
change in general interest rate environment between the first six months of
fiscal 1998 and fiscal 1999:
Treasury Bond Equivalent Yield On Bond Equivalent Yield On Bond Equivalent Yield On
------------------------ ------------------------ ------------------------
Security 6/30/97 6/30/98 9/30/97 9/30/98 12/31/97 12/31/98
- -------- ------- ------- ------- ------- -------- --------
3 month 5.17% 5.09% 5.09% 4.36% 5.34% 4.46%
6 month 5.25% 5.23% 5.27% 4.47% 5.44% 4.54%
1 year 5.65% 5.37% 5.44% 4.39% 5.47% 4.52%
2 year 6.06% 5.48% 5.78% 4.27% 5.64% 4.53%
5 year 6.37% 5.47% 5.99% 4.22% 5.71% 4.54%
10 year 6.49% 5.45% 6.11% 4.41% 5.74% 4.65%
30 year 6.78% 5.63% 6.40% 4.97% 5.92% 5.09%
In addition, the 11th District Cost Of Funds Index declined from 4.96% for
December 1997 to 4.66% for December 1998.
Interest income on loans rose 13.8% from $10.6 million during the three
months ended December 31, 1997 to $12.1 million during the quarter ending
December 31, 1998. Similarly, for the six months ending December 31, 1998,
interest income on loans rose 15.4% versus the same period during the prior
fiscal year. These increases were primarily generated by an expansion in the
Company's loan portfolio and by a gradual shift in loan mix towards a lower
concentration in residential mortgages. At December 31, 1998, 63.8% of the
Company's gross loan portfolio was comprised of residential mortgages, down from
75.9% one year earlier. The rise in interest income on loans would have been
greater if not for the year to year decline in the various indices underlying
the Company's adjustable rate loans. At December 31, 1998, 46.3% of the
Company's gross loans repriced based upon various Treasury indices.
Interest income on mortgage backed securities declined from $4.9
million and $9.5 million for the three months and six months, respectively,
ended December 31, 1997 to $3.4 million and $7.5 million during the like periods
in fiscal 1999. These reductions stemmed from both reduced average volumes and
lower average rates. The lower average rates resulted from declines in indices
underlying the Company's adjustable rate mortgage backed securities and 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 seasoned GNMA ARMs, which
historically and recently have exhibited relatively less prepayment volatility
than conventional adjustable rate mortgage backed securities.
Interest income on collateralized mortgage obligations ("CMO's")
increased from $467 thousand and $1.0 million for the three and six months,
respectively, ended December 31, 1997 to $1.5 million and $2.9 million during
the same periods in fiscal 1999. These increases were due to significantly
expanded volume. Over the past nine 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 future
increases in credit commitments. The relatively short term of the new CMO
purchases therefore constrained the yield versus what could have been acquired
for longer average lives.
Interest income on other earning assets fell significantly in fiscal
1999 when compared to the prior fiscal year 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. In addition,
restrictions contained in the definitive agreement governing the Company's sale
restrict the profile of investments which the Company may purchase. These
restrictions constrained interest income during the period following the signing
of the document.
33
34
Interest Expense
Interest expense on deposits declined from $10.4 million and $20.8
million during the three and six months ended December 31, 1997, respectively,
to $10.2 million and $20.4 million during the like periods in fiscal 1999.
Reductions in average rate were more than sufficient to offset increases in the
average balances of interest bearing deposits. 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 a reduction in the amount of variation in rate from sheet pricing controlled
by the branches
In addition, deposit rates among the Company's competition were lower in fiscal
1999 versus one year earlier due to the decline in general market interest
rates, thereby facilitating the Company's reducing its deposit price points.
Interest expense on borrowings fell from $1.8 million and $3.1 million
during the three and six months ended December 31, 1997 to $733 thousand and
$2.3 million for the same periods in fiscal 1999. These reductions were because
of both smaller average volumes and lower average rates. $65.0 million of the
Company's FHLB advances at June 30, 1998 matured in November, 1998, providing
the Company with the opportunity to reduce its debt level and acquire new FHLB
advances at rates below the maturing advances.
Net interest expense of hedging transactions declined from $462
thousand and $948 thousand during the three and six months ended December 31,
1997 to $347 thousand and $813 thousand during the same periods in fiscal 1999.
The prior fiscal year included interest expense associated with one additional
terminated interest rate swap. In addition, the amortization period for the
Company's final terminated interest rate swap concluded in November, 1998.
