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. is a unitary thrift holding company that 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. Effective as of July 21, 2011, the Company is regulated as a savings and loan holding company by the Board of Governors of the Federal Reserve System ("Federal Reserve"). 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 Company's primary business is to operate the Bank. 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 and for the Bloomington, Minnesota branch at www.infiniabank.com. Information on these websites 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 U.S. Securities and Exchange Commission ("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, 2012, the trust department of the Bank maintained approximately $92.7 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 agency 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 Federal Deposit Insurance Corporation ("FDIC") as administrator of the Deposit Insurance Fund ("DIF"). Effective as of July 21, 2011, the Bank is subject to primary supervision, regulation and examination by the Office of the Comptroller of the Currency ("OCC").
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, 2012: 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 2012. 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 years 2012 and 2011.
As a federally chartered thrift institution, the Bank is permitted by OCC 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 OCC. 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").
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. As of June 30, 2012, there were no advances on an approved line of credit of $50,000. 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, 2012, Mid America Capital had advanced $1.7 million on an approved line of credit of $7.5 million with the Bank. In July 2012, the approved line of credit was reduced to $2.5 million from $7.5 million. 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 years 2012 and 2011.
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 years 2012 and 2011.
Market Area
Based on total assets at June 30, 2012, the Bank is the largest savings association headquartered in South Dakota. The Bank has a total of 28 banking centers in its market area and an 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 banking center located in Dakota Dunes serves customers located in northwestern Iowa. The Bank has a banking center in Marshall, Minnesota, which serves customers located in southwestern Minnesota. A banking center in Bloomington, Minnesota, which serves customers in the metropolitan area of the Twin Cities, does business as Infinia Bank, a Division of Home Federal Bank of South Dakota. An Internet branch is located at www.infiniabank.com to serve the Twin Cities market area. The Bank's primary market area features a variety of agribusiness, financial services, health care and light manufacturing firms. The Internet branches and mobile banking allow access to customers beyond traditional geographical areas.
Business Strategy
The Company's business strategy is to remain a community-focused financial institution and to grow and improve its profitability by:
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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.
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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.
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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, non-locally owned competitors.
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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 and 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, 2012 was $477.5 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 $18.5 million at June 30, 2012. 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 OCC 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, phone or Internet 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 one- to four-family residential mortgage ("ARM") loans at loan-to-value ratios consistent with Federal National Mortgage Association("FNMA")/Federal Home Loan Mortgage Corporation("FHLMC") guidelines. Loan-to-values exceeding 80% are required to include private mortgage insurance in an amount sufficient to reduce the Bank's or the investor's exposure at or below the 80% level or secure additional financing up to currently 90% of the value of the property. The Bank generally offers an ARM loan with a fixed rate for the initial three, five or seven 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.
During the second quarter of fiscal 2012, the Company was informed by SDHDA that a change in business model was necessary for SDHDA to continue to meet the financing needs of its single family mortgage program in South Dakota. This change in business model effectively ended the new flow of servicing assets from SDHDA to the Company beginning April 1, 2012. Due to this change, the single family mortgage segment of the Company's servicing portfolio is expected to decrease in value over time, as principal is reduced. The Company continues to evaluate potential acquisition of servicing assets dependent upon market conditions and characteristics desirable by the Company, which may include bidding as the master servicer for SDHDA after the initial two year commitment is complete.
The Bank receives an origination fee of 1% of the loan amount from the borrower and a servicing fee, for the loans that continue to be serviced, 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 currently the largest servicer of loans for the SDHDA. At June 30, 2012, the Bank serviced $832.3 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 QuickClickTM 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 all 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'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, with a hold placed on the account restricting the withdrawal of the account balance. The interest rate on such loans is typically equal to 3% above the contract rate.
Loans secured by second mortgages, together with loans secured by all prior liens, are generally limited to a maximum of 90% of the appraised value of the property securing the loan and generally have maximum terms that do not exceed 15 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 an analysis of the value of the security, if any, in relation to the proposed loan amount.
Interest rates on home equity lines of credit are variable based upon a margin over the Wall Street Journal Prime Rate. Home Equity Lines of Credit are stress tested during underwriting to determine the borrower's capacity to repay the debt should economic conditions change. The payment is stress tested by adding 5% to the initial note rate and amortizing the entire line amount over 240 months. The borrower's debt to income ratio must remain within underwriting guidelines after including the stress tested payment on the home equity line of credit.
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 originated 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 were 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. In fiscal 2012, Mid America Capital reduced its efforts in originating new leases. It continues to service existing leases, but will continue to see a reduced level of lease balances as payments occur and reach maturity. The decision to reduce marketing efforts will not have a material impact on the Company.
Commercial Leases. In order to support the Bank and its customers and to improve the yield of its assets, Mid America Capital has originated commercial leases to customers primarily in the Bank's trade area. Mid America Capital basically has offered 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 have originated 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 agricultural loans. As part of the Company's business strategy to build the commercial, commercial real estate and agricultural portfolio segments, the Bank has hired several bankers with significant commercial and agricultural lending experience, which has led to successful growth results across these business lines. The Company's commercial, commercial real estate and agricultural portfolio segments have decreased to 76.4% of the Company's total loan and lease portfolio at June 30, 2012, while its residential and consumer portfolio segments have increased to 23.6%. 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 allowance for loan and lease losses as of the dates indicated.
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(1)
Includes tax-exempt loans and leases.
(2)
Net of deferred fees and discounts and exclusive of undisbursed portion of loans in process.
The following table sets forth information concerning the balance of the Company's undisbursed portion of loans in process excluded from total gross loans and leases above, and deferred fees and discounts which have been netted against the loans and indicated above as of the dates indicated.
The following table sets forth information concerning the balance of the Company's loans held for sale by loan class, which have been excluded from tables identifying loans and leases receivable as of the dates indicated.
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 allowance for loan and lease 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.
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(1)
Includes tax-exempt loans and leases.
(2)
Net of deferred fees and discounts and exclusive of undisbursed loans in process.
The following schedule illustrates the scheduled principal contractual repayments of the Company's loan and lease portfolio at June 30, 2012. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.
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(1)
Includes equipment finance leases and tax-exempt loans and 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.
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 OCC 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 Assistant Deputy Comptroller at the regional OCC office, who may order the establishment of additional general or specific loss allowances.
In connection with the filing of its periodic reports with the OCC 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, 2012, the Company had designated $42.9 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 OCC 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 Bank invests 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, 2012, approximately 96.8% of its investment portfolio was in AAA-rated, liquid agency residential mortgage-backed securities.
At June 30, 2012, the Bank's investments in agency residential mortgage-backed securities totaled $361.0 million, or 30.3% of its total assets, and did not include any private-label securities. As of such date, the Bank also had an $7.8 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 agency residential mortgage-backed securities are much shorter due to the combination of prepayments and the $339.3 million adjustable-rate agency 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 2012, there were no other-than-temporary impairment losses. See 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.
In fiscal year 2011, the other-than-temporary impairment losses taken against the pooled trust preferred securities was $399,000. In addition, $150,000 was recognized in other comprehensive income resulting in $549,000 of credit loss recognized through net income. During the fourth quarter of fiscal 2011, the pooled trust preferred securities were sold, which produced an after-tax charge of $3.9 million to net income. Because the Company had previously established valuation adjustments of $3.3 million for these securities on the balance sheet, the impact of the sale transactions to comprehensive income was mitigated. See 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, 2012, the Company had $373.2 million of securities available for sale, including agency residential mortgage-backed securities of $361.0 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 net income, in-market deposits, FHLB advances and other borrowings, amortization and repayments of loan principal, agency 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 of Minneapolis ("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 for our non-brokered certificates. 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, 2012, out-of-market deposits accounted for less than 2% 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 been susceptible to short-term fluctuations in deposit flows due to economic conditions, interest rate sensitivity and safety needs of customers. 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 June 30:
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, 2012.
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(1)
Includes funds from the Certificate of Deposit Account Registry Service ("CDARS") certificate of deposit program of $12.6 million.
(2)
Includes certificates of deposit of $100,000 or greater of $12.3 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 $5.8 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, 2012, and 2011 included $113.3 million and $96.5 million, respectively, of deposits from one local governmental entity.
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, agency 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, 2012, the Bank's FHLB advances totaled $142.1 million, representing 13.0% of total liabilities. 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 through the Bank, the Company 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, 2012, the Bank had a total of 279 full-time employees and 32 part-time employees. The full-time employees include five 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 Company is regulated as a savings and loan holding company by the Federal Reserve. As a savings and loan holding company, the Company is required to file reports with, and otherwise comply with, the rules and regulations of the Federal Reserve and of the SEC under federal securities laws.
The Bank is a federally chartered thrift institution that is subject to broad federal regulation and oversight extending to all of its operations by its primary federal regulator, the OCC, 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 FHLB of Des Moines.
The Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act")
Major financial reform legislation, known as the Dodd-Frank Act, was signed into law by the President in July 2010. Many of the provisions of the Dodd-Frank Act affecting the Company and Bank have effective dates ranging from immediately upon enactment of the legislation to several years following enactment of the Dodd-Frank Act.
Of particular significance to thrift institutions is that, as a result of regulatory restructuring called for by the Dodd-Frank Act, both the Company and Bank transitioned to the jurisdiction of their current primary federal regulators on July 21, 2011. Prior to that date, the Company and Bank had been subject to consolidated supervision and regulation by the Office of Thrift Supervision ("OTS").
In connection with the transition to new regulators for thrifts and their holding companies, the Dodd-Frank Act provides that OTS orders, resolutions, determinations, agreements, regulations, interpretive rules, other interpretations, guidelines, procedures and other advisory materials that were in effect before the transfer date are now to be enforced by the Federal Reserve and OCC with respect to savings and loan holding companies and federal savings associations, respectively, unless the Federal Reserve or OCC modifies, terminates, or sets aside such guidance or until superseded by the Federal Reserve or OCC, a court, or operation of law.
Among the Dodd-Frank Act's significant regulatory changes, it created a new federal consumer protection agency, the Consumer Financial Protection Bureau (the “CFPB”), that is empowered to promulgate new consumer protection regulations and revise existing regulations in many areas of consumer protection. The CFPB has exclusive authority to issue regulations, orders and guidance to administer and implement the objectives of federal consumer protection laws. The Dodd-Frank Act also transferred the enforcement authority over certain large institutions with respect to compliance with the federal consumer protection laws from the existing banking agencies to CFPB.The Company and Bank are continuing to closely monitor and evaluate developments under the Dodd-Frank Act with respect to our business, financial condition, results of operations and prospects. For further discussion on the potential impact of the Dodd-Frank Act on the Company and Bank, see "Risk Factors" below.
The following discussion is intended to provide a summary of the material statutes and regulations applicable to savings and loan holding companies and federal savings associations, and does not purport to be a comprehensive description of all such statutes and regulations.
Regulation of Federal Savings Associations
As the new primary federal regulator for federal savings associations as of July 21, 2011, the OCC has extensive authority over the operations of federal savings associations, including 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.
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, the lending authority for federal savings associations for various asset types is limited to a specified percentage of the association's capital or assets.
Loan and Investment Powers
The Bank derives its lending and investment powers from the HOLA and the OCC's implementing regulations thereunder applicable to federal savings associations. 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 OCC regulations provide that a federal savings association may invest up to 10% of its assets in tangible personal property for leasing purposes. Loans made under such general leasing authority do not have to be aggregated with the institution's loans for purposes of the HOLA's other investment and lending limitations.
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, 2012, the Bank's lending limit under this restriction was $18.5 million.
Assessments
The Dodd-Frank Act transfers authority to collect assessments for federal savings associations from the OTS to the OCC. As of the March 2012 assessment, all national banks and federal savings associations have been assessed using the OCC's assessment structure, which calculates assessments on a semi-annual basis based generally on the amount of an institution's total balance sheet assets. The OCC's assessment structure imposes a surcharge for banks and federal savings associations that require increased supervisory resources and allows for a reduced rate for non-lead banks and federal savings associations.
Enforcement
The OCC 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 Comptroller of the Currency that an enforcement action be taken with respect to a particular savings association. If action is not taken by the OCC, the FDIC may take action under certain circumstances.
Safety and Soundness Standards
Under federal law, the OCC 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 OCC is authorized to order a federal savings association that has been notified that it is not satisfying applicable safety and soundness standards to submit a compliance plan. If, after being so ordered, an association fails to submit an acceptable compliance plan or fails in any material respect to implement an accepted compliance plan, the OCC 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 OCC may seek to enforce such order in judicial proceedings and to impose civil money penalties.
Prompt Corrective Action Regulations
Under the OCC prompt corrective action regulations, the OCC is required to take certain, and is authorized to take other, supervisory actions against undercapitalized savings associations. For this purpose, a savings association is placed in one of the following five categories based on it'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 an institution's capital decreases within the three undercapitalized categories. A savings association may not pay a dividend or make any other capital distributions or pay management fees to any controlling person if, following such distribution, the savings association would be undercapitalized. The OCC is required to monitor closely the condition of an undercapitalized savings association and to restrict the growth of its assets.
An undercapitalized savings association is required to file a capital restoration plan within 45 days of the date the association receives notice that it is within any of the three undercapitalized categories, and the plan must be guaranteed by any parent holding company. As required for all depository institution holding companies, the aggregate liability of a parent savings and loan holding company is limited to the lesser of:
•
an amount equal to five percent of the association's total assets at the time it became "undercapitalized;" and
•
the amount that is necessary (or would have been necessary) to bring the association into compliance with all capital standards applicable with respect to such association as of the time it fails to comply with the plan.
If a savings association 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. A 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 OCC to meet a specific capital level.
At June 30, 2012, the Bank met the applicable regulatory criteria for being considered "well-capitalized."
On June 12, 2012, the OCC and other federal banking agencies issued notices of proposed rulemakings that revise each agency's risk-based and leverage capital requirements consistent with agreements reached by the Basel Committee on Banking Supervision (Basel III), including implementation of a new common equity tier 1 minimum capital requirement and a higher minimum tier 1 capital requirement. Additionally, consistent with Basel III, the OCC and other federal banking agencies propose to apply limits on a banking organization's capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified “buffer” of common equity tier 1 capital in addition to the minimum risk-based capital requirements. The proposed rulemaking also would revise the agencies' prompt corrective action framework by incorporating the new regulatory capital minimums and updating the definition of tangible common equity. Such proposed capital requirements are proposed to be phased in beginning in January 2013.
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. All deposits of the Bank are insured up to $250,000 per depositor for each account ownership category.
FDIC insurance of deposits is backed by the full faith and credit of the U.S. government. In order to maintain the DIF, the FDIC imposes deposit insurance premiums on member institutions 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 OCC 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.
In December 2009, along with each institution's risk-based deposit insurance assessment for the third quarter of 2009, all non-exempt insured depository institutions were required to prepay their quarterly risk-based assessments for the fourth quarter of 2009,
and for all of 2010, 2011 and 2012. For purposes of calculating the prepaid amount, the base assessment rate in effect at September 30, 2009 was used for 2010. That rate was increased by an annualized 3 basis points for 2011 and 2012 assessments. The prepayment calculation also assumed a five percent annual deposit growth rate, increased quarterly, through the end of 2012. Institutions account for the prepayment by recording the entire amount of its prepaid assessment as a prepaid expense (an asset) as of December 31, 2009. Subsequently, each institution records an expense (charge to net income) for its regular quarterly assessment and an offsetting credit to the prepaid assessment until the asset is exhausted. Once the asset is exhausted, the institution will resume paying and accounting for quarterly deposit insurance assessments as they would normally, which assessments are calculated based on the institution's average consolidated total assets minus average tangible equity. 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, 2012, the remaining balance recorded as a prepaid asset was $1.4 million.In addition, all FDIC-insured institutions are required to pay assessments to the FDIC at an annual rate of approximately 0.01% 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 utilized for the final quarter of fiscal year ending June 30, 2012, was 0.087%, annualized, and the premium paid for fiscal 2012 was $971,000. In fiscal 2012, the rate decreased compared to the prior year, due in part to the assessment base which was modified to be calculated based on total assets, rather than deposits, which was previously used in fiscal 2011. 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.
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 OCC. 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
OCC 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%.
The OCC is also authorized by statute to establish minimum capital requirements for an individual savings association as the OCC, in its discretion, deems appropriate in light of the particular circumstances at the savings association. In assessing an institution's capital adequacy, the OCC 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, 2012, the Bank exceeded each of its capital requirements as shown in the following table:
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(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.
As noted above, on June 12, 2012, the OCC and other federal banking agencies issued a notice of proposed rulemaking that seeks comment on proposals that would revise and replace the agencies' current capital rules.
The Federal Deposit Insurance Corporation Improvement Act ("FDICIA") required the 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 OCC will monitor the interest rate risk of individual savings associations through (i) the OCC requirements for interest rate risk management, (ii) the ability of the OCC 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 OCC requires that savings associations have an adequate system of internal controls to ensure the integrity of all elements of their interest rate risk (“IRR”) management process, including the adequacy of corporate governance, compliance with policies and procedures, and the comprehensiveness of IRR measurement and management information systems.
Limitations on Dividends and Other Capital Distributions
Federal regulations govern the permissibility of capital distributions by a federal savings association. Pursuant to the Dodd-Frank Act, savings associations that are part of a savings and loan holding company structure must now file a notice of a declaration of a dividend with the Federal Reserve. In the case of cash dividends, OCC regulations require that federal savings associations that are subsidiaries of a stock savings and loan holding company must file an informational copy of that notice with the OCC at the same time it is filed with the Federal Reserve. OCC regulations further set forth the circumstances under which a federal savings association is required to submit an application or notice before it may make a capital distribution.
A federal savings association proposing to make a capital distribution is required to submit an application to the OCC if: (1) the association does not qualify for expedited treatment pursuant to criteria set forth in OCC regulations; (2) the total amount of all of the association's capital distributions (including the proposed capital distribution) for the applicable calendar year exceeds the association's net income for that year to date plus the association's retained net income for the preceding two years; (3) the association would not be at least adequately capitalized following the distribution; or (4) the proposed capital distribution would violate a prohibition contained in any applicable statute, regulation, or agreement between the association and the OCC or the Company's and Bank's former regulator, the OTS, or violate a condition imposed on the association in an application or notice approved by the OCC or the OTS.
A federal savings association proposing to make a capital distribution that is not otherwise required to submit an application to the OCC is required to submit a prior notice to the OCC if: (1) the association would not be well capitalized following the distribution; (2) the proposed capital distribution would reduce the amount of or retire any part of the association's common or preferred stock or retire any part of debt instruments such as notes or debentures included in the association's capital (other than regular payments required under a debt instrument); or (3) the association is a subsidiary of a savings and loan holding company and is not required to file a notice regarding the proposed distribution with the Federal Reserve. As noted above, if a notice with the Federal Reserve is required to be filed, then an informational copy of the notice filed with the Federal Reserve needs to be simultaneously provided to the OCC.
Each of the Federal Reserve and OCC have primary reviewing responsibility for the applications or notices required to be submitted to them by savings associations relating to a proposed distribution. The Federal Reserve may disapprove of a notice, and the OCC may disapprove of a notice or deny an application, if:
•
the savings association would be undercapitalized following the distribution;
•
the proposed distribution raises safety and soundness concerns; or
•
the proposed distribution violates a prohibition contained in any statute, regulation, enforcement action or agreement between the savings association (or its holding company, in the case of the Federal Reserve) and the entity's primary federal regulator, or a condition imposed on the savings association (or its holding company, in the case of the Federal Reserve) in an application or notice approved by the entity's primary federal regulator.
Under current regulations, the Bank is not permitted to pay dividends on its stock if its regulatory capital would fall below 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.
During the fiscal year ended June 30, 2012, the Bank paid cash dividends to the Company totaling $4.5 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 OCC 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 OCC regulations preempts any state law purporting to regulate branching by federal savings associations.
Community Reinvestment
Under the Community Reinvestment Act ("CRA") as implemented by OCC 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 OCC, 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 at its last CRA 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, other offices and automated teller machines.
