ITEM 1. DESCRIPTION OF BUSINESS
GENERAL
H.F. Bancorp, Inc. (referred to herein on an unconsolidated basis as "HFB" and on a consolidated basis as the "Company") is a savings and loan holding company incorporated in the State of Delaware that was organized for the purpose of acquiring all of the capital stock of Hemet Federal Savings & Loan Association (the "Bank") upon its conversion from a federally chartered mutual savings association to a federally chartered stock savings association. On June 30, 1995, the Company completed its sale of 6,612,500 shares of common stock, and used approximately 50% of the $51.1 million in net proceeds to purchase all of the Bank's common stock issued in the Bank's conversion to stock form. Such business combination was accounted for at historical cost in a manner similar to a pooling of interests.
HFB's principal business is to serve as a holding company for the Bank and for other banking or banking related subsidiaries which the Company may establish or acquire. As a legal entity separate and distinct from its subsidiaries, HFB's principal source of funds is its existing capital and assets, and future dividends paid by and other funds advanced from its subsidiaries. Legal limitations are imposed on the amount of dividends that may be paid and loans that may be made by the Bank to HFB ( See "Item 1. Description of Business -- Supervision and Regulation"). HFB's common stock is listed on the Nasdaq National Market ("NASDAQ") under the symbol "HEMT".
At June 30, 1997, the Company had $984.7 million in total assets, $484.3 million in total net loans receivable, and $839.7 million in total deposits. The Company is subject to regulation by the Office Of Thrift Supervision ("OTS"), the Federal Deposit Insurance Corporation ("FDIC"), and the Securities and Exchange Commission ("SEC"). The principal executive offices of the Company and the Bank are located at 445 East Florida Avenue, Hemet, California, 92543, telephone number (909) 658 - 4411, toll free (800) 540-4363, facsimile number (909) 925 - 5398. The Bank is a member of the Federal Home Loan Bank of San Francisco ("FHLB") and its deposit accounts are insured by the FDIC through the Savings Association Insurance Fund ("SAIF") to the maximum extent permitted by law.
On September 27, 1996, the Bank consummated the acquisition of Palm Springs Savings Bank ("PSSB") by purchasing, for cash, their 1,131,446 shares of common stock for $16.3 million. The acquisition was accounted for under purchase accounting guidelines and therefore generated intangible assets (See "Item 7. Management's Discussion And Analysis Of Financial Condition And The Results Of Operations -- Intangible Assets").
On June 21, 1996, the Bank entered the Northern San Diego County market through the purchase of three branch offices and the assumption of deposit liabilities totaling $185.2 million from Hawthorne Savings Bank. In conjunction with the purchase, the Bank generated a core deposit
intangible of $6.6 million, or 3.6% of the deposits assumed. (See "Item 7. Management's Discussion And Analysis Of Financial Condition And The Results Of Operations -- Acquisitions").
The consolidated financial statements include the accounts of HF Bancorp, Inc., and its wholly owned subsidiary Hemet Federal Savings & Loan Association and its wholly owned subsidiaries, HF Financial Corporation, Coachella Valley Financial Services Corporation ("CVFSC"), PSSB Insurance Services, Inc. ("PSSBI") and HF Financial Corporation's subsidiary, First Hemet Corporation (collectively, the Company). CVFSC served as the trustee on deeds of trust held by Palm Springs Savings Bank. This service has been transferred to First Hemet Corporation. PSSBI was formed to offer life insurance and other investment products to customers of PSSB. In September of 1994, PSSBI discontinued marketing debt and equity securities, including mutual funds, to the general public and the PSSB customer base. HF Bancorp, Inc. and Hemet Federal are currently in the process of consolidating HF Financial Corporation, CVFSC, and PSSBI with and into First Hemet Corporation. First Hemet Corporation engages in trustee services for the Bank, conducts real estate development, and receives commissions from the sale of mortgage life insurance, fire insurance and annuities. All material intercompany transactions, profits, and balances have been eliminated.
The Company conducts business from nineteen branch offices and one centralized loan servicing center, located as follows:
Greater Hemet / San Jacinto Valley Area - ---------------------------------------- Hemet - Diamond Valley Hemet - Downtown (Main Office) Hemet - East Hemet - Sanderson (Loan Service Center) Hemet - West Idyllwild San Jacinto
Northern San Diego County Coachella Valley - ------------------------- ---------------- Oceanside Cathedral City Rancho Bernardo Desert Hot Springs Vista Palm Springs Rancho Mirage
Greater City of Riverside Area Southwestern Riverside County - ------------------------------ ----------------------------- Arlington Canyon Lake Canyon Crest Murrieta Tyler Mall Sun City
In addition, the Company supports its customers through 24 hour telephone banking and ATM access through an array of networks including STAR, CIRRUS, PLUS, and NOVUS.
Through its network of banking offices, the Bank emphasizes personalized service focused upon two primary markets: households and small businesses. The Bank offers a wide complement of lending products, including:
o a broad array of residential mortgage products, both fixed and adjustable rate
o consumer loans, including home equity lines of credit, auto loans, and personal lines of credit
o specialized financing programs to support community development
o mortgages for apartments
o commercial real estate loans
o construction lending
o commercial loans to businesses, including both revolving lines of credit and term loans
The Bank also provides an extensive selection of deposit instruments. These include:
o multiple checking products for both personal and business accounts
o various savings accounts, including those for minors
o tiered money markets accounts
o tax qualified deposit accounts (e.g. IRA's)
o a broad array of certificate of deposit products, with terms from 7 days to 7 years
The Bank also supports its customers by functioning as a federal tax depository, providing merchant bankcard services, and supplying various forms of electronic funds transfer. In addition, the Bank, through third party relationships, makes various non FDIC insured investment products available to its customers, including mutual funds and selected insurance related products.
The Company participates in the wholesale capital markets through the management of its security portfolio and its use of various forms of wholesale funding. The Company's security portfolio contains a variety of instruments, including callable debentures, fixed and adjustable rate mortgage backed securities, and collateralized mortgage obligations. The Company also participates in the secondary market for loans as both a purchaser and a seller of various types of mortgage products.
The Company's revenues are derived from interest on its loan and mortgage backed securities portfolios, interest and dividends on its investment securities, and its fee income associated with the provision of various customer services. The Company's primary sources of funds are deposits, principal and interest payments on its asset portfolios, and various sources of wholesale borrowings including FHLB advances and reverse repurchase agreements. The Company's most significant operating expenditures are its staffing expenses and the costs associated with maintaining its branch network.
Additional information concerning the Company's business is presented under Item 7. "Management's Discussion and Analysis of Financial Condition and Results of Operations", which is incorporated herein by reference.
MARKET AREA AND COMPETITION
The banking and financial services business in California generally, and in the Bank's market areas specifically, is highly competitive. The increasingly competitive environment is a result of:
o changes in regulation, technology, and product delivery systems, whereby the Bank must compete with both (i) in market entities and (ii) remote entities soliciting customers via electronic means
o the accelerating pace of consolidation among financial institutions and the continuing mergers among commercial and investment banks
o the growth of nonbank financial services providers
The Bank competes for loans, deposits, and customers for financial services with commercial banks, savings & loans, credit unions, thrift & loans, securities and brokerage companies, mortgage companies, insurance firms, finance companies, mutual funds, and other non bank service providers. Many of these competitors are much larger than the Bank in total assets, market reach, and capitalization; and enjoy greater access to capital markets and can offer a broader array of products and services than the Bank can legally furnish.
In order to compete with other financial services providers, the Bank relies upon local community involvement, personal service and the resulting personal relationships of its staff and customers, and specialized products and services tailored to meet its customers' needs.
WEAKNESS IN THE REGIONAL ECONOMY
Although recently improving, Southern California, including the Bank's market area, has, throughout much of the 1990's, experienced reduced employment and recessionary economic conditions as a result of the downsizing of the defense industry, a slowdown in construction, and corporate mergers and relocations. This economic backdrop led to a general weakening of real estate values, which in some of the Bank's market areas have yet to recover to pre-recessionary levels. The volume and quality of the Bank's loan portfolio has been impacted by these conditions. While the Bank has experienced a general improvement in its aggregate credit profile over the past several quarters, there can be no assurance that the Southern California economy and real estate market will not deteriorate; or that such deterioration, if it occurs, will not present an adverse impact on the Company's financial condition or results of operations.
EMPLOYEES
As of June 30, 1997, the Company had 201 full-time employees and 74 part-time employees. The employees are not represented by a collective bargaining unit. The Company considers its employee relations to be satisfactory.
EFFECT OF GOVERNMENTAL POLICIES
Banking is a business that depends, in large part, upon interest rate differentials. In general, the difference between the interest rates paid by the Bank on its deposits and other sources of funds and the interest rates received by the Bank on its loan and investment portfolios constitutes the major portion of the Bank's earnings. These interest rates are highly sensitive to many factors which are beyond the control of the Bank. Accordingly, the earnings and growth of the Bank and the Company are subject to the influence of domestic and foreign economic conditions, including inflation, recession, and unemployment.
The banking business is not only affected by general economic conditions, but is also significantly influenced by the monetary and fiscal policies of the federal government and the policies of regulatory agencies, including the Federal Reserve Board ("FRB"). The FRB implements national monetary policies (with objectives such as curbing inflation and avoiding recession) by its open market operations in United States Government securities, by changing the required level of reserves for applicable financial firms, and by adjusting the discount rate used for borrowings by depository institutions. The actions of the FRB in these areas influence the demand for loans and the interest rates associated with many of the Bank's products. The nature and impact of any future policy changes by the FRB cannot be predicted.
REGULATION AND SUPERVISION
General - -------
Financial institution holding companies and insured depository institutions are extensively regulated under both federal and state law. Set forth below is a summary description of certain laws and regulations which relate to the operation of the Company and its subsidiaries. The following description does not purport to be complete and is qualified in its entirety by reference to the applicable laws and regulations.
HFB, as a savings & loan holding company, is required to file certain reports with, and otherwise comply with the rules and regulations of, the OTS under the Home Owners' Loan Act, as amended (the "HOLA"). In addition, the activities of the Bank are governed by the HOLA and the Federal Deposit Insurance Act ("FDIA").
