Item 1. Business
This section should be read in conjunction with the following parts of this Form 10-K: Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations," Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk" and Part II, Item 8, "Financial Statements and Supplementary Data."
The Company
HF Financial Corp., a unitary thrift holding company, was formed in November 1991 for the purpose of owning all of the outstanding stock of Home Federal Bank (the "Bank") , its principal banking subsidiary. The Company acquired all of the outstanding stock of the Bank on April 8, 1992. The Company is incorporated under the laws of the State of Delaware and generally is authorized to engage in any activity that is permitted by the Delaware General Corporation Law. Unless otherwise indicated, all matters discussed in this Form 10-K relate to the Company and its direct and indirect subsidiaries, including, without limitation, the Bank. See "Subsidiary Activities" below for further information regarding the subsidiary operations of the Company and the Bank.
The executive offices of the Company and its direct and indirect subsidiaries are located at 225 South Main Avenue, Sioux Falls, South Dakota, 57104. The Company's telephone number is (605) 333-7556.
Website and Available Information
The website for the Company and the Bank is located at www.homefederal.com. Information on this website does not constitute part of this Form 10-K.
The Company makes available, free of charge, its Form 10-K, its quarterly reports on Form 10-Q, its current reports on Form 8-K and amendments to such reports filed or furnished pursuant to Section 13(a) or 15(d) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), as soon as reasonably practicable after such forms are filed with or furnished to the SEC. Copies of these documents are available to stockholders upon request addressed to the Secretary of the Company at 225 South Main Avenue, Sioux Falls, South Dakota, 57104.
The Bank
The Bank was founded in 1929 and is a federally chartered stock savings bank headquartered in Sioux Falls, South Dakota. The Bank provides full-service consumer and commercial business banking, including an array of financial products and services, to meet the needs of its marketplace. The Bank attracts deposits from the general public and uses such deposits, together with borrowings and other funds, to originate one- to four-family residential loans, commercial business loans, agriculture loans, consumer loans, multi-family and commercial real estate loans and construction loans. The Bank's consumer direct loan portfolio includes, among other things, automobile loans, home equity loans, loans secured by deposit accounts and student loans.
Through its trust department, the Bank acts as trustee, personal representative, administrator, guardian, custodian, agent, advisor and manager for various accounts. As of June 30, 2010, the trust department of the Bank maintained approximately $84.5 million in assets under management. Wealth management has become a strategic focus of the Bank, and the Bank has added expertise in portfolio management and business development to enhance this business line to drive future growth in assets under management and fee income.
The Bank also purchases residential mortgage-backed securities and invests in U.S. Government and agency obligations and other permissible investments. The Bank receives loan servicing income on loans serviced for others and commission income from credit life insurance on consumer loans. The Bank, through its wholly-owned subsidiaries, offers annuities, mutual funds, life insurance and other financial products and services, as well as equipment leasing services.
The Bank's deposits are insured up to applicable limits by the Deposit Insurance Fund ("DIF"), which is administered by the Federal Deposit Insurance Corporation ("FDIC"), and the Bank is subject to primary regulation and examination by the Office of Thrift Supervision ("OTS").
Segments
Operating segments are defined as components of an enterprise for which separate financial information is available that is evaluated regularly by the chief operating decision makers in deciding how to allocate resources and in assessing performance. The Company's reportable segments are "banking" (including leasing activities) and "other." The "banking" segment is conducted through the Bank and Mid America Capital Services, Inc. ("Mid America Capital") and the "other" segment is composed of smaller non-reportable segments, the Company and inter-segment eliminations. For financial information by segment see Note 1 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8, "Financial Statements and Supplementary Data" of this Form 10-K.
Subsidiary Activities
In addition to the Bank, the Company had six other wholly-owned subsidiaries as of June 30, 2010: HF Financial Group, Inc. ("HF Group"), HF Financial Capital Trust III ("Trust III"), HF Financial Capital Trust IV ("Trust IV"), HF Financial Capital Trust V ("Trust V"), HF Financial Capital Trust VI ("Trust VI") and HomeFirst Mortgage Corp. (the "Mortgage Corp.").
In August 2002, the Company formed HF Group, a South Dakota corporation. HF Group previously marketed software to facilitate employee benefits administration, payroll processing and management and governmental reporting. HF Group no longer actively markets this software and had immaterial operations in 2010. Intercompany interest income is eliminated in the preparation of consolidated financial statements.
In December 2002, the Company formed Trust III, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust III.
In September 2003, the Company formed Trust IV, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust IV.
In December 2006, the Company formed Trust V, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust V.
In July 2007, the Company formed Trust VI, a Delaware corporation, for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust VI.
The Mortgage Corp., a South Dakota corporation formed in September 1994, was previously engaged in the business of originating one- to four-family residential mortgage loans, which were sold into the secondary market. The Mortgage Corp. had no activity during fiscal 2009 and fiscal 2010.
As a federally chartered thrift institution, the Bank is permitted by OTS regulations to invest up to 2% of its assets in the stock of, or loans to, service corporation subsidiaries. The Bank may invest an additional 1% of its assets in service corporations where such additional funds are used for inner-city or community development purposes. The Bank currently has less than 1% of its assets in investments in its subsidiary service corporations as defined by the OTS. In addition to investments in service corporations, the Bank is permitted to invest an unlimited amount in operating subsidiaries engaged solely in activities in which the Bank may engage directly.
The Bank has four wholly-owned subsidiaries, Hometown Investment Services, Inc. ("Hometown"), Mid America Capital Services, Inc. ("Mid America Capital"), Mid-America Service Corporation ("Mid-America") and PMD, Inc. ("PMD"). Home Federal Securitization Corp. ("HFSC") was a wholly-owned subsidiary, but was dissolved during fiscal year 2010.
Hometown, a South Dakota corporation formed in February 1951, provides financial and insurance products to customers of the Bank and members of the general public in the Bank's market area. Insurance products offered by Hometown primarily include annuities and life insurance products. Hometown obtains its funding via a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to an operating subsidiary. In June 2010, the Bank advanced $100,000 for the purchase of common stock of the subsidiary. As of June 30, 2010, there were no advances on an approved line of credit of $75,000. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.
Mid America Capital, a South Dakota corporation formed in October 1990, specializes in equipment finance leasing. Mid America Capital obtains its funding through a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to an operating subsidiary. As of June 30, 2010, Mid America Capital had advanced $8.4 million on an approved line of credit of $35.0 million with the Bank. Intercompany interest income and interest expense are eliminated in the preparation of consolidated financial statements.
Mid-America, a South Dakota corporation formed in August 1971, in the past provided residential appraisal services to the Bank and other lenders in the Bank's market. Mid-America had no activity during fiscal 2009 and fiscal 2010.
PMD, a South Dakota corporation formed in January 1992, in the past was engaged in the business of buying, selling and managing repossessed real estate properties. PMD had no activity during fiscal 2009 and fiscal 2010.
HFSC, a Delaware corporation formed in January 2003, existed for the sole purpose of buying motor vehicle installment loans from the Bank to be securitized. HFSC had no activity during fiscal 2009 and fiscal 2010 and was dissolved effective March 24, 2010.
Market Area
Based on total assets at June 30, 2010, the Bank is the largest savings association headquartered in South Dakota. The Bank has a total of 33 banking centers in its market area and one Internet branch located at www.homefederal.com. The Bank's primary market area includes communities located in eastern and central South Dakota, including the Sioux Falls metropolitan statistical area (MSA), and the cities of Pierre, Mitchell, Aberdeen, Brookings, Dakota Dunes, Watertown, and Yankton. The Bank also has a banking center in Marshall, Minnesota, which serves customers located in southwestern Minnesota. The banking center located in Dakota Dunes also serves customers located in northwestern Iowa. The Bank's primary market area features a variety of agribusiness, financial services, health care and light manufacturing firms. The Internet branch allows access to customers beyond traditional geographical areas.
Mid America Capital provides services to customers primarily in a five-state area in the upper Midwest, but originations can and have expanded nationwide based on relationships developed with existing Bank customers and other vendor relationships.
Business Strategy
The Company's business strategy is to remain a community-focused financial institution and to grow and improve its profitability by:
•Continuing to Build Out our Distribution Capabilities in our Existing Markets. The Company strives to fulfill its mission statement every day-"...to be the leading financial services provider to businesses and individuals in the communities we serve." The Company intends to increase its market share in its core market area by providing personalized banking and customized wealth management services. The Company will continue to capitalize on the economics of its market area and strive to maintain a profitable and community-focused financial institution.
•Continuing to Build our Cornerstone Banking Businesses. The Company remains focused on building its cornerstone banking businesses of personal banking, commercial and agriculture banking and wealth management services. In the past several years, the Company has made investments in its infrastructure, technology and human capital, with the specific aim to capitalize on these businesses.
•Expanding Relationships with Existing Customers and Developing Relationships with New Customers. The Company will continue to strive to fund its business through deposits within its market area, with a strategic focus on multiple-service household growth. The Company endeavors to increase existing and new customer relationships by providing individualized personal customer attention with local decision-making authority, which the Company believes positively distinguishes it from its larger, nonlocally owned competitors.
•Taking Advantage of Opportunities with Economic Recovery. The Company will continue to position itself to take advantage of appropriate growth opportunities that may arise as the national economy recovers. The Company plans to grow its lending activities through organic growth and/or, if appropriate opportunities arise, possible acquisitions of banks, thrifts and other financial services companies.
Lending Activities
The Bank originates a variety of loans including one- to four-family residential loans, commercial business loans, agriculture loans, consumer loans, multi-family and commercial real estate loans, and construction loans. Consumer loans include loans for automobile purchases, home equity and home improvement loans and student loans.
Business Banking
Commercial Business Lending. In order to serve the needs of the local business community and improve the interest rate sensitivity and yield of its assets, the Bank originates adjustable- and fixed-rate commercial loans. Interest rates on commercial business loans generally adjust or float with a designated national index plus a specified margin. The Bank's commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment and business expansion within the Bank's market area. The Bank originates commercial business loans directly and through programs sponsored by the Small Business Administration ("SBA") of which a portion of such loans are also guaranteed in part by the SBA. The Bank generally originates commercial business loans for its portfolio and retains the servicing with respect to such loans. The Bank anticipates continued expansion and emphasis of its commercial business lending, subject to market conditions and the Home Owners' Loan Act ("HOLA") restrictions. See "Regulation-Loan and Investment Powers" below for HOLA restrictions.
Commercial business loans typically are made on the basis of the borrower's ability to make repayment from the cash flow of the borrower's business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, may be dependent upon the general economic environment). The Bank's commercial business loans are typically secured by the assets of the business, such as accounts receivable, equipment and inventory. However, the collateral securing the loans may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. Whenever possible, the Bank's commercial business loans include personal guarantees of the borrowers. In addition, the loan officer may perform on-site visits, obtain financial statements and perform a financial review of the loan.
Multi-Family and Commercial Real Estate Lending. The Bank engages in multi-family and commercial real estate lending primarily in South Dakota and the adjoining Midwestern states. These lending activities may include existing property or new construction development or purchased loans, including loans to builders and developers for the construction of one- to four-family residences and condominiums and the development of one- to four-family lots.
Loans secured by multi-family and commercial real estate properties are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans. Because
payments on loans secured by multi-family and commercial real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced (for example, if leases are not obtained or renewed), the borrower's ability to repay the loan may be impaired. In addition, loans secured by property outside of the Bank's primary market area may contain a higher degree of risk due to the fact that the Bank may not be as familiar with market conditions where such property is located. The Bank does not have a material concentration of multi-family or commercial real estate loans outside of South Dakota and the adjoining Midwestern states.
The Bank presently originates adjustable-rate, short-term balloon payment, fixed-rate multi-family and commercial real estate loans. The Bank's multi-family and commercial real estate loan portfolio is secured primarily by apartment buildings and owner occupied and non-owner occupied commercial real estate. The terms of such loans are negotiated on a case-by-case basis. Commercial real estate loans generally have terms that do not exceed 25 years. The Bank has a variety of rate adjustment features, call provisions and other terms in its multi-family and commercial real estate loan portfolio. Generally, the loans are made in amounts up to 80% of the appraised value of the collateral property and with debt service coverage ratios of 115% or higher. The debt service coverage is the ratio of net cash from operations divided by payments of debt obligations. However, these percentages may vary depending on the type of security and the guarantor. Such loans provide for a negotiated margin over a designated national index. The Bank analyzes the borrower's financial condition, credit history, prior record for producing sufficient income from similar loans, and references as well as the reliability and predictability of the net income generated by the property securing the loan. The Bank generally requires personal guarantees of borrowers.
Depending on the circumstances of the security of the loan or the relationship with the borrower, the Bank may decide to sell participations in the loan. The sale of participation interests in a loan are necessitated by the amount of the loan or the limitation of loans-to-one borrower. See "Regulation-Loans-to-One Borrower" for a discussion of the loans-to-one borrower regulations. In return for servicing these loans for the participants, the Bank generally receives a fee of 0.25% to 0.38%. Also, income is received at loan closing from loan fees and discount points. Appraisals on properties securing multi-family and commercial real estate loans originated by the Bank are performed by appraisers approved pursuant to the Bank's appraisal policy.
The Bank also makes loans to developers for the purpose of developing one- to four-family lots. These loans typically have terms of one year and carry floating interest rates based on a national designated index. Loan commitment and partial release fees are charged. These loans generally provide for the payment of interest and loan fees from loan proceeds. The principal balance of these loans is typically paid down as lots are sold. Builder construction and development loans are obtained principally through continued business from developers and builders who have previously borrowed from the Bank, as well as broker referrals and direct solicitations of developers and builders. The application process includes a submission to the Bank of plans, specifications and costs of the project to be constructed or developed. These items are used as a basis to determine the appraised value of the subject property. Loans are based on the lesser of current appraised value and/or the cost of construction (land plus building), and land development loans are generally originated with a maximum loan-to-value ratio of 65% based upon an independent appraisal.
The HOLA includes a provision that limits the Bank's non-residential real estate lending to no more than four times its total capital. This maximum limitation, which at June 30, 2010 was $442.3 million, has not materially limited the Bank's lending practices.
Under HOLA, the maximum amount which the Bank may lend to any one borrower is 15% of the Bank's unimpaired capital and surplus, or $17.4 million at June 30, 2010. Loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to the same borrower if such loans are fully secured by readily marketable collateral. The Bank may request a waiver from the OTS to exceed the 15% loans-to-one borrower limitation on a case-by-case basis. See "Regulation-Loans-to-One Borrower" for more information and a discussion of the loans-to-one borrower regulations.
Construction Lending. The Bank makes construction loans to individuals for the construction of their residences, as well as loans to builders and developers for the construction of single family and multi-family residential properties, in the Bank's primary market area.
Construction loans to individuals for their residences are structured to be converted to mortgage loans at the end of the construction phase, which typically runs six to twelve months. Residential construction loans are generally underwritten pursuant to the same guidelines used for originating residential mortgage loans.
The Bank makes loans for the construction of multi-family residential properties. Such loans are generally made at adjustable- rates, which adjust periodically based on the appropriate index.
Construction loans are generally originated with a maximum loan-to-value ratio of 80%, and up to 90% on loans to individuals for construction of their residence, based upon an independent appraisal. Because of the uncertainties inherent in estimating development and construction costs and the market for the project upon completion, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, the related loan-to-value ratios and the likelihood of ultimate success of the project. Construction and development loans to borrowers other than owner occupants also involve many of the same risks discussed above regarding multi-family and commercial real estate loans and tend to be more sensitive to general economic conditions than many other types of loans.
Prior to making a commitment to fund a construction loan, the Bank requires an appraisal of the property, or, for larger projects, both an appraisal and a study of the feasibility of the proposed project. The Bank's construction loan policy provides for the inspection of properties by independent in-house and outside inspectors at the commencement of construction and prior to disbursement of funds during the term of the construction loan.
Agricultural Loans. In order to serve the needs of the local agricultural community and improve the interest rate sensitivity and yield of its assets, the Bank originates agricultural loans through its agricultural division. The agricultural division offers loans to its customers such as: (i) operating loans that are used to fund the borrower's operating expenses, which typically have a one year term and are indexed to the national prime rate; (ii) term loans on machinery, equipment and breeding stock that may have a term up to seven years and require annual payments; (iii) agricultural farmland term loans that are used to finance (or refinance) land purchases; (iv) specialized loans to fund facilities and equipment for livestock confinement enterprises; and (v) loans to fund ethanol plant development. Agriculture real estate loans typically will have personal guarantees of the borrowers, a first lien on the real estate, interest rates adjustable to the national prime rate or Treasury Note rates, and annual, quarterly or monthly payments. Operating and term loans are secured by farm chattels (crops, livestock, machinery, etc.), which are the operating assets of the borrower. The Bank also originates agricultural loans directly and through programs sponsored by the Farmers Service Agency ("FSA") of which a portion of such loans are also guaranteed in part by the FSA. The bank also provides financing for part-time farmers and their primary residences. These loans are for customers who derive the majority of their income from non-farming related sources but do derive a portion of their income from the property they are financing. These loans are typically sold to Farmer Mac with the Bank providing the ongoing servicing. For these services the Bank is paid an annual servicing fee from Farmer Mac.
Loan customers are required to supply current financial statements, tax returns and cash flow projections which are updated on an annual basis. In addition, on major loans, the loan officer will perform an annual farm visit, obtain financial statements and perform a financial review of the loan.
Mortgage Lending
One- to Four-Family Residential Mortgage Lending. One- to four-family residential mortgage loan originations are primarily generated by the Bank's marketing efforts, its present customers, walk-in customers and referrals from real estate agents and builders. The Bank has focused its lending efforts primarily on the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences.
The Bank currently makes 15-, 20- and 30-year fixed- and adjustable-rate ("ARM") one- to four-family residential mortgage loans at loan-to-value ratios consistent with Federal National Mortgage Assoc.("FNMA")/Federal Home Loan Mortgage Corp.("FHLMC") guidelines. Loan-to-values exceeding 80% are required to include private mortgage insurance in an amount sufficient to reduce the Bank's exposure at or below the 80% level. The Bank generally offers an ARM loan with a fixed rate for the initial three to five years, which then converts to a one-year annual rate reset ARM for the remainder of the life of the loan. These loans provide for an annual cap and a lifetime cap at a set percent over the fully-indexed rate.
The Bank also offers a portfolio loan product that is a seven-year balloon loan that is fully payable at the end of the balloon term.
The Bank also offers fixed-rate 15- to 30-year mortgage loans that conform to secondary market standards. Interest rates charged on these fixed-rate loans are competitively priced on a daily basis according to market conditions. Residential loans generally do not include prepayment penalties.
The Bank also originates fixed-rate one- to four-family residential mortgage loans through the South Dakota Housing Development Authority ("SDHDA") program. These loans generally have terms not to exceed 30 years and are insured by the Federal Housing Administration ("FHA"), Veterans Administration ("VA"), Rural Development or private mortgage insurance. The Bank receives an origination fee of 1% of the loan amount from the borrower and a servicing fee of generally 0.38% from the SDHDA for these services. The servicing fee rate may subsequently decline to a minimum of 0.25% based on delinquency characteristics. The Bank is the largest servicer of loans for the SDHDA. At June 30, 2010, the Bank serviced $965.8 million of mortgage loans for the SDHDA. See Note 4 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8, "Financial Statements and Supplementary Data" in this Form 10-K, for information on loan servicing.
In underwriting one- to four-family residential mortgage loans, the Bank evaluates both the borrower's ability to make monthly payments and the value of the property securing the loan. The property that secures the real estate loans made by the Bank is appraised by an appraiser approved under the Bank's appraisal policy. The Bank requires borrowers to obtain title, fire and casualty insurance in an amount not less than the amount of the loan. Real estate loans originated by the Bank contain a "due-on-sale" clause allowing the Bank to declare the unpaid principal balance due and payable upon the sale of the collateral property.
The Bank offers online mortgage capabilities through QuickClick™ Online Mortgage Solutions, a service that allows customers to check rates, research loan options and complete mortgage applications via the Bank's website. This service is currently available to branch locations in South Dakota and Minnesota.
Consumer Lending
Other Consumer Lending. The Bank's management considers its consumer loan products to be an important component of its lending strategy. Specifically, consumer loans generally have shorter terms to maturity and carry higher rates of interest than one- to four-family residential mortgage loans. In addition, the Bank's management believes that the offering of consumer loan products helps to expand and create stronger ties to its existing customer base by increasing the number of customer relationships and providing cross-marketing opportunities. The Bank ceased originations of consumer indirect automobile loans in the first quarter of fiscal year 2008 in order to pursue other lending opportunities and a re-allocation of the use of capital. The Bank also participates in Federal student loan programs, whereby loans are serviced by a third party until sold to the secondary loan market.
The Bank's consumer direct loan portfolio includes, among other types, automobile loans, home equity loans, loans secured by deposit accounts and student loans. Consumer loan terms vary according to the type of collateral, length of contract and creditworthiness of the borrower. The Bank offers both open- and closed-end credit. Overdraft lending is extended through lines of credit that are tied to a checking account. The credit lines generally bear interest at 18% and are generally limited to no more than $2,000. Loans secured by deposit accounts at the Bank are currently originated for up to 90% of the account balance (although historically the Bank has loaned up to 100% of the account balance), with a hold placed on the account restricting the withdrawal of the account balance. The interest rate on such loans is typically equal to 2% above the contract rate.
Loans secured by second mortgages, together with loans secured by all prior liens, are generally limited to a maximum of 95% of the appraised or assessed value of the property securing the loan and generally have maximum terms that do not exceed 10 years.
The underwriting standards employed by the Bank for consumer loans include an application, a determination of the applicant's payment history on other debts, and an assessment of the ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant is a primary consideration, the underwriting process also includes a comparison of the value of the security, if any, in relation to the proposed loan amount.
Consumer loans may entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or are secured by rapidly depreciable assets, such as automobiles or boats. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans.
Leasing Activities
General. Through its wholly owned subsidiary, Mid America Capital, the Bank originates commercial and municipal leases. These products have a fixed interest rate for the duration of the lease with terms typically ranging from 24 to 60 months. The leases generally are 100% financed with either the first or first and last months' payments due at lease inception. As a result of the 100% financing and fixed interest rate, the yield on leases is higher than similar type lending products.
Leases are originated generally in the Bank's trade area in the upper Midwest. All leases are secured by the equipment leased, with personal guarantees of the borrowers normally obtained on commercial leases.
Commercial Leases. In order to support the Bank and its customers and to improve the yield of its assets, Mid America Capital originates commercial leases to customers primarily in the Bank's trade
area. Mid America Capital basically offers two types of commercial leases: capital and tax leases. Leases encompass a wide variety of equipment for a variety of commercial uses. The customer base tends to be small- to medium-sized businesses that view leasing as another financing option that augments their overall operation. Repayment terms tend to be monthly in nature. As with commercial loans, commercial leases typically are made on the basis of the borrower's ability to make repayment from the cash flow of their business. As a result, the availability of funds for the repayment of commercial leases may be substantially dependent on the success of the business itself. The collateral securing the leases will generally depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business.
Municipal Leases. The Bank and Mid America Capital also originate leases to municipal entities such as cities, counties, and public schools. The lessee must be a political subdivision of the state in order to qualify as a municipal lease. Because the interest income earned on this type of lease is exempt from federal income taxes, the rate offered to the municipality is usually substantially lower than a comparable commercial lease. Repayment terms generally are on a monthly, semi-annual or annual basis. Residual values are $1.00 for municipal leases.
Repayment is based on the municipality's ability to levy and collect taxes. Assuming the municipality has a bond rating, that bond rating, together with audited financial statements, are the basis for the lease. On larger leases, bond ratings and financial statements will be reviewed annually.
Loan and Lease Portfolio Composition. Over the past several years, the Company has transformed its loan and lease portfolio from predominantly one-to four-family residential and consumer loans to a more diverse portfolio including commercial and agriculture loans. As part of the Company's business strategy to build its commercial and agriculture loan portfolio, the Bank has hired several bankers with significant commercial and agriculture lending experience, which has led to successful growth results across these business lines. The Company's commercial and agricultural loan portfolio has increased to 67.29% of the Company's total loan and lease portfolio at June 30, 2010 from 65.04% at June 30, 2009, while its one- to- four family residential and consumer loan portfolio has decreased to 23.32% of its total loan and lease portfolio from 26.20% over that period. At the same time, the Company continues to prioritize and invest in mortgage lending as it believes this to be a core component of its personal banking strategy.
The following table sets forth information concerning the composition of the Company's loan and lease portfolio from continuing operations in dollar amounts and in percentages (before deductions for the undisbursed portion of loans in process, deferred fees and discounts and allowance for losses) as of the dates indicated.
(1)Includes one- to four-family loans held for sale.
(2)Includes tax-exempt loans and leases.
(3)Includes commercial loans held for sale.
(4)Includes student loans held for sale.
The following table sets forth the composition of the Company's loan and lease portfolio from continuing operations by fixed- and adjustable-rate in dollar amounts and in percentages (before deductions for the undisbursed portion of loans in process, deferred fees and discounts and allowance for losses) as of the dates indicated. Adjustable-rate loans are tied to various indices including prime rate and the treasury yield curve and have reset dates ranging from daily to several years.
(1)Includes one- to four-family loans held for sale.
(2)Includes tax-exempt loans and leases.
(3)Includes commercial loans held for sale.
(4)Includes student loans held for sale.
The following schedule illustrates the scheduled principal contractual repayments of the Company's loan and lease portfolio at June 30, 2010. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.
(1)Includes one- to four-family loans held for sale.
(2)Includes demand loans, loans having no stated maturity, student loans held for sale and overdraft loans.
(3)Includes equipment finance leases and tax-exempt leases.
Scheduled contractual principal repayments of loans do not reflect the actual life of such assets. The average life of loans is substantially less than their average contractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give the Bank the right to declare a conventional loan immediately due and payable in the event, among other things, that the borrower sells the real property subject to the mortgage and the loan is not repaid. The average life of mortgage loans tends to increase when current mortgage loan rates are substantially higher than rates on existing mortgage loans and decrease when rates on existing mortgages are substantially higher than current mortgage loan rates.
The following table sets forth the composition of the Company's deferred fees and discounts on loans as of the dates indicated.
Deferred fees and discounts on loans and leases have trended to a net deferred cost position. In fiscal year 2010, the net deferred fees and discounts on loans and leases decreased by $190,000. This decrease was primarily due to a $155,000 reduction in dealer reserve, as a result of lower indirect automobile loan balances as the Company ceased consumer indirect loan originations in the first quarter of fiscal year 2008.
Potential Problem Loans
Nonperforming Assets. See "Asset Quality" under Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K for discussion.
Classified Assets. Federal regulations provide for the classification of loans, leases and other assets, such as debt and equity securities considered by the OTS to be of lesser quality, as "substandard," "doubtful" or "loss." An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the Company will sustain "some loss" if the deficiencies are not corrected. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified as "loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. Assets which do not currently expose the Company to sufficient risk to warrant classification in one of the aforementioned categories, but possess weaknesses, are required to be designated "criticized" or "special mention" by management.
When the Company classifies problem assets as "loss," it is required either to establish a specific allowance for losses equal to 100% of that portion of the asset so classified or to charge-off such amount. The Company's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Bank's Regional Director at the regional OTS office, who may order the establishment of additional general or specific loss allowances.
In connection with the filing of its periodic reports with the OTS and in accordance with its classification of assets policy, the Company regularly reviews problem loans and leases in its portfolio to determine whether any loans or leases require classification, as well as investment securities, in accordance with applicable regulations. On the basis of management's monthly review of its assets, at June 30, 2010, the Company had designated $50.7 million of its assets as special mention and $38.9 million of its assets as classified. Other potential problem loans are included in criticized and classified assets. See "Asset Quality" under Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K for further discussion.
Allowance for Loan and Lease Losses. See "Application of Critical Accounting Policies" and "Asset Quality" under Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K for discussion.
Investment Activities
The Bank is required under OTS regulation to maintain a sufficient amount of liquid assets. Liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the return on loans.
Federally chartered savings institutions have the authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers' acceptances, repurchase agreements and federal funds. Subject to various restrictions, federally chartered savings institutions may also invest their assets in commercial paper, investment grade corporate debt securities and mutual funds whose assets conform to the investments that a federally chartered savings institution is otherwise authorized to make directly.
Generally, the investment policy of the Bank is to invest funds among various categories of investments and maturities based upon the Bank's asset/liability management policies, investment quality and marketability, liquidity needs and performance objectives. At June 30, 2010, approximately 89.6% of our investment portfolio was in AAA-rated, liquid residential mortgage-backed securities.
At June 30, 2010, the Company's investments in residential mortgage-backed securities totaled $241.5 million, or 19.3% of its total assets, and does not consist of any private-label securities. As of
such date, the Bank also had a $10.3 million investment in the stock of the Federal Home Loan Bank of Des Moines ("FHLB" or "FHLB of Des Moines") in order to satisfy the FHLB of Des Moines' requirement for membership.
The composition and maturities of the investment securities portfolio, excluding equity securities, are indicated in the following table.
The effective maturities for the Bank's residential mortgage-backed securities are much shorter due to the combination of prepayments and the variable-rate nature of $224.6 million of residential mortgage-backed securities. The variable or hybrid (fixed for a period of time and then variable thereafter) structure gives the Bank flexibility in risk management of the balance sheet.
Management has implemented a process to identify securities that could potentially have a credit impairment that is other-than-temporary. This process involves evaluation of the length of time and extent to which the fair value has been less than the amortized cost basis, review of available information regarding the financial position of the issuer, monitoring the rating of the security, cash flow projections, and the Company's intent to sell a security or whether it is more likely than not we will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity. To the extent we determine that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized. In fiscal year 2010, the other than temporary impairment losses taken against the pooled trust preferred securities was $2.2 million. In addition, $460,000 was recognized on the balance sheet in other comprehensive income resulting in $2.7 million of credit loss recognized through earnings.
In fiscal year 2009, the total other-than-temporary impairment losses taken against the pooled trust preferred securities was $3.9 million, of which $3.5 million was recognized on the balance sheet in other comprehensive income with $397,000 of credit loss recognized through earnings. Additionally, the Company recorded a net impairment loss of $8,000 attributed to Fannie Mae common stock held in the investment securities portfolio. No other-than-temporary impairments were recorded against earnings during fiscal years 2008 or 2007. See Note 1, "Summary of Significant Accounting Policies," and Note 2, "Investment Securities," of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 of this Form 10-K for additional information.
The Bank's investment securities portfolio is managed in accordance with a written investment policy adopted by the Bank's Board of Directors. Investments may be made by the Bank's officers within specified limits and approved in advance by the Bank's chief executive officer or president for transactions over these limits. At the present time, the Bank does not have any investments that are held for trading purposes. At June 30, 2010, the Company had $264.4 million of securities available for sale, including residential mortgage-backed securities of $241.5 million. See Note 2 of "Notes to
Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for further information on the Company's investment portfolio.
Sources of Funds
General. The Company's primary sources of funds are earnings, in-market deposits, FHLB advances and other borrowings, amortization and repayments of loan principal, residential mortgage-backed securities and callable agency securities. Secondary sources include sales of mortgage loans, sales and/or maturities of securities, out-of-market deposits and short-term investments.
Borrowings of the Bank are primarily from the FHLB of Des Moines, and may be used on a short-term basis to compensate for seasonal reductions in deposits or deposit inflows at less than projected levels, and may be used on a longer-term basis to support expanded lending activities. The Bank has established collateral at the Federal Reserve Bank ("FRB") as a contingent source of funding. See Note 7 of the "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for further detail of the Company's borrowings.
Deposits. The Bank offers a variety of deposit accounts having a wide range of interest rates and terms. The Bank's deposits consist of statement savings accounts, checking accounts, money market and certificate of deposit accounts ranging in terms from 30 days to five years. The Bank primarily solicits deposits from its market area, with a strategic focus of multiple-service household growth. The Bank relies primarily on customer service, competitive pricing policies and advertising to attract and retain these deposits. Based on liquidity needs, the Bank may, from time to time, acquire out-of-market deposits in those circumstances where wholesale funding offers either a maturity or cost efficiency not available with retail deposits. At June 30, 2010, out-of-market deposits accounted for less than 3% of total deposits.
The flow of deposits is influenced by general economic conditions, changes in money market and prevailing interest rates and competition. The variety of deposit accounts offered by the Bank has allowed it to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. In recent years, the Bank has become more susceptible to short-term fluctuations in deposit flows as customers have become more interest rate conscious. The Bank manages the pricing of its deposits in keeping with its asset/liability management and profitability objectives. Based on its experience, the Bank believes that its savings, money market, and checking accounts are stable sources of deposits. However, the ability of the Bank to attract and maintain certificates of deposit, and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions.
The following table sets forth the dollar amount of deposits in the various types of deposit accounts offered by the Bank as of the dates indicated.
The following table sets forth the amount of the Company's certificates of deposit and other deposits by time remaining until maturity as of June 30, 2010.
(1)Includes funds from the Certificate of Deposit Account Registry Service ("CDARS") certificate of deposit program of $33.2 million.
(2)Includes certificates of deposit of $100,000 or greater of $22.3 million.
(3)Includes certificates of deposit from governmental and other public entities, excluding out-of-market certificates of deposit.
(4)Includes certificates of deposit of $100,000 or greater of $50.4 million.
The Bank solicits certificates of deposit of $100,000 or greater from various state, county and local government units which carry rates which are negotiated at the time of deposit. See Note 6 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K. Deposits at June 30, 2010, and 2009 included $89.4 million and $78.1 million, respectively, of deposits from one local governmental entity, the majority of which are savings account balances.
Borrowings. Although deposits are the Bank's primary source of funds, the Bank's policy has been to utilize borrowings when they are a less costly source of funds or can be invested at a positive rate of return.
The Bank's borrowings consist primarily of advances from the FHLB of Des Moines upon the security of its capital stock of the FHLB of Des Moines and certain pledgeable loans, including but not limited to, its mortgage related loans, residential mortgage-backed securities and U.S. Government and other agency securities. Such advances can be made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. At June 30, 2010, the Bank's FHLB advances totaled $190.5 million, representing 16.4% of total liabilities.
The Company has a line of credit for $6.0 million with United Bankers' Bank for liquidity needs, but did not have any outstanding advances at June 30, 2010. The Company pledged 100% of the stock of the Bank as collateral on the line of credit. The Company had a line of credit for $6.0 million with First Tennessee Bank, NA at June 30, 2009, and had outstanding advances of $5.5 million at June 30, 2009. The line of credit matured on September 30, 2009. See Note 7 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for further detail of the Company's borrowings.
The following table sets forth the maximum month-end balances and average balances of FHLB and FRB advances and other borrowings of the Company at the dates indicated.
The following table sets forth certain information as to the Bank's FHLB and FRB advances and other borrowings of the Company at the dates indicated.
Competition
The banking business is highly competitive and the Bank experiences competition in each of its markets from many other financial institutions, many of which are larger and may have significantly greater financial and other resources. Specifically, the Bank competes with commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions, that operate offices in the Company's primary market areas and elsewhere. Many of these competitors are also well-established financial institutions.
Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to the Bank. The Bank competes with these institutions both in attracting deposits and in making loans. The Bank competes for deposits by offering a variety of deposit accounts at competitive rates, convenient business hours and convenient branch locations with inter-branch deposit and withdrawal privileges at each. The Bank competes for loans on the basis of quality of service, interest rates, loan fees and loan type. In addition, the Bank must attract its customer base from other existing financial institutions and from new residents. In new markets that the Bank may enter, the Bank will also compete against well-established community banks that have developed relationships within the community.
Employees
At June 30, 2010, the Bank had a total of 308 full-time employees and 49 part-time employees. The full-time employees include 7 employees of the Bank's subsidiary corporations. The Bank's employees are not represented by any collective bargaining group. Management considers its relations with its employees to be good.
Regulation
General
The Bank is a federally chartered thrift institution, the deposits of which are federally insured by the FDIC under the DIF. Accordingly, the Bank is subject to broad federal regulation and oversight extending to all of its operations by its primary federal regulator, the OTS, and by its deposit insurer, the FDIC. Such regulation covers all aspects of the banking business, including lending practices, safeguarding deposits, capital structure, transactions with affiliates and conduct and qualifications of personnel. The Bank is a member of the Federal Home Loan Bank of Des Moines ("FHLB" or "FHLB of Des Moines") and is subject to certain limited regulation by the Federal Reserve Board ("FRB"). As the unitary thrift holding company of the Bank, we are also subject to federal regulation and oversight by the OTS.