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, 2012, the Bank held 78.4% 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, 2012, 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 Sections 23A and 23B of the Federal Reserve Act ("FRA"), Section 11 of the HOLA and implementing regulations under Regulation W issued by the Federal Reserve. The Dodd-Frank Act transfers all OTS rulemaking authority relating to transactions with affiliates, extensions of credit to insiders and tying arrangements to the Federal Reserve. Accordingly, the Federal Reserve has proposed to amend Regulation W to implement the restrictions applicable to savings associations under Section 11 of the HOLA. The OCC, with the concurrence and non-objection of the FDIC, is authorized to grant exemptions from the restrictions of Section 23A through the issuance of exemptive orders.
Under Regulation W's restrictions on transactions with affiliates generally applicable to all insured depository institutions, 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.
Additional, amendments to Regulation W that implement the Dodd-Frank Act address the 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 ("BHCA") and provisions prohibiting a savings association from purchasing or investing in securities issued by an affiliate that is not a subsidiary.
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 governed by the requirements of Sections 22(g) and 22(h) of the FRA and Regulation O of the Federal Reserve, as made applicable to federal savings associations by the HOLA. Among other things, these provisions require that extensions of credit to insiders:
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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
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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 general, a savings association's lending limit with respect to any individual insider may not exceed 15% of the association's unimpaired capital and unimpaired surplus, with an allowance for an additional 10% if secured by readily marketable collateral. A savings association's general aggregate lending limit with respect to all insiders is the association's unimpaired capital and unimpaired surplus. Transactions between a savings association and its executive officers are subject to additional and more stringent restrictions on when such transactions are permissible. 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, generally prohibits the extension of personal loans to directors and executive officers of issuers (as defined in the Sarbanes-Oxley Act). The prohibition does not apply, however, to extensions of credit including mortgages advanced by an insured depository institution, such as the Bank, that are subject to the restrictions on transactions with insiders under Section 22(h) of the FRA.
Real Estate Lending Standards
The OCC 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 OCC
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 OCC 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.
Privacy Regulations
Pursuant to regulations implementing 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:
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Federal "Truth-In-Lending Act," governing disclosures of credit terms to consumer borrowers;
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"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;
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"Equal Credit Opportunity Act," prohibiting discrimination on the basis of race, creed or other prohibited factors in extending credit;
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"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;
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"Fair Debt Collection Act," governing the manner in which consumer debts may be collected by collection agencies;
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"Real Estate Settlement Procedures Act," as amended, governing disclosures of fee estimates that would be incurred by a borrower during the mortgage process;
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"Servicemembers Civil Relief Act"; and
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Rules and regulations of the federal agencies charged with the responsibility of implementing and enforcing these federal laws.
The Bank's deposit operations are also subject to federal laws applicable to deposit transactions, such as the:
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"Truth in Savings Act," which imposes disclosure obligations to enable consumers to make informed decisions about accounts at depository institutions;
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"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;
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"Electronic Funds Transfer Act" and Regulation E issued by the Federal Reserve Board 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
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Rules and regulations of the federal agencies charged with the responsibility of implementing and enforcing these federal laws.
Federal savings associations are subject to the same preemption standards as those applicable to national banks, with respect to the application of state consumer laws to the inter-state activities of federally chartered depository institutions. Under the preemption standards established under the Dodd-Frank Act for both national banks and federal savings associations, 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 savings associations 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 savings association'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 Title X of the Dodd-Frank Act. Additionally, the Dodd-Frank Act specifies that such preemption standards only apply to national banks and federal savings associations themselves, and not their non-depository institution subsidiaries or affiliates.
Beginning in July 2011 a new governmental entity known as the Consumer Financial Protection Bureau or"CFPB"became responsible for administering and carrying 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 CFPB 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. With its broad rulemaking powers, the new CFPB has the potential to reshape the consumer financial laws through rulemaking and enforcement of unfair, deceptive or abusive practices, which may directly impact the business operations of financial institutions offering consumer financial products or services including the Bank.
Identity Theft Prevention
Financial institutions are required 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:
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identify relevant red flags for covered accounts and incorporate those red flags into the program;
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detect red flags that have been incorporated into the identity theft prevention program;
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respond appropriately to any red flags that are detected to prevent and mitigate identity theft; and
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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 involving products or services offered by associations and their affiliates. Specifically, a depository institution is prohibited 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. This prohibition is subject to exceptions for certain product arrangements, including where the tied product is also a traditional banking product (that is, a loan, discount, deposit or trust service).
Trust Activities Regulation
The Bank derives its trust powers from Section 5(n) of the HOLA and the regulations and policies of the OCC. 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 OCC), 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, 2012, the trust department of the Bank maintained approximately $92.7 million in assets under management.
Federal Reserve System
Under Federal Reserve regulations, the Bank is required to maintain noninterest-earning reserves against its transaction accounts. Federal Reserve regulations exempt the first $11.5 million of otherwise reservable balances from the reserve requirements. A 3% reserve is required for transaction account balances over $11.5 million and up to $71.0 million. Transaction account balances over $71.0 million are subject to a reserve requirement of approximately $1.785 million plus 10% of any amount over $71.0 million. The Bank was in compliance with these reserve requirements at June 30, 2012. 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 Federal Reserve, 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 Federal Reserve 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 Federal Reserve 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 a percentage of the Bank's outstanding advances. These percentages are subject to change at the discretion of the FHLB Board of Directors.
At June 30, 2012, the Bank had $7.8 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, 2012, dividends paid by the FHLB of Des Moines to the Bank totaled approximately $261,000, which constitutes a $58,000 decrease compared to the amount of dividends received in fiscal 2011.
Anti-Money Laundering / Combating Terrorist Financing Provisions
The Bank is subject to the OCC 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:
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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.
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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.
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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.
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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.
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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 Federal Reserve examination and supervision as well as comply with certain reporting requirements. In addition, the Federal Reserve has enforcement authority over us and any of our non-savings institution subsidiaries. Among other things, this authority permits the Federal Reserve 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."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:
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control (as defined under the HOLA) of another savings institution (or a holding company parent) without prior Federal Reserve approval;
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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 Federal Reserve approval; or
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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 Federal Reserve).
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:
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in the case of certain emergency acquisitions approved by the FDIC;
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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
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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 change our status with the Federal Reserve as a savings and loan holding company and register as a bank holding company under the BHCA 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 including where the prior written approval of the Federal Reserve is obtained, 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 Federal Reserve 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.
Activities Restrictions
Prior to the Dodd-Frank Act, savings and loan holding companies were generally permitted to engage in a wider array of activities than those permissible for their bank holding company counterparts and may have concentrations in real estate lending that are not typical for bank holding companies. Section 606 of the Dodd-Frank Act amends HOLA by inserting a new requirement that conditions the ability of non-grandfathered savings and loan holding companies that are not exempt from HOLA's restrictions on activities to engage in certain activities, effective as of July 21, 2011. Pursuant to this new requirement, a covered saving and loan holding company may engage in activities that are permissible only for a financial holding company under section 4(k) of the BHCA if the covered company meets all of the criteria to qualify as a financial holding company, and complies with all of the requirements applicable to a financial holding company as if the covered savings and loan holding company was a bank holding company. Moreover, going forward, savings and loan holding companies engaging in new activities permissible for bank holding companies will need to comply with notice and filing requirements of the Federal Reserve.
If the Federal Reserve believes that an activity of a savings and loan holding company or a nonbank subsidiary constitutes a serious risk to the financial safety, soundness, or stability of a subsidiary savings association and is inconsistent with the principles of sound banking, the purposes of HOLA or other applicable statutes, the Federal Reserve may require the savings and loan holding company to terminate the activity or divest control of the nonbanking subsidiary. This obligation is established in section 10(g)(5) of HOLA and bank holding companies are subject to equivalent obligations under the BHCA and Regulation Y.
Source of Strength and Capital Requirements
The Dodd-Frank Act requires all companies that directly or indirectly control an insured depository institution, including savings and loan holding companies, to serve as a source of financial and managerial strength to its subsidiary depository institution(s). Moreover, pursuant to the Dodd-Frank Act, savings and loan holding companies will for the first time become subject to the same capital and activity requirements as those applicable to bank holding companies.
As a result of its review of the consolidated capital requirements for all depository institutions and their holding companies pursuant to section 171 of the Dodd-Frank Act and the Basel Committee on Banking Supervision's "Basel III: A global regulatory framework for more resilient banks and banking systems" report ("Basel III"), the Federal Reserve and other federal banking agencies recently issued a notice of proposed rulemaking that revises their risk-based and leverage capital requirements that are proposed to be phased in for all banks and savings associations and their U.S. holding companies beginning in January 2013.
Examination
To help facilitate the transition of savings and loan holding companies to the supervisory jurisdiction of the Federal Reserve, the Federal Reserve instructed its examiners to use the first supervisory cycle beginning in July 2011 to inform savings and loan holding companies about how their operations compare to the Federal Reserve's supervisory expectations, which is expected to allow for savings and loan holding company management to make operational changes in response to the Federal Reserve's supervisory expectations, if necessary.
After the first supervisory cycle and going forward, the Federal Reserve has indicated that it will, to the greatest extent possible take into account any unique characteristics of savings and loan holding companies and the requirements of the HOLA, to assess the condition, performance, and activities of savings and loan holding companies on a consolidated basis in a manner that is consistent with the Federal Reserve's established risk-based approach regarding bank holding company supervision. As with bank holding companies, the Federal Reserve's objective is to ensure that a savings and loan holding company and its nondepository subsidiaries are effectively supervised and can serve as a source of strength for, and do not threaten the soundness of, its subsidiary depository institution(s).
Change of Control
The federal banking laws require that appropriate regulatory approvals must be obtained before an individual or company may take actions to "control" a bank or savings association. The definition of control found in the HOLA is similar to that found in the BHCA for bank holding companies. Both statutes apply a similar three-prong test for determining when a company controls a bank or savings association. Specifically, a company has control over either a bank or savings association if the company:
(1)
directly or indirectly or acting in concert with one or more persons, owns, controls, or has the power to vote 25% or more of the voting securities of a company;
(2)
controls in any manner the election of a majority of the directors (or any individual who performs similar functions in respect of any company, including a trustee under a trust) of the board; or
(3)
directly or indirectly exercises a controlling influence over the management or policies of the bank.
The implementing regulation of the Federal Reserve includes a specific definition of "control" similar to the statutory definition, with certain additional provisions.
The Federal Reserve generally reviews investments and relationships with savings and loan holding companies by companies using the current practices and policies applicable to bank holding companies to the extent possible for purposes of implementing the HOLA. Given that Federal Reserve practice is to consider potential control relationships for all investors regardless of investment level in connection with applications submitted under the BHCA, the Federal Reserve will review potential control relationships for all investors in connection with applications submitted to the Federal Reserve under Section 10(e) or 10(o) of HOLA. The Federal Reserve often obtains a series of commitments from investors seeking non-control determinations.
The federal banking laws require minority investors that are unwilling to bear the responsibilities associated with controlling a banking organization to limit their influence over the management and policies of the banking organization. That is, investors seeking the protection of being free from regulation and oversight as a savings and loan holding company under the HOLA are limited in their involvement and influence over the management and policies of the savings and loan holding company and its subsidiaries.
Federal Securities Laws and the Sarbanes-Oxley Act
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.
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 to such plans. 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. This exemption applies to smaller reporting companies, such as the Company, under the SEC's rules.
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 net income 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, 2012, the Bank's Excess for tax purposes totaled approximately $4.8 million. The Bank does not intend to pay dividends that would result in a recapture of any portion of its bad debt reserves.
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, 2012 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 11, 2012.
Business Experience of each Executive Officer
STEPHEN M. BIANCHI, age 48, has served as the Chief Executive Officer of the Company and the Bank since November 2011, and as President of the Twin Cities market for the Bank since April 2010. Prior to joining the Bank, he worked at Associated Bank from 2006 to 2010, where he held positions including Senior Vice President, Minnesota Regional President and Minnesota Regional Commercial Banking Manager. Before that, he was Twin Cities Business Banking Manager for Wells Fargo Bank, where he held several other banking and management positions nearly 14 years. Mr. Bianchi received his B.S. degree in Finance and M.B.A. from Providence College.
BRENT R. OLTHOFF, age 41, has served as Senior Vice President, Chief Financial Officer and Treasurer of the Company since November 2010. Prior to such time, he 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.
JON M. GADBERRY, age 50, 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.
NATALIE A. SUNDVOLD, age 49, 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 45, has served as the Senior Vice President/Chief Credit Officer since January, 2011. Prior to that time, he served as the Senior Vice President/Corporate Strategy of the Bank from May 2008 to January 2011. 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 currently attends The University of Sioux Falls, majoring in Management, and is a 2008 graduate of the American Bankers Association National School of Banking.
BRUCE E. HANSON, CPA, age 49, 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 Company's executive officers, directors and director nominees.
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.
We are operating in a challenging and uncertain economic environment, including generally uncertain world, national and local conditions. The capital and credit markets have been experiencing volatility and disruption since 2008. 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 led to increased commercial and consumer deficiencies, lack of customer confidence, increased market volatility and widespread reduction in general business activity. 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:
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We face increased regulation of our industry. Compliance with such regulation may increase our costs and limit our ability to pursue business opportunities;
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Customer demand for loans secured by real estate could be further reduced due to weaker economic conditions, an increase in unemployment, a decrease in real estate values or an increase in interest rates;
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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;
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The value of the portfolio of investment securities that we hold may be adversely affected; and
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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 the resolution of problem banks continues to decrease the
funds available.
The Dodd-Frank Act will, among other things, result in increased capital standards, and further new laws and regulations, which create regulatory uncertainty and which are expected to continue to significantly increase our regulatory compliance costs.
Implementation of the Dodd-Frank Act has changed and will significantly change the current bank regulatory structure and affect the lending, investment, trading and operating activities of banking institutions and their holding companies, which is expected to continue to significantly increase our regulatory compliance costs.
The Dodd-Frank Act requires the Federal Reserve Board to set minimum capital levels for bank holding companies that are as stringent as those required for insured depository institutions. Moreover, pursuant to the Dodd-Frank Act, savings and loan holding companies will for the first time become subject to the same capital and activity requirements as those applicable to bank holding companies. The Dodd-Frank Act also requires that all companies that directly or indirectly control an insured depository institution, including savings and loan holding companies, serve as a source of financial and managerial strength to their subsidiary savings associations' depository institution(s). The legislation also establishes a floor for capital of all insured depository institutions and directs the federal banking regulators to implement new leverage and capital requirements. All of these actions are expected to further increase our regulatory compliance costs.
As a result of regulatory restructuring called for by the Dodd-Frank Act, effective July 21, 2011, the Federal Reserve became the primary federal regulator of the Company and the OCC became the primary federal regulator of the Bank. In concurrence with the transfer of parent company supervisory authority from the OTS to the Federal Reserve, the Federal Reserve has issued guidance aligning the supervisory and regulatory standards for savings and loan holding companies more closely with the standards applicable to bank holding companies. The Federal Reserve had also indicated that its supervision of savings and loan holding companies may entail a more rigorous level of review than previously applied by the OTS. As a result, we are subject to new examination, regulatory and reporting requirements that could be more stringent than the OTS examinations we have had historically.
The Dodd-Frank Act also created a new government agency, the Consumer Financial Protection Bureau ("CFPB") with broad powers to supervise and enforce consumer protection laws. The CFPB has broad rule-making authority for a wide range of consumer protection laws that apply to all banks and savings institutions like the Bank, including the authority to prohibit "unfair, deceptive or abusive" acts and practices.
We are continuing to closely monitor and evaluate developments under the Dodd-Frank Act, which have increased regulatory uncertainty and which could adversely affect our financial condition and results of operations through significant increases in our regulatory compliance costs.
Legislative and regulatory initiatives taken to date may not achieve their intended objectives; proposed and future initiatives may substantially increase compliance burdens or impact our sources of revenue 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. On June 12, 2012, the OCC and other federal banking agencies issued notices of proposed rulemakings that revise each agency's risk-based and leverage capital requirements consistent with agreements reached by the Basel Committee on Banking Supervision, including implementation of a new common equity tier 1 minimum capital requirement and a higher minimum tier 1 capital requirement. Additionally, consistent with Basel III, the OCC and other federal banking agencies propose to apply limits on a banking organization's capital distributions and certain discretionary bonus payments if the banking organization does not hold a specified "buffer" of common equity tier 1 capital in addition to the minimum risk-based capital requirements. The proposed rulemaking also would revise the agencies' prompt corrective action framework by incorporating the new regulatory capital minimums and updating the definition of tangible common equity. These capital requirements are proposed to be phased in beginning in January 2013.
We cannot predict the impact that such proposals, once adopted, would have upon our financial condition or results of operations.
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, 2012, the Bank's nonperforming loans (which consist of nonaccrual loans and loans still accruing but past due greater than 90 days) totaled $16.2 million, or 2.37% of its loan portfolio. At June 30, 2012, the Bank's nonperforming assets (which include foreclosed real estate) were $17.8 million, or 1.49% of assets. In addition, the Bank had $6.7 million in accruing loans that were 30 to 89 days delinquent at June 30, 2012. At June 30, 2012, the Bank held $10.6 million of loan and lease loss reserves, or 1.55% of total loans, and 65.29% of nonperforming 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 dependent on the prevailing economic, political and business conditions as well as the population growth in South Dakota and Minnesota.
Our success and growth is dependent 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, and Minneapolis, Minnesota. 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 predominantly 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 and Minnesota. 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 OCC, Federal Reserve and the FDIC. 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.
Non-compliance with the USA PATRIOT Act, Bank Secrecy Act, Real Estate Settlement Procedures Act, Truth-in-Lending Act or other laws and regulations could result in fines or sanctions, and curtail expansion opportunities.
Financial institutions are required under the USA PATRIOT and Bank Secrecy Acts to develop programs to prevent financial institutions from being used for money-laundering and terrorist activities. Financial institutions are also obligated to file suspicious activity reports with the U.S. Treasury Department's Office of Financial Crimes Enforcement Network if such activities are detected. These rules also require financial institutions to establish procedures for identifying and verifying the identity of customers seeking to open new financial accounts. Failure or the inability to comply with these regulations could result in fines or penalties, curtailment of expansion opportunities, intervention or sanctions by regulators and costly litigation or expensive additional controls and systems. During the last few years, several banking institutions have received large fines for non-compliance with these laws and regulations. In addition, the federal government has imposed and is expected to expand laws and regulations relating to residential and consumer lending activities that create significant new compliance burdens and financial risks. We have developed policies and continue to augment procedures and systems designed to assist in compliance with these laws and regulations.
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 an outstanding balance at June 30, 2012 and 2011. The line was advanced upon during the past 12 months for contingent funding testing purposes.
The Bank currently has a $20.0 million unsecured line of federal funds with Zions Bank, which did not have an outstanding balance at June 30, 2012 and 2011. The line was advanced upon during the past 12 months for contingent funding testing purposes.
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.
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 Federal Reserve 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.
The repeal of federal prohibitions on payment of interest on demand deposits could increase our interest expense.
All federal prohibitions on the ability of financial institutions to pay interest on demand deposit accounts were repealed as part of the Dodd-Frank Act. As a result, beginning on July 21, 2011, financial institutions could commence offering interest on demand deposits to compete for clients. Our interest expense will increase and our net interest margin will decrease if we begin offering interest on demand deposits to attract new customers or maintain current customers, which could have a material adverse effect on our business, financial condition and results of operation.
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 further 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.
We have significant exposure to risks associated with the agriculture industry due to our loan concentration.