The Bank is subject to extensive regulation, examination, and supervision by the OTS, as its primary federal regulator, and the FDIC, as the insurer of customer deposits. The Bank must file reports with the OTS and the FDIC concerning its activities and financial condition. In addition, the
Bank must obtain various regulatory approvals prior to conducting certain types of business or entering into selected transactions; e.g. acquisitions of other financial institutions. The OTS and / or the FDIC conduct periodic examinations of the Bank's safety and soundness, its operations (including technology utilization), and its compliance with applicable laws and regulations, including the Community Reinvestment Act ("CRA"), the Real Estate Settlement Procedures Act ("RESPA"), and the Bank Secrecy Act ("BSA"). These examinations are primarily conducted for the protection of the SAIF, and are not intended to provide any assurance to investors in the Company's common stock.
The regulatory structure provides the supervisory authorities with extensive discretion across a wide range of the Company's operations, including, but not limited to:
o loss reserve adequacy
o capital requirements
o credit classification
o limitation or prohibition of dividends
o assessment levels for deposit insurance and examination costs
o permissible branching
Any change in regulatory requirements or policies, whether by the OTS, the FDIC, the FRB, or Congress, could have a material adverse impact on the Company.
Holding Company Regulation - --------------------------
HFB is a non diversified unitary savings & loan holding company within the meaning of the HOLA. As such, HFB will generally not be restricted under existing laws as to the types of business activities in which it may engage, provided that the Bank continues to be a qualified thrift lender ("QTL"). However, a number of potential laws are being debated in Congress which could significantly alter the business and regulatory environment in which HFB and its subsidiaries may operate (See "Item 1. Financial Institution Reform Legislation").
Upon any non supervisory acquisition by the Company of another savings institution or savings bank which that meets the QTL test and is deemed to be a savings institution by the OTS, the Company could then become a multiple savings & loan holding company (if the acquired institution is maintained as a separate subsidiary), and would then be subject to extensive limitations on the types of business activities in which it could engage. The HOLA limits the activities of a multiple savings & loan holding company and its non FDIC insured subsidiaries primarily to those activities permissible for bank holding companies under Section 4(c)(8)of the Bank Holding Company Act ("BHCA") and certain other activities authorized by OTS regulations.
The HOLA prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from:
1) acquiring more than 5% of the voting stock of another savings institution or holding company thereof, without prior written approval of the OTS;
2) acquiring or retaining, with certain exceptions, more than 5% of a non- subsidiary company engaged in activities other than those permitted by the HOLA;
3) acquiring or retaining control of a depository institution that is not insured by the FDIC.
In evaluating applications by holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources and future prospects of the company and the institution involved, the effect of the acquisition on the risk to the deposit insurance funds, the convenience and needs of the community, and competitive factors.
The OTS is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions:
(A) the approval of interstate supervisory acquisitions by savings & loan holding companies and
(B) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions. The states vary in the extent to which they permit interstate savings & loan holding company acquisitions.
Although savings & loan holding companies are not subject to specific capital requirements or specific restrictions on the payment of dividends or other capital distributions, HOLA does prescribe such restrictions on subsidiary savings institutions, as described below. The Bank must notify the OTS 30 days before declaring any dividend to the Company. In addition, the financial impact of a holding company on its subsidiary institution is a matter that is evaluated by the OTS in its examination of the safety and soundness of the insured depository institution. The OTS also has authority to order cessation of activities or divestiture of holding company subsidiaries deemed to pose a threat to the safety and soundness of the insured depository institution.
CAPITAL REQUIREMENTS AND CAPITAL CATEGORIES
FIRREA Capital Requirements. OTS capital regulations, as mandated by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA"), require savings institutions to meet three minimum capital standards (as defined by applicable regulations):
o a 1.5% tangible capital ratio
o a 3.0% leverage (core) capital ratio
o an 8.0% risk-based capital ratio
The capital standards applicable to savings institutions must be no less stringent than those for national banks. In addition, the prompt corrective action ("PCA") standards discussed below also establish, in effect, the following minimum standards:
o a 2.0% tangible capital ratio
o a 4.0% leverage (core) capital ratio (3.0% for institutions receiving the highest regulatory rating under the CAMELS rating system)
o a 4.0% Tier One risk based capital ratio
The OTS also has the authority, after giving the affected institution notice and an opportunity to respond, to establish specific minimum capital requirements for a single institution which are higher than the general industry minimum requirements presented above. The OTS can take this action upon a determination that a higher minimum capital requirement is appropriate in light of an institution's particular circumstances.
Tangible capital is composed of:
o common stockholders' equity (including retained earnings)
o certain noncumulative perpetual preferred stock and related earnings
o minority interests in equity accounts of consolidated subsidiaries
less: -----
o intangible assets other than certain asset servicing rights
o investments in and loans to subsidiaries engaged in activities as principal, not permissible for a national bank
o deferred tax assets as defined under Statement of Financial Accounting Standards ("SFAS") Number 109 - "Accounting for Income Taxes" in excess of certain thresholds
Core capital consists of tangible capital plus various adjustments for certain intangible assets. At June 30, 1997 and 1996, the Bank's tangible capital was equivalent to its core capital, as the Bank did not maintain any qualifying adjustments. In general, total assets calculated for regulatory capital purposes exclude those assets deducted from capital in determining the applicable capital ratio.
The risk based capital standard for savings institutions requires the maintenance of Tier One capital (core capital) and total capital (defined as core capital plus supplementary capital) to risk weighted assets of 4.0% and 8.0%, respectively. In determining the amount of an institution's risk weighted assets, all assets, including certain off balance sheet positions, are multiplied by a risk weight of 0.0% to 100.0%, as assigned by OTS regulations based upon the amount of risk perceived as inherent in each type of asset. The components of supplementary capital include:
o cumulative preferred stock
o long term perpetual preferred stock
o mandatory convertible securities
o certain subordinated debt
o intermediate preferred stock
o the general allowance for loan and lease losses, subject to a limit of 1.25% of risk weighted assets
Overall, the amount of supplementary capital included as part of total capital cannot exceed 100.0% of core capital.
As disclosed in the footnotes to the Company's audited consolidated financial statements, at June 30, 1997, the Bank exceeded all minimum regulatory capital requirements.
FDICIA PCA Regulations. The Federal Deposit Insurance Corporation Improvement Act of 1991 ("FDICIA") dictated that the OTS implement a system requiring regulatory sanctions against institutions that are not adequately capitalized, with the sanctions growing more severe the lower institution's capital. The OTS has established specific capital ratios under the PCA Regulations for five separate capital categories:
1. well capitalized 2. adequately capitalized 3. under capitalized 4. significantly under capitalized 5. critically undercapitalized
Under the OTS regulations implementing FDICIA, an insured depository institution will be classified in the following categories based, in part, on the following capital measures:
Well Capitalized - ---------------- Total risk based capital ratio of at least 10.0% Tier One risk based capital ratio of at least 6.0% Leverage ratio of at least 5.0%
Adequately Capitalized - ---------------------- Total risk based capital ratio of at least 8.0% Tier One risk based capital ratio of at least 4.0% Leverage ratio of at least 4.0%
Under Capitalized - ----------------- Total risk based capital ratio of less than 8.0% Tier One risk based capital ratio of less than 4.0% Leverage ratio of less than 4.0%
Significantly Under Capitalized - ------------------------------- Total risk based capital ratio of less than 6.0% Tier One risk based capital ratio of less than 3.0% Leverage ratio of less than 3.0%
Critically Under Capitalized - ---------------------------- Tangible capital of less than 2.0%
An institution that, based upon its capital levels, is classified in one of the top three categories may be regulated as though it were in the next lower capital category if the appropriate federal banking agency, after notice and an opportunity for hearing, determines that the operation or status of the institution warrants such treatment. There are numerous mandatory supervisory restrictions on the activities of under capitalized institutions. An institution that is under capitalized must submit a capital restoration plan to the OTS that the OTS may approve only if it determines that the plan is likely to succeed in restoring the institution's capital and will not appreciably increase the risks to which the institution is exposed. In addition, the institution's performance under the capital restoration plan must be guaranteed by every company that controls the institution. Under capitalized institutions may not acquire an interest in any company, open a new branch office, or engage in a new line of business without OTS or FDIC approval. An under capitalized institution is also limited in its ability to increase average assets, accept brokered deposits, pay management fees, set deposit rates, and make capital distributions. Additional restrictions apply to significantly and critically under capitalized institutions. In addition, the OTS maintains extensive discretionary sanctions which may be applied to under capitalized institutions, including the issuance of a capital directive and the replacement of senior executive officers and directors.
As disclosed in the footnotes to the Company's audited consolidated financial statements, at June 30, 1997, the Bank met the requirements to be classified as a "well capitalized" institution under PCA regulations.
SAFETY AND SOUNDNESS STANDARDS
In addition to the PCA provisions discussed above based on an institution's regulatory capital ratios, FDICIA contains several measures intended to promote early identification of management problems at depository institutions and to ensure that regulators intervene promptly to require corrective action by institutions with inadequate operational and managerial controls. The OTS has established minimum standards in this regard related to:
o internal controls, information systems, and internal audit systems
o loan documentation
o credit underwriting
o asset growth
o earnings
o compensation, fees, and benefits
If the OTS determines that an institution fails to meet any of these minimum standards, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. In the event the institution fails to submit an acceptable plan within the time allowed by the agency or fails in any material respect to implement an accepted plan, the agency must, by order, require the institution to correct the deficiency and may implement a series of supervisory sanctions.
Effective October 1, 1996, the federal banking agencies (including the OTS) promulgated safety and soundness regulations and accompanying interagency compliance guidelines on asset quality and earnings standards. These guidelines provide six standards for establishing and maintaining a system to identify problem assets and prevent those assets from deteriorating. The institution should:
1. conduct periodic asset quality reviews to identify problem assets
2. estimate the inherent losses in those assets and establish reserves that are sufficient to absorb estimated losses
3. compare problem asset totals to capital
4. take appropriate corrective action to resolve problem assets
5. consider the size and potential risks of material asset concentrations
6. provide periodic asset reports with adequate information for management and the board of directors to assess the level of asset risk
These guidelines also set forth standards for evaluating and monitoring earnings and for ensuring that earnings are sufficient for the maintenance of adequate capital and reserves. If the institution fails to comply with a safety and soundness standard, the appropriate federal banking agency may require the institution to submit a compliance plan. Failure to submit a compliance plan or to implement an accepted plan may result in enforcement action.