The purpose of the regulation of us, like other depository institution holding companies, is to protect subsidiary institutions where deposits are federally insured and their depositors. As discussed below, under recently enacted financial reform legislation known as The Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), the OTS will be abolished 90 days after the formal transfer of its supervisory and rulemaking functions to various federal agencies in July 2011 (or else by January 2012 if a six-month extension is required). Accordingly, both the Company and Bank will be transitioning to the jurisdiction of new primary federal regulators. The primary regulator of the Company will be the FRB and the primary regulator of the Bank will be the Comptroller of the Currency.
Certain of these regulatory requirements and restrictions are discussed below or elsewhere in this Form 10-K. The following discussion is intended to be a summary of the material statutes, regulations and policies applicable to savings associations and their holding companies, and is not intended to be a complete discussion of all such statutes, regulations and policies.
Regulation of Federal Savings Associations
The OTS has extensive authority over the operations of federal savings associations, such as the Bank. This regulation and supervision establishes a comprehensive framework for activities in which a federal savings association can engage and is intended primarily for the protection of the DIF and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in such laws and regulations or interpretations thereof, whether by the OTS, the FDIC or through legislation, could have a material adverse impact on the Bank and its operations and on us and our stockholders.
The Bank is required to file periodic reports with the OTS and is subject to periodic examinations primarily by the OTS and to a lesser extent by the FDIC.
Business Activities
The activities of federal savings associations are generally governed by federal laws and regulations. These laws and regulations delineate the nature and extent of the activities in which federal savings associations may engage. In particular, many types of lending authority for federal savings associations are limited to a specified percentage of the institution's capital or assets.
However, as discussed below, the Dodd-Frank Act will significantly impact the availability of federal preemption of state consumer laws to federal savings associations and their subsidiaries.
Loan and Investment Powers
The Bank derives its lending and investment powers from the HOLA and the regulations of the OTS thereunder. Under these laws and regulations, the Bank may invest in mortgage loans secured by residential and commercial real estate, commercial and consumer loans, certain types of debt securities and certain other assets. The Bank may also establish service corporations that may engage in activities not otherwise permissible for the Bank, including certain real estate equity investments and securities and insurance brokerage activities. These investment powers are subject to various limitations, including (i) a prohibition against the acquisition of any corporate debt security that is not rated in one of the four highest rating categories; (ii) a limit of 400% of an association's capital on the aggregate amount of loans secured by non-residential real estate property; (iii) a limit of 20% of an association's assets on the aggregate amount of commercial and agricultural loans and leases with the amount of commercial loans in excess of 10% of assets being limited to small business loans; (iv) a limit of 35% of an association's assets on the aggregate amount of secured consumer loans and acquisitions of certain debt securities, with amounts in excess of 30% of assets being limited to loans made directly to the original obligor and where no third-party finder or referral fees were paid; (v) a limit of 5% of assets on non-conforming loans (loans in excess of the specific limitations of the HOLA); and (vi) a limit of the greater of 5% of assets or an association's capital on certain construction loans made for the purpose of financing what is or is expected to become residential property. In addition, the HOLA and the OTS regulations provide that a federal savings association may invest up to 10% of its assets in tangible personal property for leasing purposes. At June 30, 2010, the Bank met the 10% leasing limitation with 0.83% of total Bank assets. Such general leases, however, do not have to be aggregated with the institution's loans for purposes of the HOLA's investment and lending limitations. At June 30, 2010, the Bank met the 20% limitation on commercial and agricultural loans and leases with such loans and leases equal to 15.17% of total Bank assets.
Loans-To-One Borrower
Under the HOLA, the Bank is generally subject to the same limits on loans-to-one borrower as are imposed on national banks. With specified exceptions, the Bank may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of the association's unimpaired capital and surplus. Additional amounts may be loaned, not in excess of 10% of unimpaired capital and surplus, if such loans or extensions of credit are fully secured by readily-marketable collateral. At June 30, 2010, the Bank's lending limit under this restriction was $17.4 million.
Assessments
The OTS has established a schedule for the assessment of fees upon all savings associations to fund the operations of the OTS. The general assessment, paid on a semiannual basis, is computed by totaling three components: the Bank's total assets, supervisory condition and complexity of operations. The Bank's OTS assessment (standard assessment) for the fiscal year ended June 30, 2010, was approximately $265,000.
Enforcement
The OTS has primary enforcement responsibility over federal savings associations, including the Bank. In general, these enforcement actions may be initiated in response to violations of laws and regulations and to unsafe or unsound practices and can result in, among other things, assessments of civil money penalties, issuance of cease and desist orders and removal of directors and officers. Under the Federal Deposit Insurance Act, the FDIC has the authority to recommend to the Director of the OTS that an enforcement action be taken with respect to a particular savings association. If action is not taken by the OTS, the FDIC may take action under certain circumstances.
Safety and Soundness Standards
Under federal law, the OTS has adopted a set of guidelines prescribing safety and soundness standards. The guidelines establish general standards relating to internal controls, information systems, internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director or principal stockholder.
In addition, the OTS adopted regulations that authorize the OTS to order a bank that has been given notice by the OTS that it is not satisfying applicable safety and soundness standards to submit a compliance plan. If, after being so ordered, a bank fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the OTS must issue an order directing action to correct the deficiency and may issue an order directing corrective actions and other actions of the types to which an undercapitalized association is subject under the "prompt corrective action" provisions of federal law. If a bank fails to comply with such an order, the OTS may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Prompt Corrective Action Regulations
Under the OTS prompt corrective action regulations, the OTS is required to take certain, and is authorized to take other, supervisory actions against undercapitalized banks. For this purpose, a bank is placed in one of the following five categories based on the association's capital:
•well-capitalized;
•adequately capitalized;
•undercapitalized;
•significantly undercapitalized; or
•critically undercapitalized.
The severity of the action authorized or required to be taken under the prompt corrective action regulations increases as a bank's capital decreases within the three undercapitalized categories. All banks are prohibited from paying dividends or other capital distributions or paying management fees to any controlling person if, following such distribution, the bank would be undercapitalized. The OTS is required to monitor closely the condition of an undercapitalized bank and to restrict the growth of its assets.
An undercapitalized bank is required to file a capital restoration plan within 45 days of the date the bank receives notice that it is within any of the three undercapitalized categories, and the plan must be guaranteed by any parent holding company. The aggregate liability of a parent holding company is limited to the lesser of:
•an amount equal to five percent of the bank's total assets at the time it became "undercapitalized;" and
•the amount that is necessary (or would have been necessary) to bring the bank into compliance with all capital standards applicable with respect to such bank as of the time it fails to comply with the plan.
If a bank fails to submit an acceptable plan, it is treated as if it were "significantly undercapitalized." Banks that are "significantly" or "critically undercapitalized" are subject to a wider
range of regulatory requirements and restrictions. Under the OTS regulations, a federal savings association is generally treated as "well-capitalized" if its total risk-based capital ratio is 10% or greater, its Tier 1 risk-based capital ratio is 6% or greater, its leverage ratio is 5% or greater, and it is not subject to any order or directive by the OTS to meet a specific capital level.
At June 30, 2010, the Bank met the criteria for being considered "well-capitalized."
Federal Deposit Insurance of Accounts and Regulation by the FDIC
The Bank is a member of, and pays deposit insurance assessments to, the DIF, which is administered by the FDIC. Effective April 1, 2006, through the Federal Deposit Insurance Reform Act of 2005, the maximum insurance coverage for self-directed retirement plan deposits increased from $100,000 to $250,000 permanently. Under the Dodd-Frank Act, all other deposits of the Bank are permanently insured up to $250,000 per depositor for each account ownership category (prior to the legislation, the increased insurance coverage from $100,000 to $250,000 was temporary until December 31, 2013). FDIC insurance of deposits is backed by the full faith and credit of the U.S. government. As the insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the DIF. The FDIC also has the authority to initiate enforcement actions against savings associations, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged or is engaging in unsafe or unsound practices, or is in an unsafe or unsound condition.
The DIF was formed on March 31, 2006, following the merger of the Bank Insurance Fund and the Savings Association Insurance Fund in accordance with the Federal Deposit Insurance Reform Act of 2005 (the "Deposit Insurance Fund Act"). In addition to merging the insurance funds, the Deposit Insurance Fund Act established a statutory minimum and maximum designated reserve ratio for the DIF and granted the FDIC greater flexibility in establishing the required reserve ratio. The Dodd-Frank Act provides for an increase in the minimum designated reserve ratio for the DIF from 1.15% to 1.35% of insured deposits, which much be reached by September 30, 2020, and provides that in setting the assessments necessary to meet the new requirement, the FDIC shall offset the effect of this provision on insured depository institutions with total consolidated assets of less than $10 billion, so that more of the cost of raising the reserve ratio will be borne by the institutions with more than $10 billion.
In order to maintain the DIF, member institutions are assessed an insurance premium. The amount of each institution's premium is generally based on the balance of insured deposits and the degree of risk the institution poses to the DIF. Under the assessment system, the FDIC assigns an institution to one of four risk categories, with the first category having two sub-categories based on the institution's most recent supervisory and capital evaluations, designed to measure risk. In October 2008, the FDIC proposed raising assessment rates to implement a Restoration Plan for the DIF, which had fallen significantly below the then-applicable minimum target level of 1.15% as a result of recent bank failures. On February 27, 2009, the FDIC approved an amended Restoration Plan, under which the FDIC implemented an assessment rate schedule to raise the DIF reserve ratio to 1.15% within seven years. Pursuant to the Plan, the FDIC implemented a final rule that set assessment rates and made adjustments based on risk. Under the final rule, banks in the lowest risk category were required to pay initial base rates ranging from 12 basis points to 16 basis points of assessable deposits on an annual basis, beginning on April 1, 2009 (applicable to assessments for the second quarter of 2009 and thereafter), subject to further adjustment for banks holding unsecured debt, certain secured liabilities and brokered deposits beyond a certain amount. Banks in the highest risk category were required to pay an initial base rate of 45 basis points of assessable deposits, which may also be adjusted to between 40 basis points and 77.5 basis points of assessable deposits for excess amounts of unsecured debt,
certain secured liabilities and brokered deposits. The FDIC also reserved the right to adjust the assessment rate schedule from quarter to quarter. On May 22, 2009, the Board of Directors of the FDIC adopted a final rule establishing a special assessment of five basis points on each FDIC-insured depository institution's assets, minus its Tier 1 capital, as of June 30, 2009. The special assessment of $538,000 was collected on September 30, 2009. The FDIC is authorized to raise the assessment rates as necessary to maintain the DIF and has authority to declare additional special assessments. In addition, on November 12, 2009, the FDIC Board approved a rule requiring prepayment of the quarterly assessments for the fourth quarter of calendar 2009, and the entire calendar years of 2010, 2011, and 2012. On December 30, 2009, the Company paid $4.9 million which was recorded as a prepaid asset and will be proportionally expensed over future periods. At June 30, 2010, the remaining balance recorded as a prepaid asset was $3.7 million. The FDIC may impose additional special assessments which would be recorded as they are incurred.
The Deposit Insurance Fund Act allows "eligible insured depository institutions" to share a one-time assessment credit pool of approximately $4.7 billion. To be eligible, an institution must have been in existence on December 31, 1996 and have paid a deposit insurance assessment prior to that date, or be a "successor" to such an institution. The Bank's remaining assessment credit of $114,000 at June 30, 2008, was applied to reduce deposit insurance assessments during the first and second quarters of fiscal year 2009.
In addition, all FDIC-insured institutions are required to pay assessments to the FDIC at an annual rate of approximately 0.0124% of insured deposits to fund interest payments on bonds issued by the Financing Corporation ("FICO"), an agency of the federal government established in 1987 to recapitalize the predecessor to the DIF. These assessments, which are adjusted quarterly, will continue until the FICO bonds mature in 2017 through 2019.
The Bank's assessment rate for the fiscal year ending June 30, 2010, was 0.1404% and the premium paid for Fiscal 2010 was $1.3 million. The FDIC has authority to increase insurance assessments. A significant increase in DIF insurance premiums would have an adverse effect on the operating expenses and results of operations of the Bank. Management cannot predict what the insurance assessment rate will be in the future.
Under federal law, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. The management of the Bank does not know of any practice, condition or violation that might lead to termination of deposit insurance.
Regulatory Capital Requirements
OTS regulations require the Bank to meet three minimum capital standards:
•a tangible capital ratio requirement of 1.50%;
•a leverage (core capital) ratio requirement of 4% (3% if a savings association has been assigned the highest composite rating); and
•a risk-based capital ratio requirement of 8%.
In assessing an institution's capital adequacy, the OTS takes into consideration not only these numeric factors but also qualitative factors and has the authority to establish higher capital requirements for individual institutions where necessary. The Bank, as a matter of prudent management, targets as its goal the maintenance of capital ratios which exceed these minimum requirements and that are consistent with the Bank's risk profile.
At June 30, 2010, the Bank exceeded each of its capital requirements as shown in the following table:
(1)The Bank's investment in its subsidiaries is included for purposes of calculating regulatory capital.
(2)Tier I (core) capital figures are determined as a percentage of total adjusted assets; risk based capital figures are determined as a percentage of risk-weighted assets.
The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") required that the OTS and other federal banking agencies revise their risk-based capital standards to ensure that they take into account interest rate risk, concentration of risk and the risks of non-traditional activities. The OTS monitors the interest rate risk of individual institutions through (i) the OTS requirements for interest rate risk management, (ii) the ability of the OTS to impose individual minimum capital requirements on institutions that exhibit a high degree of interest rate risk, and (iii) regulatory requirements that provide guidance on the management of interest rate risk and outline the responsibility of boards of directors in that area.
The OTS monitors the interest rate risk of individual institutions through analysis of the change in net portfolio value, or NPV. NPV is defined as the net present value of an institution's existing assets, liabilities, and off-balance sheet contracts and, therefore, hypothetically represents the value of an institution's net worth. The OTS has also used this NPV analysis as part of its evaluation of certain applications or notices submitted by savings associations. The OTS, through its general oversight of the safety and soundness of savings associations, retains the right to impose minimum capital requirements on individual institutions to the extent the institution is not in compliance with certain written guidelines established by the OTS regarding NPV analysis. The OTS has not imposed any such requirements on the Bank.
Limitations on Dividends and Other Capital Distributions
The OTS imposes various restrictions or requirements on the Bank's ability to make capital distributions, including cash dividends. A savings institution that is the subsidiary of a savings and loan holding company must file a notice with the OTS at least 30 days before making a capital distribution.
The OTS may disapprove of a notice or application if:
•the Bank would be undercapitalized following the distribution;
•the proposed capital distribution raises safety and soundness concerns; or
•the capital distribution would violate a prohibition contained in any statute, regulation or agreement between the Bank and the OTS or the FDIC, or a condition imposed on the Bank in an OTS-approved application or notice.
During the fiscal year ended June 30, 2010, the Bank paid cash dividends to the Company totaling $2.5 million.
Liquidity
All savings associations, including the Bank, are required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation. For a discussion of what the Bank includes in liquid assets, see Part II, Item 7 "Management's Discussion and Analysis of Financial Condition and Results of Operations" of this Form 10-K.
Branching
Subject to certain limitations, the HOLA and the OTS regulations permit federally chartered savings associations to establish branches in any state of the United States. The authority to establish such branches is available (i) if the law of the state in which the branch is located, or is to be located, would permit establishment of the branch if the savings association were a state savings association chartered by such state or (ii) if the association qualifies as a "domestic building and loan association" under the Internal Revenue Code of 1986, as amended, which imposes qualification requirements similar to those for a "qualified thrift lender" under the HOLA. See the section below entitled "-Qualified Thrift Lender Test." The branching authority under the HOLA and the OTS regulations preempts any state law purporting to regulate branching by federal savings associations.
Community Reinvestment
Under the Community Reinvestment Act("CRA") as implemented by OTS regulations, the Bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community. The CRA requires the OTS, in connection with its examination of a savings association, to assess the Bank's record of meeting the credit needs of its community and to take such record into account in its evaluation of certain regulatory applications by the Bank. The CRA also requires all institutions to make public disclosure of their CRA ratings. The Bank received an "Outstanding" CRA rating in the OTS evaluation, which was last completed on May 29, 2008.
The CRA regulations rate an institution based on its actual performance in meeting community needs. In particular, the rating system focuses on three tests: (i) a lending test, to evaluate the institution's record of making loans in its assessment areas; (ii) an investment test, to evaluate the institution's record of investing in community development projects, affordable housing, and programs benefiting low or moderate income individuals and businesses; and (iii) a service test, to evaluate the institution's delivery of services through its branches, automated teller machines ("ATMs") and other offices.
Qualified Thrift Lender Test
Under the HOLA, the Bank must comply with the qualified thrift lender test("QTL test"). Under the QTL test, the Bank is required to maintain at least 65% of its "portfolio assets" (total assets less (i) specified liquid assets up to 20% of total assets, (ii) intangibles, including goodwill, and (iii) the value of property used to conduct business) in certain "qualified thrift investments" (primarily residential mortgages and related investments, including certain mortgage-backed securities, credit card
loans, student loans and small business loans) in at least nine months of the most recent 12-month period. The Bank may also satisfy the QTL test by qualifying as a "domestic building and loan association" as defined in the Internal Revenue Code of 1986, as amended.
At June 30, 2010, the Bank held 72.23% of its portfolio assets in qualified thrift investments and had more than 65% of its portfolio assets in qualified thrift investments in 12 of the 12 months during the fiscal year ended June 30, 2010, and thus qualified under the QTL test. The Bank has met the QTL test since its inception.
A savings association that fails the QTL test and is unable to demonstrate a reasonable likelihood of meeting it in the future may be required to convert to a bank charter and will generally be prohibited from: (i) engaging in any new activity not permissible for a national bank, (ii) paying dividends not permissible under national bank regulations, and (iii) establishing any new branch office in a location not permissible for a national bank. In addition, if the institution does not re-qualify under the QTL test within three years after failing the test, the institution would be prohibited from engaging in any activity not permissible for a national bank and may have to repay any outstanding advances from the Federal Home Loan Bank as promptly as possible.
Transactions with Affiliates and Insiders
The Bank's authority to engage in transactions with its "affiliates" is limited by the OTS regulations, Sections 23A and 23B of the Federal Reserve Act("FRA") Regulation W issued by the FRB and Section 11 of the HOLA as well as any additional limitations adopted by the OTS. OTS regulations regarding transactions with affiliates generally conform to Regulation W. These provisions, among other things, prohibit or limit a savings association from extending credit to, or entering into certain transactions with, its affiliates.
Under the restrictions on transactions with affiliates, the aggregate amount of covered transactions with any individual affiliate is limited to 10% of the unimpaired capital and surplus of the savings association. The aggregate amount of covered transactions with all affiliates is limited to 20% of the savings association's unimpaired capital and surplus. Loans and other specified transactions with affiliates are required to be secured by collateral in an amount and of a type described in federal law. The purchase of low-quality assets from affiliates is permitted only under certain circumstances. Transactions with affiliates must be on terms and under circumstances that are at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliates.
In addition, the OTS regulations include additional restrictions on savings associations under Section 11 of the HOLA, including provisions prohibiting a savings association from making a loan to an affiliate that is engaged in activities that are not permitted for bank holding companies under the Bank Holding Company Act and provisions prohibiting a savings association from purchasing or investing in securities issued by an affiliate that is not a subsidiary. OTS regulations also include certain specific exemptions from these prohibitions. The FRB and the OTS require each depository institution that is subject to Sections 23A and 23B to implement policies and procedures to ensure compliance with Regulation W and the OTS regulations regarding transactions with affiliates.
The Bank's authority to extend credit to its directors, executive officers and principal shareholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the FRA and Regulation O of the FRB, as made applicable to federal savings associations by the HOLA and the OTS regulations. Among other things, these provisions require that extensions of credit to insiders:
•be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with third parties
and that do not involve more that the normal risk of repayment or present other features that are unfavorable to the Bank; and
•not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of the Bank's capital.
In addition, extensions for credit in excess of certain limits must be approved by the Bank's board of directors.
Section 402 of the Sarbanes-Oxley Act of 2002, or the Sarbanes-Oxley Act, prohibits the extension of personal loans to directors and executive officers of issuers (as defined in the Sarbanes-Oxley Act). The prohibition, however, does not apply to mortgages advanced by an insured depository institution, such as the Bank, that are subject to restrictions on transactions with insiders under Section 22(h) of the FRA.
Real Estate Lending Standards
The OTS and the other federal banking agencies adopted regulations to prescribe standards for extensions of credit that (i) are secured by real estate or (ii) are made for the purpose of financing the construction of improvements on real estate. The OTS regulations require the Bank to establish and maintain written internal real estate lending standards that are consistent with safe and sound banking practices and appropriate to the size of the association and the nature and scope of its real estate lending activities. The standards also must be consistent with accompanying OTS guidelines, which include loan-to-value ratios for the different types of real estate loans. The Bank is also permitted to make a limited amount of loans that do not conform to the proposed loan-to-value limitations so long as such exceptions are reviewed and justified appropriately. The guidelines also list a number of lending situations in which exceptions to the loan-to-value standards are justified. The Bank has established and implemented these required policies regarding real estate lending activities.
Nontraditional Mortgage Products
The federal banking agencies have published final guidance for institutions that originate or service nontraditional or alternative mortgage products, defined to include all residential mortgage loan products that allow borrowers to defer repayment on principal or interest, such as interest-only mortgages and payment option adjustable-rate mortgages.
Recognizing that alternative mortgage products expose institutions to increased risks as compared to traditional loans where payments amortize or reduce the principal amount, the guidance required increased scrutiny for alternative mortgage products. Institutions that originate or service alternative mortgages should have (i) strong risk management practices that include maintenance of capital levels and allowance for loan losses commensurate with the risk; (ii) prudent lending policies and underwriting standards that address a borrower's repayment capacity; and (iii) programs and practices designed to ensure that consumers receive clear and balanced information to assist in making informed decisions about mortgage products. The guidance also recommends heightened controls and safeguards when an institution combines an alternative mortgage product with features that compound risk, such as a simultaneous second-lien or the use of reduced documentation to evaluate a loan application.
The Bank is required to comply with the guidance as it is interpreted and applied by the OTS.
Privacy Regulations
Under the OTS regulations adopted pursuant to the Gramm-Leach-Bliley Act of 1999, the Bank is required to adopt procedures to protect customers' "nonpublic personal information." The regulations generally require that the Bank disclose its privacy policy, including identifying with whom it shares a customer's "nonpublic personal information," to customers at the time of establishing the customer
relationship and annually thereafter. In addition, the Bank is required to provide its customers with the ability to "opt-out" of having it share their personal information with unaffiliated third parties and not to disclose account numbers or access codes to nonaffiliated third parties for marketing purposes. The Bank currently has a privacy protection policy in place, which has been reviewed, for compliance with the regulations.
Protection of Customer Information
In addition to certain state laws governing protection of customer information, the Bank is subject to federal regulatory guidelines establishing standards for safeguarding customer information. These regulations implement certain provisions of the Gramm-Leach-Bliley Act. The guidelines describe the federal banking agencies' expectations for the creation, implementation and maintenance of an information security program, which would include administrative, technical and physical safeguards appropriate to the size and complexity of the institution and the nature and scope of its activities. The standards set forth in the guidelines are intended to ensure the security and confidentiality of customer records and information, protect against any anticipated threats or hazards to the security or integrity of such records and protect against unauthorized access to or use of such records or information that could result in substantial harm or inconvenience to any customer. Federal guidelines also impose certain customer disclosures and other actions in the event of unauthorized access to customer information.
Consumer Protection and Compliance Provisions
The Bank is subject to various laws and regulations dealing generally with consumer protection matters. The Bank may be subject to potential liability under these laws and regulations for material violations. The Bank's loan operations are also subject to federal laws applicable to credit transactions, such as the:
•Federal "Truth-In-Lending Act," governing disclosures of credit terms to consumer borrowers;
•"Home Mortgage Disclosure Act of 1975", requiring financial institutions to provide information to enable the public and public officials to determine whether a financial institution is fulfilling its obligation to help meet the housing needs of the community it serves;
•"Equal Credit Opportunity Act," prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
•"Fair Credit Reporting Act of 1978," as amended by the Fair and Accurate Credit Transactions Act, governing the use and provision of information to credit reporting agencies, and requiring certain identity theft protections and certain credit and other disclosures;
•"Fair Debt Collection Act," governing the manner in which consumer debts may be collected by collection agencies;
•"Real Estate Settlement Procedures Act," as amended, governing disclosures of fee estimates that would be incurred by a borrower during the mortgage process;
•"Servicemembers Civil Relief Act"; and
•Rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.
The Bank's deposit operations are also subject to federal laws applicable to deposit transactions, such as the:
•"Truth in Savings Act," which imposes disclosure obligations to enable consumers to make informed decisions about accounts at depository institutions;
•"Right to Financial Privacy Act," which imposes a duty to maintain confidentiality of consumer financial records and prescribes procedures for complying with administrative subpoenas of financial records;
•"Electronic Funds Transfer Act" and Regulation E issued by the FRB to implement that Act, which govern automatic deposits to and withdrawals from deposit accounts and customers' rights and liabilities arising from the use of automated teller machines and other electronic banking services; and
•Rules and regulations of the various federal agencies charged with the responsibility of implementing these federal laws.
Identity Theft Prevention
The federal banking agencies, including the OTS, issued a joint rule implementing Section 315 of the Fair and Accurate Credit Transactions Act, requiring each financial institution or creditor to develop and implement a written identity theft prevention program to detect, prevent, and mitigate identity theft in connection with the opening of certain accounts or certain existing accounts.
Among the requirements under the rule, the Bank is required to adopt "reasonable policies and procedures" to:
•identify relevant red flags for covered accounts and incorporate those red flags into the program;
•detect red flags that have been incorporated into the identity theft prevention program;
•respond appropriately to any red flags that are detected to prevent and mitigate identity theft; and
•ensure the identity theft prevention program is updated periodically, to reflect changes in risks to customers or to the safety and soundness of the financial institution or creditor from identity theft.
Prohibitions Against Tying Arrangements
Federal savings associations are subject to statutory prohibitions on certain tying arrangements. A depository institution is prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.
Trust Activities Regulation
The Bank derives its trust powers from Section 5(n) of the HOLA and the regulations and policies of the OTS. Under these laws, regulations and policies, the trust activities of federal savings associations are governed by both federal and state laws. Generally, the scope of trust activities that the Bank can provide will be governed by the laws of the states in which the Bank is "located" (as such term is defined under the regulations of the OTS), while other aspects of the trust operations of the Bank are governed by federal laws and regulations. If the trust activities of a federal savings association are located in more than one state, however, then the scope of fiduciary services that the federal savings association can provide will vary depending on the laws of each state.
The Bank, through its trust department, acts as trustee, personal representative, administrator, guardian, custodian, record keeper, agent, registrar, advisor and manager for various accounts. As of June 30, 2010, the trust department of the Bank maintained approximately $84.5 million in assets under management.
Federal Reserve System
Under FRB regulations, the Bank is required to maintain noninterest-earning reserves against its transaction accounts. FRB regulations generally require that (i) reserves of 3% must be maintained against aggregate transaction account balances of $55.2 million or less, subject to adjustment by the FRB, and (ii) a reserve of 10% must be maintained against that portion of total transaction accounts in excess of $55.2 million. The first $10.7 million of otherwise reservable balances are exempted from the reserve requirements. The Bank was in compliance with these reserve requirements at June 30, 2010. Because required reserves must be maintained in the form of either vault cash, a noninterest bearing account at a Federal Reserve bank, or a pass-through account as defined by the FRB, the effect of this reserve requirement is to reduce the Bank's interest-earning assets to the extent that the requirement exceeds vault cash.
The FRB has, and is likely to continue to have, an important impact on the operating results of financial institutions through its power to implement national monetary policy, among other things, in order to curb inflation or combat a recession. The FRB affects the levels of bank loans, investments and deposits through its control over the issuance of United States government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject.
Federal Home Loan Bank System
The Bank is a member of the FHLB of Des Moines, which is one of 12 regional FHLBs that administer the home financing credit function of savings associations. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB system. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. These policies and procedures are subject to the regulation and oversight of the Federal Housing Finance Board. All advances from the FHLB are required to be fully secured by sufficient collateral as determined by the FHLB. The Bank, as a member of the FHLB of Des Moines, is required to acquire and hold shares of capital stock in the FHLB of Des Moines equal to 0.12% of the total assets of the Bank at December 31 annually. The Bank is also required to own activity-based stock, which is based on 4.45% of the Bank's outstanding advances. These percentages are subject to change at the discretion of the FHLB Board of Directors.
At June 30, 2010, the Bank had $10.3 million in FHLB stock, which was in compliance with this requirement. The Bank receives dividends on its FHLB stock, subject to approval by the FHLB. For the fiscal year ended June 30, 2010, dividends paid by the FHLB of Des Moines to the Bank totaled approximately $240,000, which constitutes a $29,000 decrease in the amount of dividends received in fiscal 2009.
Anti-Money Laundering / Combating Terrorist Financing Provisions
The Bank is subject to the OTS and Financial Crimes Enforcement Network regulations implementing the Bank Secrecy Act, as amended by the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, commonly known as the USA PATRIOT Act, which gives the federal government expanded powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Other provisions of the USA PATRIOT Act impose affirmative obligations on a broad range of financial institutions,
including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Exchange Act.
Among other requirements, Title III of the USA PATRIOT Act imposes the following requirements with respect to financial institutions:
•Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at a minimum: (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money laundering compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program.
•Pursuant to Section 326, financial institutions are required by rulemaking to implement reasonable procedures to (1) verify the identity of any person opening an account; (2) maintain records of the information used to verify the person's identity; and (3) determine whether the person appears on any list of known or suspected terrorists or terrorist organizations. To carry out these procedures, each financial institution must establish a written customer identification program appropriate for its size, location and type of business.
•Section 312 requires financial institutions that establish, maintain, administer or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific and, where necessary, enhanced due diligence policies, procedures and controls designed to detect and report money laundering.
•Financial institutions are prohibited from establishing, maintaining, administering or managing correspondent accounts for foreign shell banks (foreign banks that do not have a physical presence in any country), and is subject to certain recordkeeping obligations with respect to correspondent accounts of foreign banks.
•Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on FRA and Bank Merger Act applications.
Holding Company Regulation
We are a unitary savings and loan holding company within the meaning of the HOLA. As such, we are required to register with and be subject to OTS examination and supervision as well as certain reporting requirements. In addition, the OTS has enforcement authority over us and any of our non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the financial safety, soundness or stability of a subsidiary savings association.
As discussed below, under the Dodd-Frank Act all savings and loan holding companies, including the Company, will be transitioning to a new primary regulator, the FRB, upon the formal transfer of the OTS's rulemaking and supervisory powers in July 2011 (or else by January 2012 if a six-month extension is required). Additionally, all savings and loan holding companies for the first time will become subject to the same capital and activity requirements as those applicable to bank holding companies. All savings and loan holding companies will generally have a five year phase-in period to comply with the new capital requirements.
The Dodd-Frank Act requires the Comptroller General, head of the Government Accountability Office ("GAO"), to conduct various studies addressing aspects of the financial system in the United States. Among the mandated studies involving savings associations and their holding companies, the GAO is tasked with determining the adequacy of the federal bank regulatory framework applicable to such institutions, including any restrictions such as limitations on affiliate transactions or cross-marketing between an association and its holding company or affiliate. The GAO study will also
evaluate the potential consequences of subjecting savings associations and their holding companies to the requirements of the Bank Holding Company Act, by considering the availability and allocation of credit, the stability of the financial system and the economy, the safe and sound operation of savings associations, and the impact on the types of activities in which savings associations and their holding companies engage. The results of the GAO study and other studies mandated by the Dodd-Frank Act may impact the regulation of savings and loan holding companies and their savings association subsidiaries.
"Grandfathered" Savings and Loan Holding Company Status
Because we acquired the Bank prior to May 4, 1999, we are a "grandfathered" unitary savings and loan holding company under the Gramm-Leach-Bliley Act. As such, we are exempt from the limitations on certain unrelated business activities that apply to other savings and loan holding companies and their subsidiaries that are not savings associations, provided the Bank continues to be a "qualified thrift lender." If, however, we are acquired by a non-financial company, if we acquire another savings association subsidiary (and we become a multiple savings and loan holding company) or, as a result of proposed legislative changes, we will terminate our "grandfathered" unitary savings and loan holding company status, and become subject to certain additional limitations on the types of business activities in which we could engage. All "non-grandfathered" unitary savings and loan holding companies are limited to financially related activities permissible for bank holding companies, as defined under the Gramm-Leach-Bliley Act.
Restrictions Applicable to All Savings and Loan Holding Companies
Federal law prohibits a savings and loan holding company, including us, directly or indirectly, from acquiring:
•control (as defined under the HOLA) of another savings institution (or a holding company parent) without prior OTS approval;
•through merger, consolidation, or purchase of assets, another savings institution or a holding company thereof, or acquiring all or substantially all of the assets of such institution (or a holding company) without prior OTS approval; or
•control of any depository institution not insured by the FDIC (except through a merger with and into the holding company's savings institution subsidiary that is approved by the OTS).
A savings and loan holding company may not acquire as a separate subsidiary an insured institution that has a principal office outside of the state where the principal office of its subsidiary institution is located, except:
•in the case of certain emergency acquisitions approved by the FDIC;
•if such holding company controls a savings institution subsidiary that operated a home or branch office in such additional state as of March 5, 1987; or
•if the laws of the state in which the savings institution to be acquired is located specifically authorize a savings institution chartered by that state to be acquired by a savings institution chartered by the state where the acquiring savings institution or savings and loan holding company is located, or by a holding company that controls such a state chartered association.
In addition, if the Bank fails the QTL test (discussed above), we must register with the FRB as a bank holding company under the Bank Holding Company Act within one year of the Bank's failure to so qualify.
The HOLA also prohibits a savings and loan holding company (directly or indirectly, or through one or more subsidiaries) from acquiring or retaining, with certain exceptions, more than 5% of a non-subsidiary savings association, a non-subsidiary holding company, or a non-subsidiary company engaged in activities other than those permitted by the HOLA. In evaluating applications by holding companies to acquire savings associations, the OTS must consider the financial and managerial resources and future prospects of the company and institution involved, the effect of the acquisition on the risk to the DIF, the convenience and needs of the community and competitive factors.
Change of Control
Federal law requires, with few exceptions, OTS approval (or, in some cases, notice and effective clearance) prior to any acquisition of control of the Company. Among other criteria, under the HOLA, Change in Bank Control Act and OTS regulations, "control" is conclusively presumed to exist if a person or company acquires, directly or indirectly, more than 25% of any class of voting stock of a savings association or holding company. Under OTS regulations, control is also presumed to exist, subject to rebuttal, if an acquiror acquires more than 10% of any class of voting stock of a savings association or its holding company (or more than 25% of any class of stock) and is subject to any of several "control factors," including but not limited to, the relative ownership position of a person, the existence of control agreements and board composition.
Developments in Regulation of the Financial Sector
In response to deteriorating conditions in the U.S. financial system, the Obama Administration, Congress and federal banking agencies have taken various actions as part of a comprehensive strategy to stabilize the financial system and housing markets, and to strengthen the regulation of U.S. financial institutions. The numerous programs established under the various initiatives are currently in different stages of implementation as well as being phased out.
Emergency Economic Stabilization Act of 2008
The Emergency Economic Stabilization Act, enacted on October 3, 2008, provided the Secretary of the Treasury with authority to, among other things, establish the Troubled Asset Relief Program ("TARP") to purchase from financial institutions up to $700 billion of troubled assets.