Agricultural loans comprised 22.7% of our total loan and lease portfolio at June 30, 2012. A number of these loans have relatively large balances. Payments on agricultural loans are dependent on the profitable operation or management of the farm property securing the loans. The deterioration of one or a few of these loans may cause a significant increase in nonperforming loans. Our agricultural loans may involve a greater degree of risk than other loans, and the ability of the borrower to repay may be affected by many factors outside of the borrower's control, including adverse weather conditions that prevent the planting of a crop or limit crop yields (such as hail, drought and floods), loss of livestock due to disease or other factors, declines in market prices for agricultural products and the impact of government regulations (including changes in price supports, subsidies and environmental regulations). In addition, many farms are dependent on a limited number of key individuals whose injury or death may significantly affect the successful operation of the farm. If the cash flow from a farming operation is diminished, the borrower's ability to repay the loan may be impaired. The primary crops in our market areas are corn and soybeans. Accordingly, adverse circumstances affecting these crops could have an adverse effect on our agricultural loan portfolio. While virtually all of our agricultural operating loan crop borrowers utilize federal crop insurance programs to insure against weather-related losses, we cannot be certain that insurance coverages will be adequate to fully satisfy cash flow and associated operating requirements. 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 net income 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.
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:
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risks of unknown or contingent liabilities;
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unanticipated costs and delays;
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risks that acquired new businesses do not perform consistent with our growth and profitability expectations;
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risks of entering new markets or product areas where we have limited experience;
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risks that growth will strain our infrastructure, staff, internal controls and management, which may require additional personnel, time and expenditures;
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exposure to potential asset quality issues with acquired institutions;
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difficulties, expenses and delays of integrating the operations and personnel of acquired institutions, and start-up delays and costs of other expansion activities;
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potential disruptions to our business;
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possible loss of key employees and customers of acquired institutions;
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potential short-term decreases in profitability; and
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diversion of our management's time and attention from our existing operations and business.
We may participate in FDIC-assisted acquisitions, which could present additional risks to our financial condition.
We may make opportunistic whole or partial acquisitions of troubled financial institutions in transactions facilitated by the FDIC. In addition to the risks frequently associated with acquisitions, an acquisition of a troubled financial institution may involve a greater risk that the acquired assets underperform compared to our expectations. Because these acquisitions are structured in a manner that would not allow us the time normally associated with preparing for and evaluating an acquisition, including preparing for integration of an acquired institution, we may face additional risks including, among other things, the loss of customers, strain on management resources related to collection and management of problem loans and problems related to integration of personnel and operating systems. Additionally, while the FDIC may agree to assume certain losses in transactions that it facilitates, there can be no assurances that we would not be required to raise additional capital as a condition to, or as a result of, participation in an FDIC-assisted transaction. Any such transactions and related issuances of stock may have dilutive effect on earnings per share and share ownership.
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.
We may need to raise additional capital in the future, and such capital may not be available when needed or at all.
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.
We rely heavily on communications and information systems to conduct our business. Furthermore, we have access to large amounts of confidential financial information and control substantial financial assets, including those belonging to our customers, to whom we offer remote access, and we regularly transfer substantial financial assets by electronic means. Any failure, interruption or breach in security of our 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.
We also face the risk of operational disruption, failure, termination or capacity constraints caused by third parties that facilitate our business activities by providing technology such as software applications, as well as financial intermediaries. Such parties could also be the source of an attack on, or breach of, our operational systems, data or infrastructure.
Employee errors could also subject us to financial claims for negligence. We maintain a system of internal controls and insurance coverage to mitigate against operational risks, including data processing system failures and errors and customer or employee fraud. Should our internal controls fail to prevent or detect an occurrence, and if any resulting loss is not insured or exceeds applicable insurance limits, such failure could have a material adverse effect on our business, financial condition and results of operations.
The loss of one or more of our key personnel, or our inability to attract, assimilate and retain 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 personnel maintain with our customers. We depend on the talents and leadership of our executive team, including Stephen M. Bianchi, our President and Chief Executive Officer, and Brent R. Olthoff, our Senior Vice President, Chief Financial Officer and Treasurer. There is an increasing risk in our industry around the lack of human capital with experience, training and skills in financial services. Therefore, the competition for qualified personnel in the financial services industry can be intense. The inability to continue to attract, retain and motivate key personnel could adversely affect our business.
Adverse weather affecting the markets we serve could hurt our business and prospects for growth.
The South Dakota economy, in general, is heavily dependent on agriculture and therefore the overall South Dakota economy, and particularly the economies of the rural communities that we serve, can be greatly affected by severe weather conditions, including droughts, storms, tornadoes and flooding. Unfavorable weather conditions may decrease agricultural productivity or could result in damage to our branch locations or the property of our customers, all of which could adversely affect the local economy. An adverse affect on the economy of South Dakota would negatively affect our profitability.
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 net income 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, 2012. 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 during the recent economic downturn. 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:
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actual or anticipated quarterly fluctuations in our operating results and financial condition;
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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;
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failure to meet analysts' revenue or earnings estimates;
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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;
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strategic actions by us or our competitors, such as acquisitions, restructurings, dispositions or financings;
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actions by our current stockholders, including sales of common stock by existing stockholders and/or directors and executive officers;
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fluctuations in the stock price and operating results of our competitors;
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future sales of our equity, equity-related or debt securities;
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changes in the frequency or amount of dividends or share repurchases;
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proposed or adopted regulatory changes or developments;
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anticipated or pending investigations, proceedings or litigation that involve or affect us;
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trading activities in our common stock, including short-selling;
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domestic and local economic factors unrelated to our performance; and
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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. 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. 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 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:
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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;
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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 66 2/3% 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;
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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;
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require that a special meeting of stockholders be called pursuant to a resolution adopted by a majority of our Board of Directors;
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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
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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 Federal Reserve approval prior to any direct or indirect acquisition of "control" (as defined in Federal Reserve regulations) of the Bank, including any acquisition of control of us. By statute, a company would be found to "control" the Bank if the Company: (1) directly or indirectly or acting in concert with one or more persons, owns, controls, or has the power to vote 25% or more of the voting securities of the Company or Bank; (2) controls in any manner the election of a majority of the directors of the Company's or Bank's board; or (3) directly or indirectly exercises a controlling influence over the management or policies of the Company and Bank. The Federal Reserve's implementing regulations include a specific definition of "control" similar to the statutory definition, with certain additional provisions. In addition to the rebuttable presumptions of control set forth in the implementing regulations, the Federal Reserve's supervision manual for supervised institutions provides that there are a number of other circumstances that are indicative of control and may call for further investigation to uncover facts that support a determination of control.
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. At June 30, 2012, the Bank has a total of 28 banking centers in its market area and Internet access located at www.homefederal.com and www.infiniabank.com. Of such 28 total banking centers, the Bank owns 14, including the main office, and leases 14 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, 2012 was $14.8 million. 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 material legal actions or other proceedings contemplated by governmental authorities outside of the normal course of business.
Item 4.
Item 4. Mine Safety Disclosures
Not applicable.
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, 2012 and 2011. Quotations for such periods are as reported by the NASDAQ Global Market.
As of September 11, 2012, the Company had 431 holders of record of its common stock.
The transfer agent for the Company's common stock is Computershare (formerly known as 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 2012. The Company paid cash dividends on a quarterly basis of $0.1125, $0.1125, $0.1125 and $0.1125 per share in fiscal 2011. On July 30, 2012, 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 17, 2012 to stockholders of record on August 10, 2012.
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.
Federal regulations govern the permissibility of capital distributions by a federal savings association. Pursuant to the Dodd-Frank Act, savings associations that are part of a savings and loan holding company structure must now file a notice of a declaration of a dividend with the Federal Reserve. In the case of cash dividends, OCC regulations require that federal savings associations that are subsidiaries of a stock savings and loan holding company must file an informational copy of that notice with the OCC at the same time it is filed with the Federal Reserve. OCC regulations further set forth the circumstances under which a federal savings association is required to submit an application or notice before it may make a capital distribution.
A federal savings association proposing to make a capital distribution is required to submit an application to the OCC if: (1) the association does not qualify for expedited treatment pursuant to criteria set forth in OCC regulations; (2) the total amount of all of the association's capital distributions (including the proposed capital distribution) for the applicable calendar year exceeds the association's net income for that year to date plus the association's retained net income for the preceding two years; (3) the association would not be at least adequately capitalized following the distribution; or (4) the proposed capital distribution would violate a prohibition contained in any applicable statute, regulation, or agreement between the association and the OCC or violate a condition imposed on the association in an application or notice approved by the OCC.
A federal savings association proposing to make a capital distribution is required to submit a prior notice to the OCC if: (1) the association would not be well capitalized following the distribution; (2) the proposed capital distribution would reduce
the amount of or retire any part of the association's common or preferred stock or retire any part of debt instruments such as notes or debentures included in the association's capital (other than regular payments required under a debt instrument); or (3) the association is a subsidiary of a savings and loan holding company and is not required to file a notice regarding the proposed distribution with the Federal Reserve, in which case only an informational copy of the notice filed with the Federal Reserve needs to be simultaneously provided to the OCC.
Each of the Federal Reserve and OCC have primary reviewing responsibility for the applications or notices required to be submitted to them by savings associations relating to a proposed distribution. The Federal Reserve may disapprove of a notice, and the OCC may disapprove of a notice or deny an application, if:
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the savings association would be undercapitalized following the distribution;
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the proposed distribution raises safety and soundness concerns; or
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the proposed distribution violates a prohibition contained in any statute, regulation, enforcement action or agreement between the savings association (or its holding company, in the case of the Federal Reserve) and the entity's primary federal regulator, or a condition imposed on the savings association (or its holding company, in the case of the Federal Reserve) in an application or notice approved by the entity's primary federal regulator.
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 $4.0 million with United Bankers' Bank with no outstanding balance at June 30, 2012. The line of credit matures on October 1, 2012. 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, 2007, $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, 2007
ASSUMES DIVIDENDS REINVESTED
FISCAL YEAR ENDING JUNE 30, 2012
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, 2012, 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, and no common stock remains available for future awards under the 1996 Director Restricted Stock Plan. In addition, after the expiration of the 2002 Stock Option and Incentive Plan by its terms on September 20, 2012, no further awards may be made thereunder.
_____________________________________
(1)
All 405,655 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 for fiscal 2012 was $5.2 million, or $0.74 per diluted share, compared to $679,000, or $0.10 per diluted share for fiscal 2011. Return on average equity was 5.41% at June 30, 2012, compared to 0.72% at June 30, 2011. As discussed in more detail below, the increases were due to a variety of key factors, including a decrease in the provision for losses on loans and leases of $6.8 million and increases in noninterest income of $4.0 million. These were partially offset by a decrease in net interest income of $3.7 million and an increase in income taxes of $2.7 million.
Modest improvement in national economic conditions continued to offer a challenging operating environment in fiscal 2012. Generally reflective of the experience of community banks throughout the country, this challenging operating environment has resulted in increased competition among financial institutions with limited loan demand from creditworthy borrowers. During 2012, the Company benefited from continued proactive management of problem assets leading to a $19.4 million reduction in nonperforming assets from fiscal 2011. While a majority of problem asset stress in 2011 related to the agricultural portfolio, and in particular dairy operations, signs of stabilization did occur and commodity prices remained favorable for most agricultural production in 2012.
Agricultural and commercial loans accounted for the majority of the decrease in loan balances between fiscal 2012 and 2011. Agricultural real estate loans were $70.8 million at June 30, 2012, down $41.0 million or 36.7% since June 30, 2011, and comprised 10.4% of total loans outstanding. Agricultural business loans were $84.3 million at the end of 2012, down $54.5 million or 39.3% since fiscal year 2011, and comprised 12.3% of total loans outstanding. Decreases were attributable in part to proactive problem loan resolutions and competitive pressures for long-term financing. 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 each borrower's financial soundness and relationship on an ongoing basis. Commercial loans decreased $25.2 million or 24.1% since June 30, 2011, to $79.1 million at June 30, 2012. We believe many of the loan customers have been substantially deleveraging during the last three years as they have been reducing their debt while waiting for better or less risky opportunities for their businesses. We believe this phenomenon may be starting to change back to a more normal situation based upon recent activity as the economy slowly recovers, but we cannot precisely predict when or by how much our loan portfolio will start to grow due to existing customer demand.
The provision for loan losses is the charge to net income that management determines to be necessary to maintain the allowance for loan and lease losses at a sufficient level reflecting management's estimate of probable incurred losses in the loan portfolio. Management performs periodic and systematic detailed reviews of the loan portfolio to identify trends and to assess the overall collectibility of the loan portfolio. The allowance for loan and lease losses decreased $3.7 million to $10.6 million at June 30, 2012, a decrease of 26.2%. The ratio of allowance for loan and lease losses to total loans and leases was 1.55% as of June 30, 2012, compared to 1.73% at June 30, 2011. This decrease is primarily attributable to the specific valuation allowance decrease of $4.5 million, of which $4.2 million was related to the agricultural loan portfolio and improvement in related nonperforming assets. The general valuation allowance increased $770,000 due in part to increases allocated primarily to consumer loans based upon a review of historical loss and environmental factors. At June 30, 2012, classified assets declined to $42.9 million from $46.1 million at June 30, 2011 and from a high of $81.8 million at December 31, 2010. Total nonperforming assets at June 30, 2012 were $17.8 million as compared to $37.2 million at June 30, 2011. The ratio of nonperforming assets to total assets was 1.49% for June 30, 2012, compared to 3.12% at June 30, 2011.
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. See "Asset Quality" for more information.
Total deposits at June 30, 2012, were $893.9 million, an increase of $702,000, or 0.1%, from June 30, 2011. Due to the continued low interest rate environment, the Company experienced a preference by customers of non-maturity deposits. Noninterest-bearing checking accounts increased $14.6 million to $147.0 million at June 30, 2012, while interest-bearing checking accounts, money market accounts, and savings accounts increased $24.7 million, $12.7 million, and $36.6 million, respectively, to $138.1 million, $210.3 million, and $121.1 million, respectively, at June 30, 2012. Public funds, which are included in the various types of deposits account balances, decreased $14.3 million, or 7.5%, from June 30, 2011. Interest expense on deposits was $7.2 million for fiscal 2012, a decrease of $2.3 million, or 24.5%, over fiscal 2011.
Management's objectives are to provide capital sufficient to cover the risks inherent in the Company's businesses, to maintain excess capital to well-capitalized standards, and to assure ready access to the capital markets. The total risk-based capital ratio was 15.87% at June 30, 2012, compared to 13.28% at June 30, 2011. Tier I capital increased 22 basis points to 9.66% at June 30, 2012 when compared to 9.44% at June 30, 2011. This continues to allow the Bank to meet the regulatory criteria to be considered a "well-capitalized" institution at June 30, 2012. 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. The Company continued to return capital to investors through a quarterly dividend, or $0.45 per diluted common share on an annual basis.
The current interest rate environment has been directly affected by the intervention of the Federal Reserve as it assisted in the economic recovery. The target federal funds rate remained at 25 basis points during fiscal 2012. The impact of this historically low interest rate environment on the Company has been mixed. While the low interest rates negatively affected yields of loans and the securities portfolio, the impact to our cost of funds was favorable.
Net interest income for fiscal 2012 was $33.7 million, a decrease of $3.7 million or 9.9% over the same period a year ago. The net interest margin was 3.03%, compared to 3.27% for the same period a year ago, a decrease of 24 basis points. On a fully taxable equivalent basis, the net interest margin for fiscal 2012 was 3.07%, compared to 3.31% in fiscal 2011. 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 1.72% in fiscal 2011 to 1.44% in fiscal 2012, a change of 28 basis points. For the same period, yields on earning assets decreased from 4.77% to 4.25%, a decrease of 52 basis points. Decreases in volume from fiscal 2011 to fiscal 2012 of average earning assets and interest-bearing liabilities were 2.8% and 1.5% respectively.
Variability of the net interest margin ratio may be affected by many factors, including Federal Reserve policies for short-term interest rates, competitive and global economic conditions and customer preferences for various products and services. As of June 30, 2012, management believes that it has positioned the institution for a neutral to slightly earning-asset sensitive interest rate risk profile, 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.
Noninterest income for fiscal 2012 was $12.9 million, compared to $8.9 million for the same period a year ago, an increase of $4.0 million or 45.3%. Net gain on sale of securities of $1.5 million for fiscal 2012 increased by $5.1 million from a net loss on sale of securities of $3.6 million in fiscal 2011. In fiscal 2011, the Company sold its pooled trust preferred securities, which yielded a pre-tax charge to net income of $6.3 million. In addition, these securities yielded net impairment losses recognized in noninterest income of $549,000, which had no impact for fiscal 2012. Net loan servicing income decreased by $973,000, to $603,000 for fiscal 2012, which partially reduced the overall increase in noninterest income from the prior year. This reduction in net loan servicing income was due to a provision for an allowance of $888,000 recorded against the servicing asset and increased amortization of $70,000, which was due in part to increased prepayment rates within the portfolio. Another slight decrease to noninterest income was due to a loss on disposal of closed-branch fixed assets of $473,000 as the Company merged six branches into other nearby branches to optimize branch efficiencies.
During the second fiscal quarter of 2012, the Company was informed by the South Dakota Housing Development Authority (“SDHDA”) that a change in business model was necessary for SDHDA to continue to meet the financing needs of its single family mortgage program in South Dakota. This change would include the development of a new bond resolution, to support a mortgage-backed securities program. As such, a request for proposal for a master servicer with a two year commitment period was provided to interested parties, and the Company was informed that a new master servicer would begin effective April 1, 2012. This change in business model effectively ended the new flow of servicing assets from SDHDA to the Company beginning in the fourth fiscal quarter. The Company does not expect this event to have a material impact on the fiscal 2013 income statement. The single family mortgage segment of the Company's servicing portfolio is expected to decrease in value over time, as principal is reduced. The Company continues to evaluate potential acquisition of servicing assets dependent upon market conditions and characteristics desirable by the Company, which may include bidding as the master servicer for SDHDA after the initial two year commitment is complete.
The ability to successfully manage expenses is important to our long-term prosperity. During fiscal 2012, the Company executed on a strategic initiative to improve efficiency and completed six branch closures within the South Dakota market area as it merged branches into other nearby branches. Fiscal year costs related to the streamlining effort included $473,000 for the disposition of closed-branches fixed assets and additional one-time expenses of $591,000 for severance and lease terminations. In return, management anticipates annual cost savings of these branch closures to approach $1.3 million.
Noninterest expense for fiscal 2012 was $37.1 million, a decrease of $29,000 from fiscal 2011. Compensation and employee benefits and FDIC insurance decreased $1.3 million and $425,000, respectively, when compared to the prior fiscal year. Professional fees and occupancy and equipment increased $842,000 and $310,000, respectively, which partially offset the cost decreases.
Compensation and employee benefits decreased 6.2% from fiscal 2011 costs primarily from the reduction of headcount and performance based incentive pay when compared to the prior year. Management further assessed staff efficiency, and reduced full-time equivalent ("FTE") employees from 342 at June 30, 2011 to 292 at June 30, 2012. Incentive pay decreases were the direct result of lower employee performance outcomes versus performance targets. FDIC insurance decreased by 28.9% due to the modified assessment schedule implemented by the FDIC effective April 1, 2011, which modified the assessment base from deposit totals to asset totals, and in return, reduced the effective rates.
Professional fees increased 35.7% due in part to certain employment, regulatory and governance matters. Occupancy and equipment increased by 6.7% due primarily to additional lease termination costs incurred in the merging of six branches to other nearby locations. The cost to buy out the existing leases totaled $500,000 for fiscal 2012, compared to none in the prior year.