Interest expense figures for net hedging expense reflect the Company's adoption
of SFAS No. 133 effective July 1, 1998. 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 during fiscal 1999 has been constrained by 15 basis points as a
result of the interest rate swap positions.
Provision For Estimated Loan Losses
Provision for estimated loan losses totaled $600 thousand and $1.2
million in the three and six months, respectively, ended December 31, 1998.
These figures compare to $300 thousand and $400 thousand during the three and
six months, respectively, ending December 31, 1997. The Company has continued
conducting and improving its revised credit management process over the past
nine months, whereby all non homogeneous credits are reviewed at least annually
and portfolio monitoring and reporting has been enhanced.
The Company's need to provide for future potential credit losses was
moderated during fiscal 1999, as compared to the final two quarters of fiscal
1998, due to a number of factors, including:
o Real estate valuation trends in most of the market areas served by the
Company remained strong during fiscal 1999, with improvement in collateral
values providing reduced risk of loss to the Bank in a number of instances.
o Specific reserves declined from $2.5 million at June 30, 1998 to $1.5 million
at December 31, 1998, thereby freeing more of the Company's aggregate
allowance for loan losses to address unidentified potential future losses in
the loan portfolio.
o Total criticized plus classified assets declined by $4.0 million during the
six months ended December 31, 1998.
34
35
Other Income & Expense
Other income & expense for the three months ended December 31, 1998 was
$832 thousand in income, up significantly from $13 thousand in income during the
same period the prior fiscal year. For the six months ended December 31, 1998,
other income & expense totaled $1.6 million in income, comparing favorably to
$327 thousand in expense during the same period in fiscal 1998. Key factors
supporting these improved financial results included:
o Deposit related fee income for the quarter ended December 31, 1998 was $662
thousand, up 6.8% from $620 thousand for the same quarter a year earlier.
For the six months ended December 31, 1998, deposit related fee income
totaled $1.3 million, up 16.9% from the same period the prior fiscal year.
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, enhanced control over fee waivers, and the
implementation of revised fee and service charge schedules. In addition,
during the quarter ended December 31, 1998, the Company introduced debit
card services to its customers, which constitute a new source of non
interest income to the Bank while providing convenience for customers
making purchases at a wide array of retailers. Moreover, two branch sites
received their first ATM's during the most recent quarter, thereby creating
an additional source of fee income from "foreign" (non-customer)
transactions while also enhancing convenience for the Bank's customers.
o Results from real estate operations improved from losses of $198 thousand
and $641 thousand for the three and six months ended December 31, 1997 to
income of $16 thousand and $198 thousand during the like periods in fiscal
1999. During fiscal 1999, 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 net gain of $193 thousand on the sale of
foreclosed real estate was recorded during the first six months of fiscal
1999.
o Net gains on loans held for sale rose to $161 thousand and $251 thousand
for the three and six months ended December 31, 1998 from $44 thousand and
$70 thousand for the same periods during the prior fiscal year, as the
Company has continued expanding its mortgage banking program and has
benefitted from the strength of the mortgage loan refinance market in
fiscal 1999, fueled by the continued availability of residential loans with
fixed rates below 7.00%.
o Other income expanded significantly from $30 thousand and $91 thousand
during the three and six months ended December 31, 1997 to $305 thousand
and $667 thousand during the like periods in fiscal 1999 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 $145 thousand in aggregate gains
on the sale of the former Rancho Bernardo and Idyllwild branch sites.
During the first six months of fiscal 1999, the Company recorded revenue of
$518 thousand from sales of alternative investment products.
o Net gains on available-for-sale securities increased from $6 thousand and
$62 thousand for the three and six months ended December 31, 1997 to $159
thousand during fiscal 1999 (all in the most recent quarter) in conjunction
with the sale of $27.9 million in long term, fixed rate Agency mortgage
backed securities in support of the Company's interest rate risk management
program during November, 1998. The fiscal 1999 sale also better diversified
the Company's investment portfolio, as the Bank had previously maintained a
concentration in 6.50% coupon, traditional pass-through, mortgage backed
securities.