On October 14, 2008, the Treasury announced the Capital Purchase Program ("CPP") under the Emergency Economic Stabilization Act, pursuant to which the Treasury would purchase up to $250 billion of senior preferred shares from qualifying financial institutions on standardized terms. The program was voluntary and required an institution to comply with a number of restrictions and provisions, including limits on executive compensation, stock redemptions and declaration of dividends. On November 21, 2008, we entered into a purchase agreement with the Treasury under the CPP, pursuant to which we agreed to issue and sell (i) 25,000 shares of our Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share (the "Preferred Stock") and (ii) a warrant to purchase up to 302,419 shares of our common stock, par value $0.01 per share, at an initial exercise price of $12.40 per share (the "Warrant"), for an aggregate purchase price of $25.0 million in cash. On June 3, 2009, we entered into a Repurchase Letter Agreement with the Treasury pursuant to which we completed the repurchase of the Preferred Stock from the Treasury. The repurchase price of the Preferred Stock was $25.0 million, plus a final accrued dividend of $62,500. On June 30, 2009, we entered into a Warrant Repurchase Letter Agreement with the Treasury pursuant to which we repurchased the Warrant from the Treasury for a purchase price of $650,000.
On February 25, 2009, the Treasury announced the Capital Assistance Program ("CAP"), a new capital program under the Treasury's Financial Stability Plan. The purpose of the CAP was to restore confidence throughout the financial system by ensuring that the nation's largest banking institutions
have a sufficient capital cushion against larger than expected future losses, should they occur due to a more severe economic environment, and to support lending to creditworthy borrowers. The CAP did not replace the CPP and was open to qualifying institutions regardless of whether they participated in the CPP. The deadline to apply for the CAP was November 9, 2009 and the Company did not apply for this program.
American Recovery and Reinvestment Act of 2009
On February 17, 2009, the President signed the American Recovery and Reinvestment Act of 2009 into law as a $787 billion dollar economic stimulus. The stimulus included discretionary spending for among other things, infrastructure projects, increased unemployment benefits and food stamps, as well as tax relief for individuals and businesses. This act also implemented new executive compensation and corporate governance requirements applicable to CPP participants.
Temporary Liquidity Guarantee Program
The FDIC established a Temporary Liquidity Guarantee Program ("TLGP") on October 14, 2008 (i) guaranteeing certain debt issued by FDIC-insured institutions and certain holding companies on or after October 14, 2008 through June 30, 2009, which was extended to October 31, 2009, and (ii) providing unlimited insurance coverage for noninterest-bearing transaction accounts, a program which was extended through December 31, 2010.
The Debt Guarantee Program ("DGP") component of the TLG program aimed to provide liquidity to the inter-bank lending market and promote stability in the unsecured funding market. Under the DGP, the FDIC temporarily guaranteed all newly issued senior unsecured debt up to prescribed limits. In general, the maximum amount of outstanding debt that was guaranteed under the DGP for each participating entity at any time was limited to 125 percent of the par value of the participating entity's senior unsecured debt. The DGP ensured that such debt would be fully protected in the event the issuing institution subsequently fails or its holding company files for bankruptcy. The DGP concluded on October 31, 2009, with the FDIC's guarantee expiring no later than December 31, 2012. On October 20, 2009, the FDIC established a limited, six-month emergency guarantee facility upon expiration of the DGP. Under the emergency guarantee facility, certain participating entities were able to apply to the FDIC for permission to issue FDIC-guaranteed debt during the period starting October 31, 2009 through April 30, 2010. The fee for issuing debt under the emergency facility was at least 300 basis points, which the FDIC reserved the right to increase on a case-by-case basis, depending upon the risks presented by the issuing entity.
Under the Transaction Account Guarantee Program ("TAGP") component of the TLG program, noninterest-bearing transaction accounts are fully insured through December 31, 2010. The unlimited guarantee under the TAGP is in addition to, and separate from, the general deposit insurance coverage of $250,000 provided for under the DIF. On August 26, 2009, the FDIC adopted a final rule originally extending the TAGP for six months, through June 30, 2010, but subsequently extended the program to December 31, 2010, with the possibility of a further extension through December 31, 2011. For institutions choosing to remain in the program for the extended period, the annual assessment rate applicable to the extension period is either 15 basis points, 20 basis points or 25 basis points, depending on the risk category assigned to the institution under the FDIC's risk-based premium system. The Bank is a participant in the program and, as such, is bound by the requirements of the program, including the quarterly payment of an annualized assessment on any deposit amounts exceeding the existing deposit insurance limit of $250,000. This assessment is in addition to our usual risk-based assessment, as discussed above under "-Federal Deposit Insurance of Accounts and Regulation by the FDIC."
Under the Dodd-Frank Act, the FDIC is required to provide, after December 31, 2010 and until December 31, 2012, unlimited insurance coverage for noninterest-bearing transaction accounts. Unlike
the current TAGP, the legislation provides a modified definition of "noninterest-bearing transaction account" for purposes of maintaining eligibility for the unlimited guarantee, and the guarantee applies to all insured depository institutions rather than only those that have opted to participate in the program.
Term Asset-Backed Securities Loan Facility
Under the Term Asset-Backed Securities Loan Facility ("TALF"), the Federal Reserve Bank of New York had the authority to lend up to $200 billion to eligible owners of certain AAA-rated asset backed securities backed by newly and recently originated auto loans, credit card loans, student loans, and SBA-guaranteed small business loans. The facility ceased making loans collateralized by newly issued commercial mortgage-backed securities ("CMBS") on June 30, 2010, and loans collateralized by all other types of TALF-eligible newly issued and legacy asset backed securities on March 31, 2010. The FRB did not extend the facility past the June 30, 2010 deadline.
The Credit Card Accountability Responsibility and Disclosure Act of 2009
On May 22, 2009, President Obama signed into law the Credit Card Accountability Responsibility and Disclosure Act of 2009("Credit CARD Act"). The Credit CARD Act amends various acts, including the Fair Credit Reporting Act, the Electronic Fund Transfer Act and the Truth-in-Lending Act("TILA"). The Credit CARD Act makes numerous changes to the TILA, affecting the marketing, underwriting, pricing, billing and other aspects of the consumer credit card business. The Credit CARD Act superseded joint final rules issued by federal banking agencies under Section 5 of the Federal Trade Commission Act to provide clarification to the body of law surrounding unfair or deceptive acts or practices. The Credit CARD Act targets the elimination of unfair or deceptive practices associated with credit card accounts and, among other things, prohibits arbitrary interest rate increases and universal default on existing balances; requires a credit card issuer who increases a cardholder's interest rate to periodically review and decrease the rate if indicated by the review; prohibits credit card issuers from increasing rates on a cardholder in the first year after a credit card account is opened; requires promotional rates to last at least six months; prohibits exorbitant and unnecessary fees; requires fairness in application and timing of card payments; and requires enhanced disclosures of card terms and conditions. The FRB has adopted final rules amending Regulation Z that implement provisions of the Credit CARD Act.
Amendments to Truth in Savings Act Regulations
The FRB has adopted a final rule amending its regulations that implement the Truth in Savings Act. The final rule, published in the Federal Register on January 29, 2009 and later amended, addresses depository institutions' disclosure practices related to overdrafts. The final rule extends to all institutions the requirement to disclose on periodic statements the total amounts charged for overdraft fees and returned items fees, for both the statement period as well as the year-to-date. The final rule also requires institutions that provide account balance information through an automated system to provide a balance that excludes additional funds that may be made available to cover overdrafts. The effective date for the initial final rule published in January 2009 was January 1, 2010. The amended final rule generally became effective July 6, 2010, except for a section requiring institutions to disclose on each periodic statement, as applicable, the total dollar amount of all fees or charges imposed on the account for paying checks or other items when there are insufficient or unavailable funds and the account becomes overdrawn for the month and calendar year-to-date, which becomes effective on October 1, 2010.
Amendments to Electronic Fund Transfer Act Regulations
In November 2009, the FRB published a final rule amending Regulation E, which implements the Electronic Fund Transfer Act, and the official staff commentary to the regulation. The Regulation E final rule limits the ability of financial institutions to assess overdraft fees for paying ATM and one-time debit card transactions that overdraw a consumer's account, unless the consumer affirmatively consents, or opts in, to the institution's payment of overdrafts for those transactions. The rule became effective on July 1, 2010.
The Dodd-Frank Act
On July 21, 2010, the President signed the Dodd-Frank Act into law. Among other things, the Dodd-Frank Act dramatically impacts the rules governing the provision of consumer financial products and services, and implementation of the Dodd-Frank Act will require new mandatory and discretionary rulemakings by numerous federal regulatory agencies over the next several years. The new law significantly affects the operations of federal thrifts and their holding companies as, among other things, the Dodd-Frank Act: (1) abolishes the OTS, effective 90 days after the transfer of the OTS's supervisory and other functions to the FRB, FDIC, and the Office of the Comptroller of the Currency ("OCC"); (2) creates the Bureau of Consumer Financial Protection ("BCFP"), a new independent consumer watchdog agency housed within the FRB that will have primary rulemaking authority with respect to all federal consumer financial laws and is authorized to prescribe rules applicable to any covered person or service provider identifying and prohibiting acts or practices that are "unfair, deceptive, or abusive" in connection with any transaction with a consumer involving a consumer financial product or service; (3) requires that formal capital requirements be imposed on savings and loan holding companies generally commencing July 2015; (4) codifies the "source of strength" doctrine for all depository institution holding companies; (5) grants to the U.S. Department of the Treasury, FDIC and the FRB broad new powers to seize, close and wind down "too big to fail" financial (including non-bank) institutions in an orderly fashion; (6) establishes a new Financial Stability Oversight Council that is charged with identifying and responding to emerging risks throughout the financial system, composed primarily of federal financial services regulators and chaired by the Secretary of the Treasury Department; (7) adopts new standards and rules for the mortgage industry; (8) adopts new bank, thrift and holding company regulation; (9) permanently increases the standard maximum deposit insurance amount to $250,000 per depositor, per institution for each account ownership category; (10) temporarily provides for unlimited deposit insurance coverage for "noninterest-bearing transaction accounts;" (11) repeals the long-standing statutory prohibition on the payment of interest on demand deposits; (12) adopts new federal regulation of the derivatives market; (13) adopts the so-called Volcker Rule, substantially restricting proprietary trading by depository institutions and their holding companies; (14) imposes requirements for "funeral plans" by large, complex financial companies; (15) establishes new regulation of the asset securitization market through "skin in the game" and enhanced disclosure requirements; (16) establishes new regulation of interchange fees; (17) establishes new and enhanced compensation and corporate governance oversight for the financial services industry; (18) provides enhanced oversight of municipal securities; (19) provides a specific framework for payment, clearing and settlement regulation; (20) tasks the federal banking agencies with adopting new and enhanced capital standards for all depository institutions; (21) significantly narrows the scope of federal preemption for national banks and federal savings associations; (22) revises the affiliate transaction and insider lending rules; and (23) revises the requirements applicable to QTLs.
Under the Dodd-Frank Act, the ability of the Bank to rely on federal preemption of state consumer financial laws will be based on the same preemption standards applicable to national banks. A "state consumer financial law" is defined as "a state law that does not directly or indirectly discriminate against national banks and that directly and specifically regulates the manner, content, or terms and conditions of any financial transaction (as may be authorized for national banks to engage in), or any account related thereto, with respect to a consumer." Under the new preemption standards established under the Dodd-Frank Act, generally effective within one year from the date of enactment, preemption of a state consumer financial law is permissible only if: (1) application of the state law would have a discriminatory effect on national banks or federal thrifts as compared to state banks; (2) the state law is preempted under a judicial standard that requires a state consumer financial law to prevent or significantly interfere with the exercise of the national bank's or federal thrift's powers before it can be preempted, with such preemption determination being made by the OCC (by regulation or order) or by a court, in either case on a "case-by-case" basis; or (3) the state law is preempted by another provision of federal law other than the Act. Additionally, the Dodd-Frank Act specifies that such preemption standards only apply to national banks and federal thrifts themselves, and not their non-depository institution subsidiaries or affiliates. Specifically, operating subsidiaries of national banks and federal thrifts that are not themselves chartered as a national bank or federal thrift may no longer benefit from federal preemption of state consumer financial laws, which shall apply to such subsidiaries (or affiliates) to the same extent that they apply to any person, corporation or entity subject to such state laws.
We are currently evaluating the potential impact of the Dodd-Frank Act on our business, financial condition, results of operations and prospects. It is difficult to predict at this time what specific impact the Dodd-Frank Act and the yet-to-be-written implementing rules and regulations may have on us. However, given that the legislation is likely to materially change the regulatory environment for the financial services industry in which we operate, we expect at a minimum that our compliance costs will increase. For further discussion on the potential impact of the Dodd-Frank Act on the Company and Bank, see "-Risk Factors" below.
The Sarbanes-Oxley Act
As a public company, we are subject to the Sarbanes-Oxley Act, which implements a broad range of disclosure, corporate governance and accounting measures for public companies designed to promote honesty and transparency and to protect investors from corporate wrongdoing. Furthermore, the NASDAQ Global Market enacted corporate governance rules that implement some of the mandates of the Sarbanes-Oxley Act. The NASDAQ rules include, among other things, requirements ensuring that a majority of the Board of Directors are independent of management, establishing and publishing a code of conduct for directors, officers and employees, and calling for stockholder approval of all new stock option plans and all material modifications. These rules affect us because our common stock is listed on The NASDAQ Global Market.
The Dodd-Frank Act provides an exemption from the independent auditor attestation requirement under Section 404(b) of the Sarbanes-Oxley Act for small issuers that are neither a large accelerated filer nor an accelerated filer. The Company qualifies for this exemption.
Federal Securities Law
Our common stock is registered with the SEC under the Exchange Act. We are subject to the information, proxy solicitation, insider trading restrictions and other requirements of the SEC under the Exchange Act.
Our stock held by persons who are affiliates (generally officers, directors and principal stockholders) of us may not be resold without registration or unless sold in accordance with certain
resale restrictions. If we meet specified current public information requirements, each of our affiliates is able to sell in the public market, without registration, a limited number of shares in any three-month period.
Delaware General Corporation Law
We are incorporated under the laws of the State of Delaware. Thus, the rights of our stockholders are governed by the Delaware General Corporation Law.
Federal and State Taxation
The Company and its direct and indirect subsidiaries file a consolidated federal income tax return on a fiscal year basis. In addition, each of Trust III, Trust IV, Trust V and Trust VI are required to file individual trust returns on a calendar year basis.
In addition to the regular income tax, corporations, including savings associations such as the Bank, generally are subject to a minimum tax. An alternative minimum tax is imposed at a minimum tax rate of 20% on alternative minimum taxable income, which is the sum of a corporation's regular taxable income (with certain adjustments) and tax preference items, less any available exemption. The alternative minimum tax is imposed to the extent it exceeds the corporation's regular income tax and net operating losses can offset no more than 90% of alternative minimum taxable income.
To the extent earnings appropriated to a savings association's bad debt reserves for "qualifying real property loans" and deducted for federal income tax purposes exceed the allowable amount of such reserves computed under the experience method and to the extent of the association's supplemental reserves for losses on loans ("Excess"), such Excess may not, without adverse tax consequences, be utilized for the payment of cash dividends or other distributions to a shareholder (including distributions on redemption, dissolution or liquidation) or for any other purpose (except to absorb bad debt losses). As of June 30, 2010, the Bank's Excess for tax purposes totaled approximately $8.5 million.
South Dakota Taxation. The Bank is subject to the South Dakota franchise tax to the extent that such corporations are engaged in business in the state of South Dakota. South Dakota does not have a corporate income tax. The franchise tax will be imposed at a rate of 6% on franchise taxable income which is computed in the same manner as federal taxable income with some minor variations to comply with South Dakota law, other than the carryover of net operating losses which is not permitted under South Dakota law. A South Dakota return of franchise tax must be filed annually.
Minnesota Taxation. The Bank is subject to the Minnesota corporate income tax to the extent that such corporations are engaged in business in the state of Minnesota. The corporate income tax is imposed at a rate of 9.8% on corporate taxable income, which is computed in the same manner as federal taxable income with some minor variations to comply with Minnesota law. A Minnesota return of corporate income tax must be filed annually.
Delaware Taxation. As a Delaware holding company, the Company is exempted from Delaware corporate income tax but is required to file an annual report with and pay an annual fee to the State of Delaware. The Company is also subject to an annual franchise tax imposed by the State of Delaware, which is made in quarterly payments.
Taxation in Other States. Mid America Capital is required to file state income tax returns in those states which lessees have operations. The total taxes paid in the year ended June 30, 2010 were not material to the operation of the Company.
Executive Officers
Information regarding the executive officers of the Company is contained in Part I, Item 1 "Business" of this Form 10-K pursuant to Instruction 3 to Item 401(b) of Regulation S-K, and is incorporated by reference herein.
The following table lists the executive officers of the Company and the Bank as of September 3, 2010.
Business Experience of each Executive Officer
CURTIS L. HAGE, age 64, is Chairman, President and Chief Executive Officer of the Company. He was elected to the position of Chairman of the Board of Directors of the Company in September 1996 and has held the positions of President and Chief Executive Officer since February 1991. Prior to such time, Mr. Hage served as Executive Vice President of the Bank since 1986. Since joining the Bank in 1968, he served in various capacities prior to being elected Executive Vice President. Mr. Hage received his M.B.A. from the University of South Dakota and attended the Graduate School of Savings Institution Management at the University of Texas.
DARREL L. POSEGATE, age 52, has served as Executive Vice President, Chief Financial Officer and Treasurer of the Company since January 2002. He has served as President of the Bank since October 2006 and as Executive Vice President, Chief Financial Officer and Treasurer of the Bank from January 2002 until October 2006. Prior to such time, he was employed in senior leadership roles in the banking industry since 1983. Mr. Posegate received his B.A. degree from Luther College, Decorah, Iowa.
DAVID A. BROWN, age 48, has served as the Senior Vice President/Community Banking of the Bank since May 2008. Prior to May 2008, he served as the Senior Vice President/Business Banking of the Bank since November 1999. Prior to joining the Bank, Mr. Brown served as Vice President/Manager Commercial Banking of Firstar Bank, Sioux City, Iowa, a national banking institution. Mr. Brown received his M.B.A. and a B.S. in Business Administration from the University of South Dakota.
STEPHEN M. BIANCHI, age 46, has served as the President of the Twin Cities market for the Bank since April 2010. Prior to joining the Bank, he was Senior Vice President at Associated Bank, where he served as Minnesota Regional President and Minnesota Regional Commercial Banking Manager from July 2006 to April 2010. Before that, he was Twin Cities Business Banking Manager for Wells Fargo Bank, where he held several other management positions over 14 years. Mr. Bianchi received his B.S. degree in Finance and M.B.A. from Providence College.
JON M. GADBERRY, age 48, has served as Senior Vice President/Wealth Management of the Bank since December 2007. Prior to joining the Bank, Mr. Gadberry was employed by Bank of the West as Vice President/Trust Manager from April 2003 to December 2007. Mr. Gadberry received his B.S. in Business Administration from Concordia College in Moorhead, Minnesota.
MARY F. HITZEMANN, age 58, has served as the Senior Vice President/Human Resources of the Bank since October 1993. Ms. Hitzemann joined the Bank in January 1993. Prior to that time, she was employed as Vice President of Human Resources for Rapid City Regional Hospital from May 1989 to May 1992. Ms. Hitzemann received her B.A. degree from Augustana College.
BRENT R. OLTHOFF, age 39, has served as Senior Vice President, Chief Financial Officer and Treasurer of the Bank since April 2007. Mr. Olthoff first joined the Bank in July 2001, and was promoted to Vice President/Finance in July 2004. From February 2006 to April 2007, Mr. Olthoff was employed by FTN Financial, a capital markets firm in Memphis, Tennessee, where he was Vice President/Asset Strategies. Mr. Olthoff received his B.B.A degree in Finance from Iowa State University.
NATALIE A. SUNDVOLD, age 47, has served as the Senior Vice President/Service & Support of the Bank since October 2002. She joined the Bank in February 1994 as manager of the phone banking center and was promoted to Vice President/In-Touch Banking in October 1995. Prior to joining the Bank, she was employed by the Bank of New York from October 1989 to October 1993. Ms. Sundvold received her B.S. from Northern State University.
MICHAEL WESTBERG, age 43, has served as the Senior Vice President/Corporate Strategy of the Bank since May 2008. Prior to May 2008, he served as the Senior Vice President/Retail Banking of the Bank since July 2006. Mr. Westberg joined the Bank in February 1996 as a branch manager. Prior to joining the Bank, he was employed with First Savings Bank, Beresford, South Dakota, from 1992 to 1996; and The Associates, Dallas, Texas, from 1989 to 1992. Mr. Westberg attended Illinois State University majoring in business and is a graduate of the American Bankers Association National School of Banking.
BRUCE E. HANSON, age 47, has served as Vice President, Controller of the Bank since October 2008. Prior to joining the Bank, he was employed as Vice President, Controller at South Dakota State Medical Holding Co., dba Dakotacare, from 1996 to September 2008. Mr. Hanson received his B.A. degree in Accounting from the University of South Dakota.
There are no family relationships involving any of the above executive officers, directors and director nominees.
Mr. Hage notified the Board of Directors on July 21, 2010 that he will retire effective December 31, 2011 from his positions as an officer of the Company and the Bank. The Board has formed a search committee to identify the next generation of leadership for the Company and the Bank.
Item 1A.
Item 1A. Risk Factors
The following are certain material risks that our management believes are specific to us and our business. You should understand that it is not possible to predict or identify all such potential risks and, as such, this list of risk factors should not be viewed as all-inclusive or in any particular order. An investment in our common stock involves certain risks. Before making an investment decision, you should read carefully and consider the risk factors below in conjunction with the other information in this Form 10-K and information incorporated by reference into this Form 10-K, including our consolidated financial statements and related notes which are set forth in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K. Additional risks and uncertainties not presently known to us at this time or that we currently deem immaterial may also materially and
adversely affect our business and operations. The value or market price of our common stock could decline due to any of these risks, and you may lose all or part of your investment. The risks discussed below also include forward-looking statements and our actual results may differ substantially from those discussed in these forward-looking statements.
Risks Related to Our Industry and Business
Difficult economic and market conditions have adversely affected our industry.
Dramatic declines in the housing market, with decreasing home prices and increasing delinquencies and foreclosures, have negatively impacted the credit performance of mortgage and construction loans and resulted in significant write-downs of assets by many financial institutions across the United States. General downward economic trends, reduced availability of commercial credit and increasing unemployment have negatively impacted the credit performance of commercial and consumer credit, resulting in additional write-downs. Concerns over the stability of the financial markets and the economy have resulted in decreased lending by financial institutions to their customers and to each other. This market turmoil and tightening of credit has led to increased commercial and consumer deficiencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. Financial institutions have experienced decreased access to deposits and borrowings. The resulting economic pressure on consumers and businesses and the lack of confidence in the financial markets may adversely affect our business, financial condition, results of operations and stock price. A worsening of these conditions would likely exacerbate the adverse effects of these difficult market conditions on us and others in the financial institutions industry. In particular, we may face the following risks in connection with these events:
•We face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities;
•Customer demand for loans secured by real estate could be reduced due to weaker economic conditions, an increase in unemployment, a decrease in real estate values or an increase in interest rates;
•The process we use to estimate losses inherent in our credit exposure requires difficult, subjective and complex judgments, including forecasts of economic conditions and how these economic conditions might impair the ability of our borrowers to repay their loans. The level of uncertainty concerning economic conditions may adversely affect the accuracy of our estimates which may, in turn, impact the reliability of the process;
•The value of the portfolio of investment securities that we hold, including our trust preferred securities, may be adversely affected; and
•We may be required to pay significantly higher FDIC premiums in the future because market developments have significantly depleted the insurance fund of the FDIC and reduced the ratio of reserves to insured deposits.
The full impact of the recently enacted Dodd-Frank Act is currently unknown given that much of the details and substance of the new laws will be determined through agency rulemaking.
The compliance burden and impact on our operations and profitability with respect to the Dodd-Frank Act are currently unknown, as the Dodd-Frank Act delegates to various federal agencies the task of implementing its many provisions through regulation. Hundreds of new federal regulations, studies and reports addressing all of the major areas of the new law, including the regulation of federal savings associations and their holding companies, will be required, ensuring that federal rules and policies in this area will be further developing for months and years to come. Based on the provisions of the Dodd-Frank Act and anticipated implementing regulations, it is highly likely that banks and
thrifts as well as their holding companies will be subject to significantly increased regulation and compliance obligations that expose us to noncompliance risk and consequences.
The elimination of the OTS and transfer of the OTS's supervisory and rulemaking functions to various federal banking agencies will change the way that we are regulated.
As the OTS is due to be abolished 90 days after transferring its supervisory and rulemaking functions to various federal agencies, both the Bank and Company will be transitioning to the jurisdiction of new primary federal regulators, which will change the way that we are regulated. Specifically, the OTS's supervisory and rulemaking functions (except for consumer protection) relating to all federal savings associations will be transferred to the OCC, while the OTS's supervisory and rulemaking functions relating to savings and loan holding companies and their non-depository institution subsidiaries will be transferred to the FRB. While the OCC and FRB are directed to implement existing OTS regulations, orders, resolutions, determinations and agreements for thrifts and their holding companies under the HOLA, the transition of supervisory functions from the OTS to these agencies could alter the operations of the Bank and Company so as to be more closely aligned with the OCC's and FRB's respective supervision of national banks and bank holding companies. While the functions of the OTS will formally be transferred to the OCC and FRB in July 2011 (or else by January 2012 if a six-month extension is required), we may see changes in the way we are supervised and examined sooner, and may experience operational challenges in the course of transition to our new regulators.
The new BCFP may reshape the consumer financial laws through rulemaking and enforcement of unfair, deceptive or abusive practices, which may directly impact the business operations of depository institutions offering consumer financial products or services including the Bank.
The BCFP has broad rulemaking authority to administer and carry out the purposes and objectives of the "Federal consumer financial laws, and to prevent evasions thereof," with respect to all financial institutions that offer financial products and services to consumers. The BCFP is also authorized to prescribe rules, applicable to any covered person or service provider, identifying and prohibiting acts or practices that are "unfair, deceptive, or abusive" in connection with any transaction with a consumer for a consumer financial product or service, or the offering of a consumer financial product or service ("UDAP authority"). The full reach and impact of the BCFP's broad new rulemaking powers and UDAP authority on the operations of financial institutions offering consumer financial products or services is currently unknown. Notwithstanding, insured depository institutions with assets of $10 billion or less will continue to be supervised and examined by their primary federal regulators, rather than the BCFP, with respect to compliance with the federal consumer protection laws.
Legislative and regulatory initiatives taken to date may not achieve their intended objectives; proposed and future initiatives may substantially increase compliance burdens and further impact our financial condition or results of operations.
Legislative and regulatory initiatives taken to date by Congress and the federal banking regulators to address financial regulatory reform may not achieve their intended objectives, thereby requiring additional legislation or regulation of the financial services industry. Furthermore, the Basel Committee on Banking Supervision and other international bodies comprised of banking regulators have committed to raise capital standards and liquidity buffers within the banking system by imposing new requirements, for example a requirement that all regulatory capital instruments issued by depository institutions must include contractual terms that allow regulators to write them off or convert them to common shares in the event of the institution's failure. Such proposals may impose more stringent standards than currently applicable or anticipated with respect to capital and liquidity requirements for depository institutions. We cannot predict whether such proposals will ultimately be adopted, or the
impact that such proposals, if adopted, would have upon our financial condition or results of operations.
We recorded other-than-temporary impairment ("OTTI") charges in our trust preferred securities ("TRUPS") portfolio in the each of the last six consecutive quarters, and we could record additional losses in the future.
We determine the fair value of our investment securities based on GAAP and three levels of informational inputs that may be used to measure fair value. The price at which a security may be sold in a market transaction could be significantly lower than the quoted market price for the security, particularly if the quoted market price is based on infrequent trading history, the market for the security is illiquid, or a significant amount of securities are being sold.
We held six TRUPS pools with an adjusted cost basis of $9.3 million and a fair value of $3.9 million at June 30, 2010. Rating downgrades on these investments occurred during fiscal years 2009 and 2010, placing each in a below investment grade rating. Due to an inactive market for these securities, management utilized a "Level 3" fair value input according to ASC Topic 820, utilizing discounted cash flow methodologies to determine fair value and OTTI.
During fiscal 2009 and 2010, we determined that four debt securities exhibited OTTI. The aggregate OTTI losses recorded for the four securities were $6.1 million, of which $3.0 million was recognized on the balance sheet in other comprehensive income, with the balance being $3.1 million of credit loss recognized through earnings. The remaining difference between amortized cost basis and fair value of $2.4 million recognized in other comprehensive income is primarily attributable to the four TRUPS for which OTTI was not recognized at June 30, 2010.
The valuation of our TRUPS will continue to be influenced by external market and other factors, including implementation of Securities and Exchange Commission and Financial Accounting Standards Board guidance on fair value accounting, the financial condition of specific issuers within our pooled securities (including any credit deterioration thereof), deferral and default rates of specific issuer financial institutions, rating agency actions, and the prices at which observable market transactions occur. If we are required to record additional OTTI charges on our TRUPS portfolio, we could experience potentially significant earnings losses as well as an adverse impact to our capital position.
Under the recently enacted Dodd-Frank Act, trust preferred securities issued on or after May 19, 2010 are no longer eligible for inclusion in Tier 1 capital. For trust preferred securities issued before May 19, 2010, regulatory capital deductions will generally be required during a phase in period from January 1, 2013 to January 1, 2016, however depository institution holding companies with assets of less than $15 billion as of year-end 2009 enjoy a permanent grandfather right with respect to such securities for purposes of calculating regulatory capital.
As a result of current economic conditions, the Bank's allowance for loan losses may prove to be insufficient to absorb losses in its loan portfolios, which could adversely affect its operating results.
While the Bank maintains an allowance for loan and lease losses to provide for loan defaults and non-performance, losses may exceed the value of the collateral securing the loans and the allowance may not fully cover any excess loss. At June 30, 2010, the Bank's nonperforming loans (which consist of non-accrual loans and loans still accruing but past due greater than 90 days) totaled $8.2 million, or 0.92% of its loan portfolio. At June 30, 2010, the Bank's nonperforming assets (which include foreclosed real estate) were $9.2 million, or 0.73% of assets. In addition, the Bank had $15.9 million in accruing loans that were 30 to 89 days delinquent at June 30, 2010. At June 30, 2010, the Bank held $9.6 million of loan and lease loss reserves, or 1.07% of total loans, and 116.31% of non-performing loans.
Until economic and market conditions improve, the Bank may continue to incur additional losses relating to an increase in nonperforming loans. The Bank does not record interest income on non-accrual loans or other real estate owned, thereby adversely affecting its income, and increasing its loan administration costs. When the Bank takes collateral in foreclosures and similar proceedings, it is required to mark the related loan to the then fair market value of the collateral, which may result in a loss. These loans and other real estate owned also increase its risk profile and the capital its regulators believe is appropriate in light of such risks. As a result of current economic conditions, additional provisions for loan losses may be necessary.
The Bank makes various assumptions and judgments about the collectability of its loan portfolio, including the creditworthiness of its borrowers and the value of the real estate and other assets serving as collateral for the repayment of loans. The Bank's allowance for loan and lease losses is based on these judgments, as well as historical loss experience and an evaluation of the other risks associated with the loan portfolio, including but not limited to, the size and composition of the loan portfolio, current economic condition and geographic concentrations within the portfolio. The Bank's allowance is also periodically reviewed by its regulators. If the Bank's assumptions or judgments used to determine the allowance proves to be incorrect, if the value of the collateral securing the loans decreases substantially or if the Bank's regulators disagree with the Bank's judgments, the Bank may need to increase the allowance in amounts that exceed its expectations. Material additions to the allowance would adversely affect our results of operations and financial condition.
Determination of the appropriate level of the allowance for loan losses involves a high degree of subjectivity and requires significant estimates, and actual losses may vary from current estimates.
The Bank maintains an allowance for loan losses to provide for loans in its portfolio that may not be repaid in their entirety. The determination of the appropriate level of the allowance for loan losses involves a high degree of subjectivity and requires us and the Bank to make significant estimates of current credit risks and future trends, all of which may undergo material changes.
In evaluating the adequacy of the Bank's allowance for loan losses, we consider numerous quantitative factors, including our historical charge-off experience, growth of our loan portfolio, changes in the composition of our loan portfolio and the volume of delinquent and classified loans. In addition, we use information about specific borrower situations, including their financial position and estimated collateral values, to estimate the risk and amount of loss for those borrowers. Finally, we consider many qualitative factors, including general and economic business conditions, duration of the current business cycle, current general market collateral valuations, trends apparent in any of the factors we take into account and other matters, which are by nature subjective and fluid. Our estimates of the risk of loss and amount of loss on any loan are complicated by the significant uncertainties surrounding the Bank's borrowers' abilities to successfully execute their business models through changing economic environments, competitive challenges and other factors. In considering information about specific borrower situations, our analysis is subject to the risk that we are provided inaccurate or incomplete information. Because of the degree of uncertainty and susceptibility of these factors to change, the Bank's actual losses may vary from our current estimates.
Additionally, bank regulators periodically review the Bank's allowance for loan losses and may require an increase in the provision for loan losses or recognize loan charge-offs based upon their judgments, which may be different from ours. Any increase in the Bank's allowance for loan losses or loan charge-offs required by these regulatory authorities may adversely affect our operating results.
We are a community bank and our ability to maintain our reputation is critical to the success of our business and the failure to do so may materially adversely affect our performance.
We are a community bank, and our reputation is one of the most valuable components of our business. As such, we strive to conduct our business in a manner that enhances our reputation. This is done, in part, by recruiting, hiring and retaining employees who share our core values of being an integral part of the communities we serve, delivering superior service to our customers and caring about our customers and associates. If our reputation is negatively affected, by the actions of our employees or otherwise, our business and, therefore, our operating results may be materially adversely affected.
Our financial success is dependant on the prevailing economic, political and business conditions as well as the population growth in South Dakota.
Our success and growth is dependant on the income levels, deposits and population growth in our primary market area, which are communities located in eastern and central South Dakota, including the Sioux Falls metropolitan statistical area (MSA), and the cities of Pierre, Mitchell, Aberdeen, Brookings, Dakota Dunes, Watertown and Yankton. If the communities in which we operate do not grow or if prevailing economic conditions locally are unfavorable, our business will be negatively affected.
Additionally, there are inherent risks associated with our lending activities, including credit risk, which is the risk that borrowers may not repay outstanding loans or the value of the collateral securing loans decreases. Our business operations and activities are concentrated in the state of South Dakota and most of our credit exposure is in that state, so we are specifically at risk from adverse economic, political and business conditions that affect South Dakota. Accordingly, economic and business conditions in South Dakota, such as increases in unemployment, commercial and consumer delinquencies and real estate foreclosures, as well as decreases in real gross domestic product, home and land prices or home sales, will each adversely impact our credit risk.
For example, credit card issuers, a significant employer in the Sioux Falls MSA, are subject to recently enacted legislation that may result in their interest income and loan fee income being significantly reduced, which could cause these companies to scale back their operations and reduce personnel. A reduction in such operations and personnel could negatively affect the economic conditions in South Dakota, which in return could negatively impact our credit risk and business.
Our financial success is dependent on our ability to compete effectively in highly competitive markets.
We operate in the highly competitive markets of South Dakota. Our future growth and success will depend on our ability to compete effectively in these markets. Through the Bank, we compete for loans, deposits and other financial services in geographic markets with other local, regional and national commercial banks, credit unions, savings and loan associations, mortgage banking firms, consumer finance companies, securities brokerage firms, insurance companies, money market funds and other mutual funds, as well as super-regional, national and international financial institutions. Many of our competitors offer products and services different from us, and have substantially greater resources, name recognition and market presence than we do, which benefits them in attracting business. Larger competitors may be able to price loans and deposits more aggressively than we can and have broader customer and geographic bases to draw upon.
Competitors that are not depository institutions are generally not subject to the extensive regulations that apply to us. Through the Bank, we compete with these institutions both in attracting deposits and in making loans. In addition, we must attract our customer base from other existing financial institutions and from new residents. There is a risk that we will not be able to compete successfully with these other financial institutions in our markets, and that we may have to pay higher interest rates to attract deposits or charge lower interest rates to obtain loan volume, resulting in
reduced profitability. In new markets that we may enter, we will also compete against well-established community banks that have developed relationships within the community.
We are subject to extensive regulations that may limit or restrict our activities, and the cost of compliance is high.