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 securities and the loss on disposal of closed-branch fixed assets) for fiscal 2012 was 77.17%, compared to 78.34% for the same period a year ago, a decrease of 117 basis points. The operating efficiency ratio excludes both the impact of net interest expense on the variable priced trust preferred securities and losses due to non-operating activities. The operating efficiency ratio is a non-GAAP financial measure. See Item 6, "Selected Financial Data-Non-GAAP Reconciliation of the Operating Efficiency Ratio" of this Form 10-K for further analysis. The Company had 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 $1.9 million for fiscal 2012, a $39,000 increase from the prior fiscal year. The average rate paid for fiscal 2012 and fiscal 2011 was 6.69% and 6.55%, respectively. The total efficiency ratio (i.e., noninterest expense divided by total revenue) was 79.74% for the year ended June 30, 2012, compared to 80.38% for the prior year, a decrease of 64 basis points. Primary changes which affected the efficiency ratio from the prior year, were the increase in revenue from the $5.1 million increase in net gain on sale of securities, the decrease of $3.7 million in net interest income, and an allowance for servicing rights of $888,000. As a result, the overall total revenues increased by $335,000, while noninterest expenses decreased by $29,000. 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 enactment of the Dodd-Frank Act in July 2010 significantly impacted how financial services companies are regulated and authorizes expansive new regulation by various federal agencies. Many of the most sweeping changes in the Dodd-Frank Act are currently still in the process of being implemented through the agency rulemaking process and thus uncertainty exists as to the full impact of the Dodd-Frank Act and its implementing regulations. The Company and Bank continue to closely monitor and evaluate developments under the Dodd-Frank Act with respect to our business, financial condition, results of operations and prospects.
In particular, the Company and Bank believe that the following non-exclusive list of provisions or topics of the Dodd-Frank Act which are still in the process of implementation are significant to the business of the Company and the Bank:
In connection with the Federal Reserve's assumption of responsibility for the supervision and examination of savings and loan holding companies as mandated by the Dodd-Frank Act, the FRB has indicated that it intends (and has), “to the greatest extent possible taking into account any unique characteristics of savings and loan holding companies and the requirements of the Home Owners' Loan Act, as amended (“HOLA”), to assess the condition, performance, and activities of savings and loan holding companies on a consolidated risk-based basis in a manner that is consistent with the Federal Reserve's established approach regarding bank holding company supervision.” Accordingly, the Company anticipates that it may over time become subject to the same or similar supervisory standards and guidance applicable to bank holding companies.
The Dodd-Frank Act requires that savings and loan holding companies, for the first time, become subject to the same capital requirements as those applicable to bank holding companies. In addition to compliance with capital requirements pursuant to a multi-year implementation plan as proposed by the Federal Reserve and other banking agencies, savings and loan holding companies are obligated to serve as a “source of financial and managerial strength” to their depository institution subsidiaries. This statutory obligation requires savings and loan holding companies, including the Company, to provide financial assistance to a depository institution subsidiary in the event that that subsidiary experiences financial distress. It is anticipated that the Federal Reserve will be issuing interpretive guidance and rules clarifying the contours of this obligation.
The Dodd-Frank Act further requires that existing capital requirements for banking organizations be re-examined by regulators and made counter-cyclical. This effort, and the pending U.S. adoption of Basel III, will result in new capital and other standards for the Company and the Bank as set forth in proposed joint rulemaking issued in June 2012 by the banking agencies. In addition to requirements affecting capital and leverage, the proposed rules include new limits on capital distributions and discretionary bonuses for banking organizations that do not hold a specified amount of common equity tier 1 capital in addition to the common equity necessary to meet the minimum risk-based capital requirements (referred to as a capital conservation buffer).
The Dodd-Frank Act established a new consumer agency known as the Consumer Financial Protection Bureau ("CFPB") with rulemaking, supervisory, enforcement, and other authorities relating to consumer financial products and services. These authorities include the ability to issue regulations under more than a dozen federal consumer financial laws, which transferred to the CFPB from seven federal agencies on July 21, 2011. Among the expansive rulemaking authority over consumer products and practices granted to the CFPB is the authority to define unfair, deceptive or abusive practices and to centralize consumer complaints.
The Dodd-Frank Act imposed new duties on mortgage lenders, including a duty to determine the borrower's ability to repay the loan, and imposed a requirement on mortgage securitizers to retain a minimum level of economic interest in securitized pools of certain mortgage types. The CFPB is currently in the process of developing various mortgage-related rulemakings mandated by the Dodd-Frank Act.
The list above is not exhaustive. It reflects the Company's continuing assessment of the Dodd-Frank Act provisions that are reasonably likely to have a substantial impact in the future. It is possible that at least some other areas unexpectedly will become significant to the Company or the Bank as the regulatory processes unfold. For additional information on the laws and regulations governing the activities of the Company and Bank, see “Item 1: Business--Regulation” below.
Recent events in the financial markets continue to produce uncertainties for 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 and debit card 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, 2012, the Company had total assets of $1,192.6 million, a decrease of $922,000 from the level at June 30, 2011. The decrease in liabilities of $3.3 million was primarily due to decreased advances from the FHLB and other borrowings of $5.0 million offset by increased advances by borrowers for taxes and insurance of $1.1 million. Stockholders' equity increased by $2.4 million since June 30, 2011, primarily due to increases in net income and partially offset by an increase in accumulated other comprehensive loss, and the payment of dividends.
The decrease in net loans and leases receivable, which excludes loans in process and deferred fees, was $138.0 million due to the decrease in net loan balances of $141.8 million and slightly offset by the decrease in the allowance for loan and lease losses of $3.7 million. Agricultural and commercial business loans decreased $95.5 million and $28.1 million, respectively, due primarily to proactive problem asset resolution, increased competitive pressure for long term financing and borrowers adapting to the current operating environment, including reducing their debt while waiting for better or less risky opportunities for their businesses. We believe this phenomenon may be starting to change back to a more normal situation as the economy recovers based upon recent activity, but we cannot precisely predict when or by how much our loan portfolio will start to grow due to existing customer demand.
In addition, loans held for sale increased $4.2 million, primarily due to increased mortgage financing activity and the amount of one-to four-family loans held at June 30, 2012.
See the Consolidated Statement of Cash Flows for a detailed analysis of the change in cash and cash equivalents.
Deposits remained relatively constant, but had an overall increase of $702,000, to $893.9 million at June 30, 2012. Deposits, excluding time certificates, increased by $88.6 million, or 16.8%, while time certificates decreased $87.9 million, or 24.1% due primarily to a consumer shift towards transactional deposit accounts as a result of the low interest rate environment. Deposit accounts, exclusive of public funds and out-of-market certificates of deposits, increased $18.3 million, or 2.7% since June 30, 2011. Advances from the FHLB and other borrowings decreased $5.0 million, to $142.4 million at June 30, 2012 as compared to June 30, 2011, due to slightly reduced funding needs.
Stockholders' equity increased $2.4 million at June 30, 2012 when compared to June 30, 2011. Increases in stockholders' equity was derived from net income of $5.2 million, stock issuances of $174,000, the amortization of stock-based compensation of $383,000, and partially offset by a net increase in accumulated other comprehensive loss of $204,000 and cash dividends of $3.1 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 subsidiaries of the Company. 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.
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(1)
Includes loan fees and interest on accruing loans and leases past due 90 days or more.
(2)
Includes federal funds sold and interest earning reserve balances at the Federal Reserve Bank.
(3)
Yields do not reflect the tax-exempt nature of loans, equipment leases and municipal securities.
(4)
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. See the following Non-GAAP Disclosure Reconciliation of Net Interest Income (GAAP) to Net Interest Margin, TE (Non-GAAP). 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 measure, 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.
The reconciliation of the Net Interest Income (GAAP) to Net Interest Margin, TE (non-GAAP) is as follows:
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 increases and decreases resulting from 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 previous rate) and (ii) changes in rate (i.e., changes in rate multiplied by previous 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.
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(1)
Includes loan fees and interest on accruing loans and leases past due 90 days or more.
(2)
Includes federal funds sold and interest earning reserve balances at the Federal Reserve Bank.
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.
Loans and Leases Receivable. Loans receivable are stated at unpaid principal balances and net of deferred loan origination fees, costs and discounts.
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.
For purposes of the disclosures required pursuant to the adoption of amendments to ASC 310 effective December 31, 2010, the loan portfolio was disaggregated into segments and then further disaggregated into classes for certain disclosures. A portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for credit losses. A class is generally determined based on the initial measurement attribute, risk characteristics of the loan, and an entity's method for monitoring and assessing credit risk. Residential and Consumer loan portfolio segments include classes of one-to- four family, construction, consumer direct, consumer home equity, consumer overdraft and reserves, and consumer indirect. Commercial, Commercial Real Estate and Agriculture loan portfolio segments include the classes of commercial business, equipment finance leases, commercial real estate, multi-family real estate, construction, agricultural business, and agricultural real estate.
Interest on loans is recognized on an accrual basis at the applicable interest rate on the principal amount outstanding. Loan origination fees and direct costs as well as premiums and discounts are amortized as level yield adjustments over the respective loan terms. Unamortized net fees or costs are recognized upon early repayment of the loans. Loan commitment fees are generally deferred and amortized on a straight-line basis over the commitment period.
Impaired loans are generally carried on a nonaccrual status 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. For all portfolio segments and classes accrued but uncollected, interest is reversed and charged against interest income when the loan is placed on nonaccrual status. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to recover the principal balance and accrued interest. Interest payments received on nonaccrual and impaired loans are normally applied to principal. Once all principal has been received, additional interest payments are recognized on a cash basis as interest income.
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, commercial real estate and agricultural loans by either the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent.
Loans that are reported as troubled debt restructurings ("TDRs") apply the identical criteria in the determination of whether the loan should be accruing or nonaccruing. Typically, the event of classifying the loan as a TDR due to a modification of terms is independent from the determination of accruing interest on a loan in accordance with accounting standards.
For all non-homogeneous loans (including TDRs) that have been placed on nonaccrual status, our policy for returning nonaccruing loans to accrual status requires the following criteria: six months of continued performance, timely payments, positive cash flow and an acceptable loan to value ratio. For homogeneous loans (including TDRs), typical in our residential and consumer portfolio, the policy requires six months of consecutive timely loan payments for returning nonaccrual loans to accruing status.
Allowance for Loan and Lease Losses. GAAP requires the Company to maintain an allowance for 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.
The allowance for loan and lease losses is maintained at a level that management determines is sufficient to absorb estimated probable incurred losses in the loan portfolio through a provision for loan losses charged to net income. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Management charges off loans, or portions of loans, in the period that such loans, or portions thereof, are deemed uncollectible. The collectibility of individual impaired loans is determined through an estimate of the fair value of the underlying collateral and/or an assessment of the financial condition and repayment capacity of the borrower. The allowances for loan and lease losses are comprised of both specific valuation allowances and general valuation allowances that are determined in accordance with authoritative accounting guidance. Additions are made to the allowance through periodic provisions charged to current operations and recovery of principal on loans previously charged off.
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.
Specific valuation allowances are established based on the Company's analyses of individual loans that are considered impaired. If a loan is deemed to be impaired, management measures the extent of the impairment and establishes a specific valuation allowance for that amount. The Company applies this classification to loans individually evaluated for impairment in the loan portfolio segments of commercial, commercial real estate and agricultural loans. Smaller balance homogeneous loans are evaluated for impairment on a collective rather than an individual basis. The Company measures impairment on an individual loan and the extent to which a specific valuation allowance is necessary by comparing the loan's outstanding balance to the fair value of the collateral, less the estimated cost to sell, if the loan is collateral dependent, or to the present value of expected cash flows, discounted at the loan's effective interest rate. A specific valuation allowance is established when the fair value of the collateral, net of estimated costs, or the present value of the expected cash flows is less than the recorded investment in the loan.
The Company also follows a process to assign general valuation allowances to loan portfolio segment categories. General valuation allowances are established by applying the Company's loan loss provisioning methodology, and reflect the estimated probable incurred losses in loans outstanding. The loan loss provisioning methodology considers various factors in determining the appropriate quantified risk factors to use in order to determine the general valuation allowances. The factors assessed begin with the historical loan loss experience for each of the loan portfolio segments. The Company's historical loan loss experience is then adjusted by considering qualitative or environmental factors that are likely to cause estimated credit losses associated with the existing portfolio to differ from historical loss experience, including, but not limited to, the following:
•
Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices;
•
Changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments;
•
Changes in the nature and volume of the portfolio and in the terms of loans;
•
Changes in the volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans;
•
Changes in the quality of the Company's loan review system;
•
Changes in the value of the underlying collateral for collateral-dependent loans;
•
The existence and effect of any concentrations of credit, and changes in the level of such concentrations;
•
Changes in the experience, ability, and depth of lending management and other relevant staff; and
•
The effect of other external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the existing portfolio.
By considering the factors discussed above, the Company determines quantified risk factors that are applied to each non-impaired loan or loan type in the loan portfolio to determine the general valuation allowances.
The time periods considered for historical loss experience are the last five years, the last three years and the last twelve months. The Company also evaluates the sufficiency of the overall allocations used for the loan loss allowances by considering the loss experience in the most recent twelve month period.
The process of establishing the loan loss allowances may also involve:
•
Periodic inspections of the loan collateral;
•
Regular meetings of executive management with the pertinent Board committee, during which observable trends in the local economy, commodity prices and/or the real estate market are discussed; and
•
Analysis of the portfolio in the aggregate, as well as on an individual loan basis, taking into consideration payment history, underwriting analyses, and internal risk ratings.
In order to determine the overall adequacy, each loan portfolio segment's respective loan loss allowance is reviewed quarterly by management and by the Audit Committee of the Company's Board of Directors, as applicable.
Future adjustments to the allowance for loan and lease losses and methodology may be necessary if economic or other conditions differ substantially from the assumptions used in making the estimates or, if required by regulators, based upon information at the time of their examinations. Such adjustments to estimates are made in the period in which these factors and other relevant considerations indicate that loss levels vary from previous estimates.
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 income 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 from the South Dakota Housing Development Authority's first-time homebuyer's program. Due to the lack of quoted markets for the Company's servicing portfolio, the Company estimates the fair value of the MSRs using a present value of future cash flow analysis. If the fair value 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 net income by initiating a MSR valuation account. If the Company determines this impairment is temporary, any future changes in impairment are recorded as a change in net income and the valuation account. 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 net income is when the underlying mortgages are paid off 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 analysis of MSRs, an impairment valuation of $888,000 for temporary impairment was recorded during fiscal 2012.
Security Impairment. 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 net income 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 net income, 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. At June 30, 2012, the Company does not have other-than-temporarily impaired debt securities for which credit losses exist.
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 the risks involved with a self-insurance health plan, the Company has a stop-loss insurance policy through a commercial insurance carrier for coverage in excess of $75,000 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 income 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. Where appropriate, Bank personnel review 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 $19.4 million during the year to $17.8 million at June 30, 2012. The ratio of nonperforming assets to total assets, which is one indicator of credit risk exposure, decreased to 1.49% at June 30, 2012, from 3.12% at June 30, 2011.
Nonaccruing loans and leases decreased to $16.1 million at June 30, 2012 compared to $30.8 million at June 30, 2011. Included in nonaccruing loans and leases at June 30, 2012 were five loans totaling $31,000 secured by one- to four-family real estate, six commercial business loans totaling $1.8 million, one equipment finance lease totaling $17,000, 10 commercial real estate loans totaling $1.3 million, 14 agricultural real estate loans totaling $11.2 million, nine agricultural business loans totaling $1.2 million, and 17 consumer loans totaling $574,000.
Accruing loans and leases delinquent more than 90 days decreased $5.5 million, to $107,000 at June 30, 2012 compared to $5.6 million at June 30, 2011. Included in accruing loans and leases delinquent more than 90 days at June 30, 2012 was one loan for $107,000 secured by one-to four-family real estate. For the accruing loan which is greater than 90 days past due, the one-to four- family collateralized loan has a weighted average loan to value ratio of 95.2% at June 30, 2012. This loan remains in accruing status due to the government guarantee on the loan.
The Company's nonperforming loans and leases, which represent nonaccrual loans and leases past due 90 days and still accruing, have decreased $20.3 million from the levels at June 30, 2011. Approximately two-thirds of the nonperforming loans at June 30, 2012 and 2011 related to dairy loans within the agricultural sector. 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, 2012, the Company had $1.6 million of foreclosed assets. The balance of foreclosed assets consisted of $1.5 million in single-family residences, $109,000 in agricultural real estate collateral, and $3,000 in consumer collateral.
At June 30, 2012, the Company had designated $42.9 million of its loans as classified, which management has determined need to be closely monitored because of possible credit problems of the borrowers or the cash flows of the secured properties. At June 30, 2012, the Company had $7.5 million in one- to four-family, multi- family, commercial real estate, and commercial business loans purchased, of which none of the amounts were classified at June 30, 2012. 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, 2012, 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, 2012 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.
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(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.
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)
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 $10.6 million at June 30, 2012, as compared to $14.3 million at June 30, 2011. This decrease is primarily attributable to the specific valuation allowance decrease of $4.5 million, of which $4.2 million was related to the agricultural loan portfolio and an improvement in related nonperforming assets. The general valuation allowance increased $770,000 due in part to an increase in consumer loans based upon a review of historical loss and environmental factors.
The ratio of the allowance for loan and lease losses to total loans and leases was 1.55% at June 30, 2012, compared to 1.73% at June 30, 2011. 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. The Company periodically utilizes an external loan review to assist in the assessment of the appropriateness of risk ratings and of risks within the portfolio. 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.
Real estate properties acquired through foreclosure are initially recorded at 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.
At June 30, 2012, the Company also had an allowance for credit losses on off-balance sheet credit exposures of $79,000, as compared to $0 at June 30, 2011. This amount is maintained as a separate liability account to cover estimated potential credit losses associated with off-balance sheet credit instruments such as off-balance sheet loan commitments, standby letters of credit, and guarantees and is recorded in other liabilities in the Consolidated Statements of Financial Condition. Although management believes that it uses the best information available to determine the allowances, unforeseen market conditions could result in adjustments and net income being significantly affected if circumstances differ substantially from the assumptions used in making the final determinations. Future additions to the Company's allowances may 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, 2012 and June 30, 2011
General. The Company's net income was $5.2 million or $0.74 for basic and diluted earnings per common share for the year ended June 30, 2012, a $4.5 million increase in net income compared to $679,000 or $0.10 for basic and diluted earnings per common share, respectively, for the prior year. Fiscal 2012 resulted in a return on average equity (i.e., net income divided by average equity) of 5.41%, compared to 0.72% in fiscal 2011. For the year ended June 30, 2012, the return on average assets (i.e., net income divided by average assets) was 0.43% compared to 0.06% in the prior year. As discussed in more detail below, the increases were due to a variety of key factors, including a decrease in the provision for loan and lease losses of $6.8 million and an increase in noninterest income of $4.0 million, partially offset by a decrease in net interest income of $3.7 million and an increase in income taxes of $2.7 million.
Interest, Dividend and Loan Fee Income. Interest, dividend and loan fee income was $47.2 million for the year ended June 30, 2012, as compared to $54.4 million for the prior year, a decrease of $7.2 million or 13.2%. The average volume of total interest-earning assets decreased by 2.8%, resulting in a decrease of overall interest and dividends of $4.0 million, while the average yield on interest-earning assets decreased 52 basis points, resulting in a decrease to overall interest and dividend income of $3.2 million. The average volume of loans and leases receivable decreased from $867.3 million for the year ended June 30, 2011, to $772.3 million for the year ended June 30, 2012. The average yield on interest-earning assets was 4.25% for the year ended June 30, 2012, as compared to 4.77% for the prior year. For the year ended June 30, 2012, the average yield on loans and leases receivable was 5.47%, a decrease of 13 basis points from 5.60% in the prior year. The overall decrease in interest and dividend income was due primarily to the reduction in the volume of loans and an increase in lower yielding investments that generally reflected a lower interest rate environment compared to the prior year.
Interest Expense. Interest expense was $13.6 million for the year ended June 30, 2012, as compared to $17.1 million for the prior year, a decrease of $3.5 million or 20.6%. While $1.5 million of the decrease in interest expense was the result of a 1.5% decrease in the average volume of deposits, a $892,000 decrease in interest expense was the result of a decrease in average deposit rates of 29 basis points. The average rate on interest-bearing deposits was 0.94% for the year ended June 30, 2012, as compared to 1.23% for the prior year. A $1.2 million decrease in interest expense was the result of a 19.5% 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, 2012, decreased $3.7 million or 9.9%, to $33.6 million as compared to the prior fiscal year. The decrease in net interest income was due primarily to the decrease in the volume of average loan balances as compared to the decrease in the volume of average deposit balances.