35
36
General & Administrative Expenses
General & administrative expense rose 35.6% from $4.57 million during
the three months ended December 31, 1997 to $6.20 million during the most recent
quarter. For the first six months of fiscal 1999, general & administrative
expenses totaled $11.97 million, up $2.58 million (27.5%) from the same period
the prior fiscal year. Factors contributing to the rise in operating costs
included:
o The quarter ended December 31, 1997 included a $533 thousand non-recurring
reduction in salaries & employee benefits expense associated with a
restructuring of the Company's loan to the employee stock ownership plan
("ESOP").
o $356 thousand in expenses (primarily personnel related) were realized in
fiscal 1999 for the establishment of a commercial lending unit and a stand
alone loan production office in Orange County.
o $225 thousand in acquisition related costs were incurred during the most
recent quarter, including expenses for attorney, investment banker, and
accountant services.
o The conversion of the Company's alternative investment (non-FDIC insured)
product sales program to a gross (versus net) basis as part of that
program's redesign lead to the recognition of $203 thousand in employee
sales commission (compensation) expense during the first half of fiscal
1999.
o Training costs were $120 thousand higher in the six months ended December
31, 1998 versus the same period the prior fiscal year, as the Company
conducted increased training in support of sales effectiveness, customer
service, and the multiple new technologies introduced throughout the
Company in conjunction with its strategic plan.
o $74 thousand in contribution and administrative costs associated with the
implementation of a 401(k) benefits plan were incurred during the quarter
ended December 31, 1998.
o $50 thousand in employment related litigation settlement costs were
incurred during the three months ended December 31, 1998.
o In fiscal 1999, the Company "co-sourced" its internal audit function to an
outside party presenting enhanced resources and procedures, but also higher
periodic expenses.
o Credit review expenses were higher during fiscal 1999 compared to the prior
year in conjunction with an expanded credit management function, which
included the recurring use of external credit review specialists during the
current fiscal year.
o Various expenses associated with the implementation of the Company's
strategic plan of converting to a community based financial services firm
were realized during fiscal 1999, including costs for a planned new loan
origination system, opening three new sites for relocated branches,
multiple technology and telecommunications initiatives, the introduction of
debit cards, and the rollout of Internet banking.
During fiscal 1999, the Company implemented a frame relay WAN
connecting all of the Company's sites, a new teller system, and a new branch
platform (new accounts) system. Over 7,000 debit cards were issued to current
customers at a cost of $30 thousand. In addition, the Bank switched to a new
transaction capable Internet site operating under 128 bit SSL security
technology. By December, 1998, the Bank's web site was processing over 9,000
deposit and loan related transactions and inquiries per month. This significant
technology program was designed 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 furnished
the Company with a broad base of technology certified as Year 2000 compliant by
its manufacturer and / or independent third parties.
36
37
As a result of the above increases in general & administrative
expenses, the ratio of general & administrative expenses to average assets
increased from 1.78% during the six months December 31, 1997 to 2.24% during the
most recent six months. Due to the increased revenue streams from a number of
the aforementioned initiatives, however, the Company's efficiency ratio rose
less dramatically, increasing from 81.77% for the first half of fiscal 1998 to
88.68% during the six months ended December 31, 1998.
The Company's operating costs during the remaining period prior to its
planned acquisition by Temple-Inland, Inc. will most likely be inflated by
significant merger related expenses, including additional fees for investment
banker, attorney, and independent accountant services. At the same time,
revenues may be impaired due to customer and counterparty uncertainty regarding
the potential impacts of the acquisition, likely leading to continued efficiency
ratios above those of peer institutions. Management intends to communicate the
benefits arising from the acquisition. However, no assurance can be provided
concerning the nature and efficacy of such efforts.
Income Taxes
Income tax expense decreased from $515 thousand and $871 thousand
during the three and six months ended December 31, 1997 to $49 thousand and $154
thousand, respectively, during the like periods in fiscal 1999 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.
37
38
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.
38
39
Item 5. Other Information
Not applicable.
Item 6. Exhibits and Reports on Form 8-K
A. Exhibits
(27) Financial Data Schedule
B. Reports on Form 8-K
The Company filed a Form 8-K on November 30, 1998 in
conjunction with the signing of a definitive agreement to sell
the Company to Temple-Inland, Inc.
39
40
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: February 12, 1999 By: /s/ Richard S. Cupp
-------------------
Richard S. Cupp
President
Chief Executive Officer
Date: February 12, 1999 By: /s/ Mark R. Andino
------------------
Mark R. Andino
Senior Vice President
Chief Financial Officer
40