We operate in a highly regulated industry and are subject to examination, supervision and comprehensive regulation by various regulatory agencies, currently including the OTS and the FDIC, and to a limited extent, the FRB. Banking regulations are primarily intended to protect the DIF and depositors, not stockholders. Our compliance with these regulations is costly and restricts certain of our activities, including payment of dividends, mergers and acquisitions, investments, loans and interest rates charged, interest rates paid on deposits and locations of offices. We are also subject to regulatory capital requirements, which require us to maintain adequate capital to support our growth. If we fail to meet these capital and other regulatory requirements, our ability to grow, our cost of funds and FDIC insurance, our ability to pay dividends on our common stock, and our ability to make acquisitions could be materially and adversely affected.
As previously highlighted, the recently enacted Dodd-Frank Act dramatically impacts the regulation and activities of federal thrifts and their holding companies by, among other things, abolishing our primary regulator, the OTS, and providing for new rules that govern the provision of consumer financial products and services. Implementation of the Dodd-Frank Act will require new mandatory and discretionary rulemakings by numerous federal regulatory agencies over the next several years which are likely to have a significant impact on the operations of all depository institutions and their holding companies.
Liquidity risks could affect operations and jeopardize our financial condition.
Liquidity is essential to our business. An inability to raise funds through deposits, borrowings, the sale of loans and other sources to accommodate our existing and future lending and investment activities could have a substantial negative effect on our liquidity and severely constrain our financial flexibility. Our primary source of funding is retail deposits gathered through our network of branch offices. Our alternative funding sources include, without limitation, brokered certificates of deposit, federal funds purchased, Federal Reserve Discount Window borrowings, FHLB of Des Moines advances and short- and long-term debt.
The Bank has historically obtained funds principally through local deposits and it has a base of lower cost transaction deposits. Generally, we believe local deposits are a cheaper and more stable source of funds than other borrowings, because interest rates paid for local deposits are typically lower than interest rates charged for borrowings from other institutional lenders and reflect a mix of transaction and time deposits, whereas brokered deposits typically are higher cost time deposits.
Our costs of funds, profitability and liquidity will be adversely affected to the extent we have to rely upon higher cost borrowings from other institutional lenders or brokers to fund loan demand or liquidity needs, and changes in our deposit mix and growth could adversely affect our profitability and the ability to expand our loan portfolio.
The Bank currently has a $15.0 million unsecured line of federal funds with First Tennessee Bank, NA, which did not have activity or an outstanding balance at June 30, 2010 and 2009.
The Bank currently has a $10.0 million unsecured line of federal funds with Zions Bank, which did not have activity or an outstanding balance at June 30, 2010.
On September 30, 2009, we entered into a Loan Agreement (the "Loan Agreement") with United Bankers' Bank (the "Lender") in order to refinance our outstanding borrowings of $5.966 million under our line of credit with First Tennessee Bank, NA (the "FTB Line of Credit"). Our borrowings
under the FTB Line of Credit were scheduled to mature on September 30, 2009. Under the Loan Agreement, the Lender committed to lend to us an aggregate principal amount not to exceed $6 million. On November 25, 2009, the Company repaid its outstanding borrowings of $6.044 million (principal plus accrued interest) under the Loan Agreement. As of June 30, 2010, there was no outstanding balance.
We may look to sell production assets, such as mortgage loans, into the secondary market as a means to manage the size of our balance sheet and manage the use of our capital. The demand for these products in the capital markets is not driven by us and may not benefit us at the time we look to sell the loans.
Our liquidity, on a parent only basis, may be adversely affected by certain restrictions on receiving dividends from the Bank without prior regulatory approval.
Higher FDIC deposit insurance premiums and assessments could adversely affect our financial condition.
FDIC insurance premiums have increased substantially within the last year and we expect to continue to pay significantly higher FDIC premiums in the future. Market developments have significantly depleted the DIF and reduced the ratio of reserves to insured deposits.
During the calendar year 2009, the FDIC imposed additional assessments and changes for the purpose of replenishing its reserves. The FDIC adopted a revised risk-based deposit insurance assessment schedule on February 27, 2009, which raised deposit insurance premiums. On May 22, 2009, the FDIC implemented a five basis point special assessment of each insured depository institution's assets minus Tier 1 capital as of June 30, 2009, that was collected on September 30, 2009. On November 12, 2009, the FDIC adopted a rule that required insured depository institutions to prepay their quarterly risk-based assessments for the fourth quarter of 2009, and for all of 2010, 2011, and 2012, on December 30, 2009, along with each institution's risk-based deposit insurance assessment for the third quarter of 2009. Under the rule, an institution accounts for the prepayment by recording the entire amount of its prepaid assessment as a prepaid expense (an asset) as of December 30, 2009, and subsequently records an expense (charge to earnings) for its regular quarterly assessment until the asset is exhausted. Once the asset is exhausted, the institution would resume paying and accounting for quarterly deposit insurance assessments as it did previous to the ruling. It also stated that this requirement for prepaid assessments does not preclude the FDIC from changing assessment rates or from further revising the risk-based assessment system during 2009, 2010, 2011, 2012, or thereafter, pursuant to notice-and-comment rulemaking procedures provided by statute. Accordingly, continued actions by the FDIC could significantly increase the Bank's noninterest expense in fiscal 2011 and for the foreseeable future. Any future special assessments or increases could have a further material impact on our results of operations.
Under the recently enacted Dodd-Frank Act, the FDIC is required to provide, after December 31, 2010 and until December 31, 2012, unlimited insurance coverage for noninterest-bearing transaction accounts. Unlike the current transaction account guarantee portion of the TLGP, the Dodd-Frank Act provides a modified definition of "noninterest-bearing transaction account" for purposes of maintaining eligibility for the unlimited guarantee, and the guarantee applies to all insured depository institutions rather than only those that have opted to participate in the program. Continued actions by the FDIC with respect to special assessments for the unlimited guarantee could significantly increase the Bank's noninterest expense in fiscal 2011 and for the foreseeable future.
Our profitability may be affected by changes in market interest rates.
Through our banking subsidiary, the Bank, our profitability depends in large part on our net interest income, which is the difference between interest earned from interest-earning assets, such as loans and mortgage-backed securities, and interest paid on interest-bearing liabilities, such as deposits
and borrowings. Our net interest income will be adversely affected if market interest rates change such that the interest we pay on deposits and borrowings increase faster than the interest earned on loans and investments.
Our results of operations will be affected by domestic economic conditions and the monetary and fiscal policies of the U.S. government and its agencies. The FRB has, and is likely to continue to have, an important impact on the operating results of lending institutions through its power to implement national monetary policy, among other things, in order to curb inflation or combat a recession. The Federal Reserve affects the levels of bank loans, investments and deposits through its control over the issuance of U.S. government securities, its regulation of the discount rate applicable to member banks and its influence over reserve requirements to which member banks are subject. If short-term interest rates rise, and if rates on our deposits and borrowings re-price upwards faster than the rates on our long-term loans and investments, we may experience compression of our net interest margin, which will have a negative effect on our results of operations. We cannot predict the nature or impact of future changes in monetary and fiscal policies.
While we intend to manage the effects of changes in interest rates by adjusting the terms, maturities and pricing of our assets and liabilities, our efforts may not be effective in a changing rate environment and our financial condition and results of operations may suffer.
A significant portion of our loan portfolio is secured by real estate; therefore, we have a high degree of risk from a downturn in our real estate markets and the local economy and face risks that are unique to holding foreclosed real estate.
A further downturn in the real estate market and local economy in South Dakota could hurt our business because a significant portion of our loans are secured by real estate located in South Dakota. Real estate values and real estate markets are generally affected by, among other things, changes in regional or local economic conditions, fluctuations in interest rates, and the availability of loans to potential purchasers. If real estate values decline in South Dakota, the value of real estate collateral securing our loans could be significantly reduced. Our ability to recover on defaulted loans by foreclosing and selling the real estate collateral would then be diminished and we would be more likely to suffer losses on defaulted loans.
Additionally, the Bank faces certain risks that are unique to holding foreclosed real estate, such as the risk that hazardous or toxic substances are found on the foreclosed property, which may require the Bank to incur substantial expenses to remediate or materially reduce the property's value. Although the Bank has policies and procedures in place to ensure that an environmental review is performed before initiating any foreclosure action on real property, these reviews may turn out to be insufficient to detect all potential environmental hazards. The remediation costs and any other financial liabilities associated with an environmental hazard in connection with foreclosed real estate could have a material adverse effect on our financial condition and results of operations.
Our loan concentration presents a business risk if the agriculture industry suffers a downturn.
Agricultural loans comprised 31.0% of our total loan and lease portfolio at June 30, 2010. A number of these loans have relatively large balances. The deterioration of one or a few of these loans may cause a significant increase in nonperforming loans. Furthermore, any extended period of low commodity prices, significantly reduced yields on crops, reduced levels of government assistance to the agricultural industry and/or reduced farmland values could result in a significant increase in our nonperforming loans. An increase in nonperforming loans could result in a loss of earnings from these loans, an increase in the provision for loan losses, and/or an increase in loan charge-offs, which would have an adverse impact on our results of operations and financial condition.
The soundness of other financial institutions could adversely affect us.
Our ability to engage in routine funding transactions could be adversely affected by the actions and commercial soundness of other financial institutions. Financial services institutions are interrelated as a result of trading, clearing, counterparty or other relationships. As a result, defaults by, or even rumors or questions about, one or more financial services institutions, or the financial services industry generally, have led to market-wide liquidity problems and could lead to losses or defaults by us or by other institutions. Many of these transactions expose us to credit risk in the event of default of our counterparty or client. In addition, our credit risk may be exacerbated when the collateral held by us cannot be realized upon or is liquidated at prices not sufficient to recover the full amount of the financial instrument exposure. There is no assurance that any such losses would not materially and adversely affect our results of operations.
Negative developments in the financial industry and the credit markets may subject us to additional regulation.
As a result of ongoing challenges facing the U.S. economy, the potential exists for new laws and regulations regarding lending and funding practices and liquidity standards to be promulgated, and bank regulatory agencies are expected to be active in responding to concerns and trends identified in examinations, including the expected issuance of many formal enforcement orders. Negative developments in the financial industry and credit markets, and the impact of new legislation in response to those developments, may negatively impact our operations by restricting our business operations, including our ability to originate or sell loans, and may adversely impact our financial performance.
Future acquisitions and expansion activities may disrupt our business, dilute existing stockholders and adversely affect our operating results.
We intend to continue to evaluate potential acquisitions and expansion opportunities in the normal course of our business. To the extent that we grow through acquisitions, we may not be able to adequately or profitably manage this growth. Acquiring other banks, thrifts, or financial service companies, as well as other geographic and product expansion activities, involve various risks including:
•risks of unknown or contingent liabilities;
•unanticipated costs and delays;
•risks that acquired new businesses do not perform consistent with our growth and profitability expectations;
•risks of entering new markets or product areas where we have limited experience;
•risks that growth will strain our infrastructure, staff, internal controls and management, which may require additional personnel, time and expenditures;
•exposure to potential asset quality issues with acquired institutions;
•difficulties, expenses and delays of integrating the operations and personnel of acquired institutions, and start-up delays and costs of other expansion activities;
•potential disruptions to our business;
•possible loss of key employees and customers of acquired institutions;
•potential short-term decreases in profitability; and
•diversion of our management's time and attention from our existing operations and business.
Attractive acquisition opportunities may not be available to us in the future.
We expect that other banking and financial service companies, many of which have significantly greater resources than us, will compete with us in acquiring other banks, thrifts, and financial service companies. This competition could increase prices for potential acquisitions that we believe are attractive. Also, acquisitions are subject to various regulatory approvals. If we fail to receive the appropriate regulatory approvals, we will not be able to consummate an acquisition that we believe is in our best interests. Among other things, our regulators consider our capital, liquidity, profitability, regulatory compliance and levels of goodwill and intangibles when considering acquisition and expansion proposals. Any acquisition could be dilutive to our earnings and stockholders' equity per share of our common stock.
Our ability to complete acquisitions and expansion activities, if any, may require us to raise additional capital that may not be available when it is needed or may not be available on terms acceptable to us.
We are required by regulatory agencies to maintain adequate levels of capital to support our operations and such levels may be increased by legislative and regulatory developments. To complete any future acquisitions and expansion activities, we may need to raise additional capital. Our ability to raise additional capital, if needed, will depend in part on conditions in the capital markets at that time, which are outside our control. Accordingly, we may not be able to raise additional capital, if needed, on terms acceptable to us. If we cannot raise additional capital when needed, our ability to further expand our operations through organic or external growth could be materially impaired.
In the event that we are able to raise capital through the issuance of additional shares of common stock or other securities, the ownership interests of current investors would be diluted and the per share book value of our common stock may be diluted. New investors may also have rights, preferences and privileges senior to the holders of our common stock, which may adversely affect the holders of our common stock.
We are subject to security and operational risks relating to our use of technology that could damage our reputation and our business.
Security breaches in our Internet banking activities or other communication and information systems could damage our reputation, result in a loss of customer business, subject us to additional regulatory scrutiny, or expose us to civil litigation and possible financial liability, any of which could have a material adverse effect on our financial condition and results of operations. We rely on standard Internet and other security systems to provide the security and authentication necessary to effect secure transmission of data. These precautions may not protect our systems from compromises or breaches of our security measures.
The loss of one or more of our key personnel, or our failure to attract, assimilate and retain other highly qualified personnel in the future, could harm our business.
As a community bank, we expect our future growth to be driven in large part by the relationships that our key personnel, including Curtis L. Hage, our Chairman, President and Chief Executive Officer, and Darrel L. Posegate, our Executive Vice President, Chief Financial Officer and Treasurer, maintain with our customers. We do not have long-term employment agreements with any of our officers or key employees. Mr. Posegate's employment agreement has a term of one year, which automatically renews on July 1 for an additional year unless, no later than March 31 of the previous year, either the Bank or Mr. Posegate gives notice that the employment agreement shall not be extended. Mr. Hage has notified us that he will retire effective December 31, 2011 from his positions as an officer of the Company and the Bank. Search efforts are underway to identify the next generation of leadership for the Company and the Bank.
We believe that our continued growth and future success will depend in large part upon the skills of our management team. The competition for qualified personnel in the financial services industry can be intense, and the loss of key personnel or an inability to continue to attract, retain and motivate key personnel could adversely affect our business. The unexpected loss of any of our key employees could have a material adverse effect on our business and possibly result in reduced revenues and earnings.
Changes in or interpretations of accounting standards may materially impact our financial statements.
Accounting principles generally accepted in the United States and accompanying accounting pronouncements, implementation guidelines, interpretations and practices for many aspects of our business are complex and involve subjective judgments, including, but not limited to, accounting for the allowance for loan and lease losses and pending and incurred but not reported health claims. Changes in these estimates or changes in other accounting rules and principles, or their interpretation, could significantly change our reported earnings and operating results, and could add significant volatility to those measures, without a comparable underlying change in cash flow from operations.
The holders of our junior subordinated debentures have rights that are senior to those of our stockholders.
We have supported our continued growth through the issuance of trust preferred securities from special purpose trusts and accompanying sales of junior subordinated debentures to these trusts. The accompanying junior subordinated debentures have an aggregate liquidation amount totaling $27.8 million as of June 30, 2010. Payments of the principal and interest on the trust preferred securities of these trusts are conditionally guaranteed by us. Further, the accompanying junior subordinated debentures that we issued to the trusts are senior to our shares of common stock. As a result, we must make payments on the junior subordinated debentures before any dividends can be paid on our common stock and, in the event of our bankruptcy, dissolution or liquidation, the holders of the junior subordinated debentures must be satisfied before any distributions can be made on our common stock.
Risks Relating to Our Common Stock
The price of our common stock may fluctuate significantly, and this may make it difficult for you to resell shares of our common stock at times or at prices you find attractive.
The stock market and, in particular, the market for financial institution stocks, has experienced significant volatility, which has reached unprecedented levels in past months. In some cases, the markets have produced downward pressure on stock prices for certain issuers without regard to those issuers' underlying financial strength. As a result, the trading volume in our common stock may fluctuate more than usual and cause significant price variations to occur. This may make it difficult for you to resell shares of our common stock at times or at prices you find attractive.
The trading price of the shares of our common stock will depend on many factors that may change from time to time and may be beyond our control. Among the factors that could affect our stock price are those identified in the section entitled "Special Cautionary Note Regarding Forward-Looking Statements" and as follows:
•actual or anticipated quarterly fluctuations in our operating results and financial condition;
•changes in financial estimates or publication of research reports and recommendations by financial analysts or actions taken by rating agencies with respect to our common stock or those of other financial institutions;
•failure to meet analysts' revenue or earnings estimates;
•speculation in the press or investment community generally or relating to our reputation, our market area, our competitors or the financial services industry in general;
•strategic actions by us or our competitors, such as acquisitions, restructurings, dispositions or financings;
•actions by our current stockholders, including sales of common stock by existing stockholders and/or directors and executive officers;
•fluctuations in the stock price and operating results of our competitors;
•future sales of our equity, equity-related or debt securities;
•changes in the frequency or amount of dividends or share repurchases;
•proposed or adopted regulatory changes or developments;
•anticipated or pending investigations, proceedings or litigation that involve or affect us;
•trading activities in our common stock, including short-selling;
•domestic and local economic factors unrelated to our performance; and
•general market conditions and, in particular, developments related to market conditions for the financial services industry.
A significant decline in our stock price could result in substantial losses for individual stockholders and could lead to costly and disruptive securities litigation.
Our ability to pay dividends depends primarily on dividends from our banking subsidiary, the Bank, which is subject to regulatory limits.
We are a unitary thrift holding company and our operations are conducted primarily by our banking subsidiary, the Bank. Since we receive substantially all of our revenue from dividends from the Bank, our ability to pay dividends on our common stock depends on our receipt of dividends from the Bank.
Dividend payments from the Bank are subject to legal and regulatory limitations, generally based on net income and retained earnings. The ability of the Bank to pay dividends to us is also subject to its profitability, financial condition, capital expenditures and other cash flow requirements. The Bank may not be able to generate adequate cash flow to pay us dividends in the future. The inability to receive dividends from the Bank could have an adverse effect on our business and financial condition.
Furthermore, holders of our common stock are only entitled to receive the dividends as our Board of Directors may declare out of funds legally available for such payments. Although we have historically paid cash dividends on our common stock, we are not required to do so and our Board of Directors could reduce or eliminate our common stock dividend in the future. This could adversely affect the market price of our common stock.
Additionally, we may elect in the future to defer interest payments on our junior subordinated debentures discussed above. The debenture agreements prohibit dividend payments on our common stock following the deferral of interest payments on the subordinated debentures underlying the trust preferred securities.
The trading volume in our common stock has been low, and the sale of a substantial number of shares of our common stock in the public market could depress the price of our common stock and make it difficult for you to sell your shares.
Our common stock is listed to trade on The Nasdaq Global Market but is thinly traded. As a result, you may not be able to sell your shares of common stock on short notice. Additionally, thinly traded stock can be more volatile than stock trading in an active public market. The sale of a substantial number of shares of our common stock at one time could depress the market price of our common stock, making it difficult for you to sell your shares and impairing our ability to raise capital.
We may raise additional capital, which could have a dilutive effect on the existing holders of our common stock and adversely affect the market price of our common stock.
We are not restricted from issuing additional shares of common stock or securities that are convertible into or exchangeable for, or that represent the right to receive, common stock. We may evaluate opportunities to access the capital markets taking into account our regulatory capital ratios, financial condition and other relevant considerations, and subject to market conditions, we may take further capital actions in addition to issuance of the shares offered by this prospectus. Such actions could include, among other things, the issuance of additional shares of common stock in public or private transactions in order to further increase our capital levels above the requirements for a well-capitalized institution established by the federal bank regulatory agencies as well as other regulatory targets.
We face significant regulatory and other governmental risks as a financial institution, and it is possible that capital requirements and directives could in the future require us to change the amount or composition of our current capital, including common equity.
The issuance of any additional shares of common stock or securities convertible into or exchangeable for common stock or that represent the right to receive common stock, or the exercise of such securities, could be substantially dilutive to holders of our common stock, including purchasers of common stock in this offering. Holders of our shares of common stock have no preemptive rights that entitle holders to purchase their pro rata share of any offering of shares of any class or series and, therefore, such sales or offerings could result in increased dilution to our stockholders. The market price of our common stock could decline as a result of sales of shares of our common stock made after this offering or the perception that such sales could occur.
Certain provisions of our Certificate of Incorporation and Bylaws, as well as Delaware and federal law, may discourage, delay or prevent an acquisition of control of us.
Certain provisions included in our Certificate of Incorporation and Bylaws, as well as certain provisions of the Delaware General Corporation Law and federal law, may discourage, delay or prevent potential acquisitions of control of us, particularly when attempted in a transaction that is not negotiated directly with, and approved by, our Board of Directors, despite possible benefits to our stockholders.
Specifically, our Certificate of Incorporation and Bylaws, as the case may be, include certain provisions that:
•limit the voting power of shares held by a stockholder beneficially owning in excess of 10% of the then-outstanding shares of our common stock;
•require that certain business combinations between us and a stockholder beneficially owning in excess of 10% of the then-outstanding shares of our capital stock entitled to vote in the election of directors be approved by the affirmative vote of the holders of at least 662/3% of the then-outstanding shares of stock entitled to vote in the election of directors, voting together as a
single class, or be approved by the affirmative vote of the majority of the outstanding shares of our capital stock entitled to vote if the business combination (i) is approved by a majority of the Board of Directors serving prior to the 10% stockholder becoming such, and/or (ii) involves consideration per share generally equal to that paid by such 10% stockholder when such stockholder acquired his, her or its stock;
•divide our Board of Directors into three classes serving staggered three-year terms and provide that a director may only be removed prior to the expiration of a term for cause by the affirmative vote of the holders of at least 80% of the voting power of all of the then-outstanding shares of capital stock entitled to vote in an election of directors;
•require that a special meeting of stockholders be called pursuant to a resolution adopted by a majority of our Board of Directors;
•authorize the issuance of preferred stock with such designations, rights and preferences as may be determined from time to time by our Board of Directors; and
•require that an amendment to our Certificate of Incorporation be approved by a vote of at least two-thirds of our directors then in office and thereafter by our stockholders by a majority of the total votes eligible to be cast at a stockholders meeting called for that purpose; provided, however, with respect to the amendment of certain provisions regarding, among other things, provisions relating to the voting limits of holders of more than 10% of our common stock, the number, classification, election and removal of directors, amendment of the Bylaws, call of special stockholder meetings, acquisitions of control, director liability, and certain business combinations, in addition to any vote of the holders of any class or series of our capital stock required by applicable law or by our Certificate of Incorporation, such amendments must be approved by the affirmative vote of the holders of at least 80% of the voting power of all of our then-outstanding capital stock entitled to vote generally in the election of directors, voting together as a single class.
Furthermore, federal law requires OTS approval prior to any direct or indirect acquisition of "control" (as defined in OTS regulations) of the Bank, including any acquisition of control of us. Under OTS regulations, an acquiror is deemed, subject to rebuttal, to have acquired control of a savings association if the acquiror, directly or indirectly, or through one or more subsidiaries or transactions or acting in concert with one or more persons or companies, acquires more than 10 percent of any class of voting stock of a savings association and is subject to any of the enumerated control factors under the regulation.
Item 1B.
Item 1B. Unresolved Staff Comments
None.
Item 2.
Item 2. Properties
The Company and its direct and indirect subsidiaries conduct their business at the main office located at 225 South Main Avenue, Sioux Falls, South Dakota, 57104. Currently, the Bank has a total of 33 banking centers in its market area and one Internet branch located at www.homefederal.com. Of such 33 total banking centers, the Company owns 15, including the main office, and leases 18 others. For a description of the Bank's market area, see Item 1, "Business-Market Area" of this Form 10-K.
The total net book value of the Company's premises and equipment (including land, building, leasehold improvements and furniture, fixtures and equipment) at June 30, 2010 was $15.0 million. The Company's previously announced new facility in Watertown, South Dakota completed construction in fiscal 2010 and subsequently on February 1, 2010 was sold as a leased back facility to an unrelated group. This facility replaces an existing branch office in that community. Management believes there is
a continuing need to keep facilities and equipment up-to-date and continued investment will be necessary in the future.
Item 3.
Item 3. Legal Proceedings
The Company, the Bank and each of their subsidiaries are, from time to time, involved as plaintiff or defendant in various legal actions arising in the normal course of their businesses. While the ultimate outcome of any such proceedings cannot be predicted with certainty, it is generally the opinion of management, after consultation with counsel representing the Bank and the Company in any such proceedings, that the resolution of any such proceedings should not have a material effect on the Company's consolidated financial position or results of operations. The Company, the Bank and each of their subsidiaries are not aware of any legal actions or other proceedings contemplated by governmental authorities outside of the normal course of business.
Item 4.
Item 4. [Removed and Reserved]
PART II
Item 5.
Item 5. Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities
Stock Listing
The Company's common stock is traded under the symbol "HFFC" on the NASDAQ Global Market.
The following table sets forth the range of high and low sale prices for the Company's common stock for each quarter of the two most recent fiscal years ended June 30, 2010 and 2009. Quotations for such periods are as reported by the NASDAQ Global Market.
As of September 3, 2010, the Company had 461 holders of record of its common stock.
The transfer agent for the Company's common stock is BNY Mellon Shareowner Services, P.O. Box 358015, Pittsburgh, PA 15252.
Dividends
The Company paid cash dividends on a quarterly basis of $0.1125, $0.1125, $0.1125 and $0.1125 per share throughout fiscal 2010. The Company paid cash dividends on a quarterly basis of $0.1125, $0.1125, $0.1125 and $0.1125 per share in fiscal 2009. On July 26, 2010, the Board of Directors announced the approval of a cash dividend of $0.1125 per share and the Company paid the respective cash dividends on August 13, 2010 to stockholders of record on August 6, 2010.
The Company's ability to pay dividends on its common stock is dependent on the dividend payments it receives from the Bank, since the Company receives substantially all of its revenue in the form of dividends from the Bank. Future dividends are not guaranteed and will depend on the Company's ability to pay them.
The Company and the Bank are subject to the oversight of the OTS and the Bank is also subject to the oversight of the FDIC. The OTS imposes various restrictions on the Bank's ability to make capital distributions, including cash dividends. The Bank must file a notice with the OTS at least 30 days before making a capital distribution. The Bank must also file an application for prior approval to make a dividend if the total amount of its capital distributions, including the proposed distribution, for the applicable calendar year would exceed an amount equal to the Bank's net income for that year plus retained net income for the previous two years.
The OTS may disapprove of a notice or application if:
•the Bank would be undercapitalized following the distribution;
•the proposed capital distribution raises safety and soundness concerns; or
•the capital distribution would violate a prohibition contained in any statute, regulation or agreement between the Bank and the OTS or the FDIC, or a condition imposed on the Bank in an OTS-approved application or notice.
The Company's ability to pay dividends is also subject to the terms of its outstanding trust preferred securities and the accompanying junior subordinated debentures. Under the terms of these debentures, the Company may defer interest payments on the debentures for up to five years. If the Company defers such interest payments, the Company may not declare or pay any cash dividends on any shares of its common stock during the deferral period.
In addition, the Company has a line of credit for $6.0 million with United Bankers' Bank with no outstanding balance at June 30, 2010. The line of credit matures on October 1, 2010. In case of default on the line of credit, the Company's ability to pay cash dividends may be restricted.
Stockholder Return Performance
The following line graph compares the cumulative total stockholder return on the Company's common stock to the comparable cumulative total return of the NASDAQ Market Index and the NASDAQ Bank Index for the last five years.
The performance graph assumes that on July 1, 2005, $100 was invested in the Company's common stock (at the closing price of the previous trading day) and in each of the indexes. The comparison assumes the reinvestment of all dividends. Cumulative total stockholder returns for the Company's common stock, the NASDAQ Market Index and the NASDAQ Bank Index are based on the Company's fiscal year ending June 30. The performance graph represents past performance and should not be considered to be an indication of future performance.
COMPARISON OF 5-YEAR CUMULATIVE TOTAL STOCKHOLDER RETURN
AMONG HF FINANCIAL CORP.,
NASDAQ MARKET INDEX AND NASDAQ BANK INDEX
ASSUMES $100 INVESTED ON JULY 01, 2005
ASSUMES DIVIDENDS REINVESTED
FISCAL YEAR ENDING JUNE 30, 2010
Equity Compensation Plan Information
The following table sets forth certain information about the common stock that may be issued upon exercise of options, warrants and rights under all of the Company's existing equity compensation plans as of June 30, 2010, including the 2002 Stock Option and Incentive Plan, the 1996 Director Restricted Stock Plan, and the 1991 Stock Option and Incentive Plan (collectively, the "Incentive Plans"). The 1996 Director Restricted Stock Plan expired on January 1, 2007, and the 1991 Stock Option and Incentive Plan expired on October 27, 2002. Although the column below entitled "Number of Securities to be Issued Upon Exercise of Outstanding Options, Warrants and Rights" includes common stock to be issued upon unexpired options issued under the 1991 Stock Option and Incentive Plan, no common stock remains available for future awards under the 1991 Stock Option and Incentive
Plan. Additionally, no common stock remains available for future awards under the 1996 Director Restricted Stock Plan.
(1)All 349,084 shares may be issued under the 2002 Stock Option and Incentive Plan in the form of nonvested stock.
Sales of Unregistered Stock
None.
Issuer Purchases of Equity Securities
None.
Item 6.
Item 6. Selected Financial Data
The following table sets forth selected consolidated financial statement and operations data with respect to the Company for the periods indicated. This information should be read in conjunction with the Financial Statements and related notes appearing in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K and with Part II, Item 7
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations
This section should be read in conjunction with the following parts of this Form 10-K: Forward-Looking Statements, Part II, Item 8 "Financial Statements and Supplementary Data," Part II, Item 7A, "Quantitative and Qualitative Disclosures About Market Risk," and Part I, Item 1 "Business."
Executive Summary
The Company's net income available to common stockholders for fiscal 2010 was $5.7 million, or $1.00 per diluted share, compared to $6.5 million, or $1.61 per diluted share for fiscal 2009. Return on average equity was 6.82% at June 30, 2010, compared to 9.73% at June 30, 2009.
During the second quarter of fiscal 2010, the Company issued 2.9 million shares of its common stock at a public offering price of $8.00 per share, for gross proceeds of $23.0 million. The net proceeds of the offering after deducting underwriting discounts and commissions and estimated offering expenses totaled approximately $20.7 million. The proceeds were used to pay off an existing line of credit with United Bankers' Bank of $6.0 million and increase liquidity. As a result of the stock offering, average equity increased by 4.9% in fiscal 2010 compared to fiscal 2009, primarily due to the capital raised. Per share earnings calculations were based on a diluted weighted average shares outstanding of 5.8 million shares versus 4.0 million shares in fiscal 2009.
Net interest income for fiscal 2010 was $36.7 million, an increase of $1.3 million or 3.8% over the same period a year ago. The net interest margin was 3.29%, compared to 3.26% for the same period a year ago, an increase of 3 basis points. On a fully taxable equivalent basis, the net interest margin for fiscal 2010 was 3.34%, compared to 3.32% in fiscal 2009. Net Interest Margin, TE is a non-GAAP financial measure. See "Analysis of Net Interest Income" for a calculation of this non-GAAP financial measure and for further discussion as to the reasons we believe this non-GAAP financial measure is useful. The cost of funds rate on interest-bearing liabilities decreased from 2.65% in fiscal 2009 to 2.11% in fiscal 2010, a change of 54 basis points. For the same period, yields on earning assets decreased from 5.60% to 5.15%, a decrease of 45 basis points. Increases in volume from fiscal 2009 to fiscal 2010 of average earning assets and interest-bearing liabilities were 2.9% and 2.7% respectively.
Variability of the net interest margin ratio may be affected by many aspects, including Federal Reserve policies for short-term interest rates, competitive and global economic factors and customer preferences for various products and services. As of June 30, 2010, management believes that it has positioned the institution for earning asset sensitivity, whereas an asset sensitive institution will generally realize an increase in income if interest rates rise due to the fact that more assets will be reinvested at higher market rates than liabilities. However, within a twelve month time horizon there may be a slight lag effect where liabilities may initially reprice faster than assets for a portion of the time period.
Agricultural loans accounted for the majority of the loan growth between fiscal 2010 and 2009. Agricultural real estate loans were $118.4 million at the end of 2010, up $16.2 million or 15.9% since fiscal year 2009, and comprised 13.6% of total loans outstanding, up from 11.8% at the end of 2009. Agricultural business loans were $152.2 million at the end of 2010, up $23.1 million or 17.9% since fiscal year 2009, and comprised 17.4% of total loans outstanding, up from 14.9% at the end of 2009. Loans of this type are in a diverse range of agricultural enterprises, including grain production, dairy and livestock operations. The credit risk related to agricultural loans is largely influenced by general economic conditions and the resulting impact on a borrower's operations or on the value of underlying collateral, if any. Credit risk is managed by employing sound underwriting guidelines, lending primarily to borrowers in local markets, periodically evaluating the underlying collateral, and formally reviewing the borrower's financial soundness and relationship on an ongoing basis.
The allowance for loan and lease losses increased $1.1 million to $9.6 million at June 30, 2010, an increase of 13.0%. The ratio of allowance for loan and lease losses to total loans and leases was 1.07% as of June 30, 2010 compared to 0.98% at June 30, 2009. Total nonperforming assets at June 30, 2010 were $9.2 million as compared to $12.6 million at June 30, 2009. The ratio of nonperforming assets to total assets was 0.73% for June 30, 2010, compared to 1.07% at June 30, 2009. The allowance for loan and lease losses is calculated based on loan and lease levels, loan and lease loss history over 12, 36, and 60 month time periods, credit quality of the loan and lease portfolio, and environmental factors such as economic health of the region and management experience. This risk rating analysis is designed to give the Company a consistent and systematic methodology to determine proper levels for the allowance at a given time. Management intends to continue its disciplined credit administration and loan underwriting processes and to remain focused on the creditworthiness of new loan originations.
The Company held $9.3 million in trust preferred securities at June 30, 2010 that are currently impaired under applicable accounting rules. These are comprised of pooled securities issued primarily by banks throughout the United States, and were downgraded which places each in a below investment grade rating. The Company performed analysis to determine if any of the securities had a credit loss by estimating if any of the cash flows are not expected to be received as contracted. During fiscal 2010 and 2009, we determined that four debt securities exhibited other-than-temporary impairment. The aggregate OTTI losses recorded for the four securities were $6.1 million, of which $3.0 million was recognized on the balance sheet in other comprehensive income, and $3.1 million of credit loss recognized through earnings.
Total deposits at June 30, 2010, were $914.3 million, an increase of $76.4 million, or 9.1%, from June 30, 2009. Due to the continued low interest rate environment, the Company experienced a preference by customers of deposititng in non-maturity deposits. Money market accounts increased $44.6 million, or 30.7%, from June 30, 2009, noninterest bearing checking accounts increased $23.1 million, or 24.5%, and interest bearing checking accounts increased $5.4 million, or 5.7%, over the same period a year ago. Public fund account balances increased $32.4 million, or 17.8%, from June 30, 2009, which was primarily in the money market and checking account categories. Interest expense on deposits was $12.3 million for fiscal 2010, a decrease of $3.4 million, or 21.5%, over fiscal 2009.
The total risk-based capital ratio was 11.68% at June 30, 2010, compared to 11.05% at June 30, 2009. This continues to place the Bank in the "well-capitalized" category within OTS regulation at June 30, 2010, and is consistent within the "well-capitalized" OTS category in which the Company plans to operate. The Company historically has been able to manage the size of its assets through secondary market loan sales of single-family mortgages, student loans and a loan securitization.
Noninterest income for fiscal 2010 was $11.0 million, compared to $12.6 million for the same period a year ago, a decrease of $1.6 million or 12.6%. Net impairment losses recognized in earnings increased $2.3 million from fiscal 2009 to fiscal 2010. Loan servicing income, fees on deposits, and net gain on sale of loans decreased $259,000, $137,000, and $65,000, respectively, over the previous year. The decline in loan servicing income was a largely a result of changes in the portfolio's performance attributes. Net gain on sale of securities and trust income increased $949,000 and $144,000, respectively, which combined to partially offset the previously mentioned decreases from fiscal 2009 to fiscal 2010.