Average rates received decreased greater than the average rates paid, which added to the declining net interest income when compared to the prior year. The Company's net interest margin on a fully taxable equivalent basis was 3.07% for the year ended June 30, 2012, as compared to 3.31% 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 by 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 $6.8 million or 79.5%, to $1.8 million for the year ended June 30, 2012, as compared to $8.6 million in the prior year. The decrease in the provision is due in part to the declining loan balances and the amount of overall net charge-offs recorded during the fiscal year. Net charge-offs increased from $3.9 million during fiscal 2011 to $5.5 million of net charge-offs during fiscal 2012 as management continued a proactive approach to resolving problem assets. Nonperforming assets decreased by $19.4 million to $17.8 million at June 30, 2012 when compared to June 30, 2011. The balances of nonperforming assets for June 30, 2012 and 2011 are primarily composed of various dairy credits within the agricultural sector.
The allowance for losses on loans and leases at June 30, 2012 was $10.6 million. The allowance decreased from the June 30, 2011 balance of $14.3 million. This decrease is primarily attributable to $5.5 million in net charge-offs made against the allowance in fiscal 2012, of which $4.0 million had been specifically reserved in the prior fiscal year.
The ratio of allowance for loan and lease losses to nonperforming loans and leases at June 30, 2012, was 65.29% compared to 39.23% at June 30, 2011. The allowance for loan and lease losses to total loans and leases at June 30, 2012, was 1.55% compared to 1.73% at June 30, 2011. The Bank's management believes that the June 30, 2012, 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 $12.9 million for the year ended June 30, 2012, as compared to $8.9 million for the year ended June 30, 2011, which represents an increase of $4.0 million or 45.3%. For fiscal 2012, the increase over the prior fiscal year was primarily due to an increase in the net gain on sale of securities of $5.1 million and a reduction in net impairment losses recognized in earnings of $549,000 when compared to the prior year. These increases were partially offset by decreases in net loan servicing income of $973,000 and the loss on disposal of closed-branch fixed assets of $473,000. The increases in noninterest income due to the net gain on sale of securities and reduced net impairment credit losses were primarily the direct effect of the holding and subsequent sale of pooled trust preferred investment securities in the previous year.
Net gain on the sale of securities totaled $1.5 million, an increase of $5.1 million for the year ended June 30, 2012, as compared to the prior fiscal year. The Company received $78.2 million for net gains of $1.5 million and $81.8 million for net gains of $2.7 million in fiscal 2012 and fiscal 2011, respectively, exclusive of the sale of pooled trust preferred securities. During the fourth quarter of fiscal 2011, the Company received proceeds of $2.5 million for the sale of pooled trust preferred securities for a loss of $6.3 million, which entirely liquidated the pooled trust preferred securities from the Company's portfolio.
There were no net impairment credit losses recognized in net income for the year ended June 30, 2012, as compared to $549,000 for the year ended June 30, 2011. In the prior year, the Company determined that a total of $399,000 of losses due to other-than-temporary impairments for pooled trust preferred securities were incurred of which an additional $150,000 was recognized in other comprehensive income. The net of $549,000 of credit losses were recognized as a reduction in other noninterest income.
Loan servicing income decreased by $973,000 to $603,000 for fiscal 2012 primarily due to a valuation allowance recorded of $888,000 and increased amortization expense of $70,000. The valuation allowance adjustment reduced the carrying value of the capitalized portfolio asset to the estimated fair value of the capitalized asset, as required by GAAP. Prepayment speeds on the portfolio continued to increase, which increased the amount of amortization expense from the prior year.
Losses on the disposal of closed-branch fixed assets were recorded in the amount of $473,000 during fiscal 2012. The Company closed a total of six branches and merged them into nearby branches to improve operating efficiencies. No branches were closed during the twelve months ended June 30, 2011.
Noninterest Expense. Noninterest expense was $37.1 million for the year ended June 30, 2012, as compared to $37.1 million for the year ended June 30, 2011, a decrease of $29,000, or 0.1%. Increases in professional fees and occupancy and equipment of $842,000 and $310,000, respectively, were offset by decreases in compensation and FDIC insurance of $1.3 million and $425,000, respectively.
Compensation and employee benefits were $20.5 million for the year ended June 30, 2012, a decrease of $1.3 million, or 6.2% when compared to the year ended June 30, 2011. Salaries and wages decreased $716,000 or 4.7% for fiscal 2012, when compared to fiscal 2011. This decrease was due primarily to a reduction of FTE's as compared to the prior fiscal year, but was partially offset by year-over-year salary increases for existing staff. Performance-based incentive pay decreased $644,000, or 51.0%, due to a decrease in employee performance outcomes in fiscal 2012 as compared to the prior fiscal year. Payroll taxes and recruiting expense decreased $56,000 and $61,000, respectively, while director compensation and travel, meal and entertainment expense increased $96,000 and $44,000, respectively. Payroll costs decreased as a function of the lower salary and wages expense and incentive pay. Recruiting costs decreased primarily due to the completion of the CEO search from the prior fiscal year. Director compensation increased due to a base retainer increase and additional fees paid for committee meetings. Travel, meals and entertainment increased due to reimbursement related to housing and travel for the interim CEO.
FDIC Insurance decreased by $425,000, to $1.0 million for the twelve months ended June 30, 2012 compared to the same period in the prior fiscal year. Effective in the fourth quarter of fiscal 2011, the FDIC insurance assessment was modified by the FDIC and effectively reduced the amount of assessments for each quarter thereafter.
Professional fees were $3.2 million for fiscal 2012, which is an increase of $842,000, or 35.7%, from fiscal 2011. This increase was due primarily to certain employment, regulatory and governance matters.
Occupancy and equipment was $4.9 million for the year ended June 30, 2012 compared to $4.6 million for the year ended June 30, 2011, an increase of $310,000 or 6.7%. Included in this increase is $550,000 of lease terminations which was incurred in the buyout of four leases during the process of closing branches. These one-time costs to terminate the leases will result in reduced lease costs of $160,000 in fiscal 2013.
Income tax expense. The Company's income tax expense for the year ended June 30, 2012 increased to an expense of $2.5 million compared to an income tax benefit of $231,000 for the prior fiscal year. The effective tax rates were 32.6% and (51.6)% for the years ended June 30, 2012 and 2011, respectively. The fiscal 2011 tax rate is a negative percentage due primarily to permanent tax deductions which exceed the income before income taxes.
Comparison of the Years Ended June 30, 2011 and June 30, 2010
General. The Company's net income available for common stockholders was $679,000 or $0.10 for basic and diluted earnings per common share for the year ended June 30, 2011, a $5.1 million decrease in net income compared to $5.7 million or $1.00 for basic and diluted earnings per common share, respectively, for the prior year. Fiscal 2011 resulted in a return on average equity (i.e., net income divided by average equity) of 0.72%, compared to 6.82% in fiscal 2010. For the year ended June 30, 2011, the return on average assets (i.e., net income divided by average assets) was 0.06% compared to 0.48% in the prior year. As discussed in more detail below, the decreases were due to a variety of key factors, including increases in the provision for losses on loans and leases of $5.7 million, decreases in noninterest income of $2.1 million and increases in noninterest expense of $1.1 million. These were partially offset by a decrease in income taxes of $3.2 million.
Interest, Dividend and Loan Fee Income. Interest, dividend and loan fee income was $54.4 million for the year ended June 30, 2011, as compared to $57.4 million for the prior year, a decrease of $2.9 million or 5.1%. Average yield on interest-earning assets decreased 7.4% which resulted in a decrease to overall interest and dividend income of $4.0 million. This decrease was partially offset by an increase in the average volume of total interest-earning assets of 2.5%, resulting in an increase of overall interest and dividends to increase by $1.0 million. The average yield on interest-earning assets was 4.77% for the year ended June 30, 2011, as compared to 5.15% for the prior year. The average volume of loans and leases receivable increased from $860.9 million for the year ended June 30, 2010, to $867.3 million for the year ended June 30, 2011. For the year ended June 30, 2011, the average yield on loans and leases receivable was 5.60%, a decrease of 2.9% from 5.77% in the prior year. The overall decrease 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 $17.1 million for the year ended June 30, 2011, as compared to $20.7 million for the prior year, a decrease of $3.6 million or 17.4%. $2.6 million of the decrease in interest expense was the result of a 25.8% decrease in the average rate paid on interest-bearing deposits, while a $938,000 decrease in interest expense was the result of a decrease in deposit volume. The average rate on interest-bearing deposits was 1.23% for the year ended June 30, 2011, as compared to 1.65% for the prior year. An $831,000 decrease in interest expense was the result of a 12.6% 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, 2011, increased $661,000 or 1.8%, to $37.3 million as compared to the prior fiscal year. The increase in net interest income was due primarily to an increase in the volume of average loan balances compared to the decrease in the volume of average deposit balances. Average rates received decreased greater than the average rates paid, which somewhat offset the increases due to volume. The Company's net interest margin on a fully taxable equivalent basis was 3.31% for the year ended June 30, 2011, as compared to 3.34% for the prior year.
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 $5.7 million or 192.1%, to $8.6 million for the year ended June 30, 2011, as compared to $3.0 million in the prior year. The increase in the provision was due in part to adding reserves for specific credits in the agricultural sector, which required an increase in the allowance resulting from our internal analysis and related procedural guidelines. Net charge-offs increased from $1.8 million during fiscal 2010 to $3.9 million of net charge-offs during fiscal 2011. Nonperforming assets increased $28.0 million at June 30, 2011 when compared to June 30, 2010, primarily due to various dairy credits within the agricultural sector.
The allowance for losses on loans and leases at June 30, 2011 was $14.3 million. The allowance increased from the June 30, 2010 balance of $9.6 million primarily as a result of specific credits in the agricultural sector. The ratio of allowance for loan and lease losses to nonperforming loans and leases at June 30, 2011, was 39.23% compared to 116.31% at June 30, 2010. The allowance for loan and lease losses to total loans and leases at June 30, 2011, was 1.73% compared to 1.10% at June 30, 2010. The Bank's management believes that the June 30, 2011, 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 $8.9 million for the year ended June 30, 2011, as compared to $11.0 million for the year ended June 30, 2010, which represents a decrease of $2.1 million or 19.4%. For fiscal 2011, the decrease was primarily due to a net loss on sale of securities of $3.6 million compared to a net gain on sale of securities recorded in fiscal 2010 of $1.9 million. Loan servicing income also decreased by $466,000, for the twelve months ended June 30, 2011 when compared to June 30, 2010, due to increased prepayment speeds experienced within the portfolio which increased the required amount of amortization expense associated with the portfolio. Net impairment credit losses recognized in net income decreased by $2.1 million, which increased noninterest income when compared to the prior fiscal year. Other increases to noninterest income when compared to the prior fiscal year were fees on deposits and net gain on the sale of loans for $530,000 and $1.0 million, respectively. The increase in fees on deposits was largely attributed to the increases in point of sale interchange ("POS") income on debit card transactions and customer service fee charges. The net gain on sale of loans increased due to the increased number of originated loans in the residential market attributed to the low consumer rates and the subsequent sale of these loans.
Loan servicing income decreased by $466,000 to $1.6 million for the fiscal year 2011 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 increased $530,000 to $6.2 million for the year ended June 30, 2011, as compared to the year ended June 30, 2010, due largely to an increase in POS and ATM fee income of $353,000, or 16.3% and through an increase in customer deposit service fee income of $134,000, or 26.3%.
Net impairment credit losses recognized in net income were $549,000 for the year ended June 30, 2011, as compared to $2.7 million for the year ended June 30, 2010. The Company determined that a total of $399,000 of losses due to other-than-temporary impairments for trust preferred securities were incurred of which an additional $150,000 was recognized in other comprehensive income. The net of $549,000 of credit losses were recognized as a reduction in other noninterest income for the year ended June 30, 2011, compared to $2.7 million in the prior year.
Net loss on the sale of securities totaled $3.6 million, a decrease of $5.5 million for the year ended June 30, 2011, as compared to the prior fiscal year gains. During the fourth quarter of fiscal 2011, the Company sold $8.8 million of pooled trust preferred securities for a loss of $6.3 million. The Company sold other investment securities during the year which accounted for net gains of $2.7 million and partially offset the net loss on the sale of the pooled trust preferred securities.
Noninterest Expense. Noninterest expense was $37.1 million for the year ended June 30, 2011, as compared to $36.0 million for the year ended June 30, 2010, an increase of $1.1 million, or 3.1%. The increase was attributed to increases in compensation and employee benefits and professional fees of $1.1 million and $558,000, respectively, while decreases in marketing and community development and goodwill impairment of $446,000 and $585,000, respectively, partially offset the increases.
Compensation and employee benefits were $21.8 million for the year ended June 30, 2011, an increase of $1.1 million, or 5.4% when compared to the year ended June 30, 2010. Salaries and wages increased $933,000 or 6.6% for fiscal 2011, when compared to fiscal 2010. This increase was due primarily to personnel additions due to expansion and year-over-year salary increases of existing staff. Performance-based incentive pay increased $208,000, or 19.7%, due to an increase in performance outcomes through the fiscal year 2011 as compared to the prior fiscal year. Payroll taxes, director compensation and recruiting expense increased $66,000, $72,000 and $58,000, respectively, while net healthcare costs decreased $165,000 for fiscal 2011 as compared to fiscal 2010. Payroll costs increased as a function of the higher salary and wages and incentive pay. Director compensation increased due to a base retainer increase, the addition of vice chair compensation, and additional fees paid for committee meetings. Recruiting costs increased primarily due to additional costs related to an on-going CEO search. Net healthcare costs decreased $165,000, or 7.7%, to $2.0 million due to a reduction of general overall utilization for the fiscal year 2011 compared to the prior fiscal year. On January 1, 2011, the Company modified its administration of the plan to submit the claims directly to the local hospital networks, which increased the discounts received on these claims since that time.
Professional fees were $2.4 million for fiscal 2011, which is an increase of $558,000, or 31.0%, from fiscal 2010. This increase was due in part to loan review and legal fees.
Marketing and community development was $1.3 million for the year ended June 30, 2011 compared to $1.7 million for the year ended June 30, 2010, a decrease of $446,000 or 26.0%. This decrease is primarily due to reduced costs related to the Bank's point of sale debit card reward program.
There was no goodwill impairment recorded for the year ended June 30, 2011 compared to an impairment expense of $585,000 recorded for the year ended June 30, 2010. The Company performs annual testing to determine if goodwill is impaired and at June 30, 2011, it was determined that no goodwill recorded at June 30, 2011 is impaired with respect to intangible assets in the amount of $4.4 million. During fiscal 2010, the goodwill associated with the acquisition of the leasing division was determined to be impaired and accordingly, the Company wrote-off the amount of goodwill associated with this acquisition in the amount of $585,000.
Income tax expense. The Company's income tax expense for the year ended June 30, 2011 decreased to a benefit of $231,000 compared to an expense of $3.0 million for the prior fiscal year. The effective tax rates were (51.56)% and 33.97% for the years ended June 30, 2011 and 2010, respectively. The fiscal 2011 tax rate is a negative percentage of income before income taxes due primarily to permanent tax differences.
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 provided by operating activities was $10.1 million for the fiscal year ended June 30, 2012. For the fiscal year ended June 30, 2011, net cash provided by operating activities was $33.5 million. For the fiscal year ended June 30, 2012, net cash used in investing activities was $9.2 million. Net cash provided by investing activities was $68.6 million for the fiscal year ended June 30, 2011. Net cash used in financing activities for the fiscal year ended June 30, 2012, was $6.2 million. This compares to net cash used in financing activities in the prior fiscal year of $67.3 million.
The Bank's primary sources of funds are net income, in-market deposits, FHLB advances and other borrowings, repayments of loan principal, agency 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, 2012, the Bank decreased its borrowings with the FHLB and other borrowings by $5.0 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, 2012, 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;
•
$20.0 million in an uncommitted, unsecured line of federal funds with Zions Bank;
•
$55.7 million of available credit from the Federal Reserve Bank; and
•
$262.0 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, Zions Bank and the Federal Reserve Bank at June 30, 2012. 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, 2012, the Bank had $12.4 million in out-of-market certificates of deposit.
The Bank anticipates that it will have sufficient funds available to meet current loan commitments. At June 30, 2012, the Bank had outstanding commitments to originate and purchase mortgage and commercial loans of $37.6 million and to sell mortgage loans of $16.2 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, 2012, the Bank had outstanding commitments to purchase $1.9 million of investment securities available for sale and no commitments to sell investment securities available for sale.
The Company has an available line of credit with United Bankers' Bank for liquidity needs of $4.0 million with no funds advanced at June 30, 2012. The Company has pledged 100% of Bank stock as collateral for this line of credit.
The Company uses its capital resources to pay dividends to its stockholders, to support organic growth, to make acquisitions, to service its debt obligations and to provide funding for investment into the Bank as Tier 1 (core) capital.
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, 2012, the Bank met all current capital requirements.
The OCC has adopted capital requirements for savings institutions comparable to the requirement for national banks. The minimum OCC core capital requirement for well-capitalized institutions is 5% of total adjusted assets. The Bank had Tier 1 (core) capital of 9.66% at June 30, 2012. The minimum OCC total risk-based capital requirement for well-capitalized institutions is 10% of risk-weighted assets. The Bank had total risk-based capital of 15.87% at June 30, 2012.
The Company has entered into interest rate swap contracts which are classified as cash flow hedge contracts or non-designated derivative contracts. At June 30, 2012, the total notional amount of interest rate swap contracts was $71.7 million with a fair value net loss of $4.5 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
In the normal course of business, the Company makes use of a number of different financial instruments to help meet the financial needs of its customers. In accordance with GAAP, the full notional amounts of these transactions are not recorded in the accompanying consolidated financial statements and are referred to as off-balance sheet instruments. These transactions and activities include commitments to extend lines of credit and standby letters of credit and are discussed further in Note 19 in the "Notes to Consolidated Financial Statements."
Off-balance sheet arrangements also include trust preferred securities, which have been de-consolidated in this report. Further information regarding trust preferred securities can be found in Note 8 in the "Notes to Consolidated Financial Statements."
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 2012. 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 May 2011, FASB issued ASU 2011-04 “Fair Value Measurement” (ASC Topic 820). This update results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRS. The amendments in this update explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. The amendments in this update are to be applied prospectively and are effective during interim and annual periods beginning after December 15, 2011. The Company has adopted this update at January 1, 2012 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In June 2011, FASB issued ASU 2011-05 "Comprehensive Income" (ASC Topic 220). This update requires the presentation of comprehensive income in financial statements. An entity has the option to present the total comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 and early adoption is permitted. The Company anticipates to adopt this update in the first quarter of fiscal 2013 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 September 2011, FASB issued ASU 2011-08 “Intangibles - Goodwill and Other” (ASC Topic 350). The objective of this update is to simplify how entities test goodwill for impairment. This update adds a qualitative analysis to step one of the two-step process, which enables the Company to qualitatively determine if it is more likely than not that goodwill impairment exists, and if not, skip step two in determination of the amount of goodwill impairment. The Company adopted this update effective in the fourth quarter of fiscal 2012 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In December 2011, FASB issued ASU 2011-11 “Balance Sheet” (ASC Topic 210), disclosures about offsetting assets and liabilities. This update affects all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement. The requirements amend the disclosure requirements on offsetting in Section 210-20-50. The guidance is effective for annual periods beginning January 1, 2013 and the interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Company anticipates to adopt this update in the first quarter of fiscal 2014 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 December 2011, FASB issued ASU 2011-12 “Comprehensive Income” (ASC Topic 220). This update modifies the effective date pertaining to reclassification adjustments out of accumulated other comprehensive income in Accounting Standards Update 2011-05. All other requirements in Update 2011-05 are not affected by this update, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial
statements. The guidance is effective for fiscal years, and the interim periods within those years, beginning December 15, 2011 and early adoption is permitted. The Company anticipates adopting this update in the first quarter of fiscal 2013 and 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, 2012 and June 30, 2011, 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, 2012 and June 30, 2011.