POTENTIAL ENFORCEMENT ACTIONS
The OTS has primary enforcement responsibility over savings institutions and maintains the authority to bring actions against the institution and all institution affiliated parties, as defined under the applicable regulations, for unsafe or unsound practices in conducting their businesses or for violations of any law, rule, regulation, condition imposed in writing by the agency, or any written agreement with the agency. Enforcement actions may include the imposition of a conservator or receiver, the issuance of a cease and desist order that can be judicially enforced, the termination of insurance of deposits (in the case of the Bank), the imposition of civil money penalties, the issuance of directives to increase capital, the issuance of formal and informal agreements, the issuance of removal or prohibition orders against institution affiliated parties, and the imposition of restrictions of sanctions under the PCA provisions of the FDICIA. Federal law also establishes criminal penalties for certain violations. Additionally, a holding company's inability to serve as a source of strength to its subsidiary financial institutions could serve as an ancillary basis for regulatory action against the holding company. Neither HFB, the Bank, or any subsidiaries thereof are currently subject to any enforcement actions.
PREMIUMS FOR DEPOSIT INSURANCE
Legislation was enacted on September 30, 1996 to address the disparity in bank and thrift deposit insurance premiums. This legislation imposed a requirement on all SAIF members, including the Bank, to fully recapitalize the SAIF by paying a one time special assessment of approximately 65.7 basis points on all assessable deposits as of March 31, 1995. This one time special assessment resulted in the Bank recording an additional $4.8 million in FDIC insurance expense during its quarter ended September 30, 1996.
The FDIC currently assesses its premiums based upon the insured institution's position on two factors:
1. the institution's capital category under PCA regulations
2. the institution's supervisory category as determined by the FDIC based upon supervisory information provided by the institution's primary federal regulator and other information deemed pertinent by the FDIC.
The supervisory categories are:
o Group A: financially sound with only a few minor weaknesses
o Group B: demonstrates weaknesses that could result in significant deterioration
o Group C: poses a substantial probability of loss
Annual SAIF assessment rates as of July 1, 1997 were as follows:
Assessment Rates Effective July 1, 1997 *
- --------------------- * Assessment figures are expressed in terms of cents per $100 of assessed deposits.
During the quarter ended June 30, 1997, the Bank was not assessed any SAIF insurance premiums under the above schedule.
In addition to the deposit insurance premiums presented in the above table, SAIF insured institutions must also pay FDIC premiums related to the servicing of Financing Corporation ("FICO") bonds which were issued to help fund the federal government costs associated with the savings & loan problems of the late 1980's. At July 1, 1997, the Bank's premium rate for the FICO related payments was 6.3 basis points of assessable deposits per annum.
The Budget Act passed by Congress prohibits the FDIC from setting premiums under the above risk based schedule above the amount needed to meet the designated reserve ratio (currently 1.25%). The latest statistics released by the FDIC indicate that both the SAIF and the Bank Insurance Fund ("BIF") maintain reserve ratios in excess of the designated ratio. Legislation is before Congress which might, among many other events, merge the SAIF and BIF, and thereby present a potential impact upon the Bank's deposit insurance premiums. The Company's management cannot predict what legislation will be approved, if any, and what the impact of such legislation might be upon the Company.
TRANSACTIONS WITH RELATED PARTIES
The Bank's authority to engage in transactions with related parties or "affiliates" (e.g. any company that controls or is under common control with an institution, including the Company and its non-savings institution subsidiaries) is limited by Sections 23A and 23B of the Federal Reserve Act ("FRA"). Section 23A limits the aggregate amount of covered transactions with any individual affiliate to 10% of the capital and surplus of the savings institution. The aggregate amount of covered transactions with all affiliates are required to be secured by collateral in an amount and of a type described in Section 23A and the purchase of low quality assets from affiliates is generally prohibited. Section 23B generally provides that certain transactions with affiliates, including loans and asset purchases, must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary.
The Bank's authority to extend credit to executive officers, directors, and 10% shareholders, as well as entities such persons control, is governed by Sections 22(g) and 22(h) of the FRA and Regulation O thereunder. Among other things, such loans are required to be made on terms substantially the same as those offered to unaffiliated individuals and to not involve more than the normal risk of repayment. Regulation O also places individual and aggregate limits on the types and amounts of loans the Bank may make to such persons based, in part, on the Bank's capital position, and requires certain board approval procedures to be followed.
COMMUNITY REINVESTMENT ACT
The Community Reinvestment Act ("CRA") requires each savings institution, as well as certain other lenders, to identify and delineate the communities served through and by the institution's offices and to affirmatively meet the credit needs of its delineated communities and to market the types of credit the institution is prepared to extend within such communities. The CRA also requires the OTS to assess the performance of the institution in meeting the credit needs of its communities and to take such assessment into consideration in reviewing applications for mergers, acquisitions, and other transactions. An unsatisfactory CRA rating may be the basis for denying such an application. Performance is assessed on the basis of an institution's actual lending, service, and investment performance rather than the extent to which the institution conducts needs assessments, documents community outreach, or complies with other procedural requirements. In connection with its assessment of CRA performance, the OTS assigns a rating of "outstanding," "satisfactory," "needs improvement" or "substantial noncompliance." Based on its most recent examination, the Bank received a "satisfactory" rating.
QUALIFIED THRIFT LENDER TEST
The qualified thrift lender ("QTL") test requires that, in at least nine out of every twelve months, at least 65% of a savings institution's "portfolio assets", as defined, must be invested in a limited list of qualified thrift investments, including residential mortgages and qualifying mortgage backed securities. Portfolio assets for the QTL test consist of tangible assets minus
o assets utilized to satisfy liquidity requirements (subject to certain limitations) o the value of property used by the institution to conduct its business
In 1996, the Economic Growth and Regulatory Paperwork Reduction Act ("EGRPRA") was adopted, amending the QTL test requirements to allow educational loans, small business loans, and credit card loans to count as qualified thrift assets without limit. The EGRPRA also amended the QTL requirements to allow loans for personal, family, or household purposes to count as qualified thrift assets in the reporting category limited to 20.0% of portfolio assets. Finally, EGRPRA provided that as an alternative to the QTL test, thrifts such as the Bank may choose to comply with the Internal Revenue Service's domestic building and loan tax code test.
A savings institution which fails the QTL test is subject to certain operating restrictions and may be required to convert to a bank charter. As of June 30, 1997, the Bank maintained 80.0% of its portfolio assets in qualified thrift investments and therefore met the QTL test.
LIMITATION ON CAPITAL DISTRIBUTIONS
OTS regulations impose limitations upon all capital distributions by savings institutions, such as cash dividends, payments to repurchase or otherwise acquire its shares, payments to shareholders of another institution in a cash-out merger and other distributions charged against capital. The regulators separate institutions into three tiers, which are based primarily on an institution's capital level. An institution that exceeds all fully phased-in capital requirements before and after a proposed capital distribution ("Tier 1 Association") and has not been advised by the OTS that it is in need of more than normal supervision, could after prior notice but without obtaining approval of the OTS, make capital distributions during a calendar year equal to the greater of (i) 100% of its net earnings to date during the calendar year plus the amount that would reduce by one-half its "surplus capital ratio" (the excess capital over its fully phased-in capital requirements) at the beginning of the calendar year or (ii) 75% of its net income for the previous four quarters. Any additional capital distributions would require prior regulatory approval. In the event the Bank's capital fell below its regulatory requirements or the OTS notified it that it was in need of more than normal supervision, the Bank's ability to make capital distributions could be restricted. In addition, the OTS could prohibit a proposed capital distribution by any institution, which would otherwise be permitted by the regulation, if the OTS determines that such distribution would constitute an unsafe or unsound practice. At June 30, 1997, the Bank was a Tier 1 Association.
LIQUIDITY
OTS regulations require savings institutions to maintain, for each calendar month, an average daily balance of liquid assets (including cash, certain time deposits, bankers' acceptances, specified United States government, state and federal agency obligations, and balances maintained in satisfaction of the FRB reserve requirements described below) equal to at least 5% of the average daily balance of its net withdrawable accounts plus short-term borrowings during the preceding calendar month. The OTS may change this liquidity requirement from time to time to an amount within a range of 4% to 10% of such accounts and borrowings depending upon economic conditions and the deposit flows of member institutions, and may exclude from the definition of liquid assets any item other than cash and the balances maintained in satisfaction of FRB reserve requirements. The Bank's average regulatory liquidity ratio for the month of June 1997 was 5.93% and, accordingly, the Bank was in compliance with the liquidity requirement. Monetary penalties may be imposed for failure to meet liquidity ratio requirements. OTS regulations also require each member institution to maintain, for each calendar month, an average daily balance of short-term liquid assets (generally those having maturities of 12 months or less) equal to at least 1% of the average daily balance of its net withdrawable accounts plus short-term borrowings during the preceding calendar month. The average short-term liquidity ratio of the Bank for the month of June 1997 was 3.11%.
The OTS has recently proposed changing the 5.0% liquidity requirement to 4.0% and has also invited Congress to consider eliminating all formal regulatory liquidity requirements, as such are not mandated of commercial banks. The Company's management cannot predict what changes, if any, will be eventually implemented to regulatory liquidity requirements.
BRANCHING
OTS regulations permit nationwide branching by federally chartered savings institutions to the extent allowed by federal statute. This permits federal savings institutions to establish interstate networks and to geographically diversify their loan portfolios and lines of business. The OTS authority preempts any state law purporting to regulate branching by federal savings institutions. At this time, the Company's management has no plans to establish physical branches outside of California, although the Bank does serve customers domiciled outside of California via alternative delivery channels such as telephone, mail, and ATM networks.
RESTRICTIONS ON INVESTMENTS AND LOANS
In addition to those restrictions presented above in reference to the Liquidity and QTL Test requirements of federal savings institutions, OTS regulations do not permit the Bank to invest directly in equity securities, non investment grade debt securities, or real estate (other than real estate used for the institution's offices and facilities). Indirect equity investment in real estate through a subsidiary, such as the Bank's First Hemet Corporation subsidiary, is permissible, but is subject to certain limitations and deductions from regulatory capital. The Bank maintains two remaining real estate development projects, Mayberry Estates and Vista Bonita, which are being marketed for sale. Following the sale of these two projects, the Bank's management intends to refrain from further real estate investment or development activity for the foreseeable future.
Loans by a savings institution to a single borrower are generally limited to 15% of an institution's "unimpaired capital and unimpaired surplus", as defined by applicable regulations. Aggregate loans secured by non residential real property are generally limited to 400% of an institution's total capital, as defined. Because of its high portfolio concentration in residential loans and its strong total and risk based capital positions, the Bank maintains significant capacity to increase non residential real estate lending while remaining within all applicable regulatory limitations.