Noninterest expense for fiscal 2010 was $36.0 million, compared to $34.6 million for fiscal 2009, an increase of $1.5 million or 4.3%. Occupancy and equipment, marketing and community development, and check and data processing increased $498,000, $332,000, and $173,000, respectively. During the company's annual goodwill impairment testing, it was determined that the goodwill associated with the acquisition of the leasing division was impaired. Accordingly, the Company wrote-off the entire amount of goodwill associated with this acquisition, resulting in an additional $585,000 of expense for fiscal
2010. Employee compensation and benefits decreased $232,000, or 1.1%, as compared to fiscal 2009, which was attributed primarily to performance-based incentive pay and healthcare cost decreases.
The Company focuses on balancing operating costs with operating revenue levels in order to provide better efficiency ratios over time and continues to review its operations for ways to reduce its cost structure while continuing to support long-term revenue enhancements. The operating efficiency ratio (i.e., noninterest expense divided by total revenue adjusted for interest expense of trust preferred debt securities) for fiscal 2010 was 73.71%, compared to 69.83% for the same period a year ago, an increase of 388 basis points. The operating efficiency ratio excludes the impact of net interest expense on the variable priced trust preferred securities. The Company has issued trust preferred securities primarily to provide funding for stock repurchases and to repay other borrowings. Net interest expense on the $27.8 million of trust preferred securities outstanding was $1.8 million for fiscal 2010 and 2009, with an average rate paid of 6.61% and 6.57% paid in fiscal 2010 and fiscal 2009, respectively. The total efficiency ratio (i.e., non-interest expense divided by total revenue) was 75.57% for the year ended June 30, 2010, compared to 72.12% for the prior year, an increase of 345 basis points. Contributing to this change in the efficiency ratio was the goodwill impairment expense of $585,000 and the $2.3 million increase in other-than-temporary impairment. Management believes that improvement to the operating efficiency ratio can be accomplished through steady growth of the balance sheet and the containment of incremental operating expenses.
The Bank is a member of the Deposit Insurance Fund (the "DIF"), which is administered by the Federal Deposit Insurance Corporation ("FDIC"). Deposits are insured up to the applicable limits by the FDIC and such insurance is backed by the full faith and credit of the United States Government. As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. Recent bank failures have decreased the DIF to levels below its required reserve ratio. In order to replenish the DIF, the FDIC has increased deposit insurance premiums to a level designed to restore the DIF to required levels within seven years, and the Company paid a one-time special assessment of $535,000 on September 30, 2009, based upon deposits at June 30, 2009. This assessment was accrued in the fourth quarter of fiscal 2009. In addition, on November 12, 2009, the FDIC Board approved a rule requiring prepayment of the quarterly assessments for the fourth quarter of calendar 2009, and the entire calendar years of 2010, 2011, and 2012. On December 30, 2009, the Company paid $4.9 million which was recorded as a prepaid asset and will be proportionally expensed over future periods. At June 30, 2010, the remaining balance recorded as a prepaid asset was $3.7 million. The FDIC may impose additional special assessments which would be recorded as they are incurred. The FDIC also instituted the Transaction Account Guarantee Program ("TAGP"). The TAGP extended the FDIC's insurance to full coverage of non-interest bearing transaction accounts for participating institutions through December 31, 2010 and provided for the possibility of a further extension through December 31, 2011. The Bank is assessed an annualized rate of 15 basis points on deposit balances in excess of the $250,000 insurance limit. The Bank is a participant in the TAGP, but does not expect this program to have a material impact on the FDIC assessment. The Bank had previously paid assessments under the Savings Association Insurance Fund ("SAIF") and was eligible for certain credit against deposit insurance assessments when SAIF was merged into the DIF in 2005. This credit had offset the majority of the Bank's FDIC premium expense in past fiscal years, but was fully utilized during the second quarter of fiscal 2009.
Recent events in the financial markets produce uncertainties to management about future operating results and the future financial condition of the Company. The interdependencies of the national economy and financial markets do affect the macro economics reviewed by management and may produce outcomes in the future that have not impacted the Company previously.
General
The Company is a financial services provider and, as such, has inherent risks that must be managed in order to achieve net income. Primary risks that affect net income include credit risk, liquidity risk, operational risk, regulatory compliance risk and reputation risk. The Company's net income is derived by management of the net interest margin, the ability to collect fees from services provided, by controlling the costs of delivering services and the management of loan and lease losses. The primary source of revenues is the net interest margin, which represents the difference between income on interest-earning assets (i.e. loans and investment securities) and expense on interest-bearing liabilities (i.e. deposits and borrowed funding). The net interest margin is affected by regulatory, economic and competitive factors that influence interest rates, loan demand and deposit flows. Fees earned include charges for deposit services, trust services and loan services. Personnel costs are the primary expenses required to deliver the services to customers. Other costs include occupancy and equipment and general and administrative expenses.
Financial Condition Data
At June 30, 2010, the Company had total assets of $1,253.0 million, an increase of $76.2 million from the level at June 30, 2009. The increase in assets was due primarily to increases in securities available for sale of $41.5 million, net loans and leases receivable of $19.9 million and loans held for sale of $10.4 million. The increase in liabilities of $50.5 million was primarily due to increases in deposits of $76.4 million and partially offset by decreased advances from the FHLB and other borrowings of $22.2 million. In addition, stockholders' equity increased to $94.4 million at June 30, 2010, from $68.7 million at June 30, 2009, primarily due to additional stock issued of $21.6 million, net income of $5.7 million and partially offset by cash dividends paid of $2.5 million.
The increase in securities available for sale of $41.5 million was due primarily to the purchases of mortgage-backed securities during the year. The increase in net loans and leases receivable of $19.9 million was due primarily to an increase in originations over sales, amortization and repayments of principal. During the first quarter of fiscal 2008, the Company announced that it had ceased origination of indirect auto loans. Indirect auto loan outstanding balances declined $21.4 million during the fiscal year to $8.2 million at June 30, 2010. In addition, loans held for sale increased $10.4 million, primarily due to the increase in one-to four-family loans held at June 30, 2010.
See the Consolidated Statement of Cash Flows for an in-depth analysis of the change in cash and cash equivalents.
Deposits increased $76.4 million primarily due to the increase of in-market deposits, which primarily consisted of money market and checking account increases. Public funds, which are part of the in-market deposits, increased $32.4 million of the total. Advances from the FHLB and other borrowings decreased $22.2 million, at June 30, 2010 as compared to June 30, 2009, due to the reduced funding needs resulting from the increased deposits.
Stockholders' equity increased $25.8 million at June 30, 2010 when compared to June 30, 2009, due primarily to stock issuance of $20.7 million during November 2009. The Company issued 2.9 million shares of its common stock in an underwritten public offering at $8.00 per share, for gross proceeds of $23.0 million. The net proceeds of the offering after deducting underwriting discounts and commissions and estimated offering expenses totaled approximately $20.7 million. The increase in stockholders' equity was also attributed to the net income of $5.7 million and partially offset by the cash dividends paid of $2.5 million.
Analysis of Net Interest Income
Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the volume of interest-earning assets and interest-bearing liabilities and the interest rates earned or paid on them.
Average Balances, Interest Rates and Yields. The following table presents for the periods indicated, the total dollar amount of interest income from average interest-earning assets and the resulting yields, as well as the interest expense on average interest-bearing liabilities, expressed both in dollars and rates, and the net interest margin. The table does not reflect any effect of income taxes. Average balances consist of daily average balances for the Bank with simple average balances for all other companies. The average balances include nonaccruing loans and leases. The yields on loans and leases include origination fees, net of costs, which are considered adjustments to yield.
(1)Includes loan fees and interest on accruing loans and leases past due 90 days or more.
(2)Includes federal funds sold.
(3)Yields do not reflect the tax-exempt nature of loans, equipment leases and municipal securities.
(4)Net interest margin is net interest income divided by average interest-earning assets.
(5)Net interest margin expressed on a fully taxable equivalent basis ("Net Interest Margin, TE") is a non-GAAP financial measure. The tax-equivalent adjustment to net interest income recognizes the income tax savings when comparing taxable and tax-exempt assets and adjusting for federal and state exemption of interest income and certain other permanent income tax differences. We believe that it is a standard practice in the banking industry to present net interest margin expressed on a fully taxable equivalent basis, and accordingly believe the presentation of this non-GAAP financial measure may be useful for peer comparison purposes. As a non-GAAP financial mea-sure, Net Interest Margin, TE should be considered supplemental to and not a substitute for or superior to, financial measures calculated in accordance with GAAP. As other companies may use different calculations for Net Interest Margin, TE, this presentation may not be comparable to similarly titled measures reported by other companies.
Rate/Volume Analysis of Net Interest Income
The following schedule presents the dollar amount of changes in interest income and interest expense for major components of interest-earning assets and interest-bearing liabilities. It distinguishes between the increases and decreases due to fluctuating outstanding balances that are due to the levels and volatility of interest rates. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (i.e., changes in volume multiplied by old rate) and (ii) changes in rate (i.e., changes in rate multiplied by old volume). For purposes of this table, changes attributable to both rate and volume, which cannot be segregated, have been allocated proportionately to the change due to volume and the change due to rate.
(1)Includes loan fees and interest on accruing loans and leases past due 90 days or more.
(2)Includes federal funds sold.
Application of Critical Accounting Policies
GAAP requires management to utilize estimates when reporting financial results. The Company has identified the policies discussed below as Critical Accounting Policies because the accounting estimates require management to make certain assumptions about matters that may be uncertain at the time the estimate was made and a different method of estimating could have been reasonably made that could have a material impact on the presentation of the Company's financial condition, changes in financial condition or results of operations.
Allowance for Loan and Lease Losses. GAAP requires the Company to set aside reserves or maintain an allowance against probable loan and lease losses in the loan and lease portfolio. Management must develop a consistent and systematic approach to estimate the appropriate balances that will cover the probable losses. Due to the uncertainty of future events, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP.
The allowance is compiled by utilizing the Company's loan and lease risk rating system, which is structured to identify weaknesses in the loan and lease portfolio. The risk rating system has evolved to a process whereby management believes the system will properly identify the credit risk associated with the loan and lease portfolio. Due to the stratification of loans and leases for the allowance calculation, the estimate of the allowance for loan and lease losses could change materially if the loan and lease risk rating system would not properly identify the strength of a large or a few large loan and lease customers. Although management believes that it uses the best information available to determine the allowance, unforeseen market or borrower conditions could result in adjustments and net earnings being significantly affected if circumstances differ substantially from the assumptions used in making the final determinations.
Mortgage Servicing Rights ("MSR"). The Company records a servicing asset for contractually separated servicing from the underlying mortgage loans. The asset is initially recorded at fair value and represents an intangible asset backed by an income stream from the serviced assets. The asset is amortized in proportion to and over the period of estimated net servicing income.
At each balance sheet date, the MSRs are analyzed for impairment, which occurs when the fair value of the MSRs is lower than the amortized book value. The Company's MSRs are primarily servicing rights acquired on South Dakota Housing Development Authority, first-time homebuyers program. Due to the lack of quoted markets for the Company's servicing portfolio, the Company estimates the fair value of the MSRs using present value of future cash flow analysis. If the analysis produces a fair value that is greater than or equal to the amortized book value of the MSRs, no impairment is recognized. If the fair value is less than the book value, an expense for the difference is charged to earnings by initiating a MSR valuation account. If the Company determines this impairment is temporary, any future changes in fair value are recorded as a change in earnings and the valuation. If the Company determines the impairment to be permanent, the valuation is written off against the MSRs which results in a new amortized balance.
The Company has included MSRs as a critical accounting policy because the use of estimates for determining fair value using present value concepts may produce results which may significantly differ from other fair value analysis perhaps even to the point of recording impairment. The risk to earnings is when the underlying mortgages payoff significantly faster than the assumptions used in the previously recorded amortization. Estimating future cash flows on the underlying mortgages is a difficult analysis and requires judgment based on the best information available. The Company looks at alternative assumptions and projections when preparing a reasonable and supportable analysis. Based on the Company's quarterly analysis of MSRs, there was no impairment to the MSRs at June 30, 2010.
Security Impairment. Management continually monitors the investment security portfolio for impairment on a security by security basis. During the third quarter of fiscal 2009, the Company early adopted FASB Staff Position ("FSP") No. FAS 115-2, The Recognition and Presentation of Other-Than-Temporary Impairments, which changed the recognition and presentation of other-than-temporary impairment for securities. Management has a process in place to identify securities that could potentially have a credit impairment that is other than temporary. This process involves the length of time and extent to which the fair value has been less than the amortized cost basis, review of available information regarding the financial position of the issuer, monitoring the rating of the security, cash flow projections, and the Company's intent to sell a security or whether it is more likely than not the Company will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity. To the extent we determine that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized. If the Company intends to sell a security or it is more likely than not that the Company would be required to sell a security before the recovery of its amortized cost, less any current period credit loss, the Company recognizes an other-than-temporary impairment in earnings for the difference between amortized cost and fair value. If we do not expect to recover the amortized cost basis, we do not plan to sell the security and if it is not more likely than not that the Company would be required to sell a security before the recovery of it amortized cost, less any current period credit loss, the recognition of the other-than-temporary impairment is bifurcated. For those securities, the Company separates the total impairment into a credit loss component recognized in earnings, and the amount of the loss related to other factors is recognized in other comprehensive income net of taxes.
The amount of the credit loss component of a debt security impairment is estimated as the difference between amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset- backed or floating rate security. Cash flow estimates for trust preferred securities are derived from scenario-based outcomes of forecasted default rates, loss severity, prepayment speeds and structural support.
Level 3 Fair Value Measurement. GAAP requires the Company to measure the fair value of financial instruments under a standard which describes three levels of inputs that may be used to measure fair value. Level 3 measurement includes significant unobservable inputs that reflect the Company's own assumptions about the assumptions that market participants would use in pricing an asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Although management believes that it uses a best estimate of information available to determine fair value, due to the uncertainty of future events, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP.
Self-Insurance. The Company has a self-insured healthcare plan for its employees up to certain limits. To mitigate a portion of these risks, the Company has a stop-loss insurance policy through a commercial insurance carrier for coverage in excess of $65,000 per individual occurrence. The estimate of self-insurance liability is based upon known claims and an estimate of incurred, but not reported ("IBNR") claims. IBNR claims are estimated using historical claims lag information received by a third party claims administrator. Due to the uncertainty of health claims, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP. Although management believes that it uses the best information available to determine the accrual, unforeseen health claims could result in adjustments to the accrual. These adjustments could significantly affect net earnings if circumstances differ substantially from the assumptions used in estimating the accrual.
Asset Quality
When a borrower fails to make a required payment on a loan within 10 to 15 days after the payment is due, the Bank generally institutes collection procedures by issuing a late notice. The customer is contacted again when the payment is between 17 and 40 days past due. In most cases, delinquencies are cured promptly; however, if a loan has been delinquent for more than 40 days, the Bank attempts additional written as well as verbal contacts and, if necessary, personal contact with the borrower in order to determine the reason for the delinquency and to effect a cure, and, where appropriate, reviews the condition of the property and the financial circumstances of the borrower. Based upon the results of any such investigation, the Bank may: (i) accept a repayment program which under appropriate circumstances could involve an extension in the case of consumer loans for the arrearage from the borrower, (ii) seek evidence, in the form of a listing contract, of efforts by the borrower to sell the property if the borrower has stated that he is attempting to sell, or (iii) initiate foreclosure proceedings. When a loan payment is delinquent for 90 days, the Bank generally will initiate foreclosure proceedings unless management is satisfied the credit problem is correctable.
Loans are generally classified as nonaccrual when there are reasonable doubts as to the collectability of principal and/or interest and/or when payment becomes 90 days past due, except loans which are well secured and in the process of collection. Interest collections on nonaccrual loans, for which the ultimate collectability of principal is uncertain, are applied as principal reductions.
Leases are generally classified as nonaccrual when there are reasonable doubts as to the collectability of principal and/or interest. Leases may be placed on nonaccrual when the lease has experienced either four consecutive months with no payments or once the account is five months in arrears. Interest collections on nonaccrual leases, for which the ultimate collectability of principal is uncertain, are applied as principal reductions.
When a lessee fails to make a required lease payment within 10 days after the payment is due, Mid America Capital generally institutes collection procedures. The lessee may be contacted by telephone on the 10th, but no later than the 30th day of delinquency. A late notice is automatically issued by the system on the 11th day of delinquency and is sent to the lessee. The lease may be referred to legal counsel when the lease is past due beyond four payments and no positive response has been received or when other considerations are present.
Nonperforming assets (i.e., nonaccrual loans and leases, accruing loans and leases delinquent more than 90 days and foreclosed assets) decreased $3.4 million to $9.2 million at June 30, 2010. The decrease in non-performing assets was primarily attributable to one credit relationship, which was restructured in the third quarter of fiscal 2010 and returned $4.0 million to performing status. The ratio of nonperforming assets to total assets, which is one indicator of credit risk exposure, decreased to 0.73% at June 30, 2010, from 1.07% at June 30, 2009.
Nonaccruing loans and leases decreased to $6.0 million at June 30, 2010 compared to $9.4 million at June 30, 2009. Included in nonaccruing loans and leases at June 30, 2009 were five loans totaling $159,000 secured by one- to four-family real estate, seven commercial real estate loans totaling $716,000, one agricultural real estate loan totaling $85,000, ten commercial business loans totaling $469,000, 12 agricultural business loans totaling $3.1 million, 25 equipment finance leases totaling $862,000, and 26 consumer loans totaling $649,000.
The Company's nonperforming loans and leases, which represent nonaccrual and past due 90 days and still accruing, have decreased $3.2 million from the levels at June 30, 2009. The risk rating system in place is designed to identify and manage the nonperforming loans and leases. Commercial and agricultural loans and equipment finance leases will have specific reserve allocations based on collateral values or based on the present value of expected cash flows if the loans or leases are deemed impaired. Loans and leases that are not performing do not necessarily result in a loss.
As of June 30, 2010 the Company had $946,000 of foreclosed assets. The balance of foreclosed assets at June 30, 2010 consisted of $212,000 in single-family residences, $212,000 in equipment finance leases, $8,000 in consumer collateral, $32,000 in commercial business collateral, and $482,000 in agricultural collateral.
At June 30, 2010, the Company had designated $50.7 million of its assets as special mention and classified $38.9 million of its assets that management has determined need to be closely monitored because of possible credit problems of the borrowers or the cash flows of the secured properties and investment securities. At June 30, 2010, the Company had $12.7 million in multi- family, commercial real estate, commercial business, and agricultural participation loans purchased, of which none of the amounts were classified at June 30, 2010. These loans and leases were considered in determining the adequacy of the allowance for loan and lease losses. The allowance for loan and lease losses is established based on management's evaluation of the risks probable in the loan and lease portfolio and changes in the nature and volume of loan and lease activity. Such evaluation, which includes a review of all loans and leases for which full collectability may not be reasonably assured, considers the estimated fair market value of the underlying collateral, present value of expected principal and interest payments, economic conditions, historical loss experience and other factors that warrant recognition in providing for an adequate loan and lease loss allowance.
Although the Company's management believes that the June 30, 2010, recorded allowance for loan and lease losses was adequate to provide for probable losses on the related loans and leases, there can be no assurance that the allowance existing at June 30, 2010 will be adequate in the future.
In accordance with the Company's internal classification of assets policy, management evaluates the loan and lease portfolio on a monthly basis to identify loss potential and determines the adequacy of the allowance for loan and lease losses quarterly. Loans are placed on nonaccrual status when the collection of principal and/or interest becomes doubtful. Foreclosed assets include assets acquired in settlement of loans.
The following table sets forth the amounts and categories of the Company's nonperforming assets from continuing operations for the periods indicated.
(1)Total foreclosed assets do not include land or other real estate owned held for sale.
(2)Nonperforming assets include nonaccruing loans and leases, accruing loans and leases delinquent more than 90 days and foreclosed assets.
(3)Percentage is calculated based upon total assets of the Company and its direct and indirect subsidiaries on a consolidated basis.
(4)Nonperforming loans and leases include both nonaccruing and accruing loans and leases delinquent more than 90 days.
(5)Total loans and leases include loans held for sale.
The following table sets forth information with respect to activity in the Company's allowance for loan and lease losses from continuing operations during the periods indicated.
(1)Total loans and leases include loans held for sale.
(2)Nonperforming loans and leases include both nonaccruing and accruing loans and leases delinquent more than 90 days.
The distribution of the Company's allowance for loan and lease losses and impaired loss summary are summarized in the following tables.
(1)Includes construction loans.
(2)Includes equipment finance leases.
The allowance for loan and lease losses was $9.6 million at June 30, 2010, as compared to $8.5 million at June 30, 2009. The ratio of the allowance for loan and lease losses to total loans and leases was 1.07% at June 30, 2010, compared to 0.98% at June 30, 2009. The Company's management has considered nonperforming assets and other assets of concern in establishing the allowance for loan and lease losses. The Company continues to monitor its allowance for possible loan and lease losses
and make future additions or reductions in light of the level of loans and leases in its portfolio and as economic conditions dictate. The current level of the allowance for loan and lease losses is a result of management's assessment of the risks within the portfolio based on the information revealed in credit reporting processes. The Company utilizes a risk-rating system on commercial business, agricultural, construction, multi-family and commercial real estate loans, including purchased loans. A periodic credit review is performed on all types of loans and leases to establish the necessary reserve based on the estimated risk within the portfolio. This assessment of risk takes into account the composition of the loan and lease portfolio, historical loss experience for each loan and lease category, previous loan and lease experience, concentrations of credit, current economic conditions and other factors that in management's judgment deserve recognition. OTS regulators have reviewed the Company's methodology for determining allowance requirements on the Company's loan and lease portfolio and have made no required recommendations for changes in methodology in the allowances during the three year period ended June 30, 2010.
Real estate properties acquired through foreclosure are recorded at the lower of cost or fair value (less a deduction for disposition costs). Valuations are periodically updated by management and a specific provision for losses on such properties is established by a charge to operations if the carrying values of the properties exceed their estimated net realizable values.
Although management believes that it uses the best information available to determine the allowances, unforeseen market conditions could result in adjustments and net earnings being significantly affected if circumstances differ substantially from the assumptions used in making the final determinations. Future additions to the Company's allowances result from periodic loan, property and collateral reviews and thus cannot be predicted in advance. See Note 1 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K for a description of the Company's policy regarding the provision for losses on loans and leases.
Comparison of the Years Ended June 30, 2010 and June 30, 2009
General. The Company's net income available for common stockholders was $5.7 million or $1.00 for basic and diluted earnings per common share for the year ended June 30, 2010, a $755,000 decrease in earnings compared to $6.5 million or $1.62 and $1.61 for basic and diluted earnings per common share, respectively, for the prior year. Fiscal 2010 resulted in a return on average equity (i.e., net income divided by average equity) of 6.82%, compared to 9.73% in fiscal 2009. For the year ended June 30, 2010, the return on average assets (i.e., net income divided by average assets) was 0.48% compared to 0.68% in the prior year. As discussed in more detail below, the decreases were due to a variety of key factors, including decreases in noninterest income of $1.6 million and increases in noninterest expense of $1.5 million. These were partially offset by a decrease in preferred stock dividends and accretion of $1.3 million and income taxes of $914,000.
Interest, Dividend and Loan Fee Income. Interest, dividend and loan fee income was $57.4 million for the year ended June 30, 2010, as compared to $60.7 million for the prior year, a decrease of $3.3 million or 5.5%. Average yield on interest-earning assets decreased 8.0% which resulted in a decrease to overall interest and dividend income of $5.2 million. This decrease was partially offset by an increase in the average volume of total interest-earning assets of 2.9%, resulting in an increase of overall interest and dividends to increase by $1.9 million. The average yield on interest-earning assets was 5.15% for the year ended June 30, 2010, as compared to 5.60% for the prior year. The average volume of loans and leases receivable increased from $829.5 million for the year ended June 30, 2009, to $860.9 million for the year ended June 30, 2010. For the year ended June 30, 2010, the average yield on loans and leases receivable was 5.77%, a decrease of 3.2% from 5.96% in the prior year. The overall increase in interest and dividend income was due in part to the repricing of loans and investments that generally reflected national interest rates.
Interest Expense. Interest expense was $20.7 million for the year ended June 30, 2010, as compared to $25.4 million for the prior year, a decrease of $4.7 million or 18.4%. The $4.7 million decrease in interest expense was the result of a 26.7% decrease in the average rate paid on interest-bearing deposits, while a $1.3 million increase in interest expense was the result of increase in deposit volume. The average rate on interest-bearing deposits was 1.65% for the year ended June 30, 2010, as compared to 2.26% for the prior year. A $517,000 decrease in interest expense was the result of a 7.4% decrease in the average yield on FHLB advances and other borrowings to 3.13% for the year ended June 30, 2010, compared to 3.38% for the prior fiscal year, and a $774,000 decrease in interest expense was the result of a 10.0% decrease in the average balance of FHLB advances and other borrowings.
Net Interest Income. The Company's net interest income for the year ended June 30, 2010, increased $1.3 million or 3.8%, to $36.7 million as compared to the prior fiscal year. The increase in net interest income was due primarily to increases in the average volume on loans and leases receivable in excess of the increase in average volume of the interest-bearing liabilities. The Company's net interest margin on a fully taxable equivalent basis was 3.34% for the year ended June 30, 2010, as compared to 3.32% for the prior year. The Company continues to have a diversified loan portfolio comprised of a mix of consumer and business type lending. This mix helps the Company manage the net interest margin and interest rate risk by retaining loan and lease production on the balance sheet or looking at alternatives through secondary markets.
Provision for Losses on Loans and Leases. The allowance for loan and lease losses is maintained at a level which is believed by management to be adequate to absorb probable losses on existing loans and leases that may become uncollectible, based on an evaluation of the collectability of the loans and leases and prior loan and lease loss experience. The evaluation takes into consideration such factors as changes in the nature and volume of the loan and lease portfolio, overall portfolio quality, review of specific problem loans and leases, and current economic conditions that may affect the borrower's ability to pay. The allowance for loan and lease losses is established through a provision for losses on loans and leases charged to expense. See "Asset Quality" above for further discussion.
Provision for losses on loans and leases increased $1.3 million or 75.7%, to $3.0 million for the year ended June 30, 2010, as compared to $1.7 million in the prior year. The increase in the provision was due in part to adding reserves for an increasing loan portfolio and continuing a policy of maintaining conservatism in estimating loan losses. Net charge-offs increased from a net recovery of $858,000 during fiscal 2009 to $1.8 million of net charge-offs during fiscal 2010. The net recovery in fiscal 2009 was largely a result of a previously announced net loan loss recovery of $2.2 million from a settlement of a previously disclosed lawsuit against MetaBank. Nonperforming assets decreased $3.4 million for the year ended June 30, 2010, primarily due to one particular agriculture loan relationship, which was restructured in the third quarter of fiscal 2010 and returned $4.0 million to performing status.
The allowance for losses on loans and leases at June 30, 2010 was $9.6 million. The allowance increased from the June 30, 2009 balance of $8.5 million primarily as a result of the increased balance in loans and leases receivable at June 30, 2010 of $21.0 million compared to the balance at June 30, 2009. The ratio of allowance for loan and lease losses to nonperforming loans and leases at June 30, 2010 was 116.31% compared to 73.83% at June 30, 2009. The allowance for loan and lease losses to total loans and leases at June 30, 2010 was 1.07% compared to 0.98% at June 30, 2009. The Bank's management believes that the June 30, 2010 recorded allowance for loan and lease losses is adequate to provide for probable losses on the related loans and leases, based on its evaluation of the collectability of loans and leases and prior loss experience.
Noninterest Income. Noninterest income was $11.0 million for the year ended June 30, 2010, as compared to $12.6 million for the year ended June 30, 2009, a decrease of $1.6 million or 12.6%.
During fiscal 2010, the decrease was primarily due to loan servicing income decrease of $259,000, fees on deposits decrease of $137,000 and net impairment losses recognized in earnings increase of $2.3 million. Net gain on sale of securities increase of $949,000 and trust income increase of $144,000 partially offset the other decreases.
Loan servicing income decreased by $259,000 to $2.0 million for the fiscal year 2010 due primarily to changes in the portfolio's performance attributes during the period based upon the Company's quarterly analysis of portfolio prepayment experience.
Fees on deposits decreased $137,000 to $5.6 million for the year ended June 30, 2010 as compared to the year ended June 30, 2009 due largely to a decrease in NSF and overdraft fees of $597,000 and partially offset by an increase in point-of-sale interchange and ATM fee income of $519,000.
Net impairment losses recognized in earnings were $2.7 million for the year ended June 30, 2010, as compared to $405,000 for the year ended June 30, 2009. The Company determined that a total of $2.2 million of losses due to other-than-temporary impairments for trust preferred securities were incurred of which an additional $460,000 was recognized in other comprehensive income. The net of $2.7 million of losses were recognized as a reduction in other noninterest income for the year ended June 30, 2010, compared to $405,000 in the prior year.
Net gain on the sale of securities totaled $1.9 million, an increase of $949,000 for the year ended June 30, 2010 as compared to the prior fiscal year. The Company took advantage of elevated fixed-rate mortgage-backed securities prices which were influenced by U.S. government participation in the mortgage-backed securities market, while also restructuring the portfolio for a higher rate environment.
Trust income increased by $144,000 to $820,000 during the year ended June 30, 2010, due in part to an increase in customers and managed assets from increased market values when compared to the prior year. Assets under management increased from $77.5 million to $83.3 million.
Noninterest Expense. Noninterest expense was $36.0 million for the year ended June 30, 2010 as compared to $34.6 million for the year ended June 30, 2009, an increase of $1.4 million, or 4.3%. The increase was attributed to increases in salaries and wages of $925,000, occupancy and equipment of $498,000, marketing and community development of $332,000 and goodwill impairment write-off of $585,000. The increases in noninterest expense were neutralized primarily by a decrease in performance-based incentive pay and healthcare costs of $1.2 million and $415,000, respectively.
Compensation and employee benefits were $20.7 million for the year ended June 30, 2010, a decrease of $232,000 or 1.1% when compared to the year ended June 30, 2009. Performance-based incentive pay decreased $1.2 million, or 53.6%, due to a reduction in performance outcomes through the fiscal year 2010 as compared to the prior fiscal year. This decrease in compensation was partially offset by an increase in salaries and wages of $925,000, or 6.5%, to $15.1 million for fiscal year 2010. The salary and wage expense increase was due to year-over-year salary increases and personnel additions. Retirement costs, which are included in the total for compensation and employee benefits, increased $318,000, or 36.8%, to $1.2 million for the fiscal year 2010 compared to fiscal year 2009 primarily due to the increased costs determined during the actuarial valuation in the first quarter of fiscal 2010. Net healthcare costs decreased $415,000, or 16.2%, to $2.1 million due to a reduction of specific high dollar claims and general overall utilization for the fiscal year 2010 compared to the prior fiscal year. Management currently believes the self-insured structure is a reasonable alternative to traditional healthcare plans over the long term. The level of healthcare costs which the Company incurs may vary from year to year.
Occupancy and equipment increased $498,000, or 12.5%, to $4.5 million for the year ended June 30, 2010 as compared to the prior fiscal year. A new facility in Watertown, South Dakota was placed in service in July 2009, and subsequently sold and leased-back from an unrelated group in the third quarter of fiscal 2010. The depreciation of equipment, rental expense, and other operating
expenses related to this new facility accounted for the majority of increased costs. Other equipment purchased during fiscal year 2010 also contributed to the increase in depreciation expense since the prior fiscal year.
Marketing and community development was $1.7 million for the year ended June 30, 2010 compared to $1.4 million for the year ended June 30, 2009, an increase of $332,000 or 24.0%. This increase is primarily due to the costs related to the point of sale debit cards reward program implemented July 1, 2009.
Goodwill impairment expense of $585,000 was recorded for the year ended June 30, 2010 compared to no impairment expense in the prior fiscal year. The Company performs annual testing to determine if goodwill is impaired and at June 30, 2010, it was determined that the goodwill associated with the acquisition of the leasing division was impaired. Accordingly, the Company wrote-off the amount of goodwill associated with this acquisition in the amount of $585,000. As of June 30, 2010, there was no impairment with respect to intangible assets for the remaining amount of $4.4 million.
Income tax expense. The Company's income tax expense for the year ended June 30, 2010 decreased to $3.0 million compared to $3.9 million for the prior fiscal year. The effective tax rates were 33.97% and 33.12% for the years ended June 30, 2010 and 2009, respectively. The amount of permanent tax difference as a net deduction was a higher percentage to income before income taxes for fiscal year 2010 than for the prior fiscal year. Permanent tax differences as a net deduction decreased by $341,000 for the year ended June 30, 2010 as compared to the prior year, primarily due to the write-off of goodwill of in the amount of $585,000.
Comparison of the Years Ended June 30, 2009 and June 30, 2008
General. The Company's net income available for common stockholders was $6.5 million or $1.62 and $1.61 for basic and diluted earnings per common share, respectively, for the year ended June 30, 2009, a $657,000 increase in earnings compared to $5.8 million or $1.47 and $1.45 for basic and diluted earnings per common share, respectively, for the prior year. Fiscal 2009 resulted in a return on average equity (i.e., net income divided by average equity) of 9.73%, which is a 6.7% increase compared to 9.12% in fiscal 2008. For the year ended June 30, 2009, the return on average assets (i.e., net income divided by average assets) was 0.68%, a 19.3% increase compared to 0.57% in the prior year. As discussed in more detail below, the increases were due to a variety of key factors, including increases in net interest income of $5.5 million and non-interest income of $1.3 million. These increases were partially offset by increases in noninterest expense and preferred stock dividends and accretion in the amounts of $4.0 million and $1.3 million, respectively, for fiscal 2009.
Interest, Dividend and Loan Fee Income. Interest, dividend and loan fee income was $60.7 million for the year ended June 30, 2009, as compared to $63.2 million for the prior year, a decrease of $2.5 million or 3.9%. Average yield on interest-earning assets decreased 14.9% which resulted in a decrease to overall interest and dividend income of $9.7 million. This decrease was partially offset by an increase in the average volume of total interest-earning assets of 12.7%, resulting in an increase of overall interest and dividends to increase by $7.2 million. The average yield on interest-earning assets was 5.60% for the year ended June 30, 2009, as compared to 6.58% for the prior year. The average volume of loans and leases receivable increased from $775.6 million for the year ended June 30, 2008, to $829.5 million for the year ended June 30, 2009. For the year ended June 30, 2009, the average yield on loans and leases receivable was 5.96%, a decrease of 14.4% from 6.96% in the prior year. The overall increase in interest and dividend income was due in part to the repricing of loans and investments that generally reflected national interest rates.
Interest Expense. Interest expense was $25.4 million for the year ended June 30, 2009, as compared to $33.3 million for the prior year, a decrease of $7.9 million or 23.8%. A $10.1 million
decrease in interest expense was the result of a 37.7% decrease in the average rate paid on interest-bearing deposits, while a $1.1 million increase in interest expense was the result of increase in deposit volume. The average rate on interest-bearing deposits was 2.26% for the year ended June 30, 2009, as compared to 3.63% for the prior year. A $2.0 million decrease in interest expense was the result of a 20.7% decrease in the average yield on FHLB advances and other borrowings to 3.38% for the year ended June 30, 2009, compared to 4.26% for the prior fiscal year, and a $3.4 million increase in interest expense was the result of a 52.5% increase in the average balance of FHLB advances and other borrowings. In addition, interest expense decreased $299,000 due to the average yield on subordinated debentures payable to trust decreasing to 6.61% for the year ended June 30, 2009, compared to 7.58% for the prior fiscal year.
Net Interest Income. The Company's net interest income for the year ended June 30, 2009, increased $5.5 million or 18.3%, to $35.3 million as compared to the prior fiscal year. The increase in net interest income was due primarily to decreases in the average rate paid on interest-bearing liabilities. The Company's net interest margin on a fully taxable equivalent basis was 3.32% for the year ended June 30, 2009, as compared to 3.16% for the prior year. The Company continues to have a diversified loan portfolio comprised of a mix of consumer and business type lending. This mix helps the Company manage the net interest margin and interest rate risk by retaining loan and lease production on the balance sheet or looking at alternatives through secondary markets.