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, 2012. Operating lease obligations are primarily related to the lease of certain branch offices, which the Company has committed to as of June 30, 2012.
Subsequent Event
Management has evaluated subsequent events for potential disclosure or recognition through September 17, 2012, the date of the filing of the consolidated financial statements with the Securities and Exchange Commission.
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 extent 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 objectives in the most prudent, 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. The Bank has entered into interest rate swap contracts to convert variable-rate deposits into a fixed rate instrument. In addition, the Bank has
entered into back-to-back customer interest rate swap contracts to provide a facility to mitigate the fluctuations in the variable rate on the respective loans. 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 agency 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, 2012, the Company had investment securities available for sale of $10.6 million with contractual maturities of five years or less. Adjustable-rate agency residential mortgage-backed securities totaled $339.3 million at June 30, 2012. Agency 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 $137.5 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. Management believes 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, 2012, the Company had $121.1 million of savings accounts, $210.3 million of money market accounts and $285.0 million of checking accounts, representing 69.0% of the Bank's 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 President and Chief Executive Officer and its Senior 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, 2012 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, 2012.
Pursuant to a permanent exemption granted under the Dodd-Frank Act for smaller reporting companies, the Company is not required to include an attestation report from the Company's public accounting firm with respect to management's assessment of the effectiveness of the Company's internal control over financial reporting.
/s/ STEPHEN M. BIANCHI
/s/ BRENT R. OLTHOFF
Stephen M. Bianchi
President and
Chief Executive Officer
Brent R. Olthoff
Senior Vice President,
Chief Financial Officer and Treasurer
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON THE FINANCIAL STATEMENTS
INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM'S REPORT ON THE INTERNAL CONTROLS OVER FINANCIAL REPORTING
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, 2012 and 2011, 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, 2012. 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, 2012 and 2011, and the results of its operations and its cash flows for each of the years in the three-year period ended June 30, 2012, in conformity with accounting principles generally accepted in the United States of America.
As discussed in Note 24, the Company adopted the provisions of Accounting Standards Codification 350, Intangibles - Goodwill and Other, which provide for the application of qualitative assessment of goodwill for impairment considerations.
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, 2012, 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 17, 2012 expressed an unqualified opinion.
Sioux Falls, South Dakota
September 17, 2012
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors and Stockholders
HF Financial Corp.
Sioux Falls, South Dakota
We have audited management's assertion, included in the accompanying Management Report, that HF Financial Corp. maintained effective internal control over financial reporting, including controls over the preparation of regulatory financial statements in accordance with the instructions for the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C), as of June 30, 2012, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). HF Financial Corp.'s management is responsible for maintaining effective internal control over financial reporting, and for its assertion of the effectiveness of internal control over financial reporting, included in the accompanying Management Report. Our responsibility is to express an opinion on management's assertion based on our audit.
We conducted our audit in accordance with attestation standards established by the American Institute of Certified Public Accountants. Those standards require that we plan and perform the examination to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk. Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
An entity's internal control over financial reporting is a process effected by those charged with governance, management, and other personnel, designed to provide reasonable assurance regarding the preparation of reliable financial statements in accordance with accounting principles generally accepted in the United States of America. Because management's assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), our examination of HF Financial Corp.'s internal control over financial reporting included controls over the preparation of the financial statements in accordance with accounting principles generally accepted in the United States of America and with the instruction to the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C). An entity's internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the entity; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with accounting principles generally accepted in the United States of America, and that receipts and expenditures of the entity are being made only in accordance with authorizations of management and those charged with governance; and (3) provide reasonable assurance regarding prevention, or timely detection and correction of unauthorized acquisition, use, or disposition of the entity's assets that could have a material effect on the financial statements.
Because of its inherent limitations, internal control over financial reporting may not prevent, or detect and correct misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management's assertion that HF Financial Corp. maintained effective internal control over financial reporting, including controls over the preparation of regulatory financial statements in accordance with the instructions for regulatory reporting in conformity with the Consolidated Financial Statements for Bank Holding Companies (Form FR Y-9C), as of June 30, 2012 is fairly stated, in all material respects, based on criteria established in Internal Control - Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).
We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statement of financial condition of HF Financial Corp. as of June 30, 2012, and the related consolidated statements of income, stockholders' equity and cash flows for the year then ended and our report dated September 17, 2012, expressed an unqualified opinion on those financial statements.
Sioux Falls, South Dakota
September 17, 2012
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED JUNE 30, 2012, 2011 AND 2010
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
YEARS ENDED JUNE 30, 2012, 2011 AND 2010
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED JUNE 30, 2012, 2011 AND 2010
(DOLLARS IN THOUSANDS, except share data)
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
JUNE 30, 2012 AND 2011
(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 agency 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 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 17, 2012, 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, due from banks, federal funds sold 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.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
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. Sales of securities available for sale are recorded on a trade date basis.
Premiums and discounts on securities are amortized over the contractual lives of those securities, except for agency 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 and 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 net income 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 its 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 net income, 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. Currently, the Company does not have other-than-temporarily impaired debt securities for which credit losses exist.
Level 3 Fair Value Measurement
Generally Accepted Accounting Principles ("GAAP") requires the Company to measure the fair value of financial instruments under a standard which describes three levels of inputs that are 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 valuing 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.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
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.
Loans and Leases Receivable, Net
Loans receivable are stated at unpaid principal balances, less the allowance for loan losses, and net of deferred loan origination fees, costs and discounts.
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.
For purposes of the disclosures required pursuant to the adoption of amendments to ASC 310, the loan portfolio was disaggregated into segments and then further disaggregated into classes for certain disclosures. A portfolio segment is defined as the level at which an entity develops and documents a systematic method for determining its allowance for credit losses. A class is generally determined based on the initial measurement attribute, risk characteristics of the loan, and an entity's method for monitoring and assessing credit risk. Residential and Consumer loan portfolio segments include classes of one-to- four family, construction, consumer direct, consumer home equity, consumer overdraft and reserves, and consumer indirect. Commercial, Commercial Real Estate and Agriculture loan portfolio segments include the classes of commercial business, equipment finance leases, commercial real estate, multi-family real estate, construction, agricultural business, and agricultural real estate.
Interest on loans is recognized on an accrual basis at the applicable interest rate on the principal amount outstanding. Loan origination fees and direct costs as well as premiums and discounts are amortized as level yield adjustments over the respective loan terms. Unamortized net fees or costs are recognized upon early repayment of the loans. Loan commitment fees are generally deferred and amortized on a straight-line basis over the commitment period.
Impaired loans are generally carried on a nonaccrual status 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. For all portfolio segments and classes accrued but uncollected, interest is reversed and charged against interest income when the loan is placed on nonaccrual status. Management may elect to continue the accrual of interest when the estimated net realizable value of collateral is sufficient to recover the principal balance and accrued interest. Interest payments received on nonaccrual and impaired loans are normally applied to principal. Once all principal has been received, additional interest payments are recognized on a cash basis as interest income.
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, commercial real estate and agricultural loans by either the present value of expected future cash flows discounted at the loan's effective interest rate or the fair value of the collateral if the loan is collateral dependent.
As part of the Company's ongoing risk management practices, management attempts to work with borrowers when necessary to extend or modify loan terms to better align with their current ability to repay. Extensions and modifications to loans are made in accordance with internal policies and guidelines which conform to regulatory guidance. Each occurrence is unique to the borrower and is evaluated separately. In a situation where an economic concession has been granted to a borrower
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
that is experiencing financial difficulty, the Company identifies and reports that loan as a troubled debt restructuring ("TDR"). Management considers regulatory guidelines when restructuring loans to ensure that prudent lending practices are followed. As such, qualification criteria and payment terms consider the borrower's current and prospective ability to comply with the modified terms of the loan. Additionally, the Company structures loan modifications with the intent of strengthening repayment prospects.
The Company considers whether a borrower is experiencing financial difficulties, as well as whether a concession has been granted to a borrower determined to be troubled, when determining whether a modification meets the criteria of being a TDR under ASC 310-40. For such purposes, evidence which may indicate that a borrower is troubled includes, among other factors, the borrower's default on debt, the borrower's declaration of bankruptcy or preparation for the declaration of bankruptcy, the borrower's forecast that entity-specific cash flows will be insufficient to service the related debt, or the borrower's inability to obtain funds from sources other than existing creditors at an effective interest rate equal to the current market interest rate for similar debt for a non-troubled debtor. If a borrower is determined to be troubled based on such factors or similar evidence, a concession will be deemed to have been granted if a modification of the terms of the debt occurred that management would not otherwise consider. Such concessions may include, among other modifications, a reduction of the stated interest for the remaining original life of the debt, an extension of the maturity date at a stated interest rate lower than the current market rate for new debt with similar risk, a reduction of accrued interest, or a reduction of the face amount or maturity amount of the debt.
A modification of loan terms that management would generally not consider to be a TDR could be a temporary extension of maturity to allow a borrower to complete an asset sale whereby the proceeds of such transaction are to be paid to satisfy the outstanding debt. Additionally, a modification that extends the term of a loan, but does not involve reduction of principal or accrued interest, in which the interest rate is adjusted to reflect current market rates for similarly situated borrowers is not considered a TDR. Nevertheless, each assessment will take into account any modified terms and will be comprehensive to ensure appropriate impairment assessment.
Loans that are reported as TDRs apply the identical criteria in the determination of whether the loan should be accruing or nonaccruing. Typically, the event of classifying the loan as a TDR due to a modification of terms is independent from the determination of accruing interest on a loan in accordance with accounting standards.
For all non-homogeneous loans (including TDRs) that have been placed on nonaccrual status, our policy for returning nonaccruing loans to accrual status requires the following criteria: six months of continued performance, timely payments, positive cash flow and an acceptable loan to value ratio. For homogeneous loans (including TDRs), typical in our residential and consumer portfolio, the policy requires six months of consecutive timely loan payments for returning nonaccrual loans to accruing status.
The allowance for loan and lease losses is maintained at a level that management determines is sufficient to absorb estimated probable incurred losses in the loan portfolio through a provision for loan losses charged to net income. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. Management charges off loans, or portions of loans, in the period that such loans, or portions thereof, are deemed uncollectible. The collectability of individual loans is determined through an estimate of the fair value of the underlying collateral and/or an assessment of the financial condition and repayment capacity of the borrower. The allowances for loan and lease losses are comprised of both specific valuation allowances and general valuation allowances that are determined in accordance with authoritative accounting guidance. Additions are made to the allowance through periodic provisions charged to current operations and recovery of principal on loans previously charged off.
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.
Specific valuation allowances are established based on the Company's analysis of individual loans that are considered impaired. If a loan is deemed to be impaired, management measures the extent of the impairment and as required establishes a
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
specific valuation allowance for that amount. The Company applies this classification as necessary to loans individually evaluated for impairment in the loan portfolio segments of commercial, commercial real estate and agricultural loans. Smaller balance homogeneous loans are evaluated for impairment on a collective rather than an individual basis. The Company generally measures impairment on an individual loan and the extent to which a specific valuation allowance is necessary by comparing the loan's outstanding balance to either the fair value of the collateral, less the estimated cost to sell or the present value of expected cash flows, discounted at the loan's effective interest rate. A specific valuation allowance is established when the fair value of the collateral, net of estimated costs, or the present value of the expected cash flows is less than the recorded investment in the loan.
The Company also follows a process to assign general valuation allowances to loan portfolio segment categories. General valuation allowances are established by applying the Company's loan loss provisioning methodology, and reflect the estimated probable incurred losses in loans outstanding. The loan loss provisioning methodology considers various factors in determining the appropriate quantified risk factors to use in order to determine the general valuation allowances. The factors assessed begin with the historical loan loss experience for each of the loan portfolio segments. The Company's historical loan loss experience is then adjusted by considering qualitative or environmental factors that are likely to cause estimated credit losses associated with the existing portfolio to differ from historical loss experience, including, but not limited to, the following:
•
Changes in lending policies and procedures, including changes in underwriting standards and collection, charge-off, and recovery practices;
•
Changes in international, national, regional, and local economic and business conditions and developments that affect the collectability of the portfolio, including the condition of various market segments;
•
Changes in the nature and volume of the portfolio and in the terms of loans;
•
Changes in the volume and severity of past due loans, the volume of non-accrual loans, and the volume and severity of adversely classified or graded loans;
•
Changes in the quality of the Company's loan review system;
•
Changes in the value of the underlying collateral for collateral-dependent loans;
•
The existence and effect of any concentrations of credit, and changes in the level of such concentrations;
•
Changes in the experience, ability, and depth of lending management and other relevant staff; and
•
The effect of other external factors, such as competition and legal and regulatory requirements, on the level of estimated credit losses in the existing portfolio.
By considering the factors discussed above, the Company determines quantified risk factors that are applied to each non-impaired loan or loan type in the loan portfolio to determine the general valuation allowances.
The time periods considered for historical loss experience are the most recent five years, three years and twelve month periods. The Company also evaluates the sufficiency of the overall allocations used for the loan loss allowances by considering the loss experience in the most recent twelve month period.
The process of establishing the loan loss allowances may also involve:
•
Periodic inspections of the loan collateral;
•
Regular meetings of executive management with the pertinent Board committee, during which observable trends in the local economy, commodity prices and/or the real estate market are discussed;
•
Analysis of the portfolio in the aggregate, as well as on an individual loan basis, taking into consideration payment history, underwriting analyses, and internal risk ratings.
In order to determine their overall adequacy, each loan portfolio segment respective loan loss allowance is reviewed
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
quarterly by management and by the Audit Committee of the Company's Board of Directors, as applicable.
Future adjustments to the allowance for loan and lease losses and methodology may be necessary if economic or other conditions differ substantially from the assumptions used in making the estimates or, if required by regulators, based upon information at the time of their examinations. Such adjustments to original estimates, as necessary, are made in the period in which these factors and other relevant considerations indicate that loss levels vary from previous estimates.
Revenue Recognition
The Company derives a portion of its revenues from fee-based services. Noninterest income from transaction-based fees is generally recognized when the transactions are completed. Noninterest income from service-based fees is generally recognized over the period in which the service was provided.
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, 2012, $888 was determined to be impaired and a valuation allowance was recorded. As of June 30, 2011, there was no impairment to loan servicing rights purchased and retained servicing rights.
Servicing rights acquired for cash from other financial institutions are classified as an investing activity within the cash flow statement. Originated mortgage loans for sale where servicing rights are retained is included within the operating activity section of the cash flow statement as a non-cash activity adjustment.
Trust Services and Investment Management
Trust services and investment management fees include investment management, personal trust, employee benefits, and custodial trust services.
Commission and Insurance Income
Commission and insurance revenues are derived from the sales of financial and insurance products, including acting as an independent agent to provide life, long-term care, and disability insurance for individuals and hail and multi-peril crop insurance for agricultural customers.
Transfers of Financial Assets
Transfers of financial assets are accounted for as sales, when control over the assets has been surrendered. Control over transferred assets is deemed to be surrendered when (1) the assets have been isolated from the Company-put presumptively beyond the reach of the transferor and its creditors, even in bankruptcy or other receivership, (2) the transferee obtains the right (free of conditions that constrain it from taking advantage of that right) to pledge or exchange the transferred assets, and (3) the Company does not maintain effective control over the transferred assets through an agreement to repurchase them before their maturity or the ability to unilaterally cause the holder to return specific assets.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
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.
On an annual basis and at interim periods when circumstances require, the Company tests the recoverability of its goodwill. The Company has the option, when each test of recoverability is performed, to first assess qualitative factors to determine whether the existence of events or circumstances leads to a determination that it is more likely than not that the fair value of a reporting unit is less than its carrying amount. If the Company determines that it is more likely than not that the fair value of a reporting unit is greater than its carrying amount, then additional analysis is unnecessary. If the Company concludes otherwise, then a two-step impairment analysis, whereby the Company compares the carrying value of each identified reporting unit to its fair value, is required. The first step is to quantitatively determine if the carrying value of the reporting unit is greater than its fair value. If the Company determines that this is true, the second step is required, where the implied fair value of goodwill is compared to its carrying value.
In fiscal 2012, goodwill testing did not result in recording of an impaired amount. In fiscal 2010, it was determined that the goodwill associated with the acquisition of the leasing division was impaired, and the Company wrote-off the amount of goodwill associated with this acquisition of $585. As of June 30, 2012 and 2011, there was no impairment with respect to goodwill 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 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
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
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.
Marketing and Community Development
Marketing and community development costs are generally expensed as incurred and are included as noninterest expenses on the consolidated statements of income. Advertising costs, which are included within this total, were $926, $1,008, and $1,023 for the periods ended June 30, 2012, 2011 and 2010, respectively. Prepaid advertising costs at June 30, 2012 and 2011 totaled $41 and $35, respectively.
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. The non-vested shares of common stock issued to employees and directors are included in the outstanding shares of common stock in calculating basic and diluted EPS.
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 operating decisions, allocating resources, and monitoring performance, which is primarily based on products.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Stock-based Compensation
The Company uses the Black-Scholes option-pricing model and the modified prospective method in which compensation cost is recognized for all awards granted as well as for the unvested portion of awards outstanding. See Note 16 for more information on the Company's stock option and incentive plans.
Self-insurance
The Company has a self-insured health plan for its employees, subject to certain limits. 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 $75 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.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
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 income 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 2012, 2011 and 2010.
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 net income could be significant, as discussed below.
Derivative instruments are recorded on the Consolidated Statements of Financial Condition as Other assets or Accrued expenses or Other liabilities measured at fair value through adjustments to either accumulated other comprehensive income within stockholders' equity or within net income. Fair value is defined as the price that would be received to sell a derivative asset or paid to transfer a derivative liability in an orderly transaction between market participants on the transaction date. Fair value is determined using available market information and appropriate valuation methodologies.
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 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 net income. 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 net income.
Interest rate swaps utilized by the Company are typically accounted for as cash flow hedges, including hedging the interest rate risk in the cash flows of long-term, variable-rate instruments, including subordinated debentures. The Company also has utilized interest rate swaps to hedge the interest rate risk in the cash flows of variable-rate deposits, accounted for as a cash flow hedge. 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, are deferred and reported as a component of other comprehensive income ("OCI"). The differential to be paid or received on cash flow swap agreements is accrued as interest rates change and is recognized in interest expense.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
The Company also enters into interest rate swaps with loan customers to provide a facility to mitigate the fluctuations in the variable rate on the respective loans. These swaps are matched in exact offsetting terms to interest rate swaps that the Company enters into with an outside third party. The interest rate swaps are reported at fair value in other assets or accrued expenses and other liabilities. The Company's interest rate swaps qualify as derivatives, but are not designated as hedging instruments.
Further discussion of the Company's financial derivatives is set forth in Note 9 of the Consolidated Financial Statements.
Recent Accounting Pronouncements
In May 2011, FASB issued ASU 2011-04 “Fair Value Measurement” (ASC Topic 820). This update results in common fair value measurement and disclosure requirements in U.S. GAAP and IFRS. The amendments in this update explain how to measure fair value. They do not require additional fair value measurements and are not intended to establish valuation standards or affect valuation practices outside of financial reporting. The amendments in this update are to be applied prospectively and are effective during interim and annual periods beginning after December 15, 2011. The Company has adopted this update at January 1, 2012 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In June 2011, FASB issued ASU 2011-05 "Comprehensive Income" (ASC Topic 220). This updated requires the presentation of comprehensive income in financial statements. An entity has the option to present the total comprehensive income, the components of net income and the components of other comprehensive income either in a single continuous statement of comprehensive income or in two separate but consecutive statements. The guidance is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011 and early adoption is permitted. The Company anticipates to adopt this update in the first quarter of fiscal 2013 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 September 2011, FASB issued ASU 2011-08 “Intangibles - Goodwill and Other” (ASC Topic 350). The objective of this update is to simplify how entities test goodwill for impairment. This update adds a qualitative analysis to step one of the two-step process, which enables the Company to qualitatively determine if it is more likely than not that goodwill impairment exists, and if not, skip step two in determination of the amount of goodwill impairment. The Company adopted this update effective in the fourth quarter of fiscal 2012 and the adoption did not have a material effect on the Company's consolidated financial condition, results of operations or cash flow.