CLASSIFICATION OF ASSETS
Savings institutions are required to classify their assets on a regular basis, to establish appropriate allowances for losses, and to report the results of such classifications quarterly to the OTS. A savings institution is also required to set aside adequate valuation allowances, and to establish liabilities for off balance sheet items, such as letters of credit, when a loss becomes probable and estimable. The OTS has the authority to review the institution's classification of its assets and to determine whether additional assets must be classified, or whether the institution's allowances must be increased. Such instruction by the OTS to increase valuation allowances could have a material impact upon both the Bank's reported earnings and financial condition.
Assets are classified into one of five categories:
Pass. These assets present no apparent weakness of deficiency.
Special Mention. These assets present weaknesses or deficiencies deserving continued monitoring and heightened management attention.
Substandard. These assets, or portions thereof, possess well defined weaknesses which could jeopardize the timely liquidation of the asset or the realization of the collateral at values at least equal to the Company's investment in the asset. These assets are therefore characterized by the possibility that the institution will sustain some loss if the deficiencies are not corrected. The Company classifies all real estate owned for investment and real estate acquired through foreclosure as substandard.
Doubtful. These assets, or portions thereof, present probable loss of principal, but the amount of loss, if any, is subject to the outcome of future events which are not fully determinable at the time of classification.
Loss. These assets, or portions thereof, present quantified losses to the institution. The institution must either establish a specific reserve for the amount of loss or charge off a like amount of the asset.
In December 1993, the federal banking agencies issued an interagency policy statement on the allowance for loan and lease losses ("ALLL") which, among other things, establishes certain benchmark ratios of loan loss reserves to classified assets (defined at those categorized as other than "Pass"). The Company's internal credit policy is to comply with this policy statement and to maintain adequate reserves for estimable losses. However, the determination of estimable losses is by nature an uncertain practice, and hence no assurance can be given that the Company's loss allowances will prove adequate to cover future losses.
FEDERAL HOME LOAN BANK SYSTEM
The Federal Home Loan Banks ("FHLB's") provide a comprehensive credit facility to member institutions. As a member of the FHLB of San Francisco, the Bank is required to own capital stock in that FHLB in an amount at least equal to the greater of:
1. 1.0% of the aggregate principal amount of outstanding residential loans, as defined, at the beginning of each calendar year
2. 5.0% of its advances from the FHLB
3. 0.3% of total assets
The Bank was in compliance with this requirement, with a $6.2 million investment in FHLB-San Francisco capital stock at June 30, 1997. FHLB advances must be secured by specific types of collateral, including various types of mortgage loans and investment securities. It is the policy of the Bank's management to maintain an excess of collateral at the FHLB-San Francisco at all times to serve as a ready source of additional liquidity.
The FHLB's are required to provide funds to contribute toward the payment of certain bonds issued in the past to fund the resolution of insolvent thrifts. In addition, the FHLB's are required by statute to contribute funds toward affordable housing programs. These requirements could reduce the amount of dividends the FHLB's pay on their capital stock and could also negatively impact the pricing offered for on and off balance sheet credit products -- events which could unfavorably impact the profitability of the Company.
Legislation is currently before Congress which could significantly alter the requirements for FHLB membership, the financial burdens placed on the FHLB's associated with outstanding bonds, and the scope of allowable investments for FHLB's. The Company's management is unable to predict what, if any, legislation might eventually be passed and the potential impact of such legislation upon the Company.
FEDERAL RESERVE SYSTEM
The FRB requires savings institutions to maintain, on a recurring cycle basis, non interest bearing reserves against certain deposit accounts (primarily deposit accounts that may be accessed by writing unlimited checks). The amount of required reserves are calculated according to a formula updated periodically by the FRB, while such requirement must be met on an average balance basis during each two week measurement cycle. The Bank was in compliance with these reserve requirements for the cycle which included June 30, 1997. The balances maintained to meet the FRB reserve requirements may be used to satisfy the liquidity requirements imposed by the OTS.
Various proposals have been introduced in Congress to permit the payment of interest on required reserve balances, and to permit savings institutions to pay interest to checking account customers other than individuals, sole proprietorships, non profit organizations, and government units. The Company's management cannot predict the outcome, if any, of such legislative proposals.
As a financial institution, the Bank is subject to many regulations promulgated by the FRB, including, but not limited to:
o Regulation B: Equal Credit Opportunity Act
o Regulation D: Reserve Requirements
o Regulation E: Electronic Funds Transfer
o Regulation F: Limitations On Correspondent Bank Credit Exposure
o Regulation Z: Truth In Lending Act
o Regulation CC: Expedited Funds Availability Act
o Regulation DD: Truth In Savings Act
FEDERAL SECURITIES LAWS
The Company's common stock is registered with the SEC under Section 12(g) of the Securities Exchange Act of 1934, as amended (the "Exchange Act"). The Company is subject to periodic reporting requirements, proxy solicitation rules, insider trading restrictions, tender offer rules, and other requirements under the Exchange Act. In addition, certain activities of the Company, its executive officers, and directors are covered under the Securities Act of 1933, as amended (the "Securities Act").
NON BANKING REGULATION
The Company is impacted by a series of laws and regulations not specific to the banking industry, including environmental and bankruptcy laws. There have been recent legislative proposals to modify both environmental and bankruptcy laws, which could present potential material impacts to the Company. The Company's management cannot, however, predict what legislation, if any, will eventually be adopted and the likely financial impact of such legislation, if any. However, most of the recent legislative proposals have sought to insulate financial institutions from liability for environmental remediation for real property acquired through foreclosure. If approved, this legislation would complement the Company's policies of taking steps to identify and review environmental issues pertaining to its borrowers and the real properties securing the loans of its borrowers prior to the extension of credit.
FEDERAL AND STATE TAXATION
Under a tax sharing agreement, the Company files consolidated federal and state tax returns for itself and all its subsidiaries on a fiscal year basis under the accrual method of accounting, and is subject to taxation in a manner similar to other like financial institutions. The Company is also subject to the corporate Alternative Minimum Tax ("AMT"), the environmental tax, and California State franchise taxes (at special rates applicable to financial institutions). HFB also pays certain fees, not classified as income taxes, to the State of Delaware as a Delaware holding company not earning income in that state.
Effective for taxable years beginning after 1995, legislation enacted in 1996 repealed, for federal purposes, the reserve method of accounting for bad debts for thrift institutions. While thrifts qualifying as "small banks" may continue to use the experience method, Hemet Federal, deemed a "large bank", is required to use the specific charge off method commencing with its federal tax return for the fiscal year ended June 30, 1997. In addition, the legislation enacted in 1996 contains certain income recapture provisions which are discussed below.
Thrift institutions deemed "large banks" are required to include into income ratably over six years, beginning with the first taxable year commencing after 1995, the institution's "applicable excess reserves". The applicable excess reserves are the excess of:
1. the balance of the institution's reserves for losses on loans other than supplemental reserves at the close of its last taxable year beginning before January 1, 1996, over
2. the adjusted balance of such reserves as of the close of its last taxable year beginning before January 1, 1988.
The Bank's applicable excess reserves at June 30, 1996 are $350,000. This amount will be recognized into taxable income over six years at the rate of approximately $58,000 per year starting with the taxable year ended June 30, 1997.
The adjusted pre-1988 total reserve balance of $13.8 million as of June 30, 1996 will be recaptured into taxable income:
1. in the event the Bank ceases to be a "bank" or "thrift" under applicable IRS definitions
2. to the extent the Bank makes distributions to shareholders in excess of post-1951 earnings and profits, redemptions, or liquidations
Federally supervised banks and savings associations are required to report deferred tax assets and liabilities in accordance with SFAS Number 109. The federal banking agencies issued final rules applicable to the Bank which became effective April 1, 1995. These rules limit the amount of deferred tax assets that are allowable in computing an institution's regulatory capital. Deferred tax assets that can be realized for taxes paid in prior carryback years and from future reversals of existing taxable temporary differences are generally not limited. Deferred tax assets that can only be
recognized through future taxable earnings are limited for regulatory capital purposes to the lesser of:
1. the amount that can be realized with one year of the quarter end report date, based upon projected taxable income for that year
2. 10.0% of Tier One capital
The amount of any deferred tax assets in excess of this limit would be excluded from Tier One capital and total assets under regulatory capital calculations.
Congress recently passed and the President signed the Taxpayer Relief Act of 1997. This legislation presents a series of potential impacts to the Company, including the encouragement of consumer savings through expanded IRA's and a reduction in the federal net operating loss carryback period from three years to two years for future tax returns. Because of the newness of this legislation, the uncertainty of future consumer behavior, and the lack of presently available interpretation and implementation guidance, management cannot predict the net financial impact of the Taxpayer Relief Act of 1997 upon the Company.
FINANCIAL INDUSTRY REFORM LEGISLATION
Congress is currently developing a bill which could extensively reform the laws and regulations applicable to the financial services industry. Topics under consideration include:
o a relaxation or elimination of the laws separating banking from commerce
o the elimination of the federal thrift charter
o a merger of the Bank Insurance Fund ("BIF") and SAIF
o the ability of banks to sell various insurance and investment related products
o the termination of ATM surcharges
o the merger of the OTS into the Office Of The Comptroller Of The Currency ("OCC")
o grandfathering of investments and activities currently available to federal savings institutions but not permitted for national banks
At this time, the Company's management cannot predict what legislation, if any, will emerge from the current hearings, and what impact such legislation might present to the Company.
FEDERAL JUDICIAL REVIEW
The US Supreme Court has agreed to hear a case involving the breadth of members permitted for credit unions under applicable "common bond" regulations. In recent years, many credit unions have attempted to increase in size and scope by permitting progressively broader classes of membership. Federal limitations upon the membership range of credit unions, which enjoy privileged tax status, would be generally beneficial to the Company, and vice-versa.
FACTORS THAT MAY AFFECT FUTURE RESULTS
The following discusses certain factors which may affect the Company's financial results and operations and should be considered in evaluating the Company.