Provision for Losses on Loans and Leases. The allowance for loan and lease losses is maintained at a level which is believed by management to be adequate to absorb probable losses on existing loans and leases that may become uncollectible, based on an evaluation of the collectability of the loans and leases and prior loan and lease loss experience. The evaluation takes into consideration such factors as changes in the nature and volume of the loan and lease portfolio, overall portfolio quality, review of specific problem loans and leases, and current economic conditions that may affect the borrower's ability to pay. The allowance for loan and lease losses is established through a provision for losses on loans and leases charged to expense. See "Asset Quality" above for further discussion.
Provision for losses on loans and leases decreased $315,000 or 15.8%, to $1.7 million for the year ended June 30, 2009, as compared to $2.0 million in the prior year. The reduction in the provision was due in part to a large loan loss recovery which increased the allowance for loan and lease losses during the second quarter of fiscal 2009. Net charge-offs decreased from $1.9 million during fiscal 2008 to a net recovery of $858,000 during fiscal 2009. The net recovery was largely a result of a previously announced net loan loss recovery of $2.2 million from a settlement of a previously disclosed lawsuit against MetaBank. During the second quarter of fiscal 2009, the Company bolstered its methodology for calculating the allowance for loan and lease losses to better capture the impact of the economic recession currently being experienced across the country. Nonperforming assets increased $8.8 million for the year ended June 30, 2009, primarily due to one particular agriculture loan relationship.
The allowance for losses on loans and leases at June 30, 2009 was $8.5 million. The allowance increased from the June 30, 2008, balance of $5.9 million primarily as a result of recoveries exceeding charge-offs by $858,000 and provision for losses on loans and leases of $1.7 million recorded in fiscal 2009. The ratio of allowance for loan and lease losses to nonperforming loans and leases at June 30, 2009, was 73.83% compared to 191.08% at June 30, 2008. The allowance for loan and lease losses to total loans and leases at June 30, 2009, was 0.98% compared to 0.75% at June 30, 2008. The Bank's management believes that the June 30, 2009, recorded allowance for loan and lease losses is adequate to provide for probable losses on the related loans and leases, based on its evaluation of the collectability of loans and leases and prior loss experience.
Noninterest Income. Noninterest income was $12.6 million for the year ended June 30, 2009, as compared to $11.3 million for the year ended June 30, 2008, an increase of $1.3 million or 11.2%. During fiscal 2009 the Company experienced increases in net gain on sale of loans of $709,000, net gain
on sale of securities of $901,000, fees on deposits of $372,000, and loan servicing income of $90,000. Trust income decreased $290,000 and net impairment losses recognized in earnings were $405,000, which partially offset the other increases.
Net gain on sale of loans increased by $709,000 to $1.9 million for the year ended June 30, 2009, as compared to $1.2 million for the prior year, primarily due to an increase in mortgage loan activity and the related loan sales. Net gain on sale of securities increased to $904,000 for the year ended June 30, 2009, compared to $3,000 for the prior year.
Fees on deposits increased by $372,000 to $5.8 million during the year ended June 30, 2009, as compared to $5.4 million for the prior year, primarily due to a $152,000 net increase in income from point-of-sale purchases by customers and ATM service fees, and a $201,000 increase in net fees from insufficient funds and depositor overdrafts.
Loan servicing income increased by $90,000 to $2.3 million for the year ended June 30, 2009, as compared to $2.2 million for the prior year, primarily due to increased originated and purchased servicing rights for mortgage loans. At June 30, 2009, the Bank serviced mortgage loans totaling $1.1 billion.
Trust income decreased by $290,000 to $676,000 during the year ended June 30, 2009, due in part to a decrease in managed assets from decreased market values when compared to the prior year. Assets under management decreased from $95.4 million to $77.5 million.
Net impairment losses recognized in earnings were $405,000 for the year ended June 30, 2009. The Company determined that a total of $3.9 million of losses due to other-than-temporary impairments for trust preferred securities were incurred of which $3.5 million were recognized in other comprehensive income. The net of $397,000 of losses were recognized as a reduction in other noninterest income, in addition to $8,000 of impairment losses recognized in earnings for FNMA common stock. There were no impairment losses recognized in the prior fiscal year.
Noninterest Expense. Noninterest expense was $34.6 million for the year ended June 30, 2009, as compared to $30.6 million for the prior year, an increase of $4.0 million. The increase in noninterest expense was due primarily to increases in compensation and employee benefits of $1.3 million and FDIC insurance of $1.3 million.
Compensation and employee benefits increased $1.3 million during the year ended June 30, 2009, as compared to the prior fiscal year. Employee compensation increased $887,000, or 7.2%, variable pay relating to employee incentives and commissions decreased $606,000, or 24.6%, and net healthcare costs increased $1.1 million, or 72.9%. Employee compensation increased due to annual raises awarded and sales-related personnel additions. Variable pay relating to employee incentive programs decreased due to a reduced change in performance outcomes. Healthcare costs increased as a result of higher claim activity for fiscal year 2009. The Company has had a self-insured health plan since January 1994. Management continues to believe the current structure is a reasonable alternative to traditional healthcare plans over the long term. The level of healthcare costs which the Company incurs may vary from year to year. The Company continues to monitor its healthcare plans in an effort to provide its employees with affordable health care.
FDIC insurance premiums increased $1.3 million during the year ended June 30, 2009, as compared to the prior fiscal year. The increase is a combination of new deposit guarantee programs and assessment schedule changes initiated by the FDIC and the expiration of credits previously used to lower costs. On January 1, 2009, the FDIC raised premium rates by approximately 7 basis points to a total of 12.5 basis points. The FDIC announced a special assessment to be accrued for June 30, 2009, and paid in September 2009, for which the Company's special assessment accrual totaled $536,000.
Professional fees increased $634,000 during the year ended June 30, 2009, as compared to the prior fiscal year. These costs increased due in part to continuing costs associated with participation in the CPP.
Income Tax Expense. The Company's income tax expense increased $1.1 million for the year ended June 30, 2009 to $3.9 million compared to $2.8 million for the prior year. The increase was due primarily to the increase in income before taxes. The effective tax rate for the years ended June 30, 2009, and June 30, 2008, was 33.12% and 32.13%, respectively.
Liquidity and Capital Resources
The Company's liquidity is comprised of three primary classifications: cash flows from operating activities, cash flows from investing activities and cash flows from financing activities. Net cash used in operating activities was $5.0 million for the fiscal year ended June 30, 2010. For the fiscal year ended June 30, 2009, net cash provided by operating activities was $2.4 million. Net cash used in investing activities was $64.8 million for the fiscal year ended June 30, 2010. For the fiscal year ended June 30, 2009, net cash used in investing activities was $71.6 million. Net cash provided by financing activities for the fiscal year ended June 30, 2010, was $72.1 million. This compares to net cash provided by financing activities in the prior fiscal year of $66.6 million.
The Bank's primary sources of funds are earnings, in-market deposits, FHLB advances and other borrowings, repayments of loan principal, residential mortgage-backed securities and callable agency securities and, to a lesser extent, sales of mortgage loans, sales and maturities of securities, out-of-market deposits and short-term investments. While scheduled loan payments and maturing securities are relatively predictable, deposit flows and loan and security prepayments are more influenced by interest rates, general economic conditions and competition. The Bank attempts to price its deposits to meet its asset/liability objectives consistent with local market conditions. Excess balances are invested in overnight funds.
Liquidity management is both a daily and long-term responsibility of management. The Bank adjusts its investments in liquid assets based upon management's assessment of (i) expected loan demand, (ii) projected loan sales, (iii) expected deposit flows, (iv) yields available on interest-bearing deposits, and (v) the objectives of its asset/liability management program. Excess liquidity is invested generally in interest-bearing overnight deposits and other short-term government and agency obligations. During the year ended June 30, 2010, the Bank decreased its borrowings with the FHLB and other borrowings by $22.2 million.
Although in-market deposits is one of the Bank's primary source of funds, the Bank's policy has been to utilize borrowings where the funds can be invested in either loans or securities at a positive rate of return or to use the funds for short-term liquidity purposes. As of June 30, 2010, the Bank had the following sources of additional borrowings:
•$15.0 million in an uncommitted, unsecured line of federal funds with First Tennessee Bank, NA;
•$10.0 million in an uncommitted, unsecured line of federal funds with Zions Bank;
•$60.8 million of available credit from the Federal Reserve Bank (after deducting outstanding borrowings with the Federal Reserve Bank); and
•$49.2 million of available credit from FHLB of Des Moines (after deducting outstanding borrowings with FHLB of Des Moines).
The Bank may also seek other sources of contingent liquidity including additional federal funds purchased lines with correspondent banks and lines of credit with the Federal Reserve Bank. There were no funds drawn on the uncommitted, unsecured line of federal funds with First Tennessee Bank,
NA and Zions Bank at June 30, 2010. The Bank, as a member of the FHLB of Des Moines, is required to acquire and hold shares of capital stock in the FHLB of Des Moines equal to 0.12% of the total assets of the Bank at December 31 annually. The Bank is also required to own activity-based stock, which is based on 4.45% of the Bank's outstanding advances. These percentages are subject to change at the discretion of the FHLB Board of Directors. For further discussion of our advances from FHLB of Des Moines, see Note 7 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K.
In addition to the above sources of additional borrowings, the Bank has implemented arrangements to acquire out-of-market certificates of deposit as an additional source of funding. As of June 30, 2010, the Bank had $22.9 million in out-of-market certificates of deposit.
On September 30, 2009, the Company entered into a Loan Agreement (the "Loan Agreement") with United Bankers' Bank (the "Lender") in order to refinance its outstanding borrowings of $5.966 million under its line of credit with First Tennessee Bank, NA that matured. Under the Loan Agreement, the Lender committed to lend to the Company an aggregate principal amount not to exceed $6.0 million. On November 25, 2009, the Company repaid its outstanding borrowings of $6.044 million (principal plus accrued interest) under the Loan Agreement. The loan is evidenced by a promissory note, accrues interest at the United Bankers' Bank Rate with a minimum interest rate of 4.75% per annum, and the principal balance (plus any accrued and unpaid interest) is due and payable in full on October 1, 2010. There was no additional activity or an outstanding balance at June 30, 2010. The Company was required to pledge 100% of the Bank's stock as collateral. See Note 7 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K, Part II, Item 7 "Financial Condition Data" of this Form 10-K and Exhibit 10.36 of this Form 10-K for additional information.
The Bank anticipates that it will have sufficient funds available to meet current loan commitments. At June 30, 2010, the Bank had outstanding commitments to originate and purchase mortgage and commercial loans of $28.4 million and to sell mortgage loans of $29.4 million. Commitments by the Bank to originate loans are not necessarily executed by the customer. The Bank monitors the ratio of commitments to funding for use in liquidity management. At June 30, 2010, the Bank had one outstanding commitment to purchase $160,000 investment securities available for sale and no commitments to sell investment securities available for sale.
The Company uses its capital resources to pay dividends to its stockholders, to repurchase Company stock in the market pursuant to a Board of Directors-approved stock buyback program, to support organic growth, to make any acquisitions, to service its debt obligations and to provide funding for investment into the Bank as Tier 1 (core) capital.
The Company had in effect a stock buyback program, which began on May 1, 2008, and was publicly announced on April 28, 2008. Under this program, the Company was permitted to repurchase up to 10% of the common stock of the Company outstanding on May 1, 2008. In conjunction with the Company's participation in the CPP, the Company's Board of Directors terminated the stock buy back program in the second quarter of fiscal year 2009, which had been in place through November 21, 2008. There were no shares purchased under the program during fiscal 2010 and 2009.
Savings institutions insured by the FDIC are required to meet three regulatory capital requirements. If a requirement is not met, regulatory authorities may take legal or administrative actions, including restrictions on growth or operations or, in extreme cases, seizure. Institutions not in compliance may apply for an exemption from the requirements and submit a recapitalization plan. Under these capital requirements, at June 30, 2010, the Bank met all current capital requirements.
The OTS has adopted capital requirements for savings institutions comparable to the requirement for national banks. The minimum OTS core capital requirement for well-capitalized institutions is 5%
of total adjusted assets. The Bank had Tier 1 (core) capital of 8.69% at June 30, 2010. The minimum OTS risk-based capital requirement for well-capitalized institutions is 10% of risk-weighted assets. The Bank had risk-based capital of 11.68% at June 30, 2010.
The Company has entered into interest rate swap contracts to convert variable-rate trust preferred debt and deposits into a fixed rate instrument to modify interest rate risk. At June 30, 2010, the total notional amount of interest rate swap contracts was $79.0 million with a fair value loss of $3.0 million. The Company is exposed to losses if the counterparties fail to make their payments under the contract in which the Company is in a receiving status. The Company minimizes its risk by monitoring the credit standing of the counterparties. The Company anticipates the counterparties will be able to fully satisfy their obligations under the remaining agreements. See Note 9 of "Notes to Consolidated Financial Statements" of this Form 10-K for additional information.
Impact of Inflation and Changing Prices
The Consolidated Financial Statements and Notes thereto presented in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K have been prepared in accordance with GAAP, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Bank's operations. Unlike most industrial companies, nearly all the assets and liabilities of the Bank are monetary in nature. As a result, interest rates have a greater impact on the Bank's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
Off-Balance Sheet Arrangements
None.
Effect of New Accounting Standards
Note 1, "Summary of Significant Accounting Policies," of "Notes to Consolidated Financial Statements" of this Form 10-K discusses new accounting policies adopted by the Company during fiscal 2010. The expected impact of accounting policies recently issued or proposed but not yet required to be adopted are discussed below. To the extent the adoption of new accounting standards materially affects the Company's financial condition, results of operations, or liquidity, the impacts are discussed in the applicable sections of this financial review and the notes to consolidated financial statements.
In December 2007, FASB issued SFAS No. 141 (revised 2007), "Business Combinations" (ASC Topic 805). This guidance requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose the information necessary to evaluate and understand the nature and financial effect of the business combination. The Company adopted this guidance effective July 1, 2009 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In December 2007, FASB issued Statement of Financial Accounting Standards No. 160 (SFAS 160), "Non-controlling Interests in Consolidated Financial Statements-an amendment of ARB No. 51." SFAS 160 is effective for the Company beginning July 1, 2009. SFAS 160 improves the relevance, comparability, and transparency of financial information provided to investors by requiring all entities to report non-controlling (minority) interest in subsidiaries in the same way-as equity in
the consolidated financial statements. The Company does not currently have any non-controlling interests to be included in the consolidated financial statements.
In December 2008, FASB issued Staff Position No. FAS 132(R)-1 (FAS 132(R)-1), amending the disclosure guidance in FASB Statement No. 132, "Employers' Disclosures about Pensions and Other Postretirement Benefits." FAS 132(R)-1 states that the purpose is to increase the transparency in the disclosure of Postretirement Benefit Plan Assets and to provide users an understanding of the following: investment allocation decision-making, including the factors that are pertinent to the investment policies and strategies; the major categories of plan assets; the valuation techniques used to measure the fair value of plan assets, the effect of fair value measurements using significant unobservable inputs (Level 3) on changes in plan assets for the period; and significant concentrations of risk with plan assets. The Company adopted this guidance effective July 1, 2009 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In April 2009, FASB issued Staff Position No. 141(R)-1 (FAS 141R-1), "Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies." FAS 141R-1 amends and clarifies FAS 141R to address the application issues on the initial recognition and measurement, subsequent measurement and accounting, and disclosure of assets and liabilities arising from contingencies in a business combination. FAS 141R-1 is effective July 1, 2009. The Company adopted this guidance effective July 1, 2009 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In June, 2009, the FASB issued Statement of Financial Accounting Standards No. 166 (SFAS 166), "Accounting for Transfers of Financial Assets-an amendment of FASB Statement No. 140," which removes the concept of a qualifying special-purpose entity from GAAP, changes the requirements for derecognizing financial assets, including defining the term "participating interest" to establish specific conditions for reporting a transfer of a portion of a financial asset as a sale, and requires additional disclosures about a transferor's continuing involvement in transferred financial assets. SFAS 166 is effective for annual reporting periods beginning after November 15, 2009 for interim periods within that first annual reporting period and for interim and annual reporting periods thereafter. Management has reviewed SFAS 166 does not expect the adoption of this statement on July 1, 2010 to have a material impact on the Company's consolidated financial condition, results of operations or cash flow.
In June, 2009, the FASB issued Statement of Financial Accounting Standards No. 167 (SFAS 167), "Amendments to FASB Interpretation No. 46(R)," which eliminates exceptions to consolidating qualifying special purpose entities, contains new criteria for determining the primary beneficiary, and increases the frequency of required reassessments to determine whether a company is the primary beneficiary of a variable interest entity. SFAS 167 clarifies, but does not significantly change, the characteristics that identify a variable interest entity. SFAS 167 also contains a new requirement that any term, transaction, or arrangement that does not have a substantive effect on an entity's status as a variable interest entity, a company's power over a variable interest entity, or a company's obligation to absorb losses or its right to receive benefits of a variable interest entity must be disregarded in applying the provisions of Interpretation 46(R). SFAS 167 is effective for interim and annual reporting periods beginning after November 15, 2009. The adoption of SFAS 167 is not expected to impact the Company's consolidated financial statements.
In June, 2009, the FASB issued Statement of Financial Accounting Standards No. 168 (SFAS 168), "The FASB Accounting Standards Codification and the Hierarchy of Generally Accepted Accounting Principles-a replacement of FASB Statement No. 162," which replaces the GAAP hierarchy with two levels of GAAP: authoritative and nonauthoritative. On July 1, 2009, the FASB Accounting Standards Codification became the single source of authoritative nongovernmental GAAP, except for rules and interpretive releases of the SEC. All other non-grandfathered accounting literature became
nonauthoritative. SFAS 168 is effective July 1, 2009. The Company adopted this guidance effective July 1, 2009 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In January 2010, FASB issued ASU No. 2010-06, "Improving Disclosures about Fair Value Measurements", (ASC Topic 820). This accounting standard provides additional guidance relating to fair value measurement disclosures. Specifically, companies are required to separately disclose significant transfers into and out of Level 1 and Level 2 measurements in the fair value hierarchy and the reasons for those transfers. Significance should generally be based on earnings and total assets or liabilities, or when changes are recognized in other comprehensive income, based on total equity. Companies may take different approaches in determining when to recognize such transfers, including using the actual date of the event or change in circumstances causing the transfer, or using the beginning or ending of a reporting period. For Level 3 fair value measurements, the new guidance requires presentation of separate information about purchases, sales, issuances and settlements. Additionally, the FASB also clarified existing fair value measurement disclosure requirements relating to the level of disaggregation, inputs, and valuation techniques. This accounting standard is effective for interim and annual reporting periods after July 1, 2009, except for the detailed Level 3 disclosures, which will be effective for interim and annual reporting periods after July 1, 2010. The Company adopted this update in the first quarter of fiscal 2010, except for the detailed Level 3 disclosures, and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow. The Company will adopt the Level 3 disclosures in the first quarter of fiscal 2011 and does not expect the adoption to have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In April 2010, FASB issued ASU No. 2010-18,"Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset". As a result of this update, modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. ASU No. 2010-18 is effective for the Company in the first interim period of fiscal 2011 (September 30, 2010) and the annual reporting period beginning June 30, 2011. Management is currently evaluating the impact of adopting this update on the Company's consolidated financial condition, results of operations and cash flow.
In July 2010, FASB issued ASU 2010-20, "Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses" (ASC Topic 310). This guidance will expand disclosures by requiring additional disaggregated information related to the current disclosures. It will also require additional disclosures to provide information based on credit quality, past due aging information, trouble debt restructuring information, and significant purchases and sales of financing receivables. ASU 2010-20 is effective for the Company for interim and annual reporting periods ending after December 15, 2010 and the Company does not expect the adoption to have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
Asset/Liability and Risk Management
Interest rate risk is the most significant market risk affecting the Company. Other types of market risk, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company's business activities. The Bank, like other financial institutions, is subject to interest rate risk to the extent that its interest-bearing liabilities with short- and medium-term maturities mature or reprice more rapidly than its interest-earning assets. The Company does not currently engage in trading activities to control interest rate risk although it may in the future, if necessary, to manage interest rate risk. Interest rate swaps may be entered into to modify interest rate
risk. See Note 9 of "Notes to Consolidated Financial Statements," which is included in Part II, Item 8 "Financial Statements and Supplementary Data" of this Form 10-K, for additional information related to interest rate contracts.
As a continuing part of its financial strategy, the Bank considers methods of managing this asset/liability mismatch consistent with maintaining acceptable levels of net interest income. In order to properly monitor interest rate risk, the Board of Directors has created an Asset/Liability Committee whose principal responsibilities are to assess the Bank's asset/liability mix and recommend strategies to the Board that will enhance income while managing the Bank's vulnerability to changes in interest rates.
In managing market risk and the asset/liability mix, the Bank has placed its emphasis on developing a portfolio in which, to the extent practicable, assets and liabilities reprice within similar periods. The goal of this policy is to provide a relatively consistent level of net interest income in varying interest rate cycles and to minimize the potential for significant fluctuations from period to period.
One approach used to quantify interest rate risk is the Bank's net portfolio value ("NPV") analysis. In essence, this analysis calculates the difference between the present value of the liabilities and the present value of expected cash flows from assets and off-balance sheet contracts. The following table sets forth, at June 30, 2010 and June 30, 209, an analysis of the Company's interest rate risk as measured by the estimated changes in NPV resulting from instantaneous and sustained parallel shifts in the yield curve (+300 or -100 basis points, measured in 100 basis point increments). Due to the low prevailing interest rate environment, -200 and -300 NPV was not estimated by the Bank at June 30, 2010 and June 30, 2009.
Even if interest rates change in the designated amounts, there can be no assurance that the Company's assets and liabilities would perform as set forth below. In addition, a change in U.S. Treasury rates in the designated amounts accompanied by a change in the shape of the Treasury yield curve would cause significantly different changes to the NPV than indicated below.
Contractual Obligations
The following table sets forth information with respect to the Company's contractual obligations as of June 30, 2010. Operating lease obligations are primarily related to the lease of certain branch offices, which the Company has committed to as of June 30, 2010.
Subsequent Event
Management has evaluated subsequent events for potential disclosure or recognition through the date that the financial statements were available to be issued. In September 2010, the Company has been notified by a borrower of the borrower's intention to no longer perform on its agricultural loan obligations. The current balance related to this obligation is $3,138. The Company has initiated formal collection procedures and collateral evaluation. The financial effect of this transaction cannot be reasonably estimated as of the date that the financial statements were available to be issued.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
Interest Rate Risk Management
The Company's net income is largely dependent on its net interest income. Net interest income is susceptible to interest rate risk to the degree that interest-bearing liabilities with short- and medium-term maturities mature or reprice more rapidly than its interest-earning assets. When interest-bearing liabilities mature or reprice more quickly than interest-earning assets in a given period, a significant increase in market rates of interest could adversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quickly than interest-bearing liabilities, falling interest rates could result in a decrease in net income.
In an attempt to manage its exposure to changes in interest rates, management monitors the Company's interest rate risk. The Asset/Liability Committee meets periodically to review the Bank's interest rate risk position and profitability, and to recommend adjustments for consideration by executive management. Management also reviews the Bank's securities portfolio, formulates investment strategies, and oversees the timing and implementation of transactions to assure attainment of the Board's objectives in the most effective manner. In managing market risk and the asset/liability mix, the Bank has placed its emphasis on developing a portfolio in which, to the extent practicable, assets and liabilities reprice within similar periods. Notwithstanding the Company's interest rate risk management activities, the potential for changing interest rates is an uncertainty that can have an adverse effect on net income. The Company does not currently engage in trading activities to control interest rate risk although it may in the future, if necessary, to manage interest rate risk. The Company has entered into interest rate swap contracts to convert variable-rate trust preferred debt into a fixed rate instrument to modify interest rate risk. In addition, the Bank has entered into interest rate swap contracts to convert
variable-rate deposits into a fixed rate instrument. See Note 9 of "Notes to Consolidated Financial Statements" of this Form 10-K for additional information.
In adjusting the Company's asset/liability position, management attempts to manage the Company's interest rate risk while enhancing net interest margins. At times, depending on the level of general interest rates, the relationship between long and short-term interest rates, market conditions and competitive factors, management may determine to increase the Company's interest rate risk position somewhat in order to increase its net interest margin. The Company's results of operations and net portfolio values remain vulnerable to increases in interest rates and to fluctuations in the difference between long- and short-term interest rates.
Consistent with the asset/liability management philosophy described above, the Company has taken several steps to manage its interest rate risk. The Company has structured its security portfolio to shorten the repricing of its interest-earning assets. The Company's residential mortgage-backed securities and securities available for sale typically have either short or medium terms to maturity or adjustable interest rates. At June 30, 2010, the Company had investment securities available for sale of $10.7 million with contractual maturities of five years or less. Adjustable-rate residential mortgage-backed securities totaled $224.6 million at June 30, 2010. Residential mortgage-backed securities amortize and experience prepayments of principal. The Company has received average cash flows from principal paydowns, maturities, sales and calls of all securities available for sale of $100.6 million annually over the past three fiscal years. The Company also manages interest rate risk reduction by utilizing non-certificate depositor accounts for certain liquidity purposes. The Board and management believe that such accounts carry a lower cost than certificate accounts, and that a material portion of such accounts may be more resistant to changes in interest rates than are certificate accounts. At June 30, 2010, the Company had $83.1 million of savings accounts, $189.8 million of money market accounts and $217.4 million of checking accounts, representing 53.63% of total depositor account balances.
One approach used to quantify interest rate risk is the Bank's NPV analysis. In essence, this analysis calculates the difference between the present value of liabilities and the present value of expected cash flows from assets and off-balance sheet contracts. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations-Asset/Liability and Risk Management" of this Form 10-K for further discussion regarding the NPV analysis and an analysis of the Company's interest rate risk as measured by the estimated changes in NPV resulting from instantaneous and sustained parallel shifts in the yield curve.
Item 8.
Item 8. Financial Statements and Supplementary Data
Management's Report on
Internal Control over Financial Reporting
The management of HF Financial Corp. and its subsidiaries (the "Company") is responsible for establishing and maintaining adequate internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) of the Securities Exchange Act of 1934, as amended) for the Company. The Company's internal control over financial reporting was designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles.
Under the supervision and with the participation of the Company's management, including its Chairman, President and Chief Executive Officer and its Executive Vice President, Chief Financial Officer and Treasurer, the Company conducted an evaluation of the effectiveness of its internal control over financial reporting as of June 30, 2010 based on the criteria set forth in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Based on this evaluation, management concluded that the Company's internal control over financial reporting was effective as of June 30, 2010.
This Annual Report on Form 10-K does not include an attestation report of the Company's registered public accounting firm regarding internal control over financial reporting. Management's report was not subject to attestation by the Company's registered public accounting firm pursuant to Section 989G of the Dodd-Frank Wall Street Reform Act, which exempts the Company from the requirement that it include an attestation report of the Company's public accounting firm regarding internal control over our management's assessment of internal controls over financial reporting.
/s/ CURTIS L. HAGE
Curtis L. Hage
Chairman, President and
Chief Executive Officer
/s/ DARREL L. POSEGATE
Darrel L. Posegate
Executive Vice President,
Chief Financial Officer and Treasurer
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S
REPORT ON THE FINANCIAL STATEMENTS
CONSOLIDATED FINANCIAL STATEMENTS
Statements of Financial Condition
Statements of Income
Statements of Stockholders' Equity
Statements of Cash Flows
Notes to Consolidated Financial Statements
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders
HF Financial Corp.
Sioux Falls, South Dakota
We have audited the accompanying consolidated statements of financial condition of HF Financial Corp. as of June 30, 2010 and 2009, and the related consolidated statements of income, stockholders' equity and cash flows for each of the years in the three-year period ended June 30, 2010. HF Financial Corp.'s management is responsible for these consolidated financial statements. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe our audits provide a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of HF Financial Corp. as of June 30, 2010 and 2009, and the results of its operations and its cash flows for each of the years in the three-year period ended June 30, 2010, in conformity with accounting principles generally accepted in the United States of America.
We also have audited, in accordance with attestation standards established by the American Institute of Certified Public Accountants, HF Financial Corp.'s internal control over financial reporting as of June 30, 2010, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated September 10, 2010 expressed an unqualified opinion.
Sioux Falls, South Dakota
September 10, 2010
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED JUNE 30, 2010, 2009 AND 2008
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED JUNE 30, 2010, 2009 AND 2008
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JUNE 30, 2010, 2009 AND 2008
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of HF Financial Corp. and subsidiaries ("the Company") conform to accounting principles generally accepted in the United States of America and to general practice within the industry. The following is a description of the more significant of those policies that the Company follows in preparing and presenting its consolidated financial statements.
Nature of Operations
The Company, a unitary thrift holding company, was formed in November 1991, for the purpose of owning all of the outstanding stock of Home Federal Bank ("the Bank"). The Company is incorporated under the laws of the State of Delaware and generally is authorized to engage in any activity that is permitted by the Delaware General Corporation Law. The executive offices of the Company and its direct and indirect subsidiaries are located in Sioux Falls, South Dakota.
The Bank was founded in 1929 and is a federally chartered stock savings bank headquartered in Sioux Falls, South Dakota. The Bank provides full-service consumer and commercial business banking, including an array of financial products, to meet the needs of its market place. The Bank attracts deposits from the general public and uses such deposits, together with borrowings and other funds, to originate one-to-four family residential, commercial business, consumer, multi-family, commercial real estate, construction and agricultural loans. The Bank's consumer loan portfolio includes, among other things, automobile loans, home equity loans, loans secured by deposit accounts and student loans. The Bank also purchases residential mortgage-backed securities and invests in U.S. Government and agency obligations and other permissible investments. The Bank receives loan servicing income on loans serviced for others and commission income from credit-life insurance on consumer loans. Through its trust department, the Bank acts as trustee, personal representative, administrator, guardian, custodian, agent, advisor and manager for various accounts. The Bank, through its wholly-owned subsidiaries, offers annuities, mutual funds, life insurance and other financial products, and equipment leasing services.
Principles of Consolidation
The accompanying consolidated financial statements include the accounts of the Company, the Company's wholly-owned subsidiaries, HomeFirst Mortgage Corp. (the Mortgage Corp.), HF Financial Group, Inc. (HF Group), and Home Federal Bank (the Bank) and the Bank's wholly-owned subsidiaries, Hometown Investment Services, Inc. (Hometown), Mid America Capital Services, Inc. (Mid America Capital), Home Federal Securitization Corp. (HFSC), Mid-America Service Corporation (Mid-America) and PMD, Inc (PMD). All intercompany balances and transactions have been eliminated in consolidation.
Basis of Financial Statement Presentation and Use of Estimates
In preparing the consolidated financial statements, management is required to make estimates and assumptions that affect the reported amounts of assets and liabilities as of the date of the statement of financial condition and revenues and expenses for the fiscal year. Actual results could differ significantly from those estimates. Material estimates that are particularly susceptible to significant
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
change in the near-term related to the determination of the allowance for loan and lease losses, self-insurance, security impairment and servicing rights. Management has evaluated subsequent events for potential disclosure or recognition through September 10, 2010, the date of the filing of the consolidated financial statements with the Securities and Exchange Commission.
Cash and Cash Equivalents
For purposes of reporting the statements of cash flows, the Company includes as cash equivalents all cash accounts which are not subject to withdrawal restrictions or penalties and time deposits with original maturities of 90 days or less.
Trust Assets
Assets of the trust department, other than trust cash on deposit at the Bank, are not included in these consolidated financial statements because they are not assets of the Bank.
Securities
Management determines the appropriate classification of securities at the date individual securities are acquired and evaluates the appropriateness of such classifications at each statement of financial condition date.
Securities available for sale are those debt securities that the Company intends to hold for an indefinite period of time, but may not hold necessarily to maturity, and all equity securities. Any decision to sell a security classified as available for sale would be based on various factors, including significant movements in interest rates, changes in the maturity mix of the Company's assets and liabilities, liquidity needs, regulatory capital considerations, and other similar factors. Securities available for sale are carried at fair value and unrealized gains or losses are reported as increases or decreases in other comprehensive income net of the related deferred tax effect.
Premiums and discounts on securities are amortized over the contractual lives of those securities, except for residential mortgage-backed securities, for which prepayments are probable and predictable, which are amortized over the estimated expected repayment terms of the underlying mortgages. The method of amortization results in a constant effective yield on those securities (the interest method). Interest on debt securities is recognized in income as accrued. Realized gains and losses on the sale of securities are determined using the specific identification method.
Securities Impairment
Management continually monitors the investment security portfolio for impairment on a security by security basis. During the third quarter of Fiscal 2009, the Company early adopted FASB Staff Position ("FSP") No. FAS 115-2, The Recognition and Presentation of Other-Than-Temporary Impairments, which changed the recognition and presentation of other-than-temporary impairment for securities. Management has a process in place to identify securities that could potentially have a credit impairment that is other than temporary. This process involves the length of time and extent to which
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
the fair value has been less than the amortized cost basis, review of available information regarding the financial position of the issuer, monitoring the rating of the security, cash flow projections, and the Company's intent to sell a security or whether it is more likely than not the Company will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity. To the extent we determine that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized. If the Company intends to sell a security or it is more likely than not that the Company would be required to sell a security before the recovery of its amortized cost, less any current period credit loss, the Company recognizes an other-than-temporary impairment in earnings for the difference between amortized cost and fair value. If we do not expect to recover the amortized cost basis, we do not plan to sell the security and if it is not more likely than not that the Company would be required to sell a security before the recovery of it amortized cost, less any current period credit loss, the recognition of the other-than-temporary impairment is bifurcated. For those securities, the Company separates the total impairment into a credit loss component recognized in earnings, and the amount of the loss related to other factors is recognized in other comprehensive income net of taxes.
The amount of the credit loss component of a debt security impairment is estimated as the difference between amortized cost and the present value of the expected cash flows of the security. The present value is determined using the best estimate cash flows discounted at the effective interest rate implicit to the security at the date of purchase or the current yield to accrete an asset-backed or floating rate security. Cash flow estimates for trust preferred securities are derived from scenario-based outcomes of forecasted default rates, loss severity, prepayment speeds and structural support.
Level 3 Fair Value Measurement
GAAP requires the Company to measure the fair value of financial instruments under a standard which describes three levels of inputs that may be used to measure fair value. Level 3 measurement includes significant unobservable inputs that reflect the Company's own assumptions about the assumptions that market participants would use in pricing an asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation. Although management believes that it uses a best estimate of information available to determine fair value, due to the uncertainty of future events, the approach includes a process that may differ significantly from other methodologies and still produce an estimate that is in accordance with GAAP.
Loans Held for Sale
Loans receivable, which the Bank may sell or intend to sell prior to maturity, are carried at the lower of net book value or fair value on an aggregate basis. Such loans held for sale include loans receivable that management intends to use as part of its asset/liability strategy, or that may be sold in response to changes in interest rates, changes in prepayment risk or other similar factors.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Loans and Leases Receivable
Loans receivable are stated at unpaid principal balances, less the allowance for loan losses, and net of deferred loan origination fees, costs and discounts.
Interest income on loans is accrued over the term of the loan based upon the outstanding principal amount. Discounts and premiums on loans are amortized to income using the interest method over the remaining period to contractual maturity, adjusted for prepayments.
Loans and leases are generally classified as nonaccrual when there are reasonable doubts as to the collectability of principal and/or interest and/or when payment becomes 90 days past due, except loans which are well secured and in the process of collection. Uncollectible interest on loans and leases that are impaired or contractually past due is charged off based on management's periodic evaluation. The charge to interest income is equal to all interest previously accrued, and income is subsequently recognized only to the extent cash payments are received until, in management's judgment, the borrower's ability to make periodic interest and principal payments is no longer in doubt, in which case the loan is returned to accrual status.
The Company's leases receivable are classified as direct finance leases. Under the direct financing method of accounting for leases, the total net payments receivable under the lease contracts and the residual value of the leased equipment, net of unearned income, are recorded as a net investment in direct financing leases and the unearned income is recognized each month on a basis which approximates the interest method.
The allowance for loan and lease losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes the uncollectability of a loan balance is confirmed.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management's periodic review of the collectability of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
A loan is considered impaired when, based on current information and events, it is probable that the Company will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and insignificant payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower's prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial and construction loans by either the present value of expected future cash flows
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
discounted at the loan's effective interest rate, the loan's obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of similar balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Company does not separately identify individual consumer and residential loans for impairment disclosures.