In December 2011, FASB issued ASU 2011-11 “Balance Sheet” (ASC Topic 210), disclosures about offsetting assets and liabilities. This update affects all entities that have financial instruments and derivative instruments that are either (1) offset in accordance with either Section 210-20-45 or Section 815-10-45 or (2) subject to an enforceable master netting arrangement or similar agreement. The requirements amend the disclosure requirements on offsetting in Section 210-20-50. The guidance is effective for annual periods beginning January 1, 2013 and the interim periods within those annual periods. An entity should provide the disclosures required by those amendments retrospectively for all comparative periods presented. The Company anticipates to adopt this update in the first quarter of fiscal 2014 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 December 2011, FASB issued ASU 2011-12 “Comprehensive Income” (ASC Topic 220). This update modifies the effective date pertaining to reclassification adjustments out of accumulated other comprehensive income in Accounting Standards Update 2011-05. All other requirements in Update 2011-05 are not affected by this update, including the requirement to report comprehensive income either in a single continuous financial statement or in two separate but consecutive financial statements. The guidance is effective for fiscal years, and the interim periods within those years, beginning December 15, 2011 and early adoption is permitted. The Company anticipates adopting this update in the first quarter of fiscal 2013 and 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 2012, FASB issued several ASUs: ASU No. 2011-08 through ASU No. 2011-12. Except for those ASUs mentioned above, the remaining 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, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 1 - SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (Continued)
Reclassification
Certain balances from June 30, 2011 and 2010 have been reclassified in the Notes to Consolidated Financial Statements to conform to the fiscal 2012 presentation.
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, 2012 AND 2011
(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.
The following tables present the fair value and age of gross unrealized losses by investment category:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 2-INVESTMENTS IN SECURITIES (Continued)
The unrealized losses reported for municipal bonds relate to eight 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, 2012, 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.
The unrealized losses reported for agency residential mortgage-backed securities relate to 40 securities issued by 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, 2012, 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.
During the fourth quarter of fiscal 2011, the Company sold the six pooled trust preferred securities which attributed to $5,355 of unrealized losses recorded at June 30, 2010. Rating downgrades regarding those investments had occurred placing each in a below investment grade rating in 2009. The securities had an amortized cost of $6,931 rated Ca and $1,271 rated C at March 31, 2011. The market for these securities remained inactive. The Company performed assessments of available information for each security during fiscal year 2011, 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 utilized the security's original discount margin at the time of purchase based upon the purchase price. The discount margin was then added to the appropriate 3-Month LIBOR spot rate obtained from the forward LIBOR curve used to project future principal and interest payments. For the fixed rate security, management utilized the security's effective interest rate. The difference between the present value of cash flows and the amortized cost basis was recorded as credit loss impairment and recognized in net income in the amount of $549 in fiscal year 2011. The amortized cost basis was reduced by the amount of credit loss. In May 2011, the Company received an unsolicited bid from a third party for all six pooled trust preferred securities. Management carefully examined the bid prices provided for the securities, and through further market research noticed recent additional transactional activity for these classes of securities demonstrating some strengthening in market prices, although remaining a relatively inactive market historically. Management was not required by any regulatory body to sell the securities. The Company subsequently sought additional bids from the marketplace in June 2011, which improved upon the initial unsolicited bid prices, and completed the sale transactions prior to quarter end. The sales produced an after-tax charge of $3,905 to net income. Because the Company had previously established valuation adjustments of $3,347 for
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 2-INVESTMENTS IN SECURITIES (Continued)
these securities on the balance sheet, the impact of the sale transactions to comprehensive income was minimal.
The following table presents the amounts recognized in the Consolidated Statements of Income for other-than-temporary impairments charge to net income:
_____________________________________
(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, 2012, 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 2012 were $78,188 and resulted in gross gains and gross losses of $1,491 and $1, respectively. Proceeds from the sale of securities available for sale in fiscal 2011 were $84,276 and resulted in gross gains and gross losses of $2,698 and $6,300, respectively. 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.
At June 30, 2012, and 2011, securities with a fair value of $369,694 and $229,025, respectively, were pledged as collateral for public deposits, borrowing and other purposes.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE
Loans and leases receivable by classes within portfolio segments at June 30, consist of the following:
_____________________________________
(1)
Includes $2,262 and $2,377 tax exempt leases at June 30, 2012 and 2011, respectively
(2)
Exclusive of undisbursed portion of loans in process of $21,700 and $15,600, at June 30, 2012 and 2011, respectively.
(3)
Net of deferred loan fees of $553 and $574, at June 30, 2012 and 2011, respectively.
Loans held for sale totaling $16,207 at June 30, 2012, consist of one-to-four family fixed-rate loans. Loans held for sale totaling $11,991 at June 30, 2011, consist of $11,083 of one-to-four family fixed-rate loans and $908 of student loans.
On June 30, 2012, $80,161 of commercial and agricultural operating loans were pledged to secure potential discount window borrowings from the Federal Reserve Bank. Additionally, $371,258 of one-to-four family, commercial and agricultural real estate loans were pledged to secure potential borrowings from the Federal Home Loan Bank. See Note 7,“Advances from Federal Home Loan Bank and Other Borrowings,” for information on the advance equivalents related to the loans pledged.
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 $1,666 and $2,417 at June 30, 2012, and 2011,
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
respectively. Activity in the allowance for loan losses included in continuing operations is summarized as follows for the fiscal years ended June 30:
The following tables summarize the activity in the allowance for loan and lease losses by portfolio segment for the fiscal years ended June 30:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
The following tables summarize the related statement balances by portfolio segment at June 30:
Credit Quality Indicators
The Company categorizes loans into risk categories based on relevant information about the ability of borrowers to service their debt such as: current financial information, historical payment experience, credit documentation, public information and current economic trends, among other factors. For loans other than residential and consumer, the Company analyzes loans individually, by classifying the loans as to credit risk. This analysis includes non-term loans, regardless of balance and term loans with an outstanding balance greater than $100. Each loan is reviewed annually, at a minimum. Specific events applicable to the loan may trigger an additional review prior to its scheduled review, if such event is determined to possibly modify the risk classification. The summary of the analysis for the portfolio is calculated on a monthly basis. The Company uses the following definitions for risk ratings:
Pass-Loans classified as pass represent loans that are evaluated and are performing under the stated terms. Pass rated assets are analyzed by the pay capacity, the current net worth, and the value of the loan collateral of the obligor.
Special Mention-Loans classified as special mention possess potential weaknesses that require management attention, but do not yet warrant adverse classification. While the status of a loan put on this list may not technically trigger their classification as Substandard or Doubtful, it is considered a proactive way to identify potential issues and address them before
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
the situation deteriorates further and does result in a loss for the Company.
Substandard-Loans classified as substandard are inadequately protected by the current net worth, paying capacity of the obligor, or by the collateral pledged. Substandard loans must have a well-defined weakness or weaknesses that jeopardize the repayment of the debt as originally contracted. They are characterized by the distinct possibility that the Company will sustain a loss if the deficiencies are not corrected.
Doubtful-Loans classified as doubtful have the weaknesses of those classified as substandard, with the added characteristic that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, highly questionable and improbable. Loans that fall into this class are deemed collateral dependent and an individual impairment analysis is performed on all relationships. Loans in this category are allocated a specific reserve if the estimated discounted cash flows from the loan (or collateral value less cost to sell for collateral dependent loans) does not support the outstanding loan balance or charged off if deemed uncollectible.
The following tables summarize the credit quality indicators used to determine the credit quality by class within the portfolio segments at June 30:
Credit risk profile by internally assigned grade-Commercial, Commercial real estate and Agricultural portfolio segments
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
Credit risk profile based on payment activity-Residential and Consumer portfolio segments
The following table summarizes the aging of the past due financing receivables by classes within the portfolio segments and related accruing and nonaccruing balances at June 30:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
_____________________________________
(1)
Loans accruing which are delinquent greater than 90 days have either government guarantees or acceptable loan-to-value ratios.
(2)
Net of deferred loan fees and discounts and exclusive of undisbursed portion of loans in process.
At June 30, 2012, the Bank had identified $16,666 of loans as impaired which includes performing troubled debt restructurings. A loan is identified as impaired when, based on current information and events, it is probable that the Bank will be unable to collect all amounts due according to the contractual terms of the loan agreement and thus are placed on non-accrual status. Interest income on impaired loans is recognized on a cash basis. The average carrying amount is calculated for each quarter by using the daily average balance, which is then averaged with the other quarters' averages to determine an annual average balance.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
The following table summarizes impaired loans by class of loans and the specific valuation allowance at June 30:
_____________________________________
(1)
Represents the borrower's loan obligation, gross of any previously charged-off amounts.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
The following table summarizes the Company's average recorded investment in impaired loans by class of loans and the related interest income recognized for the fiscal years ended June 30:
No additional funds are committed to be advanced in connection with impaired loans.
Modifications of terms for the Company's loans and their inclusion as troubled debt restructurings are based on individual facts and circumstances. Loan modifications that are included as troubled debt restructurings may involve reduction of the interest rate or renewing at an interest rate below current market rates, extension of the term of the loan and/or forgiveness of principal, regardless of the period of the modification.
Loans and leases that are considered troubled debt restructurings are factored into the determination of the allowance for loan and lease losses through impaired loan analysis and any subsequent allocation of specific valuation allowance, if applicable. The Company measures impairment on an individual loan and the extent to which a specific valuation allowance is necessary by comparing the loan's outstanding balance to either the fair value of the collateral, less the estimated cost to sell or the present value of expected cash flows, discounted at the loan's effective interest rate. During the 12-month period ended June 30, 2012, two commercial real estate and two agricultural real estate TDRs were evaluated for impairment based upon collateral value, while one commercial real estate and one agricultural real estate TDR were evaluated for impairment based upon the present value of discounted cash flows.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 3-LOANS AND LEASES RECEIVABLE (Continued)
The following is a summary of our performing troubled debt restructurings which are in-compliance with their modified terms at June 30:
_____________________________________
(1)
Includes eight customers, which are in compliance with their restructure terms, that are not accruing interest and have a recorded investment balance of $11,213.
Excluded from above, the Company currently has one agricultural relationship with a recorded balance of $117 at June 30, 2012, that was originally restructured in fiscal 2011 which is not in compliance with its restructured terms and is in nonaccrual status. At June 30, 2011, the Company had one commercial business loan with a recorded balance of $75, which was not in compliance with its restructured terms. It was in nonaccrual status at the time of the original restructuring in fiscal 2011. Loans can retain their accrual status at the time of their modification if the restructuring is not a result of terminated loan payments. For nonaccruing loans, a minimum of six months of performance related to the restructured terms are required before a loan is returned to accruing status.
During the year ended June 30, 2012, six borrower relationships were classified as new troubled debt restructures (TDR). Three agricultural loan relationships were added to the TDR loan classification due to loan maturity extensions that did not reduce interest rates below market rates, but revised payments and revised the maturity schedules. Three commercial real estate loan relationships were added to the TDR loan classification due to loan maturity extensions that did not reduce interest rates below market rates, but reduced payments and set a new maturity schedule. The TDRs initiated in fiscal 2012 had recorded balances of $3,064 and $442 related to agricultural and commercial real estate loans, respectively, at June 30, 2012.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
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.
_____________________________________
(1)
Changes to carrying amounts are reported net of loan servicing income on the statements of income for the periods presented.
Custodial balances maintained in connection with mortgage loan servicing, and included in advances by borrowers for taxes and insurance, were approximately $11,619 and $10,498, at June 30, 2012, and 2011, respectively.
The fair values of mortgage servicing rights were $11,932 and $15,396, at June 30, 2012, and 2011, 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% at June 30, 2012, and 2011, respectively. Prepayment speeds calculated at June 30, 2012 and June 30, 2011 were 16.1% and 10.3%, respectively, which are used in the calculation of the amortization expense for the subsequent quarter. Prepayment speeds are analyzed and adjusted each quarter.
NOTE 5-OFFICE PROPERTIES AND EQUIPMENT
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 5-OFFICE PROPERTIES AND EQUIPMENT (Continued)
The Company leases office equipment, which requires minimum rentals totaling $7 through May 2013. The Company incurred rent expense of $1,702, $1,140 and $973, for fiscal years 2012, 2011 and 2010, respectively. Fiscal 2012 rent expense included accelerated lease termination obligations of $550 due to branch closures. In addition, the Company has leased property under various operating lease agreements, which expire at various times.
The total rental commitments at June 30, 2012, under the leases are as follows:
NOTE 6-DEPOSITS
Deposits at June 30 consist of the following:
Scheduled maturities of certificates of deposit are as follows:
As a result of the Dodd-Frank Act, all deposit accounts are permanently insured up to $250 by the Deposit Insurance Fund (DIF) under management of the Federal Deposit Insurance Corporation (FDIC). Prior to enactment of the legislation in
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 6-DEPOSITS (Continued)
2010, only IRA deposit accounts were permanently insured up to $250 and the coverage of $250 for all other deposit accounts was temporary until December 2013. The aggregate amount of jumbo certificates of deposit with a minimum denomination of $100 was approximately $131,584 and $185,318 at June 30, 2012, and 2011, respectively. Deposits at June 30, 2012, and 2011 include $113,333 and $96,531, respectively, of deposits from one local governmental entity, the majority of which are savings account balances.
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 $952 and $952 at June 30, 2012, and 2011.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
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 are summarized as follows:
_____________________________________
(1)
The Company has an available line of credit with United Bankers' Bank for liquidity needs of $4,000 with no funds advanced at June 30, 2012. The Company has pledged 100% of bank stock as collateral for this line of credit.
(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, 2012, and 2011 were $294 and $295, respectively.
Aggregate maturities of advances from FHLB and other borrowings, computed based upon contractual maturity date, are as follows:
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 on a percentage of total assets as of the preceding December 31. At June 30, 2012, and 2011, the Bank held $1,469 and $1,469, respectively, in membership stock. The activity-based stock requirement is based on 4.45% of advances outstanding. At June 30, 2012, and 2011, the Bank held $6,323 and $6,596, 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
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 7-ADVANCES FROM FEDERAL HOME LOAN BANK AND OTHER BORROWINGS (Continued)
been pledged with the FHLB. At June 30, 2012, the Bank had total collateral with the FHLB of $407,416, of which $262,038 was available for additional borrowing. At June 30, 2011, the Bank had total collateral with the FHLB of $289,992, of which $142,892 was available for additional borrowing.
Advances with the Federal Reserve Bank are secured by commercial and agricultural business loans. At June 30, 2012, the Bank had total collateral with the Federal Reserve Bank of $55,705 of which $55,705 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 an outstanding balance at June 30, 2012 and 2011. The line was advanced upon during the past 12 months for contingent funding testing purposes.
The Bank currently has a $20,000 unsecured line of federal funds with Zions Bank, which did not have an outstanding balance at June 30, 2012 and 2011. The line was advanced upon during the past 12 months for contingent funding testing purposes.
The Company has a line of credit for $4,000 with United Bankers' Bank for liquidity needs, which was renewed on October 1, 2011. At June 30, 2012, there are no outstanding advances under this Loan Agreement and the note has a maturity of October 1, 2012. In connection with entering into the Loan Agreement, the Company also entered into a Commercial Pledge Agreement with the Lender, granting the Lender a first security interest in 100% of the stock of the Bank. The Loan Agreement contains customary events of default and affirmative covenants with which the Company and Bank were in compliance at June 30, 2012.
NOTE 8-SUBORDINATED DEBENTURES PAYABLE TO TRUSTS
The Company has issued and outstanding 27,000 shares totaling $27,000 of Company Obligated Mandatorily Redeemable Preferred Securities. These four Trusts were established and exist 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 assets of the four Trusts. The securities provide for cumulative cash distributions calculated at a rate based on three-month LIBOR plus a range from 1.65% to 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 the respective maturity date. At the end of the deferral period, all accumulated and unpaid distributions must be paid. The capital services have redemption dates ranging from January 7, 2033 to October 1, 2037; however, the Company has the option to shorten the respective maturity date for three of the four securities as the call option date has passed. The remaining security of $5,000 has a call option date of 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.
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 counterparties. The Company anticipates the counterparties will be able to fully satisfy its obligations under the remaining agreements. These contracts are typically designated as cash flow hedges.
The Company has outstanding interest rate swap agreements with notional amounts totaling $27,000 to convert four variable-rate trust preferred securities into fixed-rate instruments. The agreements have a weighted average maturity of 2.5 years and have fixed rates ranging from 5.68% to 6.91% with a weighted average rate of 6.12%. The fair value of the derivatives was an unrealized loss of $2,064 at June 30, 2012 and an unrealized loss of $1,810 at June 30, 2011. The Company also has two forward-starting interest rate swap agreements totaling $7,000, which will replace the existing swap agreements upon their expiration. The agreements have a weighted average effective date of 0.3 years, a weighted average maturity date, once effective, of 4.1 years, and have fixed rates ranging from 5.95% to 6.58% with a weighted average rate of 6.13%. The fair value of the derivatives was an unrealized loss of $922 at June 30, 2012 and an unrealized loss of $382 at June 30, 2011. The Company pledged $2,964 in cash under collateral arrangements as of June 30, 2012, to satisfy collateral requirements
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 9-INTEREST RATE CONTRACTS (Continued)
associated with these interest rate swap contracts.
The Company has outstanding five interest rate swap agreements with notional amounts totaling $35,000 to convert the variable-rate attributes of a pool of deposits into fixed-rate instruments. The agreements have a weighted average maturity of 1.9 years and have fixed rates ranging from 2.09% to 2.56% with a weighted average rate of 2.36%. The fair value of the agreements was an unrealized loss of $1,547 at June 30, 2012 and an unrealized loss of $1,654 at June 30, 2011. The Company pledged $2,479 in investment securities under collateral arrangements as of June 30, 2012, to satisfy collateral requirements associated with these interest rate swap contracts.
The Company has outstanding one borrower interest rate swap agreement with a notional amount totaling $1,342 to facilitate customer transactions and meet the borrower's financing needs. These swaps qualify as derivatives, but are not designated as hedging instruments. Interest rate swap contracts involve the risk of dealing with counterparties and their ability to meet contractual terms. When the fair value of a derivative instrument contract is positive, this generally indicates that the counterparty or customer owes the Company, and results in credit risk to the Company. When the fair value of a derivative instrument contract is negative, the Company owes the customer or counterparty and therefore, has no credit risk. The swap positions are offset to minimize the potential impact on the Company's financial statements. The fair value of these derivatives were an unrealized gain of $65 reported in other assets and an unrealized loss of $65 reported as accrued expenses and other liabilities at June 30, 2012. At June 30, 2011, the fair value of these derivatives were an unrealized gain of $31 reported in other assets and an unrealized loss of $31 reported as accrued expenses and other liabilities. The derivatives had no impact on the consolidated statements of income for the fiscal years ended June 30, 2012 and 2011. Any amounts due to the Company are expected to be collected from the borrower. Credit risk exists if the borrower's collateral or financial condition indicates that the underlying collateral or financial condition of the borrower makes it probable that amounts due will be uncollectible. Management monitors this credit exposure on a quarterly basis.
No gain or loss was recognized in net income for the fiscal years 2012 and 2011 related to interest rate swaps. No deferred net losses on interest rate swaps in other comprehensive loss as of June 30, 2012, are expected to be reclassified into net income during the next twelve months. See Note 17 "Accumulated Other Comprehensive Loss" for amounts reported as other comprehensive loss.