Economic Conditions and Geographic Concentration. The Company's operations are located in Southern California and are concentrated in Riverside and northern San Diego counties. Although management has recently made initial efforts to geographically diversify the Bank's loan portfolio into Northern California, the vast majority of the Bank's credits remain concentrated in the two Southern California counties. As a result of this geographic concentration, the Company's results depend largely upon economic conditions in these areas, which have been relatively volatile over the past decade. While the Southern California economy has recently exhibited improved trends in employment and real estate valuation, there is no assurance such progress will continue. A deterioration in economic conditions in Riverside and northern San Diego counties could have a material adverse impact on the quality of the Company's loan portfolio and the demand for its products and services.
Interest Rates. By nature, all financial institutions are impacted by changing interest rates, due to the impact of such upon the demand for new loans, the credit profile of existing loans, and the rates received on loans and securities and the rates paid on deposits and borrowings. As presented under Item 7. "Management's Discussion And Analysis Of Financial Condition And The Results Of Operations", the Company is financially exposed to both parallel shifts in general market interest rates (particularly upward shifts) and to changes in the relative pricing of the term structure of general market interest rates.
Government Regulations and Monetary Policy. The financial services industry is subject to extensive federal and state supervision and regulation. Significant new laws, changes in existing laws, or repeals of present laws could cause the Company's financial results to materially differ. Further, federal monetary policy, particularly as implemented through the Federal Reserve System, significantly affects credit conditions for the Company.
Competition. The financial services business in the Company's market areas is highly competitive, and is becoming more so due to technological advances, changes in the regulatory environment, and the accelerating pace of consolidation among financial services providers. The results of the Company may differ in future periods depending upon the nature or level of competition.
Credit Quality. A significant source of risk arises from the possibility that losses will be sustained because borrowers, guarantors, and related parties may fail to perform in accordance with the terms of their loans. The Company has adopted underwriting and credit monitoring procedures and credit policies, including the establishment and review of the allowance for credit losses, that management believes are appropriate to control this risk by assessing the likelihood of non performance, tracking loan performance, and diversifying the credit portfolio. Such policies and procedures may not, however, prevent unexpected losses that could have a material adverse effect on the Company's results. For example, relatively few of the real properties securing the Company's real estate loan portfolio are covered by earthquake insurance, with has generally been unavailable, significantly limited in scope, or not affordable to many of the Company's borrowers.
Other Risks. From time to time, the Company details other risks with respect to its business and / or financial results in its filings with the SEC.
ADDITIONAL ITEM - EXECUTIVE OFFICERS OF THE REGISTRANT
The following table sets forth certain information with respect to each executive officer of the Company who is not also a director of the Company. The Board of Directors appoints or reaffirms the Appointment of all of the Company's Executive Officers each November. Each executive officer serves until the following year or until a respective successor is appointed.
Officers of the Bank who were Executive Officers of the Company as defined by Rule 405 of Regulation C of the Securities and Exchange Commission.
ITEM 2.
ITEM 2. PROPERTIES
The following table sets forth information relating to each of the Company's offices as of June 30, 1997:
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
From time to time, the Company and the Bank are party to claims and legal proceedings arising in the ordinary course of business. After considering information furnished by counsel to the Company and the Bank, management believes that the ultimate aggregate liability represented thereby, if any, will not present a material adverse effect on the Company's consolidated financial position or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE COMMON STOCK AND RELATED SHAREHOLDER MATTERS
The Common Stock of HF Bancorp, Inc. is traded over the counter on the NASDAQ stock market under the symbol "HEMT". The stock commenced trading on June 30, 1995, when the Company went public and sold 6,612,500 shares at a price of $8.00 per share. On February 8, 1996, the OTS approved a five percent repurchase program authorized by the Board of Directors of the Company. 330,625 shares were repurchased by May 28, 1996, for a total of $3,347,578. At June 30, 1997, there were 6,281,875 shares of the Company's Common Stock outstanding, excluding Treasury shares.
The following table sets forth the high and the low daily closing prices of the Company's common stock for each of the following quarters:
The number of holders of record of the Company's Common Stock at September 5, 1997 was 729.
The Company has paid no dividends on the Common Stock since its inception. In the future, the Board of Directors may consider a policy of paying cash or stock dividends on the Common Stock. However, there is no plan to commence the payment of cash dividends during fiscal 1998.
ITEM 6.
Item 6. "Selected Consolidated Financial And Other Data Of The Company".
In conjunction with the PSSB acquisition, the Company acquired a small business loan portfolio and commercial business lending expertise, which management has been leveraging throughout the branch system since the conclusion of the acquisition. The Company has been marketing a more comprehensive small business service line during the last six months of fiscal 1997, which includes not only commercial lines of credit, but also demand deposit account analysis, integration with third party payroll service providers, merchant bankcard services, deposit collection via courier, and safe deposit boxes.
In fiscal 1997, the Company commenced originating home equity line of credit ("HELOC") loans under three separately priced and marketed programs:
1. 80% or lower loan to value credits with commitments up to $100,000
2. 81% -- 90% loan to value credits with commitments up to $100,000
3. 80% or lower loan to value credits with commitments over $100,000
These revolving credit lines are priced based upon the Wall Street Journal Prime Rate, reprice monthly, provide annual fees after the first year, present early closure fees, and are originated at no cost to the consumer (in the case of the first two programs). In addition, all HELOC's receive credit reviews at least annually. At June 30, 1997, the Company had $7.7 million in HELOC credit commitments outstanding.
The Company also commenced originating consumer loans for autos, boats, and recreational vehicles for its own account during fiscal 1997. In prior periods, the Company referred such business to third parties in exchange for a fee. In fiscal 1998, the Company's management intends to evaluate the provision of credit cards to its consumer and business customers, either of its own account or via a third party, in order to offer a complete community banking product line to its clients.
The Company continues to originate construction, apartment, and commercial real estate loans. A majority of the Company's construction loans are associated with the construction of single family residences. The Company also offers fully amortizing loans for the purchase of land and developed housing lots. In fiscal 1998, management intends to pursue the origination of a greater volume of high credit quality apartment and commercial real estate loans in order to better utilize the Bank's strong risk based capital position and high available liquidity. However, there can be no assurances that the Company will be successful in generating such originations. In addition, commercial real estate and multifamily loans, even though prudently underwritten, are generally considered to involve a higher degree of credit risk than one to four family mortgage loans.
The following table presents the distribution of the Company's loan portfolio at the dates indicated.
For information concerning the scheduled maturities of the Company's loans at June 30, 1997, please refer to the static gap table presented under "Asset/Liability Management".
Since the Company lends primarily in Southern California, its real estate loan collateral is concentrated in this region. This concentration is considered when determining the adequacy of the Company's Allowance for Loan and Lease Losses ("ALLL"). Commencing in the second half of fiscal 1997, the Company began pursuing the purchase of residential loan pools which included at least some properties in Northern California, as a means of starting to diversify its geographic concentration. However, despite these efforts, the vast majority of the Company's real estate collateral was located in Riverside and San Diego counties at June 30, 1997.
The following table sets forth at June 30, 1997, the amount of gross loans receivable, including non performing loans, and whether such loans have fixed or adjustable interest rates. Adjustable rate loans which reprice based upon movements in the 11th District Cost Of Funds Index ("COFI") are separated from variable rate loans which reprice based upon movements in other indices, including the Prime Rate and the Treasury One Year Constant Maturities Index.
Additional information concerning fixed and adjustable rate loans, and the scheduled maturities thereof, including those loans contractually due more than one year from June 30, 1997, is presented in the static gap table under "Asset/Liability Management".
During the past fiscal year, the Company has emphasized the origination and purchase of loans tied to adjustable rate indices other than COFI in order to diversify its portfolio and because of concerns regarding the long term status of the COFI, as the number of savings institutions in the 11th District continues to decline in conjunction with merger and acquisition activity. As the determination of the COFI becomes concentrated in fewer institutions, funding decisions by a relatively few large institutions could potentially further reduce the correlation of COFI to changes in general market interest rates and the Company's cost of funds.
CREDIT QUALITY
General. Although the Company's management believes that non performing loans are generally well secured and reserved, other real estate owned is properly valued, and potential losses are provided for in the ALLL, there can be no assurance that future deterioration in economic conditions or collateral values will not result in future credit losses and associated charges against the Company's income. In regards to real estate owned via foreclosure, although all such properties are being actively marketed, the Company's management cannot predict when these properties will be sold or what the terms of sale will be when they are sold. It is the Company's general policy to maintain recent (within eighteen months) appraisals for all foreclosed properties.
Non Performing Assets. At December 31, 1997, gross non performing assets, which include non performing loans, real estate acquired via foreclosure, and repossessed consumer assets, totaled $11.5 million. This represented an increase of $8.7 million from total non performing assets of $2.8 million at June 30, 1996. During fiscal 1996, non performing assets decreased $1.4 million, or 33.9%, from a total of $4.2 million at June 30, 1995. The significant increase in non performing assets in fiscal 1997 resulted primarily from loans originated by PSSB prior to its acquisition. Approximately $3.6 million of the $5.2 million in non performing loans at June 30, 1997 were originated by PSSB prior to the acquisition. In conjunction with its due diligence of PSSB, the Bank's management and third party consultants identified the weaknesses in the PSSB credit portfolio and required PSSB to recognize an additional $2.2 million in loss reserves immediately prior to the consummation of the acquisition.
The following table provides information on gross non performing assets at the dates indicated:
Delinquencies. The following table sets forth delinquencies in the Company's loan portfolio as of the dates indicated:
The following table stratifies the Company's foreclosed properties as of June 30, 1997 by underlying collateral.
The figures reported for foreclosed real estate at June 30, 1997 include six loans with a net investment of $804,000, before valuation allowances, reclassified to foreclosed real estate as a result of their not meeting the thresholds for classification as loans under SFAS Number 66.
Classified Assets. Since the PSSB acquisition, the Company's management has diligently worked to reduce the classified asset total through various means including aggressive collection efforts, foreclosure with subsequent property sales, and settlement of troubled loans for less than the principal balance owed. Total classified assets have declined from $43.5 million at September 30, 1996 (immediately following the PSSB acquisition) to $32.4 million at June 30, 1997, as detailed in the following table.