Loan Origination Fees and Related Discounts
Loan fees and certain direct loan origination costs are deferred, and the net fee or cost is recognized as an adjustment to interest income using the interest method over the contractual life of the loans, adjusted for prepayments.
Commitment fees and costs relating to commitments, the likelihood of exercise of which is remote, are recognized during the commitment period. If the commitment is subsequently exercised during the commitment period, the remaining unamortized commitment fee at the time of exercise is recognized over the life of the loan as an adjustment of yield.
Loan Servicing
The cost allocated to servicing rights purchased or retained has been recognized as a separate asset, is initially measured at fair value, and is being amortized in proportion to and over the period of estimated net servicing income. Servicing rights are periodically evaluated for impairment based on the fair value of those rights. Fair values are estimated using discounted cash flows based on current market rates of interest. For purposes of measuring impairment, the rights are stratified by one or more predominant risk characteristics of the underlying loans. The Bank stratifies its capitalized servicing rights based on loan type. The Company performs quarterly testing to determine if loan servicing rights purchased and retained servicing rights are impaired. As of June 30, 2010, and 2009, there was no impairment to loan servicing rights purchased and retained servicing rights.
Goodwill
Goodwill is the difference between the purchase price and the amounts assigned to the net assets acquired and accounted for under the purchase method of accounting. The Company performs annual testing to determine if goodwill is impaired. During this testing, it was determined that the goodwill associated with the acquisition of the leasing division was impaired at June 30, 2010. Accordingly, the Company wrote-off the amount of goodwill associated with this acquisition of $585. As of June 30, 2010, there is no impairment with respect to intangible assets for the remaining amount of $4,366.
Foreclosed Real Estate and Other Properties
Real estate and other properties acquired through, or in lieu of, loan foreclosure are initially recorded at lower of cost or fair value less estimated costs to sell at the date of foreclosure. Costs relating to improvement of property are capitalized, whereas costs relating to the holding of property
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
are expensed. Valuations are periodically performed by management and charge-offs to operations are made if the carrying value of a property exceeds its estimated fair value less estimated costs to sell.
Office Properties and Equipment
Land is carried at cost. All other properties and equipment are carried at cost, less accumulated depreciation and amortization. Buildings and improvements and leasehold improvements are depreciated primarily on the straight-line method over the estimated useful lives of the assets, which are five to fifty years. Furniture, fixtures, equipment and automobiles are depreciated using both the straight-line and declining balance methods over the estimated useful lives of the assets, which are three to twelve years.
Income Taxes
Income taxes are accounted for using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax-basis carrying amounts. Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.
In the preparation of income tax returns, tax positions are taken based on interpretation of federal and state income tax laws. Management periodically reviews and evaluated the status of uncertain tax positions and makes estimates of amounts ultimately due or owed. The benefits of tax positions is recorded in income tax expense in the consolidated financial statements, net of the estimates of ultimate amounts due or owed including any applicable interest and penalties. The Company's policy is to report interest and penalties, if any, related to unrecognized tax benefits in income tax expense in the Consolidated Statements of Income. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in income in the period in which the enactment date occurs.
The determination of current and deferred income taxes is an accounting estimate which is based on the analyses of many factors including interpretation of federal and state income tax laws, the evaluation of uncertain tax positions, differences between the tax and financial reporting bases of assets and liabilities (temporary differences), estimates of amounts due or owed such as the timing of reversal of temporary differences and current financial accounting standards. Actual results could differ from the estimates and tax law interpretations used in determining the current and deferred income tax liabilities.
Earnings Per Share (EPS)
Basic EPS represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period, inclusive of non-vested share-based payment awards. Diluted EPS reflects additional common shares that would have been outstanding if dilutive potential common shares had been issued.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Segment Reporting
Operating segments are defined as components of an enterprise for which discrete financial information is available that is evaluated regularly by the chief operating decision makers in deciding how to allocate resources and in assessing performance. The Company's reportable segments are "banking" (including leasing activities) and "other." The "banking" segment is conducted through the Bank and Mid America Capital and the "other" segment is composed of smaller non-reportable segments, the Company and intersegment eliminations.
The management approach is used as the conceptual basis for identifying reportable segments and is based on the way that management organizes the segments within the enterprise for making
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
operating decisions, allocating resources, and monitoring performance, which is primarily based on products.
Stock-based compensation
The Company adopted SFAS No. 123R Share-Based Payment effective as of July 1, 2005 using the Black-Scholes option-pricing model and the modified prospective method in which compensation cost is recognized for all awards granted subsequent to the Company's adoption of this statement as well as for the unvested portion of awards outstanding as of the Company's adoption of this statement. See Note 16 for more information on stock option and incentive plans.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Self-insurance
The Company has had a self-insured health plan for its employees, subject to certain limits, since January 1994. The Bank is named the plan administrator for this plan and has retained the services of an independent third party administrator to process claims and handle other duties for this plan. The third party administrator does not assume liability for benefits payable under this plan. To mitigate a portion of the risks involved with a self-insured health plan, the Company has a stop-loss insurance policy through a commercial insurance carrier for coverage in excess of $65 per individual occurrence.
The Company assumes the responsibility for funding the plan benefits out of general assets; however, employees cover some of the costs of covered benefits through contributions, deductibles, co-pays and participation amounts. An employee is eligible for coverage upon completion of 30 calendar days of regular employment. The plan, which is on a calendar year basis, is intended to comply with, and be governed by, the Employee Retirement Income Security Act of 1974, as amended.
The accrual estimate for pending and incurred but not reported health claims is based upon a pending claims lag report provided by a third party provider. Although management believes that it uses the best information available to determine the accrual, unforeseen health claims could result in adjustments and net earnings being significantly affected if circumstances differ substantially from the assumptions used in estimating the accrual. Net healthcare costs are inclusive of health claims expenses and administration fees offset by stop loss and employee reimbursement. The following table is a summary of net healthcare costs by quarter during fiscal years 2010, 2009 and 2008.
Interest Rate Contracts and Hedging Activities
The Company uses derivative financial instruments to modify exposures to changes in interest rates and market prices for other financial instruments. To qualify for and maintain hedge accounting, the Company must meet formal documentation and effectiveness evaluation requirements both at the hedge's inception and on an ongoing basis. The application of the hedge accounting policy requires strict adherence to documentation and effectiveness testing requirements, judgment in the assessment of hedge effectiveness, identification of similar hedged item groupings, and measurement of changes in the fair value of hedged items. If in the future derivative financial instruments used by the Company no longer qualify for hedge accounting, the impact on the consolidated results of operations and reported earnings could be significant, as discussed below.
The Company discontinues hedge accounting prospectively when (1) it is determined that the derivative is no longer effective in offsetting changes in the cash flows of a hedged item (including
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
forecasted transactions); (2) the derivative expires or is sold, terminated, or exercised; (3) the derivative is de-designated as a hedge instrument, because it is unlikely that a forecasted transaction will occur; or (4) management determines that designation of the derivative as a hedge instrument is no longer appropriate.
When hedge accounting is discontinued because it is probable that a forecasted transaction will not occur, the derivative will continue to be carried on the balance sheet at its fair value, and gains and losses that were accumulated in other comprehensive income will be recognized immediately in earnings. In all other situations in which hedge accounting is discontinued, the derivative will be carried at its fair value on the balance sheet, with subsequent changes in its fair value recognized in current-period earnings.
Interest rate swaps utilized by the Company are each accounted for as a cash flow hedge, which hedge the interest rate risk in the cash flows of long-term, variable-rate subordinated debentures. Interest rate swaps utilized by the Bank are each accounted for as a cash flow hedge, which hedge the interest rate risk in the cash flows of variable-rate deposits. The cumulative change in fair value of the hedging derivatives, to the extent that it is expected to be offset by the cumulative change in anticipated interest cash flows from the hedged exposures, will be deferred and reported as a component of other comprehensive income (OCI). Any hedge ineffectiveness will be charged to current-period earnings.
Recent Accounting Pronouncements
FASB Establishes Accounting Standards Codification
In June 2009, FASB issued Accounting Standards Update No. 2009-01, "Generally Accepted Accounting Principles" (ASC Topic 105), which establishes the FASB Accounting Standards Codification ("the Codification" or "ASC") as the official single source of authoritative U.S. generally accepted accounting principles ("GAAP"). All existing accounting standards are superseded. All other accounting guidance not included in the Codification will be considered non-authoritative. The Codification also includes all relevant Securities and Exchange Commission ("SEC") guidance organized using the same topical structure in separate sections within the Codification.
Following the Codification, the Board will not issue new standards in the form of Statements, FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it will issue Accounting Standards Updates ("ASU") which will serve to update the Codification, provide background information about the guidance and provide the basis for conclusions on the changes to the Codification.
The Codification is not intended to change GAAP, but it will change the way GAAP is organized and presented. The Codification was effective for our first quarter fiscal 2010 financial statements and the principal impact on our financial statements is limited to disclosures as all future references to authoritative accounting literature will be referenced in accordance with the Codification. In order to ease the transition to the Codification, we are providing the Codification cross-reference alongside the references to the standards issued and adopted prior to the adoption of the Codification.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Fair Value Accounting
In September 2006, FASB issued SFAS No. 157, "Fair Value Measurements" (ASC Topic 820) which defines fair value, establishes a market-based framework or hierarchy for measuring fair value and expands disclosures about fair value measurements. This guidance is applicable whenever another accounting pronouncement requires or permits assets and liabilities to be measured at fair value. It does not expand or require any new fair value measures; however the application of this statement may change current practice. The Company adopted this guidance for financial assets and liabilities effective July 1, 2008 and for non financial assets and liabilities effective July 1, 2009. The adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In 2008, FASB issued Staff Position No. FAS 132(R)-1, "Employers' Disclosures about Postretirement Benefit Plan Assets" (ASC Topic 715-20-65). This guidance will expand disclosure by requiring the following new disclosures: 1) how investment allocation decisions are made by management; 2) major categories of plan assets; and 3) significant concentrations of risk. Additionally, ASC 715-20-65 will require an employer to disclose information about the valuation of plan assets similar to that required in ASC Topic 820 Fair Value Measurements and Disclosures. ASC 715-20-65 is effective for the Company for annual reporting periods beginning July 1, 2009 and the Company does not expect the adoption to have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In August 2009, FASB issued ASU No. 2009-05 which amends "Fair Value Measurements and Disclosures-Overall" (ASC Topic 820-10) to provide guidance on the fair value measurement of liabilities. This update requires clarification for circumstances in which a quoted price in an active market for the identical liability is not available, a reporting entity is required to measure fair value using one or more of the following techniques: 1) a valuation technique that uses either the quoted price of the identical liability when traded as an asset or quoted prices for similar liabilities or similar liabilities when traded as an asset; or 2) another valuation technique that is consistent with the principles in ASC Topic 820 such as the income and market approach to valuation. The amendments in this update also clarify that when estimating the fair value of a liability, a reporting entity is not required to include a separate input or adjustment to other inputs relating to the existence of a restriction that prevents the transfer of the liability. This update further clarifies that if the fair value of a liability is determined by reference to a quoted price in an active market for an identical liability, that price would be considered a Level 1 measurement in the fair value hierarchy. Similarly, if the identical liability has a quoted price when traded as an asset in an active market, it is also a Level 1 fair value measurement if no adjustments to the quoted price of the asset are required. The Company adopted this update effective in the second quarter of fiscal 2010 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In January 2010, FASB issued ASU No. 2010-06, "Improving Disclosures about Fair Value Measurements", (ASC Topic 820). This accounting standard provides additional guidance relating to fair value measurement disclosures. Specifically, companies are required to separately disclose significant transfers into and out of Level 1 and Level 2 measurements in the fair value hierarchy and the reasons for those transfers. Significance should generally be based on earnings and total assets or
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
liabilities, or when changes are recognized in other comprehensive income, based on total equity. Companies may take different approaches in determining when to recognize such transfers, including using the actual date of the event or change in circumstances causing the transfer, or using the beginning or ending of a reporting period. For Level 3 fair value measurements, the new guidance requires presentation of separate information about purchases, sales, issuances and settlements. Additionally, the FASB also clarified existing fair value measurement disclosure requirements relating to the level of disaggregation, inputs, and valuation techniques. This accounting standard is effective for interim and annual reporting periods after July 1, 2009, except for the detailed Level 3 disclosures, which will be effective for interim and annual reporting periods after July 1, 2010. The Company adopted this update in the first quarter of fiscal 2010, except for the detailed Level 3 disclosures, and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow. The Company will adopt the Level 3 disclosures in the first quarter of fiscal 2011 and does not expect the adoption to have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
Business Combinations and Noncontrolling Interests
In December 2007, FASB issued SFAS No. 141 (revised 2007), "Business Combinations" (ASC Topic 805). This guidance requires the acquiring entity in a business combination to recognize the full fair value of assets acquired and liabilities assumed in the transaction (whether a full or partial acquisition); establishes the acquisition date fair value as the measurement objective for all assets acquired and liabilities assumed; requires expensing of most transaction and restructuring costs; and requires the acquirer to disclose the information necessary to evaluate and understand the nature and financial effect of the business combination. The Company adopted this guidance effective July 1, 2009 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In April 2009, FASB issued Staff Position No. FSP FAS 141(R)-1, "Accounting for Assets Acquired and Liabilities Assumed in a Business Combination That Arise from Contingencies" (ASC Topic 805-20). This updated guidance amended the accounting treatment for assets and liabilities arising from contingencies in a business combination and requires that pre-acquisition contingencies be recognized at fair value, if fair value can be reasonably determined. If fair value cannot be reasonably determined, measurement should be based on the best estimate in accordance with SFAS No. 5, "Accounting for Contingencies" (ASC Topic 405). This updated guidance was effective July 1, 2009 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In June 2009, FASB issued SFAS No. 167, "Amendments to FASB Interpretation No. 46(R), Consolidation of Variable Interest Entities" (ASC Topic 810-10). This updated guidance requires an analysis to determine whether a variable interest gives the entity a controlling financial interest in a variable interest entity. It also requires an ongoing reassessment and eliminates the quantitative approach previously required for determining whether an entity is the primary beneficiary. This updated guidance was effective January 1, 2010, and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 1-SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Other Accounting Changes
In June 2009, FASB issued SFAS No. 166, "Accounting for Transfers of Financial Assets", (ASC Topic 860). This updated guidance removed the concept of a qualifying special-purpose entity and removed the exception from applying consolidation guidance to these entities. This update also clarified the requirements for isolation and limitations on portions of financial assets that are eligible for sale accounting. ASC Topic 860 is reportable for interim and annual reports and effective for the Company on reporting periods beginning July 1, 2010 and the Company does not expect the adoption to have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In April 2010, FASB issued ASU No. 2010-18,"Effect of a Loan Modification When the Loan Is Part of a Pool That Is Accounted for as a Single Asset". As a result of this update, modifications of loans that are accounted for within a pool under Subtopic 310-30 do not result in the removal of those loans from the pool even if the modification of those loans would otherwise be considered a troubled debt restructuring. An entity will continue to be required to consider whether the pool of assets in which the loan is included is impaired if expected cash flows for the pool change. ASU No. 2010-18 is effective for the Company in the first interim period of fiscal 2011 (September 30, 2010) and the annual reporting period beginning June 30, 2011. Management is currently evaluating the impact of adopting this update on the Company's consolidated financial condition, results of operations and cash flow.
In July 2010, FASB issued ASU 2010-20, "Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses" (ASC Topic 310). This guidance will expand disclosures by requiring additional disaggregated information related to the current disclosures. It will also require additional disclosures to provide information based on credit quality, past due aging information, trouble debt restructuring information, and significant purchases and sales of financing receivables. ASU 2010-20 is effective for the Company for interim and annual reporting periods ending after December 15, 2010 and the Company does not expect the adoption to have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
During fiscal 2010, FASB issued several ASUs: ASU No. 2009-03 through ASU No. 2010-24. Except for ASU no. 2010-06, 2010-18 and 2010-20 mentioned above, the ASUs issued entail technical corrections or clarifications to existing guidance or affect guidance related to specialized industries or entities and therefore have minimal, if any, impact on the Company.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 2-INVESTMENTS IN SECURITIES
The amortized cost and fair value of investments in securities, all of which are classified as available for sale according to management's intent, are as follows:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 2-INVESTMENTS IN SECURITIES (Continued)
Management has a process to identify securities that could potentially have a credit impairment that is other-than-temporary. This process involves evaluating the length of time and extent to which the fair value has been less than the amortized cost basis, reviewing available information regarding the financial position of the issuer, monitoring the rating of the security, and projecting cash flows. Management also determines if it is more likely than not we will be required to sell the security before the recovery of its amortized cost which, in some cases, may extend to maturity. To the extent we determine that a security is deemed to be other-than-temporarily impaired, an impairment loss is recognized.
For all securities that are considered temporarily impaired, the Company does not intend to sell these securities (has not made a decision to sell) and it is not more likely than not that the Company will be required to sell the security before recovery of its amortized cost, which may occur at maturity. The Company believes that it will collect all principal and interest due on all investments that have amortized cost in excess of fair value that are considered only temporarily impaired.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 2-INVESTMENTS IN SECURITIES (Continued)
The following tables present the age of gross unrealized losses and fair value by investment category.
The unrealized losses reported for municipal bonds relate to 16 municipal general obligation or revenue bonds. The unrealized losses are primarily attributed to changes in credit spreads or market interest rate increases since the securities were originally acquired, rather than due to credit or other causes. Management does not believe any individual unrealized losses as of June 30, 2010, represent an other-than-temporary impairment for these investments. The Company does not have the intent to sell these securities (has not made a decision to sell) and has assessed that it is not more likely than not that the Company will be required to sell these securities before anticipated recovery of fair value.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 2-INVESTMENTS IN SECURITIES (Continued)
The unrealized losses reported for residential mortgage-backed securities relate to 32 securities issued by the Federal National Mortgage Association ("FNMA"), the Government National Mortgage Association ("GNMA"), or the Federal Home Loan Mortgage Corporation ("FHLMC"). These unrealized losses are primarily attributable to changes in interest rates and the contractual cash flows of those investments which are guaranteed by an agency of the U.S. government. Management does not believe any of these unrealized losses as of June 30, 2010, represent an other-than-temporary impairment for those investments. The Company does not have the intent to sell these securities (has not made a decision to sell) and has assessed that it is not more likely than not that the Company will be required to sell these securities before anticipated recovery of fair value.
The unrealized losses reported for trust preferred securities are attributable to six rated pooled securities. Rating downgrades regarding these investments have occurred placing each in a below investment grade rating. The securities have an amortized cost of $1,908 rated Caa3, $2,341 rated Caa1, and $5,008 rated Ca. The market for these securities is currently inactive. The CUSIPs of the trust preferred securities are 74042TAE1 rated Caa3, 740417AB6 and 74042CAE8 rated Caa1, and 74041EAC9, 74041RAB2 and 55312HAE9 rated Ca. The Company performed assessments of available information for each security during fiscal year 2010, and also considered factors such as overall deal structure and its position within the structure, quality of underlying issuers within each pool, defaults and recoveries, loss severities and prepayments. Based upon scenarios developed in regard to this information, management compared the present value of best estimates of cash flows expected to be collected from each security at the security's effective interest rate to the amortized cost basis of each security. Management determined that four trust preferred securities exhibited an other-than-temporary impairment. The difference between the present value of cash flows and the amortized cost basis for each of the four securities was recorded as credit loss impairment and recognized in earnings in the amount of $2,683. The amortized cost basis of the four securities was reduced by the amount of credit loss. The amount of recognized losses due to amounts in other comprehensive income was $460, thus reducing the overall credit impairment losses related to these securities to $2,223. The unrealized losses on these trust preferred securities can primarily be attributed to changes in credit spreads since the securities were acquired. See Note 18 "Financial Instruments" for additional information related to the determination of fair value. The Company does not have the intent to sell these six securities (has not made a decision to sell) and has assessed that it is not more likely than not that the Company will be required to sell these securities before anticipated recovery of fair value. Within this segment, five securities with amortized cost of $7,424 are quarterly variable-rate securities tied to 3-month LIBOR.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 2-INVESTMENTS IN SECURITIES (Continued)
The following table presents the amounts recognized in the Consolidated Statements of Income for other-than-temporary impairments charged to earnings:
(1)Includes $8 of other-than-temporary impairment related to Fannie Mae common stock
The amortized cost and fair value of debt securities as of June 30, 2010, by contractual maturity, are shown below. Expected maturities will differ from contractual maturities because the borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
Equity securities have been excluded from the maturity table above because they do not have contractual maturities associated with debt securities.
Proceeds from the sale of securities available for sale in fiscal 2010 were $60,961 and resulted in gross gains and gross losses of $1,969 and $116, respectively. Proceeds from the sale of securities available for sale in fiscal 2009 were $57,246 and resulted in gross gains and gross losses of $952 and $48, respectively. Proceeds from the sale of securities available for sale in fiscal 2008 were $5,511 and resulted in gross gains of $3.
At June 30, 2010, and 2009, securities with a fair value of $245,341 and $209,114, respectively, were pledged as collateral for public deposits, borrowing and other purposes.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE
Loans and leases receivable at June 30, 2010, and 2009, consist of the following:
Loans held for sale totaling $25,287 at June 30, 2010, consist of $20,394 of one-to-four family fixed-rate loans and $4,893 of student loans. Loans held for sale totaling $14,881 at June 30, 2009, consist of $8,888 of one-to-four family fixed-rate loans and $5,993 of student loans.
Activity in the allowance for loan losses included in continuing operations is summarized as follows for the fiscal years ended June 30:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
The following is a summary of information pertaining to impaired loans and nonaccrual loans as of and for the fiscal years ended June 30, 2010, 2009, and 2008:
No additional funds are committed to be advanced in connection with impaired loans.
The Company has granted loans to directors, executive officers or related interests in the normal course of business. These loans were made on substantially the same terms, including rates and collateral, as those prevailing at the time for comparable transactions with other unrelated customers, and do not involve more than a normal risk of collection. The aggregate amount of loans to such related parties was approximately $2,877 and $3,651 at June 30, 2010, and 2009.
NOTE 4-LOAN SERVICING
Mortgage loans serviced for others (primarily the South Dakota Housing Development Authority) are not included in the accompanying consolidated statements of financial condition. The unpaid principal balances of mortgage loans serviced for others were $1,138,793 and $1,046,600, at June 30, 2010, and 2009, respectively.
Custodial balances maintained in connection with mortgage loan servicing, and included in advances by borrowers for taxes and insurance, were approximately $10,388 and $10,911, at June 30, 2010, and 2009, respectively.
The carrying values of mortgage rights were $12,733 and $11,768, at June 30, 2010, and 2009, respectively. The fair values of these rights were $17,022 and $15,055, at June 30, 2010, and 2009, respectively. The fair values of the servicing rights were estimated as the present value of the expected future cash flows using a discount rate of 9% and 10% at June 30, 2010, and 2009, respectively. During fiscal years 2010 and 2009, servicing rights approximating $2,477 and $1,920, respectively, were capitalized. The Company recognized expense for amortization of the cost of servicing rights in the amount of $1,512, $1,341 and $1,317 for the fiscal years ended June 30, 2010, 2009, and 2008, respectively.
No valuation allowances were provided for servicing rights capitalized during the fiscal years ended June 30, 2010, and 2009.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 5-OFFICE PROPERTIES AND EQUIPMENT
The Company leases numerous telephone and office equipment, which require minimum rentals totaling $84 through May 2013. The Company incurred rent expense of $973, $858 and $791, for fiscal years 2010, 2009 and 2008, respectively. In addition, the Company has leased property under various operating lease agreements, which expire at various times. The total rental commitments at June 30, 2010, under the leases are as follows:
NOTE 6-DEPOSITS
Deposits at June 30, 2010, and 2009 consist of the following:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 6-DEPOSITS (Continued)
Scheduled maturities of certificates of deposit are as follows:
Under the Dodd-Frank Act, non-IRA deposit accounts are permanently insured up to $250 by the Deposit Insurance Fund (DIF) under management of the Federal Deposit Insurance Corporation (FDIC). Previous to the legislation in 2010, the coverage of $250 was temporary until December 2013. IRA deposit accounts are permanently insured up to $250 by the DIF under management of the FDIC. The aggregate amount of jumbo certificates of deposit with a minimum denomination of $100 was approximately $212,270 and $214,930 at June 30, 2010, and 2009, respectively. Deposits at June 30, 2010, and 2009 include $89,408 and $78,087, respectively, of deposits from one local governmental entity, the majority of which are savings accounts.
The Company has deposits from directors, executive officers or related interests in the normal course of business. These deposits are substantially at the same terms and rates for comparable transactions with other unrelated customers. The aggregate amount of deposits from such related parties was approximately $624 and $713 at June 30, 2010, and 2009.
NOTE 7-ADVANCES FROM FEDERAL HOME LOAN BANK AND OTHER BORROWINGS
Advances from the Federal Home Loan Bank of Des Moines (FHLB) and other borrowings at June 30, 2010, and 2009, are summarized as follows:
(1)The Company has an available line of credit with United Bankers' Bank for liquidity needs of $6,000 with no funds advanced at June 30, 2010. The Company had a line of credit for $6,000 with First Tennessee Bank, NA with outstanding advances of $5,500 at June 30, 2009. The Company's has pledged 100% of bank stock as collateral for the United Bankers' Bank line of credit.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 7-ADVANCES FROM FEDERAL HOME LOAN BANK AND OTHER BORROWINGS (Continued)
(2)The Bank is a participating lender in the South Dakota Housing Development Authority program for flood victims in the north-eastern part of the state of South Dakota, as of May 2007. The money is provided to the Bank at a zero percent interest rate to be used in making loans to such flood victims. This is a revolving line of credit, in which the participating lender may borrow, prepay and re-borrow for a term of 10 years. The outstanding balances at June 30, 2010, and 2009 were $214 and $219, respectively.
Aggregate maturities of advances from FHLB and other borrowings, computed based upon contractual maturity date, are as follows:
(1)Includes the maturity of the overnight federal funds purchased.
Prepayment of convertible, or callable, advances results in a prepayment fee as negotiated between the Bank and the FHLB. Convertible advances without a strike rate are subject to be called at the FHLB's discretion. Convertible advances tied to LIBOR strike rates may only be called if the three-month LIBOR rate is equal to or greater than the indicated strike rate.
Advances with the FHLB are secured by stock in the FHLB, which is comprised of membership stock and activity-based stock. The membership stock requirement is based as a percentage of total assets as of the preceding December 31. At June 30, 2010, and 2009, the Bank held $1,407 and $1,407, respectively, in membership stock. The activity-based stock requirement is based on 4.45% of advances outstanding. At June 30, 2010, and 2009, the Bank held $8,927 and $11,069, respectively, in activity-based stock.
In addition, advances with the FHLB are secured by one-to-four family first mortgage loans, multi-family first mortgage loans and investment securities. In order to provide additional borrowing collateral, commercial real estate first mortgage loans, agricultural real estate first mortgage loans, home equity line of credit loans and home equity second mortgage loans have also been pledged with the FHLB. At June 30, 2010, the Bank had total collateral with the FHLB of $239,671 of which $49,166 was available for additional borrowing. At June 30, 2009, the Bank had total collateral with FHLB of $217,820 of which $10,670 was available for additional borrowing.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 7-ADVANCES FROM FEDERAL HOME LOAN BANK AND OTHER BORROWINGS (Continued)
Advances with the Federal Reserve Bank are secured by commercial business loans. At June 30, 2010, the Bank had total collateral with the Federal Reserve Bank of $60,766 of which $60,766 was available for borrowing.
The Bank currently has a $15,000 unsecured line of federal funds with First Tennessee Bank, NA, which did not have activity or an outstanding balance at June 30, 2010 and 2009.
The Bank currently has a $10,000 unsecured line of federal funds with Zions Bank, which did not have activity or an outstanding balance at June 30, 2010.
On September 30, 2009, the Company entered into a Loan Agreement (the "Loan Agreement") with United Bankers' Bank (the "Lender") in order to refinance its outstanding borrowings of $5,966 under its line of credit with First Tennessee Bank, NA that matured. Under the Loan Agreement, the Lender committed to lend to the Company an aggregate principal amount not to exceed $6,000. On November 25, 2009, the Company repaid its outstanding borrowings of $6,044 (principal plus accrued interest) under the Loan Agreement. The loan is evidenced by a promissory note, accrues interest at the United Bankers' Bank Rate with a minimum interest rate of 4.75% per annum, and the principal balance (plus any accrued and unpaid interest) is due and payable in full on October 1, 2010. There was no additional activity or an outstanding balance at June 30, 2010.
NOTE 8-SUBORDINATED DEBENTURES PAYABLE TO TRUSTS
On July 11, 2002, the Company issued 5,000 shares totaling $5,000 of Company Obligated Mandatorily Redeemable Preferred Securities of Trust II. Trust II was established and exists for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust II. The securities provide for cumulative cash distributions calculated at a rate based on three- month LIBOR plus 3.65% adjusted quarterly. The Company may, at one or more times, defer interest payments on the capital securities for up to 20 consecutive quarterly periods, but not beyond October 7, 2032. The capital securities were scheduled for redemption on October 7, 2032; however on July 7, 2007, the Company exercised its option to redeem the 5,000 shares totaling $5,000 of Trust II. Proceeds from Trust VI were used to fund this redemption.
On December 19, 2002, the Company issued 5,000 shares totaling $5,000 of Company Obligated Mandatorily Redeemable Preferred Securities of Trust III. Trust III was established and exists for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust III. The securities provide for cumulative cash distributions calculated at a rate based on three-month LIBOR plus 3.35% adjusted quarterly. The Company may, at one or more times, defer interest payments on the capital securities for up to 20 consecutive quarterly periods, but not beyond January 7, 2033. At the end of the deferral period, all accumulated and unpaid distributions must be paid. The capital securities must be redeemed on January 7, 2033; however, the Company has the option to shorten the maturity date as the call option date has passed. Holders of the capital securities have no voting rights, are unsecured,
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 8-SUBORDINATED DEBENTURES PAYABLE TO TRUSTS (Continued)
and rank junior in priority of the payment to all of the Company's indebtedness and senior to the Company's capital stock.
On September 25, 2003, the Company issued 7,000 shares totaling $7,000 of Company Obligated Mandatorily Redeemable Preferred Securities of Trust IV. Trust IV was established and exists for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust IV. The securities provide for cumulative cash distributions calculated at a rate based on three-month LIBOR plus 3.10% adjusted quarterly. The Company may, at one or more times, defer interest payments on the capital securities for up to 20 consecutive quarterly periods, but not beyond October 8, 2033. At the end of the deferral period, all accumulated and unpaid distributions must be paid. The capital securities must be redeemed on October 8, 2033; however, the Company has the option to shorten the maturity date as the call option date has passed. Holders of the capital securities have no voting rights, are unsecured, and rank junior in priority of the payment to all of the Company's indebtedness and senior to the Company's capital stock.
On December 7, 2006, the Company issued 10,000 shares totaling $10,000 of Company Obligated Mandatorily Redeemable Preferred Securities of Trust V. Trust V was established and exists for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust V. The securities provide for cumulative cash distributions calculated at a rate based on three-month LIBOR plus 1.83%, fixed for five years at 6.61%; thereafter, adjusted quarterly. The Company may, at one or more times, defer interest payments on the capital securities for up to 20 consecutive quarterly periods, but not beyond March 1, 2037. At the end of the deferral period, all accumulated and unpaid distributions must be paid. The capital securities must be redeemed on March 1, 2037; however, the Company has the option to shorten the maturity date to a date not earlier than March 1, 2012. Holders of the capital securities have no voting rights, are unsecured, and rank junior in priority of the payment to all of the Company's indebtedness and senior to the Company's capital stock.
On July 5, 2007, the Company issued 5,000 shares totaling $5,000 of Company Obligated Mandatorily Redeemable Preferred Securities of Trust VI. Trust VI was established and exists for the sole purpose of issuing trust preferred securities and investing the proceeds in subordinated debentures of the Company. These subordinated debentures constitute the sole asset of Trust VI. The securities provide for cumulative cash distributions calculated at a rate based on three- month LIBOR plus 1.65% adjusted quarterly. The Company may, at one or more times, defer interest payments on the capital securities for up to 20 consecutive quarterly periods, but not beyond October 1, 2037. At the end of the deferral period, all accumulated and unpaid distributions must be paid. The capital securities must be redeemed on October 1, 2037; however, the Company has the option to shorten the maturity date to a date not earlier than October 1, 2012. Holders of the capital securities have no voting rights, are unsecured, and rank junior in priority of the payment to all of the Company's indebtedness and senior to the Company's capital stock.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 9-INTEREST RATE CONTRACTS
Interest rate swap contracts are entered into primarily as an asset/liability management strategy of the Company to modify interest rate risk. The primary risk associated with all swaps is the exposure to movements in interest rates and the ability of the counterparties to meet the terms of the contract. The Company is exposed to losses if the counterparty fails to make its payments under a contract in which the Company is in a receiving status. The Company minimizes its risk by monitoring the credit standing of the counterparty. The Company anticipates the counterparty will be able to fully satisfy its obligations under the remaining agreements.
During the first quarter of fiscal 2008, the Company entered into an interest rate swap agreement with a $5,000 notional amount to convert the variable-rate Trust Preferred VI security into a fixed-rate instrument for a term of five years at a fixed rate of 6.69%. This rate swap is designated as a cash flow hedge. The fair value of the derivative was an unrealized loss of $514 and $494 at June 30, 2010, and 2009, respectively. During the second quarter of fiscal 2010, the Company entered into a forward-starting interest rate swap agreement and will replace the existing swap agreement for the variable-rate Trust Preferred VI security upon the existing swap's maturity. The $5,000 notional amount fixed-rate instrument has a term of five years at a fixed rate of 5.95%, effective October 1, 2012. The fair value of the derivative was an unrealized loss of $234 at June 30, 2010.
During the fourth quarter of fiscal 2008, the Company entered into an interest rate swap agreement with a $7,000 notional amount to convert the variable-rate Trust Preferred IV security into a fixed-rate instrument for a term of three years at a fixed rate of 6.19%. This rate swap is designated as a cash flow hedge. The fair value of the derivative was an unrealized loss of $138 and $235 at June 30, 2010, and 2009, respectively. During the second quarter of fiscal 2010, the Company entered into a forward-starting interest rate swap agreement and will replace the existing swap agreement for the variable-rate Trust Preferred IV security upon the existing swap's maturity. The $7,000 notional amount fixed-rate instrument has a term of three years at a fixed rate of 5.93%, effective January 8, 2011. The fair value of the derivative was an unrealized loss of $243 at June 30, 2010.
During the first quarter of fiscal 2009, the Company entered into an interest rate swap agreement with a $3,000 notional amount to convert a portion of the variable-rate Trust Preferred III security into a fixed-rate instrument for a term of three years at a fixed rate of 6.70%. The Company also entered into an interest rate swap agreement with a $2,000 notional amount to convert the remaining portion of variable-rate Trust Preferred III security into a fixed rate instrument for a term of four years at a fixed rate of 6.91%. The fair value of the $3,000 notional derivative was an unrealized loss of $121 and $129 at June 30, 2010, and 2009, respectively. The fair value of the $2,000 notional derivative was an unrealized loss of $131 and $94 at June 30, 2010, and 2009, respectively. During the fourth quarter of fiscal 2010, the Company entered into two forward-starting interest rate swap agreements and will replace the existing swap agreements for the variable-rate Trust Preferred III security upon the existing swaps' maturity. The $3,000 notional amount fixed-rate instrument has a term of four years at a fixed rate of 6.58%, effective October 7, 2011. The $2,000 notional amount fixed-rate instrument has a term of two years at a fixed rate of 6.58%, effective October 9, 2012. The fair values of the $3,000 and $2,000 notional amount derivatives were unrealized losses of $82 and $23, respectively, at June 30, 2010.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 9-INTEREST RATE CONTRACTS (Continued)
During the second quarter of fiscal 2010, the Company entered into a forward-starting interest rate swap agreement with a $10,000 notional amount to convert the variable-rate Trust Preferred V security into a fixed-rate instrument. The $10,000 notional amount fixed-rate instrument has a term of five years at a fixed rate of 5.68%, effective December 1, 2011. The fair value of the derivative was an unrealized loss of $471 at June 30, 2010.