The following table summarizes the derivative financial instruments utilized as of June 30, 2012.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 9-INTEREST RATE CONTRACTS (Continued)
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, 2012.
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 2008. 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, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 10-INCOME TAX MATTERS (Continued)
The components of the net deferred tax asset as of June 30 are as follows:
Retained earnings at June 30, 2012 and 2011, 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, 2012 and 2011. The Company recognized no interest and penalties on the underpayment of income taxes during fiscal years June 30, 2012 and 2011, and had no accrued interest and penalties on the balance sheet as of June 30, 2012 and 2011. 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.
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, 2012, and 2011, that the Bank meets all capital adequacy requirements to which it is subject.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 11-REGULATORY CAPITAL (Continued)
As of June 30, 2012, the Bank met the regulatory criteria for being considered a "well capitalized" institution. 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 following 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:
NOTE 12-STOCKHOLDERS' EQUITY
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 U.S. Treasury Department's Capital Purchase Program 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 from 1996 to 2008, the Company purchased an aggregate of 2.08 million shares of its common stock.
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.
Federal regulations govern the permissibility of capital distributions by a federal savings association. Pursuant to the Dodd-Frank Act, savings associations that are part of a savings and loan holding company structure must now file a notice of a declaration of a dividend with the Federal Reserve. In the case of cash dividends, OCC regulations require that federal savings associations that are subsidiaries of a stock savings and loan holding company must file an informational copy of that notice with the OCC at the same time it is filed with the Federal Reserve. OCC regulations further set forth the circumstances under which a federal savings association is required to submit an application or notice before it may make a capital distribution.
A federal savings association proposing to make a capital distribution is required to submit an application to the OCC if: (1) the association does not qualify for expedited treatment pursuant to criteria set forth in OCC regulations; (2) the total amount of all of the association's capital distributions (including the proposed capital distribution) for the applicable calendar year exceeds the association's net income for that year to date plus the association's retained net income for the preceding two years; (3) the association would not be at least adequately capitalized following the distribution; or (4) the proposed capital distribution would violate a prohibition contained in any applicable statute, regulation, or agreement between the association and the OCC or violate a condition imposed on the association in an application or notice approved by the OCC.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 12-STOCKHOLDERS' EQUITY (Continued)
A federal savings association proposing to make a capital distribution is required to submit a prior notice to the OCC if: (1) the association would not be well capitalized following the distribution; (2) the proposed capital distribution would reduce the amount of or retire any part of the association's common or preferred stock or retire any part of debt instruments such as notes or debentures included in the association's capital (other than regular payments required under a debt instrument); or (3) the association is a subsidiary of a savings and loan holding company and is not required to file a notice regarding the proposed distribution with the Federal Reserve, in which case only an informational copy of the notice filed with the Federal Reserve needs to be simultaneously provided to the OCC.
Each of the Federal Reserve and OCC have primary reviewing responsibility for the applications or notices required to be submitted to them by savings associations relating to a proposed distribution. The Federal Reserve may disapprove of a notice, and the OCC may disapprove of a notice or deny an application, if:
•
the savings association would be undercapitalized following the distribution;
•
the proposed distribution raises safety and soundness concerns; or
•
the proposed distribution violates a prohibition contained in any statute, regulation, enforcement action or agreement between the savings association (or its holding company, in the case of the Federal Reserve) and the entity's primary federal regulator, or a condition imposed on the savings association (or its holding company, in the case of the Federal Reserve) in an application or notice approved by the entity's primary federal regulator.
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 for fiscal 2010 were based on a diluted weighted average shares outstanding of 5.77 million shares compared to 7.00 million shares and 6.97 million shares in the comparable periods in fiscal 2012 and fiscal 2011, respectively.
On July 30, 2012, the Board of Directors declared a $0.1125 per share dividend payable on August 17, 2012, to shareholders of record as of August 10, 2012. 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:
Options and SARs outstanding of approximately 154,100 shares of common stock at a weighted average share price of $14.07 during the fiscal year ended June 30, 2012, 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 and SARs outstanding of approximately 258,000 shares of common stock at a weighted average share price of $14.12 during the
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 13-EARNINGS PER SHARE (Continued)
fiscal year ended June 30, 2011, 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 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.
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. 100% vesting occurs after 3 years with a retirement age of the later of age 65 or 3 years of participation.
Information relative to the components of net periodic benefit cost measured at/or for the fiscal years ended June 30 for the Company's defined benefit plan is presented below.
_____________________________________
(1)
Amounts included in other liabilities and other assets on the Consolidated Statements of Financial Condition for June 30, 2012 and 2011, respectively,
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(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 $0.
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.
The Company's pension plan weighted-average asset allocations by asset category are as follows:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 14-DEFINED BENEFIT PLAN (Continued)
_____________________________________
(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%
The fair value of the Company's pension plan assets at June 30 by asset category are as follows:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 14-DEFINED BENEFIT PLAN (Continued)
The following methods and assumptions were used by the Company in estimating the fair value of its financial instruments:
Cash-The carrying amounts reported in the plan assets for cash approximate their fair values.
Securities-Fair values for investment securities are based on quoted market prices
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 14-DEFINED BENEFIT PLAN (Continued)
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 $400 to its pension plan in fiscal 2013. 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:
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 $319, $371 and $311 for 2012, 2011 and 2010, 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 provided for the grant of nonvested stock awards and for stock appreciation rights ("SARs") settled in stock under the 2002 Option Plan if the Company achieved certain performance levels. For fiscal 2009, the Company met a performance level in the plan and issued 16,232 shares of nonvested stock and 115,747 SARs under the 2002 Option Plan during fiscal 2010. 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 for fiscal 2010 and is being amortized over the vesting period of 4 years with the unamortized balance included in additional paid in capital in the consolidated statements of financial condition. No nonvested shares were issued in fiscal years 2012 and 2011. During fiscal years 2012, 2011 and 2010, $61, $153 and $331, respectively, were recorded as amortization expense. The issuance value of the fiscal 2010 SARs was $203 and is being amortized over the vesting period of 4 years. No SARs were issued in fiscal years 2012 and 2011. During fiscal years 2012, 2011 and 2010, $65, $104 and $77, 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 2013 as compensation for service during fiscal 2012 under the plan.
The 2002 Option Plan will expire by its terms on September 20, 2012, and no new awards may be made thereunder after such date.
During fiscal 2004, the Company created a pool of 12,100 nonvested shares for grants under the 2002 Option Plan (2002 Pool). In January, 2012, the Board of Directors authorized an additional 50,000 nonvested shares to be added to the pool under
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 16-STOCK-BASED COMPENSATION PLANS (Continued)
this plan. 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 2012, 2011 and 2010, 33,150, 6,847 and 2,204 nonvested shares, respectively, were awarded under the Pool. The issuance value of these nonvested shares was $405, $68 and $28, respectively, and is being amortized over their vesting periods with the unamortized balance included in additional paid in capital in the consolidated balance sheet. During fiscal years 2012, 2011 and 2010, $62, $39 and $40, respectively, were recorded as amortization expense. The nonvested shares of common stock issued to employees are included in the outstanding shares of common stock which is used in calculating earnings per share.
In association with the 2002 Option Plan, awards of nonvested shares of the Company's common stock have been 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 2012, 2011 and 2010, shares of nonvested stock awarded were 20,409, 18,777 and 19,626, respectively. The nonvested shares vest on the first anniversary of the date of grant. During fiscal years 2012, 2011 and 2010, amortization expenses recorded were $195, $186 and $141, respectively. The nonvested shares of common stock issued to outside directors are included in the outstanding shares of common stock which is used in calculating earnings per share.
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. There were no issuances in fiscal years 2012 and 2011, but the following assumptions were used for grants in fiscal year 2010:
Stock option activity for the fiscal year ended June 30, 2012, was as follows:
Stock appreciation rights activity for the fiscal year ended June 30, 2012, was as follows:
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 16-STOCK-BASED COMPENSATION PLANS (Continued)
The Company applied a forfeiture rate of 15.0% when calculating the amount of options and stock appreciation rights expected to vest at June 30, 2012. 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 year 2010 was $1.75. The total intrinsic value of options exercised during the fiscal years 2012, 2011 and 2010, was $35, $5 and $18, respectively. During fiscal years 2012, 2011 and 2010, $65, $104 and $77, respectively, were recorded as amortization expense. As of June 30, 2012, there was $54 of total unrecognized compensation cost related to nonvested SARs awards. The cost is expected to be recognized over a weighted-average period of 13 months for SARs awards. Cash received from the exercise of options and SARs for the fiscal years 2012, 2011 and 2010, was $175, $139 and $7, respectively. The tax benefit realized for the tax deductions from cashless option exercises totaled $0, $0 and $6 for the fiscal years 2012, 2011 and 2010, 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 2012, 2011 and 2010, was $123, $192 and $455, respectively. The tax benefit for the fiscal years 2012, 2011 and 2010 was $47, $73 and $173, respectively. As of June 30, 2012, there was $404 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 28 months. The total fair value of shares vested during the fiscal years 2012, 2011 and 2010 was $94, $529 and $675, 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 2012, 2011 and 2010, was $195, $186 and $141, respectively. The tax benefit for the fiscal years 2012, 2011 and 2010 was $74, $71 and $54, respectively. As of June 30, 2012, there was $131 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 7 months. The total fair value of shares vested during the fiscal years 2012, 2011 and 2010 was $207, $160 and $181, respectively.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(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 gain (loss) balances were:
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
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
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 correspondent bank stock 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. Many of the Company's off-statement-of-financial-condition instruments, primarily loan commitments and standby letters of credit, are expected to expire without being drawn upon; therefore, the commitment amounts do not necessarily represent future cash requirements.
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 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.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
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, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
Fair Value Measurement
The Company uses fair value measurements to record fair value adjustments to certain assets and liabilities and to determine fair value disclosures. The fair value of a financial instrument is the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date. Fair value is best determined based upon quoted market prices. However, in many instances, there are no quoted market prices for the Company's various financial instruments. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instrument.
Fair value accounting guidance provides a consistent definition of fair value, which focuses on exit price in an orderly transaction (that is, not a forced liquidation or distressed sale) between market participants at the measurement date under current market conditions. If there has been a significant decrease in the volume and level of activity for the asset or liability, a change in valuation technique or the use of multiple valuation techniques may be appropriate. In such instances, determining the price at which willing market participants would transact at the measurement date under current market conditions depends on the facts and circumstances and requires the use of significant judgment. The fair value a reasonable point within the range that is most representative of fair value under current market conditions.
The Company groups its financial assets and financial liabilities generally measured at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine 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, 2012 AND 2011
(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, 2012:
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 yield 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. Management reviews this third party analysis and has approved the values estimated for the fair values.
Interest rate swap contracts: The fair values of interest rate swap contracts relate to cash flow hedges of trust preferred debt securities issued by the Company, cash flow hedges of variable-rate deposits, and for specific borrower interest rate swap contracts classified as non-designated derivatives. 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. Management reviews this third party analysis and has approved the values estimated for the fair values.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(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, 2012:
The significant unobservable inputs used in the fair value measurement of impaired loans not dependent on collateral primarily relate to present value of cash flows. Cash flows are derived from scenarios which estimate the probability of default and factor in the amount of estimated principal loss. The resulting fair value is then compared to the carrying value of each credit and a specific valuation allowance is recorded when the carrying value exceeds the fair value.
The significant unobservable inputs used in the fair value measurement of collateral for collateral-dependent impaired loans primarily relate to customized discounting criteria applied to the customer's reported amount of collateral. The amount of the collateral discount depends upon the marketability of the underlying collateral. The Company's primary objective in the event of default would be to monetize the collateral to settle the outstanding balance of the loan, in which collateral with lesser marketability characteristics would receive a larger discount.
The Credit Administration department evaluates the valuations on impaired loans and other real estate owned monthly. The results of these valuations are reviewed at least quarterly by the internal Asset Classification Committee and are considered in the overall calculation of the allowance for loan and lease losses. Unobservable inputs are monitored and adjusted if market conditions change.
Servicing rights, net 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
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 18-FINANCIAL INSTRUMENTS (Continued)
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), not fair value measurement accounting, for its servicing rights assets. During the year, the estimated fair value was less than the amortized cost and a valuation allowance was recorded, which classifies servicing rights, net as a nonrecurring valuation.
Foreclosed real estate and other properties include those assets which have subsequent market adjustments after the original possession as a foreclosed asset. The estimated fair value is based on what the local markets are currently offering for assets with similar characteristics, less costs to sell, which the Company classifies as a Level 3 fair value measurement. Foreclosed assets which have market adjustments due to the modifications in values that are not reflected in the most recent appraisal or valuation, or have updated appraisals with valuation changes since its inclusion as a foreclosed asset are included as a nonrecurring valuation.
For Level 3 assets and liabilities measured at fair value on a recurring or nonrecurring basis as of June 30, 2012, the significant unobservable inputs used in the fair value measurements were as follows:
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 $158,588 and $133,231 at June 30, 2012, and 2011, respectively. Unused letters of credit amounted to $4,185 and $453 at June 30, 2012, and 2011, respectively. The lines of credit and letters of credit are collateralized in substantially the same manner as loans receivable.
The Bank had outstanding commitments to originate or purchase loans of $37,603 and to sell loans of approximately $16,207 at June 30, 2012. The portion of commitments to originate or purchase fixed rate loans totaled $37,075 with a range in interest rates of 3.75% to 6.00%. At June 30, 2012, the Bank had three outstanding commitments to purchase $1,924 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.
At June 30, 2012, the Bank had an allowance for credit losses on off-balance sheet credit exposures of $79,000, as compared to $0 at June 30, 2011. This amount is maintained as a separate liability account to cover estimated potential credit losses associated with off-balance sheet credit instruments such as off-balance sheet loan commitments, standby letters of credit, and guarantees.The Company is involved in various claims and legal actions arising in the ordinary course of business.
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 19-COMMITMENTS, CONTINGENCIES AND CREDIT RISK (Continued)
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:
NOTE 21-FINANCIAL INFORMATION OF HF FINANCIAL CORP. (PARENT ONLY)
The Company's condensed balance sheets as of June 30, 2012, and 2011 and related condensed statements of income and cash flows for each of the years in the three-year period ended June 30, 2012, are as follows:
Condensed Statements of Financial Condition
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(DOLLARS IN THOUSANDS, except share data)
NOTE 21-FINANCIAL INFORMATION OF HF FINANCIAL CORP. (PARENT ONLY) (Continued)
Condensed Statements of Income
Condensed Cash Flows
HF FINANCIAL CORP.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (Continued)
JUNE 30, 2012 AND 2011
(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. There are no subsequent events that occurred that require additional disclosure.
NOTE 24-CHANGE IN ACCOUNTING PRINCIPLE
In accordance with Financial Accounting Standards Board (FASB) Accounting Standards Update (ASU) 2011-08, Testing Goodwill for Impairment, an entity may elect to initially assess qualitative factors in determining whether it is more likely than not that goodwill may be impaired. The Company adopted the provisions of ASU 2011-08 during the year ended June 30, 2012.
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, 2012, an evaluation was performed by the Company's management, including the Company's President and Chief Executive Officer and the Company's Senior 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 President and Chief Executive Officer and the Company's Senior Vice President, Chief Financial Officer and Treasurer concluded that the Company's disclosure controls and procedures were effective as of June 30, 2012.
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, 2012, 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 2012 Annual Meeting of Stockholders, a copy of which will be filed not later than 120 days after June 30, 2012 (the "2012 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 2012 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 2012 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 2012 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 2012 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 2012 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 2012 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 2012 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 2012 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 2012 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:
(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 17, 2012
By:
/s/ STEPHEN M. BIANCHI
Stephen M. Bianchi,
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 Stephen M. Bianchi and Brent R. Olthoff, 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
EXHIBIT 31.1
CERTIFICATION
I, Stephen M. Bianchi, certify that:
1.
I have reviewed this Annual Report on Form 10-K of HF Financial Corp.;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;
(c)
Evaluated the effectiveness of the registrant`s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financing reporting; and
5.
The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date: September 17, 2012
/s/ Stephen M. Bianchi
Stephen M. Bianchi,
President and Chief Executive Officer
EXHIBIT 31.2
CERTIFICATION
I, Brent R. Olthoff, certify that:
1.
I have reviewed this Annual Report on Form 10-K of HF Financial Corp.;
2.
Based on my knowledge, this report does not contain any untrue statement of a material fact or omit to state a material fact necessary to make the statements made, in light of the circumstances under which such statements were made, not misleading with respect to the period covered by this report;
3.
Based on my knowledge, the financial statements, and other financial information included in this report, fairly present in all material respects the financial condition, results of operations and cash flows of the registrant as of, and for, the periods presented in this report;
4.
The registrant's other certifying officer(s) and I are responsible for establishing and maintaining disclosure controls and procedures (as defined in Exchange Act Rules 13a-15(e) and 15d-15(e)) and internal control over financial reporting (as defined in Exchange Act Rules 13a-15(f) and 15d-15(f)) for the registrant and have:
(a)
Designed such disclosure controls and procedures, or caused such disclosure controls and procedures to be designed under our supervision, to ensure that material information relating to the registrant, including its consolidated subsidiaries, is made known to us by others within those entities, particularly during the period in which this report is being prepared;
(b)
Designed such internal control over financial reporting, or caused such internal control over financial reporting to be designed under our supervision, 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;
(c)
Evaluated the effectiveness of the registrant`s disclosure controls and procedures and presented in this report our conclusions about the effectiveness of the disclosure controls and procedures, as of the end of the period covered by this report based on such evaluation; and
(d)
Disclosed in this report any change in the registrant's internal control over financial reporting that occurred during the registrant's most recent fiscal quarter (the registrant's fourth fiscal quarter in the case of an annual report) that has materially affected, or is reasonably likely to materially affect, the registrant's internal control over financing reporting; and
5.
The registrant's other certifying officer(s) and I have disclosed, based on our most recent evaluation of internal control over financial reporting, to the registrant's auditors and the audit committee of the registrant's board of directors (or persons performing the equivalent functions):
(a)
All significant deficiencies and material weaknesses in the design or operation of internal control over financial reporting which are reasonably likely to adversely affect the registrant's ability to record, process, summarize and report financial information; and
(b)
Any fraud, whether or not material, that involves management or other employees who have a significant role in the registrant's internal control over financial reporting.
Date: September 17, 2012
/s/ BRENT R. OLTHOFF
Brent R. Olthoff
Senior Vice President, Chief Financial Officer and Treasurer
EXHIBIT 32.1
CERTIFICATION PURSUANT TO
18 U.S.C. §1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report on Form 10-K of HF Financial Corp. (the “Company”) for the fiscal year ended June 30, 2012, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Stephen M. Bianchi, President and Chief Executive Officer of the Company, certify, pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1)
The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
*
A signed original of this written statement required by Section 906 has been provided to HF Financial Corp. and will be retained by HF Financial Corp. and furnished to the Securities and Exchange Commission or its staff upon request.
EXHIBIT 32.2
CERTIFICATION PURSUANT TO
18 U.S.C. §1350,
AS ADOPTED PURSUANT TO
SECTION 906 OF THE SARBANES-OXLEY ACT OF 2002
In connection with the Annual Report on Form 10-K of HF Financial Corp. (the “Company”) for the fiscal year ended June 30, 2012, as filed with the Securities and Exchange Commission on the date hereof (the “Report”), I, Brent R. Olthoff, Senior Vice President, Chief Financial Officer and Treasurer of the Company, certify, pursuant to 18 U.S.C. §1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002, that:
(1)
The Report fully complies with the requirements of Section 13(a) or 15(d) of the Securities Exchange Act of 1934; and
(2)
The information contained in the Report fairly presents, in all material respects, the financial condition and results of operations of the Company.
*
A signed original of this written statement required by Section 906 has been provided to HF Financial Corp. and will be retained by HF Financial Corp. and furnished to the Securities and Exchange Commission or its staff upon request.