Impaired Loans. The Company adopted SFAS Number 114, - "Accounting By Creditors For Impairment Of a Loan" as amended by SFAS Number 118, - "Accounting By Creditors For Impairment Of A Loan - Income Recognition And Disclosures" as of July 1, 1995 and recognized no impact upon adoption. The Company has historically defined a loan as impaired when it meets one or more of the following criteria:
o it is probable that the Company will be unable to collect all contractual principal and interest in accordance with the terms of the loan agreement
o the loan is ninety or more days past due
o the loan is placed on non accrual status (although less than ninety days past due)
o a specific valuation reserve has been allocated against the loan
o the loan has been classified as "substandard" (or worse) by an internal credit review process
At June 30, 1997, the Company had impaired loans totaling $16.3 million, which have related specific reserves of $1.5 million. Of this $16.3 million, $5.7 million was fully current in regards to the timely payment of principal and interest. Total impaired loans at June 30, 1996 were $8.9 million. The average recorded investment in impaired loans during the twelve month period ending June 30, 1997 was $16.2 million. The increase in impaired loans during fiscal 1997 was disproportionately represented by the portfolio of loans originated by PSSB prior to its acquisition, as highlighted in the following table which presents information as of June 30, 1997.
The consolidated financial statements and related footnotes included in this Form 10-K present additional information concerning the Company's impaired loans.
INTANGIBLE ASSETS
The purchase of three branches from Hawthorne Savings and the acquisition of PSSB each generated intangible assets. The following tables provide information concerning the initial amount of such intangible assets, their periodic amortization against income, and their current balances as of June 30, 1997. Under OTS regulations, intangible assets reduce regulatory capital, resulting in lower capital ratios than would otherwise be the case.
In March of 1997, the Company commenced payment to a former officer of PSSB following the resignation of the executive while he was covered under a salary continuation contract. The total payments due under the contract were capitalized as an adjustment to the core deposit intangible associated with the PSSB acquisition, as the potential cost of the contract, which existed prior to the acquisition, was included in the initial valuation of the core deposits acquired. The payments due under the contract were not capitalized at the date of acquisition due to uncertainty regarding whether the contract would be triggered; i.e. whether the executive would remain with the Company. This adjustment to the core deposit intangible will be amortized over the remaining initial life of the core deposit intangible. Because the payments are taxable to the executive, the Company can deduct the payments for tax purposes on a faster schedule than they will be recognized for book reporting purposes, thus generating a deferred tax liability under SFAS Number 109.
DEPOSITS
The Company reported total deposits of $839.7 million at June 30, 1997. This represented an increase of $169.9 million, or 25.4%, over total deposits of $669.7 million at June 30, 1996. The increase in deposits stemmed primarily from the PSSB acquisition. Total deposits at June 30, 1995 were $472.3 million, with the increase during fiscal 1996 primarily associated with the purchase of the three Hawthorne Savings Bank branches. The following table presents the deposit activity of the Company for the periods indicated.
At June 30, 1997, the Company had outstanding $110.0 million in certificate of deposit accounts in amounts of $100,000 or more, maturing as presented in the following table.
The Bank is currently eligible to accept brokered deposits, and has in place agreements with two investment banking firms to obtain brokered deposits should the need for such funds arise and should the relative pricing of such funds compare favorably to alternative sources of liquidity. However, at June 30, 1997, the Bank had no brokered deposits outstanding.
The Company's mix of deposits has changed over recent years. For example, at June 30, 1995, non interest bearing checking accounts constituted 1.1% of total deposits. By June 30, 1997, this proportion had increased to 3.7%. Transaction account (non certificate) products comprised 21.0% of total deposits at June 30, 1996, following the Hawthorne Savings Bank branch acquisitions, which were heavily populated with certificate accounts. This percentage increased to 26.7% at June 30, 1997. Consistent with the objective of serving as a premier community bank, the Company in recent years, and particularly in fiscal 1997, has emphasized business operating accounts, consumer demand deposit accounts, 24 hour telephone banking, ATM access, and ACH services, thereby gradually evolving the deposit portfolio toward a reduced concentration in certificate of deposit products, which are typically more price sensitive than transaction accounts. The Company intends to continue encouraging the migration of its deposit portfolio in the coming fiscal year, taking advantage of market dissatisfaction with the service levels provided by large and merging competitors while also improving shareholder returns through lower cost and more stable funding. However, there can be no assurance that the Company will be successful in this regard.
BORROWINGS
At June 30 1997, the Company had $50.0 million in total borrowings, composed of two standard term advances from the FHLB-San Francisco. This was a decline of $20.0 million from the $70.0 million outstanding at June 30, 1996, as the Company during fiscal 1997 prepaid a $20.0 million advance, at no prepayment penalty, whose rate exceeded the Bank's marginal return on liquid investments at the time.
From time to time, the Bank utilizes other types and sources of borrowings, including reverse repurchase agreements and putable FHLB advances. During the upcoming fiscal year, the Bank's management intends to employ a broader range of wholesale borrowings in an effort to increase the Bank's net interest income, control interest rate risk, and fund the potential balance sheet expansion associated with the more effective deployment of the Company's capital.
The following table presents certain information regarding the Company's borrowed funds at or for the periods ended on the dates indicated:
LIQUIDITY
Liquidity is actively managed to ensure sufficient funds are available to meet the ongoing needs of both the Company in general and the Bank in particular. Liquidity management includes projections of future sources and uses of funds to ensure the availability of sufficient liquid reserves to provide for unanticipated circumstances.
For the Bank, the primary sources of liquidity are:
o deposits
o principal and interest payments on loans, mortgage backed, and investment securities
o retained earnings
o FHLB advances
o other borrowings, including reverse repurchase agreements
For the Bank, the primary uses of funds include:
o loan originations
o customer drawdowns on lines of credit
o loan purchases
o customer withdrawals of deposits
o interest paid on liabilities
o operating expenses
The Bank's investment portfolio is structured to provide an ongoing source of cash from scheduled payments and anticipated prepayments from mortgage backed securities, in addition to cash flows from periodic maturities, typically from securities with balloon final payments. The Company's strategy over the past year has been to reinvest available monthly cash flows, to the extent economically and operationally feasible, into new whole loan originations and purchases, in order to bolster net interest income and better utilize the Bank's strong risk based capital position.
In the coming year, the Company's management intends to pursue the acquisition of short term, unsecured lines of credit from the institution's correspondent banks, as an additional means to provide for contingent liquidity needs. However, there can be no assurances that the Company will be successful in securing such lines of credit.
At June 30, 1997, the Bank maintained untapped borrowing capacity at the FHLB-San Francisco in the amount of $178.2 million. In addition, due to the Company's relatively low loan to deposit ratio of 57.7% at June 30, 1997, the Company maintained significant excess collateral in both loans and securities; collateral which is available for either liquidation or secured borrowings in order to meet future liquidity requirements.
At June 30, 1997, cash and cash equivalents totaled $18.4 million, compared to $100.6 million at June 30, 1996, and $88.6 million at June 30, 1995. The figure at June 30, 1997 represented a more normalized amount, as the figures at the two prior year ends were each inflated by particular events. At June 30, 1996, the Company had recently acquired the three branches from Hawthorne Savings Bank and had not yet completed the longer term deployment of cash received. At June 30, 1995, the Company had just accomplished its initial public offering, and had also not yet completed the longer term investment of the proceeds. It is management's intention, while ensuring adequate cash availability for operating needs, to constrain cash and cash equivalent balances in favor of higher yielding assets, subject to meeting all regulatory liquidity requirements.
OTS regulations currently present two liquidity requirements. The key requirement is based upon cash, cash equivalents, and certain short term investments equaling at least 5.0% of deposits plus short term borrowings. The Bank's regulatory liquidity ratio for the month of June, 1997 was 5.93%, placing the Bank in compliance.
Liquidity needs for HFB on a stand alone basis are met through available cash, periodic earnings, and cash flows from its investment portfolio.
CAPITAL RESOURCES
The Bank's position as a "well capitalized" financial institution under the PCA regulatory framework is further enhanced by the additional capital present at the HFB holding company level. The value of the additional capital in the holding company was highlighted during June, 1997, when HFB downstreamed $5.0 million in capital to the Bank in preparation for the financial impact of the retirement plan terminations. At June 30, 1997, the consolidated GAAP capital position of the Bank was $72.5 million, while the consolidated GAAP capital position of the Company was $81.0 million.
Despite the presence of capital in excess of current regulatory requirements, the Company does not presently intend to evaluate the initiation of cash dividend payments until the core profitability of the Company improves and the Company displays a more regular stream of improved earnings per share.
OFF BALANCE SHEET
Over the past decade, the Company has utilized a variety of financial instruments to control its interest rate risk and manage its net interest margin, including off balance sheet transactions such as interest rate agreements including swaps, caps, and floors. The Company originally entered into its existing off balance sheet positions to synthetically adjust the duration of the Company's liabilities to more closely match that of its assets. On July 10, 1995, the Bank terminated four interest rate swap contracts with an aggregate notional amount of $60.0 million, invoking a termination fee of $4.9 million which, for accounting purposes, is being amortized to interest expense over the individual remaining contract lives of each swap.
During the twelve months ended June 30, 1997, the Company amortized $1.8 million of the deferred loss to interest expense, and charged interest expense for $1.1 million related to current existing interest rate swaps with an aggregate notional amount of $35.0 million. The comparable figures for the prior fiscal year were $2.0 million and $1.2 million, respectively. The year to year decrease in recognition of the deferred loss stemmed from the conclusion of the amortization periods for two of the terminated swaps during fiscal 1997. The end of the amortization period associated with another terminated swap will occur in fiscal 1998, with the accounting impact of the final terminated swap finishing in fiscal 1999. The conclusion of these amortization periods will result in the Company's reporting a reduction in interest expense and effective cost of funding, all else held constant.
Additional information concerning the Company's active and terminated interest rate swap positions is provided in the following table.
Active Interest Rate Swaps - --------------------------
IMPACT OF INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and Notes thereto presented herein have been prepared in accordance with GAAP, which require the measurement of most financial positions and operating results in terms of historical dollars without considering the changes in the relative purchasing power of money over time due to inflation. Unlike industrial companies, the Company's assets and liabilities are nearly all monetary in nature. Consequently, relative and absolute interest rates present a greater impact on the Company's performance and condition 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 price of goods and services. The Company's operating costs, however, are subject to the impact of inflation, particularly in the case of salaries and benefits costs, which typically constitute approximately one-half of the Company's total general & administrative expenses.
RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board ("FASB") has recently released the following Statements, which are discussed in footnote 1 to the Company's consolidated financial statements included in this report, incorporated herein by reference.
o SFAS Number 128: "Earnings Per Share"
o SFAS Number 129: "Disclosure Of Information About Capital Structure"
o SFAS Number 130: "Reporting Comprehensive Income"
o SFAS Number 131: "Disclosures About Segments Of An Enterprise and Related Information"
The above Statements are primarily related to the disclosure and reporting requirements applicable to the Company. As such, the Company's management does not believe that the adoption of these Statements will have a significant impact upon the Company's financial condition or results of operations.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
Independent Auditors' Report.............................................. 78
Consolidated Statements of Financial Condition as of June 30, 1996 and 1997 79
Consolidated Statements of Operations for the Fiscal Years Ended June 30, 1995, 1996 and 1997........................ 81
Consolidated Statements of Stockholders' Equity........................... 83
Consolidated Statements of Cash Flows for the Fiscal Years Ended June 30, 1995, 1996 and 1997........................ 84
Notes to Consolidated Financial Statements................................ 87
INDEPENDENT AUDITORS' REPORT
The Board of Directors HF Bancorp, Inc. Hemet, California
We have audited the accompanying consolidated statements of financial condition of HF Bancorp, Inc. and subsidiary (the "Company") as of June 30, 1997 and 1996, and the related consolidated statements of operations, stockholders' equity and cash flows for each of the three years in the period ended June 30, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audits 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 that 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 Bancorp, Inc. and subsidiary as of June 30, 1997 and 1996, and the results of their operations and their cash flows for each of the three years in the period ended June 30, 1997 in conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
August 8, 1997
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
HF BANCORP, INC. AND SUBSIDIARY
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION (CONTINUED) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF OPERATIONS (CONTINUED) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY - -------------------------------------------------------------------------------- (IN THOUSANDS)
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED) - --------------------------------------------------------------------------------
See notes to consolidated financial statements.
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1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BASIS FOR PRESENTATION - HF Bancorp, Inc. (the "Company") is a savings and loan holding company incorporated in the State of Delaware that was organized for the purpose of acquiring all of the capital stock of Hemet Federal Savings and Loan Association (the "Bank") upon its conversion from a federally chartered mutual savings association to a federally chartered stock savings association. On June 30, 1995, HF Bancorp, Inc. completed its sale of 6,612,500 shares of its common stock through subscription and community offerings to the Bank's depositors, Board of Directors, management, employees and the public and used approximately 50% of the net proceeds from such sales to purchase all of the Bank's common stock issued in the Bank's conversion to stock form. Such business combination was accounted for at historical cost in a manner similar to a pooling of interests.
At June 30, 1995, the Bank established a liquidation account in an amount equal to its equity, as reflected in the latest statement of financial condition used in the final conversion prospectus. The liquidation account will be maintained for the benefit of eligible account holders who continue to maintain their accounts at the Bank after the conversion. The liquidation account will be reduced annually to the extent that eligible account holders have reduced their qualifying deposits as of each anniversary date. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the event of a complete liquidation of the Bank, each eligible account holder will be entitled to receive a distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held. The liquidation account balance was $14,800,155 at June 30, 1997.
DESCRIPTION OF BUSINESS - The Company's business consists principally of the business of the Bank; however, it does have investments in loans, mortgage-backed securities and other investments from which interest income is earned (Note 18). Headquartered in Hemet, California, the Bank conducts business from its main office and three branch offices located in Hemet, California and from fifteen branch offices located in the Riverside and San Diego counties of California. The Bank is regulated by the Office of Thrift Supervision (OTS) and the Federal Deposit Insurance Corporation (FDIC), and its deposits are insured up to the applicable limits under the Savings Association Insurance Fund (SAIF) of the FDIC.
The Bank's revenues are derived from interest on its loan and mortgage-backed securities portfolios, interest and dividends on its investment securities, and its fee income associated with the provision of various customer services. The Bank's primary sources of funds are deposits, principal and interest payments on its assets portfolios, and various sources of wholesale borrowings including Federal Home Loan Bank (FHLB) advances and reverse repurchase agreements. The Bank's most significant operating expenditures are its staffing expenses and the costs associated with maintaining its branch network.
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PRINCIPLES OF CONSOLIDATION - The consolidated financial statements include the accounts of HF Bancorp, Inc. and its wholly-owned subsidiary Hemet Federal Savings and Loan Association and its wholly-owned subsidiaries, HF Financial Corporation, Palm Springs Savings Bank Insurance Services, Inc., and Coachella Valley Financial Services Corporation, and HF Financial Corporation's wholly-owned subsidiary, First Hemet Corporation (collectively, the "Company"). First Hemet Corporation, who provides trustee services for the Bank, is engaged in real estate development, and receives commissions from the sale of mortgage life insurance, fire insurance and annuities. All material intercompany transactions, profits and balances have been eliminated.
SECURITIES AVAILABLE-FOR-SALE - Securities to be held for indefinite periods of time, including securities that management intends to use as part of its asset/liability strategy that may be sold in response to changes in interest rates, prepayments or other factors, are classified as available-for-sale and carried at estimated fair value. Gains or losses on the sale of securities are determined on the specific-identification method. Premiums and discounts are recognized in interest income using the interest method over the period to maturity. Unrealized holding gains or losses, net of tax, for securities available-for-sale are excluded from earnings and reported as a net amount in a separate component of stockholders' equity until realized.
SECURITIES HELD-TO-MATURITY - Securities held-to-maturity are recorded at cost with any discount accreted or premium amortized over the life of the security using the interest method. The Company has the positive intent and ability to hold these securities to maturity. The Company designates securities as held-to-maturity or available-for-sale upon acquisition.
MORTGAGE-BACKED SECURITIES - Securities available-for-sale and held-to-maturity include privately issued mortgage-backed securities ("MBS") and collateralized mortgage obligations ("CMO's") that expose the Company to certain risks that are not inherent in agency securities, primarily credit risk and liquidity risk. Because of this added risk, private-issue securities have historically paid a greater rate of interest than agency securities, enhancing the overall yield of the portfolio.
LOANS RECEIVABLE - During the period of origination, loans originated as held-for-investment are carried at amortized cost.
Interest on loans is credited to income as earned and is accrued only if deemed collectible. Generally, interest is not accrued on loans delinquent three payments or more. Discounts or premiums on loans are included in loans receivable held-for-investment and are credited or charged to income (for loans that are probable of collection) on the interest method over the term of the loan, adjusted for anticipated prepayments.
Loan origination and commitment fees and certain incremental direct loan origination costs are deferred, and the net fee or cost is amortized into interest income over the contractual lives of the related loans held-for-investment.
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LOANS HELD-FOR-SALE - Loans originated and intended for sale in the secondary market are carried at the lower of aggregate cost or estimated fair values. Gains and losses on such loans are accounted for under the specific-identification method. Qualified loan origination fees and costs are retained and not amortized over the contractual lives of the related loans held-for-sale.
DERIVATIVE FINANCIAL INSTRUMENTS - The Company has entered into various interest rate exchange agreements as part of its asset and liability management strategy. These exchange agreements consist of interest rate swaps, caps and floors. Swap income and expense is recorded using the accrual method and is classified as interest income or expense, net in the consolidated statements of operations. The cost of the interest rate floor and cap agreements has been capitalized and is being amortized to interest expense over the terms of the agreements.
REAL ESTATE OWNED - Properties acquired through foreclosure are initially recorded at the lower of cost or fair value less estimated costs to sell through a charge to the allowance for estimated loan losses. Subsequent declines in value are charged to operations. Properties acquired for sale or investment are recorded at cost not to exceed fair value.
Costs incurred that are directly related to the development of real estate are capitalized. Costs of holding real estate under development (principally interest and real estate taxes) are also capitalized. Provisions for estimated losses are charged to current operations.
Recognition of gains on the sale of real estate is dependent on the transaction meeting certain criteria relating to the nature of the property sold and the terms of sale. Under certain circumstances, the gain, or a portion thereof, may be deferred until the criteria are met. Losses on disposition of real estate, including expenses incurred in connection with the disposition, are charged to operations.
ALLOWANCES FOR ESTIMATED LOAN AND REAL ESTATE LOSSES - The Company accounts for impaired loans in accordance with Statement of Financial Accounting Standards (SFAS) No. 114, ACCOUNTING BY CREDITORS FOR IMPAIRMENT OF A LOAN, as amended by SFAS No. 118, ACCOUNTING BY CREDITORS FOR IMPAIRMENT OF A LOAN-INCOME RECOGNITION AND DISCLOSURES. SFAS No. 114 generally requires all creditors to account for impaired loans, except those loans that are accounted for at fair value or at the lower of cost or fair value, at the present value of the expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral-dependent. SFAS No. 114 indicates that a creditor should evaluate the collectibility of both contractual interest and contractual principal when assessing the need for a loss accrual.
The Company considers a loan to be impaired when it is deemed probable by management that the Company will be unable to collect all contractual principal and interest payments in accordance with the terms of the original loan agreement. However, in determining when a loan is impaired, management also considers the loan documentation, current loan to value ratios, and the borrower's current financial position. Included as impaired loans are all loans delinquent 90 days or more and all
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loans that have a specific loss allowance applied to adjust the loan to fair value. The accrual of interest on impaired loans is discontinued after a 90-day delinquent period or when, in management's opinion, the borrower will be unable to meet payments as they become due. When interest accrual is discontinued, all unpaid accrued interest is reversed. Interest income is subsequently recognized to the extent of full cash payments received and accepted. The Company applies the measurement provision of SFAS No. 114 to all loans in its portfolio.
Valuation allowances for estimated loan and real estate losses are provided when any significant decline in value is deemed to have occurred. Specific loss allowances are established for loans that are deemed to be impaired, if the fair value of the loan or the collateral is estimated to be less than the gross carrying value of the loan. In estimating losses, management considers the estimated sales price, cost of refurbishment, payment of delinquent taxes, cost of holding the property (if an extended period is anticipated) and cost of disposal. Additionally, general valuation allowances for loan and real estate losses have been established. The estimates for these allowances are normally influenced by current economic conditions, actual loss experience, industry trends and other factors, such as the current economic conditions experienced in the area in which the Company's lending and real estate activities are concentrated. These estimates may result in either additions to or recaptures of the current provision, based on management's current evaluation of the loan and real estate portfolios. Accordingly, the amounts of such loan and real estate loss provisions (credits) can vary from period to period.
In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Bank's allowance for loan losses. Such agencies may require the Bank to recognize additions to the allowance based on judgments different from those of management.
While management uses the best information available to make these estimates, future adjustments to the allowances may be necessary because of economic, operating, regulatory and other conditions that may be beyond the Company's control.