During the fourth quarter of fiscal 2010, the Bank entered into five forward-starting interest rate swap agreements with notional amounts totaling $35,000 to convert the variable-rate attributes of deposits into fixed-rate instruments. The $3,000 notional amount fixed-rate instrument has a term of four years at a fixed rate of 2.20%, effective November 18, 2010. The $7,000 notional amount fixed-rate instrument has a term of 30 months at a fixed rate of 2.09%, effective March 7, 2011. The $10,000 notional amount fixed-rate instrument has a term of 42 months at a fixed rate of 2.44%, effective May 10, 2011. The $10,000 notional amount fixed-rate instrument has a term of three years at a fixed rate of 2.56%, effective April 21, 2011. The $5,000 notional amount fixed-rate instrument has a term of three years at a fixed rate of 2.30%, effective January 21, 2011. The fair values of the $3,000, $7,000, $10,000, $10,000 and $5,000 notional amount derivatives were unrealized losses of $84, $163, $271, $329 and $153, respectively, at June 30, 2010.
No gain or loss was recognized in earnings for the fiscal years 2010 and 2009 related to interest rate swaps. No deferred net losses on interest rate swaps in other comprehensive loss as of June 30, 2010, are expected to be reclassified into earnings during the next twelve months. See Note 17 "Accumulated Other Comprehensive Loss" for amounts reported as other comprehensive income.
The Company posted $1,944 in cash and $858 in securities under collateral arrangements as of June 30, 2010, to satisfy collateral requirements associated with our interest rate swap contracts.
The following table summarizes the derivative financial instruments utilized as of June 30, 2010:
The following table details the derivative financial instruments, the average remaining maturities and the weighted-average interest rates being paid and received as of June 30, 2010:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 10-INCOME TAX MATTERS
The Company and subsidiaries file a consolidated federal income tax return on a fiscal year basis in the U.S. federal jurisdiction and various states. The Company is no longer subject to U.S. federal, state and local, or non-U.S. income tax examinations by tax authorities for years before 2006. The Bank is allowed bad debt deductions based on actual charge-offs.
The consolidated provision for income taxes from continuing operations consists of the following for the years ended June 30:
Income tax expense is different from that calculated at the statutory federal income tax rate. The reasons for this difference in tax expense are as follows:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 10-INCOME TAX MATTERS (Continued)
The components of the net deferred tax asset as of June 30, 2010, and 2009 are as follows:
Retained earnings at June 30, 2010, and 2009, include approximately $4,805 related to the pre-1987 allowance for loan losses for which no deferred federal income tax liability has been recognized. These amounts represent an allocation of income to bad debt deductions for tax purposes only. If the Bank no longer qualifies as a bank, or in the event of a liquidation of the Bank, income would be created for tax purposes only, which would be subject to the then current corporate income tax rate. The unrecorded deferred income tax liability on the above amount for financial statement purposes was approximately $1,634.
The Company had no unrecognized tax benefits as of June 30, 2010 and 2009. The Company recognized no interest and penalties on the underpayment of income taxes during fiscal years June 30, 2010 and 2009, and had no accrued interest and penalties on the balance sheet as of June 30, 2010 and 2009. The Company has no tax positions for which it is reasonably possible that the total amounts of unrecognized tax benefits will significantly increase with the next twelve months.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 11-REGULATORY CAPITAL
The Bank is subject to various regulatory capital requirements administered by federal banking agencies. Failure to meet minimum capital requirements can initiate certain mandatory-and possibly additional discretionary-actions by regulators that, if undertaken, could have a direct material effect on the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank's assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank's capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to adjusted total assets (as defined). Management believes, as of June 30, 2010, and 2009, that the Bank meets all capital adequacy requirements to which it is subject.
As of June 30, 2010, the Office of Thrift Supervision (OTS) categorized the Bank as "well capitalized" under the regulatory framework. To be categorized as well capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I (core) capital ratios as set forth in the table. There are no conditions or events since that notification that management believes have unfavorably changed the Bank's category.
The following table summarizes the Bank's compliance with its regulatory capital requirements at June 30, 2010, and 2009:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 12-STOCKHOLDERS' EQUITY
During the second quarter of fiscal 2010, the Company issued 2.875 million shares of its common stock at a public offering price of $8.00 per share, for gross proceeds of $23,000. The net proceeds of the offering after deducting underwriting discounts and commissions and estimated offering expenses totaled approximately $20,667. Per share earnings calculations were based on a diluted weighted average shares outstanding of 5.77 million shares versus 4.03 million and 4.02 million shares in the comparable periods in fiscal 2009 and fiscal 2008, respectively.
The Company previously had in effect a publicly announced stock buy-back program in which up to 10% of the common stock of the Company outstanding on a stated date could be acquired within a year. In conjunction with the Company's participation in the CPP in November 2008, the Company's Board of Directors terminated the stock buy-back program. Pursuant to a series of stock buy-back programs initiated by the Company since 1996, the Company has purchased an aggregate of 2.08 million shares of common stock through June 30, 2010.
The Company has authorized 50,000 shares of Preferred Stock, designated as "Series A Junior Participating Preferred Stock" with a stated value of $1.00 per share. Outstanding shares of the Junior Preferred Stock are entitled to cumulative dividends. Such shares have voting rights of 100 votes per share and a preference in liquidation. The shares are not redeemable after issuance.
Under current regulations, the Bank is not permitted to pay dividends on its stock if its regulatory capital would reduce below (i) the amount required for the liquidation account established to provide a limited priority claim to the assets of the Bank to qualifying depositors (Eligible Account Holders) at March 31, 1992, who continue to maintain deposits at the Bank after its conversion from a federal mutual savings and loan association to a federal stock savings bank pursuant to its Plan of Conversion adopted August 21, 1991, or (ii) the Bank's regulatory capital requirements. Capital distributions are limited to the greater of 100% of net income for the year to date plus 50% of the amount of which the lesser of the institution's tangible core or risk-based capital exceeds its capital requirement for such capital commitment, as measured at the beginning of the calendar year or up to 75% of net income over the most recent four quarter period. Subsequent to June 30, 2010, the Bank will provide written notification to the OTS of its intention to pay dividends for each quarter in the year ending June 30, 2011, to the Company, while maintaining its capital requirements.
The Company entered into an agreement with the U.S. Department of the Treasury pursuant to which the Company issued and sold to the Treasury Department (i) 25,000 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, par value $0.01 per share and having a liquidation preference of $1,000 per share, and (ii) a ten-year warrant to purchase up to 302,419 shares of the Company's common stock, par value $0.01 per share, at an initial exercise price of $12.40 per share, for an aggregate purchase price of $25,000 in cash. The securities were issued and sold in a private placement exempt from registration pursuant to Section 4(2) of the Securities Act of 1933, as amended. Cumulative dividends on the Preferred Stock accrued on the liquidation preference at a rate of 5.00% per annum for the first five years, and at a rate of 9.00% per annum thereafter, but paid only if, as and when declared by the Company's Board of Directors. As the issuance of Preferred Stock included a warrant for common stock, this transaction increased the weighted average number of diluted common shares outstanding by a total of 3,301 for the fiscal year ended June 30, 2009.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 12-STOCKHOLDERS' EQUITY (Continued)
The Company repurchased all of its outstanding shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A, on June 3, 2009 and completed its repurchase of the warrant on June 30, 2009. The repurchase price of the preferred stock was $25,000 plus a final accrued dividend of $63, while the warrant was repurchased at a price of $650. The preferred stock and warrant were issued to the Treasury on November 21, 2008 as part of the voluntary Capital Purchase Program (CPP).
On July 21, 2010, the Board of Directors declared a $0.1125 per share dividend payable on August 13, 2010, to shareholders of record as of August 6, 2010. This cash dividend has not been reflected in the consolidated financial statements.
NOTE 13-EARNINGS PER SHARE
A reconciliation of the income available to common shareholders and common stock share amounts used in the calculation of basic and diluted EPS for the fiscal years ended June 30, 2010, 2009, and 2008, follow:
Options and SARs outstanding of approximately 280,100 shares of common stock at a weighted average share price of $14.11 during the fiscal year ended June 30, 2010, were not included in the computation of diluted earnings per share because the exercise price of those instruments exceeded the average market price of the common shares during the year. Options outstanding of approximately 170,000 shares of common stock at a weighted average share price of $15.23 during the fiscal year ended June 30, 2009, were not included in the computation of diluted earnings per share because the exercise price of those instruments exceeded the average market price of the common shares during the year. Options outstanding of approximately 16,100 shares of common stock at a weighted average share price of $17.27 during the fiscal year ended June 30, 2008, were not included in the computation of diluted earnings per share because the exercise price of those instruments exceeded the average market price of the common shares during the year.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 14-DEFINED BENEFIT PLAN
The Company has a noncontributory (cash balance) defined benefit pension plan covering all employees of the Company and its wholly-owned subsidiaries who have attained the age of 21 and have completed 1,000 hours in a plan year. The benefits are based on 6% of each eligible participant's annual compensation, plus income earned in the accounts at a rate determined annually based on 30-year treasury note rates. The Company's funding policy is to make the minimum annual required contribution plus such amounts as the Company may determine to be appropriate from time to time. One hundred percent vesting occurs after three years with a retirement age of the later of age 65 or three years of participation.
Information relative to the components of net periodic benefit cost measured as of June 30, 2010, and June 30, 2009, for the Company's defined benefit plan is presented below.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 14-DEFINED BENEFIT PLAN (Continued)
The components of net periodic benefit cost for the fiscal years ended June 30 consist of the following:
The estimated net loss that will be amortized from accumulated other comprehensive loss into net periodic benefit cost over the next fiscal year is $94.
The weighted-average assumptions used to determine benefit obligations at June 30 are as follows:
The weighted-average assumptions used to determine net periodic benefit cost for fiscal years ended June 30 are as follows:
The overall expected long-term rate of return on assets is based on economic forecasts and projected asset allocation.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 14-DEFINED BENEFIT PLAN (Continued)
The Company's pension plan weighted-average asset allocations by asset category are as follows:
(1)includes a plus/minus range of 10.0%
(2)includes a plus/minus range of 5.0% and includes cash and cash equivalents
(3)maximum allowed of 10.0%
(1)includes a plus/minus range of 10.0%
(2)includes a plus/minus range of 5.0% and includes cash and cash equivalents
(3)maximum allowed of 10.0%
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 14-DEFINED BENEFIT PLAN (Continued)
The fair value of the Company's pension plan assets at June 30, 2010, by asset category are as follows:
The objective of the pension plan investment policy for equities is to pursue a growth strategy that results in capital appreciation. The objective of the pension plan investment policy for fixed rate instruments and cash equivalents is to ensure safety of principal and interest.
The Company expects to contribute $455 to its pension plan in fiscal 2011. The minimum required contribution is $0.
Estimated Future Benefit Payments: The following benefit payments which reflect expected future service, as appropriate, are expected to be paid during the years ended June 30:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 15-RETIREMENT SAVINGS PLAN
The Company has a retirement savings plan covering all employees of the Company who have attained age 21 and completed one expected year of service during which they worked at least 1,000 hours. The plan is intended to be a qualified profit sharing plan with a cash or deferred arrangement pursuant to IRS Code Section 401(k) and regulations issued there under. The plan allows voluntary contributions by eligible employees, and also allows discretionary contributions by the Company as determined annually by the Board of Directors. The total compensation cost charged to expense related to the plan was $311, $282 and $335 for 2010, 2009 and 2008, respectively.
NOTE 16-STOCK-BASED COMPENSATION PLANS
During fiscal 2003, the Company established the 2002 Stock Option and Incentive Plan (2002 Option Plan). Under the 2002 Option Plan, awards for an aggregate amount of 907,500 common shares may be granted to directors and employees of the Bank. Options granted under the Option Plan may be either options that qualify as Incentive Stock Options, as defined in the Code, or options that do not qualify. Options granted may have a maximum term of 10 years. The 2002 Option Plan also provides for the award of stock appreciation rights, limited stock appreciation rights and nonvested stock.
The Company has a long-term incentive plan, which provides for the grant of nonvested stock awards and for stock appreciation rights ("SARs") settled in stock under the 2002 Option Plan if the Company achieves certain performance levels. For fiscal years 2009 and 2008, the Company met a performance level in the plan and, accordingly, for fiscal 2010 no nonvested stock or SARs will be issued in fiscal 2011. During fiscal years 2010 and 2009, 16,232 and 6,584 shares, respectively of nonvested stock were issued and 115,747 and 47,051 SARs were issued in fiscal 2010 and 2009 respectively, under the 2002 Option Plan. The nonvested shares and SARs vest 25% in each of the first through fourth anniversaries of the date of grant. The issuance value of the nonvested shares was $203 and $97 for fiscal years 2010 and 2009, respectively, and is being amortized over the vesting period of four years with the unamortized balance included in additional paid in capital in the consolidated statements of financial condition. During fiscal years 2010, 2009 and 2008, $331, $336 and $391, respectively, were recorded as amortization expense. The issuance value of the 2010 and 2009 SARs was $203 and $97 and each issuance is being amortized over the vesting period of four years. During fiscal years 2010, 2009 and 2008, $77, $38 and $30, respectively, were recorded as amortization expense.
In connection with the failure to meet the performance level of the long-term incentive plan, no shares of nonvested stock or SARs will be issued in fiscal 2011 under the plan.
During fiscal 2004, the Company created a pool of 12,100 nonvested shares for grants under the 2002 Option Plan (2002 Pool). The key provisions of the 2002 Pool include: outright grant of shares with restrictions as to sale, transfer, and pledging; during the restriction period, the grantee receives dividends and has voting rights related to the shares awarded; and all nonvested shares are forfeited upon termination. During fiscal years 2010 and 2009, 2,204 and 2,507 nonvested shares, respectively, were awarded under the Pool. The issuance value of these nonvested shares was $28 and $37 in 2010 and 2009, respectively, and is being amortized over their vesting periods with the unamortized balance
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 16-STOCK-BASED COMPENSATION PLANS (Continued)
included in additional paid in capital in the consolidated balance sheet. During fiscal years 2010, 2009, and 2008, $40, $38 and $28, respectively, were recorded as amortization expense.
In association with the 2002 Option Plan, awards of nonvested shares of the Company's common stock are made to outside directors of the Company. Each outside director is entitled to all voting, dividend and distribution rights during the vesting period. During fiscal years 2010 and 2009, shares of nonvested stock awarded were 19,626 and 14,511, respectively. The nonvested shares vest on the first anniversary of the date of grant. During fiscal years 2010, 2009, and 2008, amortization expenses recorded was $141, $177 and $138, respectively.
The fair value of each incentive stock option and each stock appreciation right grant is estimated at the grant date using the Black-Scholes option pricing model. The following assumptions were used for grants in fiscal years 2010, 2009, and 2008:
Stock option activity for the fiscal year ended June 30, are as follows:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 16-STOCK-BASED COMPENSATION PLANS (Continued)
Stock appreciation rights activity for the fiscal year ended June 30, are as follows:
The Company applied a forfeiture rate of 14.00% when calculating the amount of options and stock appreciation rights expected to vest at June 30, 2010. This rate is based upon historical activity and will be revised if necessary in subsequent periods if actual forfeitures differ from these estimates. The weighted-average grant date fair value of stock appreciation rights granted during the fiscal years 2010, 2009, and 2008 was $1.75, $2.06 and $2.84. The total intrinsic value of options exercised during the fiscal years 2010, 2009, and 2008, was $18, $188 and $155, respectively. During fiscal years 2010, 2009, and 2008, $77, $38 and $53, respectively, were recorded as amortization expense. As of June 30, 2010, there was $252 of total unrecognized compensation cost related to nonvested SARs awards. The cost is expected to be recognized over a weighted-average period of 26 months for SARs awards. Cash received from the exercise of options and SARs for the fiscal years 2010, 2009, and 2008, was $7, $526 and $432, respectively. The tax benefit realized for the tax deductions from cashless option exercises totaled $6, $1 and $7 for the fiscal years 2010, 2009, and 2008, respectively. The company generally uses treasury shares to satisfy stock option exercises.
Nonvested share activity for the fiscal years ended June 30 follows:
Pretax compensation expense recognized for nonvested shares for the fiscal years 2010, 2009, and 2008, was $455, $373 and $419, respectively. The tax benefit for the fiscal years 2010, 2009, and 2008
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 16-STOCK-BASED COMPENSATION PLANS (Continued)
was $173, $142 and $159, respectively. As of June 30, 2010, there was $378 of total unrecognized compensation cost related to nonvested shares granted under the Plan. That cost is expected to be recognized over a weighted-average period of 19 months. The total fair value of shares vested during the fiscal years 2010, 2009, and 2008 was $675, $698 and $350, respectively.
In association with the 2002 Option Plan, awards of nonvested shares of the Company's common stock are made to outside directors of the Company. Each outside director is entitled to all voting, dividend and distribution rights during the vesting period. Pretax compensation expense recognized for nonvested shares for the fiscal years 2010, 2009, and 2008, was $141, $172 and $92, respectively. The tax benefit for the fiscal years 2010, 2009, and 2008 was $54, $65 and $35, respectively. As of June 30, 2010, there was $80 of total unrecognized compensation cost related to nonvested shares granted under the Plan. That cost is expected to be recognized over a weighted-average period of 6 months. The total fair value of shares vested during the fiscal years 2010, 2009, and 2008 was $181, $174 and $103, respectively.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 17-ACCUMULATED OTHER COMPREHENSIVE LOSS
The components of accumulated other comprehensive loss as of June 30, are as follows:
Cumulative other comprehensive (loss) balances were:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS
The Bank is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit, standby letters of credit and financial guarantees. Those instruments involve, to varying degrees, elements of credit and interest-rate risk in excess of amounts recognized in the consolidated statements of financial condition. The contract or notional amounts of those instruments reflect the extent of the Bank's involvement in particular classes of financial instruments.
The Bank's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit, standby letters of credit, and financial guarantees written is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance-sheet instruments.
Unless noted otherwise, the Bank does not require collateral or other security to support financial instruments with credit risk.
The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:
Cash and cash equivalents-The carrying amounts reported in the statements of financial condition for cash and cash equivalents approximate their fair values.
Securities-Fair values for investment securities are based on quoted market prices or whose value is determined using discounted cash flow methodologies, except for stock in the Federal Home Loan Bank for which fair value is assumed to equal cost.
Loans and leases, net-The fair values for loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms and credit quality. Leases are stated at cost which equals fair value.
Accrued interest receivable-The carrying value of accrued interest receivable approximates its fair value.
Servicing rights-Fair values are estimated using discounted cash flows based on current market rates of interest.
Interest rate swap contracts-Valuations of interest rate swap contracts are based on inputs observed in active markets for similar instruments. Typical inputs include the LIBOR curve, option volatility and option skew.
Off-statement-of-financial-condition instruments-Fair values for the Company's off-statement-of-financial-condition instruments (unused lines of credit and letters of credit), which are based upon fees currently charged to enter into similar agreements taking into account the remaining terms of the agreements and counterparties' credit standing, are not significant.
Deposits-The fair values for deposits with no defined maturities equal their carrying amounts, which represent the amount payable on demand. Fair values for fixed-rate certificates of deposit
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
are estimated using a discounted cash flow calculation that applies interest rates currently being offered on a comparably termed wholesale funding alternative (i.e., FHLB borrowings).
Interest rate swap contracts on deposits-Valuations of interest rate swap contracts are based on inputs observed in active markets for similar instruments. Typical inputs include the LIBOR curve, option volatility and option skew.
Borrowed funds-The carrying amounts reported for variable rate advances approximate their fair values. Fair values for fixed-rate advances and other borrowings are estimated using a discounted cash flow calculation that applies interest rates currently being offered on advances and borrowings with corresponding maturity dates.
Subordinated debentures payable to trusts-Fair values for subordinated debentures are estimated using a discounted cash flow calculation that applies interest rates on comparable borrowing instruments with corresponding maturity dates.
Accrued interest payable and advances by borrowers for taxes and insurance-The carrying values of accrued interest payable and advances by borrowers for taxes and insurance approximate their fair values.
Estimated fair values of the Company's financial instruments are as follows at June 30:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
Fair Value Measurement
Effective July 1, 2008, the Company adopted Statement of Financial Accounting Standards (SFAS) No. 157, Fair Value Measurements(ASC topic 820). In accordance with the FASB Staff Position 157-2, Effective Date of SFAS No. 157, the Company applied the provisions of this statement to non-financial assets and liabilities effective July 1, 2009 and it did not have a material impact on the Company's consolidated financial condition, results of operations or cash flow. The Company early adopted FASB Staff Position 157-4, dated April 9, 2009, Determining Fair Value When the Volume and Level of Activity for the Asset or Liability Have Significantly Decreased and Identifying Transactions That Are Not Orderly, during the third quarter of Fiscal 2009 which amended FASB Staff Position 157-3, dated October 10, 2008, Determining the Fair Value of a Financial Asset When the Market for That Asset Is Not Active. SFAS 157 defines fair value and establishes a consistent framework for measuring fair value under GAAP and expands disclosure requirements for fair value measurements. Fair values represent the estimated price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date under current market conditions. The standard describes three levels of inputs that may be used to measure fair value:
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
Level 2: Significant other observable inputs other than Level 1 prices such as quoted prices for similar assets or liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.
Level 3: Significant unobservable inputs that reflect a company's own assumptions about the assumptions that market participants would use in pricing an asset or liability. Level 3 assets and liabilities include financial instruments whose value is determined using pricing models, discounted cash flow methodologies, or similar techniques, as well as instruments for which the determination of fair value requires significant management judgment or estimation.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
The table below presents the Company's balances of financial instruments measured at fair value on a recurring basis by level within the hierarchy at June 30, 2010:
The Company used the following methods and significant assumptions to estimate the fair value of items:
Securities available for sale: The fair values of securities available for sale are determined by obtaining quoted prices on nationally recognized securities exchanges (Level 1 inputs), or matrix pricing, which is a mathematical technique widely used in the industry to value debt securities without relying exclusively on quoted prices for the specific securities, but rather by relying on the securities' relationship to other benchmark quoted securities (Level 2 inputs). The Company outsources this valuation primarily to a third party provider which utilizes several sources for valuing fixed-income securities. Sources utilized by the third party provider include pricing models that vary based by asset class and include available trade, bid, and other market information. This methodology includes broker quotes, proprietary models, descriptive terms and conditions databases, as well as extensive quality control programs. As further valuation sources, the third party provider uses a proprietary valuation model and capital markets trading staff. This proprietary valuation model is used for valuing municipal securities. This model includes a separate curve structure for Bank-Qualified municipal securities. The grouping of municipal securities is further broken down according to insurer, credit support, state of issuance, and rating to incorporate additional spreads and municipal curves.
The securities shown in Level 3 relate to trust preferred securities which are currently part of an inactive market. The inactivity was evidenced first by a significant widening of the bid-ask spread in the brokered markets in which these securities trade, and then by a significant decrease in the volume of
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
trades relative to historical levels. Given conditions in the debt markets and the absence of observable orderly transactions in the secondary and new issue markets, management determined that an income valuation approach technique (present value technique) that maximizes the use of relevant observable inputs and minimizes the use of unobservable inputs will be equally or more representative of fair value than the market approach valuation technique. The results of a third party valuation and a valuation derived by management were weighted each at 50% and used to measure fair value for each security.
The approaches to determining fair value for the trust preferred securities included the following factors:
1.The credit quality of the collateral estimated using average probability of default values.
2.The loss given default was assumed to be 100% (i.e. no recovery) for third party valuations. Management utilized a range of loss given default based upon a review of the financial condition of underlying issuers in each pool.
3.The cash flows were forecasted for the underlying collateral and applied to each tranche to determine the resulting distribution among the securities.
4.The best estimates of expected cash flows were discounted to calculate the present value of the security. Management considered a range of discount rates based upon three factors: (1) a risk-free rate based on the rate of return on government debt securities, (2) the credit spread for BBB Bank Corporate Debt Index, and (3) a liquidity or "risk premium".
5.The calculations were modeled in several thousand scenarios and the average price was used for the third party valuations. Management utilized an average price derived from various cash flow scenarios.
Interest Rate Swaps: The fair values of interest rate swaps relate to cash flow hedges of trust preferred debt securities issued by the Company. The fair value is estimated by a third party using inputs that are observable or that can be corroborated by observable market data and, therefore, are classified within Level 2 of the valuation hierarchy. These fair value estimations include primarily market observable inputs, such as yield curves, and include the value associated with counterparty credit risk.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
The following table reconciles the beginning and ending balances of the assets or liabilities of the Company that are measured at fair value on a recurring basis using significant unobservable inputs for the fiscal years ended June 30:
Fair Value Measurements Using Significant
Unobservable Inputs (Level 3)
The table below presents the Company's balances of financial instruments measured at fair value on a nonrecurring basis by level within the hierarchy at June 30, 2010:
Loans held for sale, which consist generally of current production of certain fixed-rate, first-lien residential mortgage loans and student loans, are carried at the lower of cost or estimated fair value. The estimated fair value is based on what secondary markets are currently offering for portfolios with similar characteristics, which the Company classifies as a Level 2 nonrecurring fair value measurement.
Impaired loans are evaluated and valued at the time the loan is identified as impaired, at the lower of cost or market value. Market value is measured based on the value of the collateral securing these loans. Collateral is primarily real estate and its fair value is generally determined based on real estate appraisals or other evaluations by qualified professionals. Impaired loans are reviewed and evaluated on at least a quarterly basis for additional impairment and adjusted accordingly, based on the same factors identified above. Impaired loans that are collateral dependent are written down to their fair value, less costs to sell, through the establishment of specific reserves or by recording charge-offs when the carrying value exceeds the fair value. Valuation techniques consistent with the market
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
approach, income approach, and/or cost approach were used to measure fair value and primarily included observable inputs such as recent sales of similar assets or observable market data for operational or carrying costs.
Mortgage servicing rights do not trade in an active, open market with readily observable prices. While sales of mortgage servicing rights do occur, the precise terms and conditions typically are not readily available to allow for a "quoted price for similar assets" comparison. Accordingly, the Company relies on an internal discounted cash flow model to estimate the fair value of its mortgage servicing rights. The Company uses a valuation model to project mortgage servicing rights cash flows based on the current interest rate scenario, which is then discounted to estimate an expected fair value of the mortgage servicing rights. The valuation model considers portfolio characteristics of the underlying mortgages, contractually specified servicing fees, prepayment assumptions, discount rate assumptions, other ancillary revenue, costs to service, and other economic factors. The Company reassesses and periodically adjusts the underlying inputs and assumptions used in the model to reflect market conditions and assumptions that a market participant would consider in valuing the mortgage servicing rights asset. In addition, the Company compares its fair value estimates and assumptions to observable market data for mortgage servicing rights, where available, and to recent market activity and actual portfolio experience. Due to the nature of the valuation inputs, mortgage servicing rights are classified within Level 3 of the fair value hierarchy. The Company uses the amortization method (i.e., lower of amortized cost or estimated fair value measured on a nonrecurring basis), not fair value measurement accounting, for its mortgage servicing rights assets.
Goodwill does not have readily observable prices for valuation and is classified within Level 3 of the fair value hierarchy. The Company uses a two-step valuation process to determine if there has been impairment to existing goodwill and the amount which has become impaired, if any. The first step includes a screen for potential impairment and the second step measures the amount of impairment. The analysis uses both an income and market approach as part of that analysis. The key assumptions used to determine fair value under the income approach included the cash flow period, terminal values based on a terminal growth rate and the discount rate. The market approach calculated the change of control price a market participant could have been reasonably expected to pay for the reporting unit by adding a change of control premium. Goodwill was tested for impairment at the reporting unit level and an impairment loss for the Mid America Capital subsidiary was recorded as a result of management's determination that the carrying amount of goodwill exceeded its implied fair value.
NOTE 19-COMMITMENTS, CONTINGENCIES AND CREDIT RISK
The Bank originates first mortgage, consumer and other loans primarily in eastern South Dakota and holds residential and commercial real estate loans which were purchased from other originators of loans located throughout the United States. Collateral for substantially all consumer loans are security agreements and/or Uniform Commercial Code (UCC) filings on the purchased asset. Unused lines of credit amounted to $138,797 and $129,627 at June 30, 2010, and 2009, respectively. Unused letters of credit amounted to $3,347 and $2,055 at June 30, 2010, and 2009, respectively. The lines of credit and letters of credit are collateralized in substantially the same manner as loans receivable.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 19-COMMITMENTS, CONTINGENCIES AND CREDIT RISK (Continued)
The Bank had outstanding commitments to originate or purchase loans of $28,386 and to sell loans of approximately $29,431 at June 30, 2010. The portion of commitments to originate or purchase fixed rate loans totaled $11,325 with a range in interest rates of 4.13% to 7.05%. At June 30, 2010, the Bank had one outstanding commitment to purchase $160 investment securities available for sale and no commitments to sell investment securities available for sale. No losses are expected to be sustained in the fulfillment of any of these commitments.
The Company is involved in various claims and legal actions arising in the ordinary course of business. In the opinion of management, based upon consultation with legal counsel, the ultimate disposition of these matters will not have a materially adverse effect on the Company's consolidated financial position.
NOTE 20-CASH FLOW INFORMATION
Changes in other assets and liabilities for the years ended June 30, consist of:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 21-FINANCIAL INFORMATION OF HF FINANCIAL CORP. (PARENT ONLY)
The Company's condensed balance sheets as of June 30, 2010, and 2009, and related condensed statements of income and cash flows for each of the years in the three-year period ended June 30, 2010, are as follows:
Condensed Statements of Financial Condition
Condensed Statements of Income
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 21-FINANCIAL INFORMATION OF HF FINANCIAL CORP. (PARENT ONLY) (Continued)
Condensed Cash Flows
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2010 AND 2009
(DOLLARS IN THOUSANDS, except share data)
NOTE 22-QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
NOTE 23-SUBSEQUENT EVENTS
Management has evaluated subsequent events for potential disclosure or recognition through the date that the financial statements were available to be issued. In September 2010, the Company has been notified by a borrower of the borrower's intention to no longer perform on its agricultural loan obligations. The current balance related to this obligation is $3,138. The Company has initiated formal collection procedures and collateral evaluation. The financial effect of this transaction cannot be reasonably estimated as of the date that the financial statements were available to be issued.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosures
Not applicable.
Item 9A.
Item 9A. Controls and Procedures
Evaluation of Disclosure Controls and Procedures
As of June 30, 2010, an evaluation was performed by the Company's management, including the Company's Chairman, President and Chief Executive Officer and the Company's Executive Vice President, Chief Financial Officer and Treasurer, of the effectiveness of the design and operation of the Company's disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended) to provide reasonable assurance that information required to be disclosed in the reports the Company files and submits under the Securities Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time periods specified in the Securities and Exchange Commission's rules and forms. Based upon that evaluation, the Company's Chairman, President and Chief Executive Officer and the Company's Executive Vice President, Chief Financial Officer and Treasurer concluded that the Company's disclosure controls and procedures were effective as of June 30, 2010.
Management's Report on Internal Control over Financial Reporting
Management's report on internal control over financial reporting is included in Part II, Item 8 "Financial Statements and Supplementary Data," and is furnished herein.
Changes in Internal Control Over Financial Reporting
There were no changes in the Company's internal control over financial reporting that occurred during the fourth quarter ended June 30, 2010, that have materially affected, or are reasonably likely to materially affect, the Company's internal control over financial reporting.
Item 9B.
Item 9B. Other Information
None.
PART III
Item 10.
Item 10. Directors, Executive Officers and Corporate Governance
Directors
Information regarding Directors of the Company is incorporated by reference from the discussion under the heading "Information with Respect to Nominees and Continuing Directors" in the Company's Proxy Statement for the Annual Meeting of Stockholders to be held on November 17, 2010, a copy of which will be filed not later than 120 days after June 30, 2010 (the "2010 Proxy Statement").
Executive Officers
Information regarding Executive Officers of the Company is contained in Part I, Item 1 "Business" of this Form 10-K pursuant to Instruction 3 to Item 401(b) of Regulation S-K, and is incorporated by reference herein.
Compliance with Section 16(a) of the Exchange Act
Information regarding compliance with Section 16(a) of the Securities Exchange Act of 1934, as amended, is incorporated by reference from the discussion under the heading "Section 16(a) Beneficial Ownership Reporting Compliance" in the Company's 2010 Proxy Statement.
Code of Ethics
Information regarding the Company's Code of Conduct and Ethics is incorporated by reference from the discussion under the heading "Code of Conduct and Ethics" in the Company's 2010 Proxy Statement.
Director Nominations
Information regarding material changes, if any, to the procedures by which the Company's stockholders may recommend nominees to the Company's Board of Directors is incorporated by reference from the discussion under the heading "Director Nominations" in the Company's 2010 Proxy Statement.
Audit Committee and Audit Committee Financial Expert
Information regarding the Company's Audit Committee and Audit Committee Financial Expert is incorporated by reference from the discussion under the heading "Meetings of the Board of Directors, Committees of the Board of Directors and Independent Directors" in the Company's 2010 Proxy Statement.
Item 11.
Item 11. Executive Compensation
Information regarding executive compensation and other related disclosures required by this Item are incorporated by reference from the discussion under the headings "Compensation Discussion and Analysis," "Personnel Compensation and Benefits Committee Report," "Executive Compensation," "Director Compensation" and "Personnel, Compensation And Benefits Committee Interlocks and Insider Participation" in the Company's 2010 Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters
Information on the securities authorized for issuance under the Company's compensation plans (including any individual compensation arrangements) is contained in Part II, Item 5 "Market for Registrant's Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities" of this Form 10-K, and is incorporated by reference herein.
Information concerning security ownership of certain beneficial owners and management is incorporated by reference from the discussion under the heading "Security Ownership of Certain Beneficial Owners and Management" in the Company's 2010 Proxy Statement.
Item 13.
Item 13. Certain Relationships and Related Transactions, and Director Independence
Certain Transactions
Information concerning transactions with related persons and the review, approval or ratification thereof is incorporated by reference from the discussion under the headings "Transactions with Related Persons" and "Policy on Review, Approval or Ratification of Transactions with Related Persons" in the Company's 2010 Proxy Statement.
Information concerning director independence is incorporated by reference from the discussion under the headings "Meetings of the Board of Directors, Committees of the Board of Directors and Independent Directors" in the Company's 2010 Proxy Statement.
Item 14.
Item 14. Principal Accountant Fees and Services
Information concerning the fees for professional services rendered by the Company's registered public accounting firm and the pre-approval policies and procedures of the Company's Audit Committee is incorporated by reference from the discussion under the heading "Proposal No. II-Ratification of Independent Registered Public Accounting Firm" in the Company's 2010 Proxy Statement.
PART IV
Item 15.
Item 15. Exhibits and Financial Statement Schedules
(a) The following documents are filed as part of this Form 10-K:
(1)Consolidated Financial Statements:
Report of Independent Registered Public Accounting Firm
Management's Report on Internal Control Over Financial Reporting
Consolidated Statements of Financial Condition at June 30, 2010 and 2009
Consolidated Statements of Income for the years ended June 30, 2010, 2009 and 2008
Consolidated Statements of Stockholders' Equity for the years ended June 30, 2010, 2009 and 2008
Consolidated Statements of Cash Flows for the years ended June 30, 2010, 2009 and 2008
Notes to Consolidated Financial Statements
(2)All financial statement schedules are omitted because of the absence of conditions under which they are required or because the information is shown in the Consolidated Financial Statements or notes thereto in Item 8 above.
(3)See "Exhibit Index".
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
HF FINANCIAL CORP.
Date: September 10, 2010
By:
/s/ CURTIS L. HAGE
Curtis L. Hage,
Chairman, President and Chief Executive Officer
(Duly Authorized Representative)
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears below constitutes and appoints Curtis L. Hage and Darrel L. Posegate, or any of them, his or her attorneys-in-fact, for such person in any and all capacities, to sign any amendments to this report and to file the same, with exhibits thereto, and other documents in connection therewith, with the Securities and Exchange Commission, hereby ratifying and confirming all that either of said attorneys-in-fact, or substitute or substitutes, may do or cause to be done by virtue hereof
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons in the capacities and on the dates indicated.
Exhibit Index
*Filed herewith.
**Furnished herewith.
+Indicates a management contract or compensation plan.
Index of Attached Exhibits