PREMISES AND EQUIPMENT - Premises and equipment are stated at cost less accumulated depreciation and amortization. Depreciation and amortization are computed principally on the straight-line method over the estimated useful lives of the various assets.
Depreciable lives used for the principal classes of assets are as follows:
Furniture, fixtures and equipment 3 to 10 years Buildings and leasehold improvements 5 to 40 years
Effective July 1, 1996, the Company adopted SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF. The statement establishes accounting standards of the impairment of long-lived assets that either will be held and used in operations or that will be disposed of. Accordingly, the Company periodically evaluates the recoverability of long-lived
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assets, such as premises and equipment and intangible assets, to ensure the carrying value has not been impaired. The adoption of SFAS No. 121 did not have a material impact on the results of operations or financial position of the Company.
AMORTIZATION - The Company computes amortization on the straight-line method over the estimated useful life of the related asset.
STOCKHOLDERS' EQUITY - The Company's financial statement equity includes tax bad debt deductions for which no provision for federal income taxes has been made. If distributions to shareholders are made in excess of current or accumulated earnings and profits or if stock of the Bank is partially redeemed, this tax bad debt reserve, which approximates $13,827,000 at June 30, 1997, will be recaptured into income at the then-prevailing federal income tax rate. The related unrecognized deferred tax liability is approximately $4,839,000. It is not contemplated that the Bank will make any disqualifying distributions that would result in the recapture of these reserves.
During 1996, the Company acquired 330,625 shares of treasury stock for $3,348,000. Retained earnings are restricted for dividends in the amount of $3,348,000, the cost of the treasury stock acquired. No additional shares were repurchased during 1997.
Earnings per share for the year ended June 30, 1997 and 1996 are based on the weighted average common shares and equivalents outstanding of 5,755,859 and 5,953,823, respectively. The total issued shares of 6,612,500 have been adjusted for the weighted average of: unallocated shares under the Employee Stock Ownership Plan (ESOP) of 359,526 and 424,069, reduction of outstanding shares purchased for the stock compensation plan of 166,490 and 198,375 and acquisition of shares of treasury stock of 330,625 and 36,233, respectively.
Earnings per share are not presented for periods prior to conversion to stock form, as no stock was outstanding.
FEDERAL AND STATE INCOME TAXES - The Company accounts for income taxes under SFAS No. 109, ACCOUNTING FOR INCOME TAXES. Accordingly, deferred tax assets and liabilities represent the tax effects of the temporary differences in the basis of certain assets and liabilities for tax and financial statement purposes, calculated at currently effective tax rates, of future deductible or taxable amounts attributable to events that have been recognized on a cumulative basis in the financial statements.
USE OF ESTIMATES IN THE PREPARATION OF CONSOLIDATED FINANCIAL STATEMENTS - The preparation of the consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting years. Actual results could differ from those estimates.
HF BANCORP, INC. AND SUBSIDIARY
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PRESENTATION OF CASH FLOWS - All highly-liquid instruments with original maturities of three months or less are considered to be cash equivalents. Cash equivalents consisted of federal funds sold of $3,355,000 and $88,460,000 at June 30, 1997 and 1996, respectively, and a repurchase agreement of $4,075,000 at June 30, 1996.
RECENT ACCOUNTING DEVELOPMENTS - On July 1, 1996, the Company adopted SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, which establishes financial accounting and reporting standards for stock-based employee compensation plans. This statement establishes a fair-value-based method of accounting for stock-based compensation plans. It encourages, but does not require, entities to adopt that method in place of the provisions of Accounting Principles Board (APB) Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES, for all arrangements under which employees receive shares of stock or other equity instruments of the employer or the employer incurs liabilities to employees in amounts based on the price of its stock. SFAS No. 123 also applies to transactions in which an entity issues its equity instruments to acquire goods or services from nonemployees. Those transactions must be accounted for based on the fair value of the consideration received or the fair value of the equity instruments issued, whichever is more reliably measurable.
The Company has elected to continue to apply the accounting provisions of APB No. 25 to its stock-based compensation awards to employees and discloses the pro forma effect on net earnings and earnings per share as if the fair-value-based method of accounting defined in SFAS No. 123 had been applied (Note 13).
As of December 31, 1996, the Company adopted SFAS No. 125, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, which was amended by SFAS No. 127, DEFERRAL OF THE EFFECTIVE DATE OF CERTAIN PROVISIONS OF FASB STATEMENT NO. 125. These statements provide accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities. The reporting requirements are effective for transfers and servicing occurring after December 31, 1996 or December 31, 1997 for certain transactions.
In February 1997, the FASB issued SFAS No. 128, EARNINGS PER SHARE. The statement establishes standards for computing and presenting earnings per share (EPS) and applies to entities with publicly held common stock or potential common stock. This statement simplifies the standards for computing earnings per share previously found in APB Opinion No. 15, EARNINGS PER SHARE, and makes them comparable to international EPS standards. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic and diluted EPS on the face of the income statement for all entities with complex capital structures and requires a reconciliation of the numerator and denominator of the basic EPS computation to the numerator and denominator of the diluted EPS computation. The disclosure requirements of SFAS No. 128 are effective for periods ending after December 15, 1997. Management does not believe that the adoption of SFAS No. 128 will have a significant impact on its financial statements.
HF BANCORP, INC. AND SUBSIDIARY
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In February 1997, the FASB issued SFAS No. 129, DISCLOSURE OF INFORMATION ABOUT CAPITAL STRUCTURE. The statement establishes standards for disclosing information about an entity's capital structure. The disclosure requirements of SFAS No. 129 are effective for periods ending after December 15, 1997. Management does not believe that the adoption of SFAS No. 129 will have a significant impact on its financial statements.
In June 1997, the FASB issued SFAS No. 130, REPORTING COMPREHENSIVE INCOME and SFAS No. 131, DISCLOSURES ABOUT SEGMENTS OF AN ENTERPRISE AND RELATED INFORMATION. SFAS No. 130 establishes standards for reporting and display of comprehensive income and its components in a full set of general-purpose financial statements. SFAS No. 131 establishes standards of reporting by publicly-held business enterprises and disclosure of information about operating segments in annual financial statements and to a lesser extent, in interim financial reports issued to shareholders. SFAS Nos. 130 and 131 are effective for fiscal years beginning after December 15, 1997. As both SFAS Nos. 130 and 131 deal with financial statement disclosure, the Company does not anticipate the adoption of these new standards will have a material impact on its financial position or results of operations.
RECLASSIFICATIONS - Certain reclassifications have been made to the 1996 and 1995 financial statements to conform them to the 1997 presentation.
2. REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by the 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 table below) 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 average assets (as defined). Management believes, as of June 30, 1997, that the Bank meets all capital adequacy requirements to which it is subject.
As of June 30, 1997, the most recent notification from the OTS categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. To be categorized as well-capitalized, the Bank must maintain minimum total risk-based, Tier I risk-based, and Tier I leverage ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank's category.
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Additionally, in accordance with the Financial Institutions Reform, Recovery and Enforcement Act ("FIRREA"), the OTS established regulations requiring the Bank to maintain (i) core capital equal to 3% of adjusted total assets, (ii) tangible capital equal to 1.5% of adjusted total assets, and (iii) total capital equal to 8% of risk-weighted assets.
The following table summarizes the OTS regulatory capital requirements under FIRREA for the Bank at June 30, 1997.
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Management believes that, under the current regulations, the Bank will continue to meet its minimum capital requirements in the coming year. However, events beyond the control of the Bank, such as changing interest rates or a downturn in the economy in the areas where the Bank has most of its loans, could adversely affect future earnings and, consequently, the ability of the Bank to meet its future minimum capital requirements.
OTS regulatory capital regulations require that all equity investments in equity securities and real property (except real property used as offices for the conduct of the business and certain real estate owned) be deducted from total capital for purposes of the risk-based capital standard. At June 30, 1997, the Bank's equity investments in real property and subsidiary subject to this deduction amounted to $1,026,000.
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In conjunction with the implementation of SFAS No. 125, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND EXTINGUISHMENTS OF LIABILITIES, during the quarter ended March 31, 1997, the Company transferred a $250,000 interest only security investment from the held-to-maturity to the available-for-sale classification.
Gross realized gains and losses on sales of investment securities available-for-sale were $10,000 and $303,000, respectively, for the year ended June 30, 1997. There were no sales of investment securities during the year ended June 30, 1996. Gross realized losses from sales of investment securities available-for-sale were $13,000 for the year ended June 30, 1995.
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As of June 30, 1997, the Company has pledged a $5,000,000 note with Union Bank of California in conjunction with certain deposit accounts.
The Company's collateralized mortgage obligations are in the form of nonequity debt instruments with stated principal amounts and stated interest rate terms. On a monthly basis, the Company reviews the expected recoverability of its investment in the interest only, stripped, mortgage-backed security.
At June 30, 1997, investment securities held-to-maturity, with an amortized cost of $26,757,000, have fixed interest rates and $37,000 have adjustable interest rates. At June 30, 1997, investment securities available-for-sale, with an estimated fair value of $117,713,000, have fixed interest rates and $27,284,000 have adjustable interest rates.
The scheduled maturities of federal agency bonds and notes held-to-maturity and available-for-sale at June 30, 1997 were as follows:
Collateralized mortgage obligations and the interest only, mortgage-backed security have been excluded from the above table, as they are not due at a single maturity date.
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4. MORTGAGE-BACKED SECURITIES
Mortgage-backed securities are summarized as follows:
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The weighted average interest rates on mortgage-backed securities held-to-maturity were 6.82% and 6.81% at June 30, 1997 and 1996, respectively. The weighted average interest rates on mortgage-backed securities available-for-sale were 7.14% and 7.46% at June 30, 1997 and 1996, respectively.
Gross realized gains and losses on sales of mortgage-backed securities were $1,461,000 and $129,000, respectively, for the year ended June 30, 1997. There were no sales of mortgage-backed securities during the years ended June 30, 1996 and 1995.
As of June 30, 1997 and 1996, the Company has pledged $292,999,000 and $211,154,000, respectively, of real estate loans, mortgage-backed securities and its investment in the capital stock of the FHLB of San Francisco in conjunction with certain advances from the FHLB (Note 10). Additionally, as of June 30, 1997 and 1996, the Company has pledged $7,422,000 and $8,346,000 of mortgage-backed securities in conjunction with interest rate swap transactions with other brokerage agencies (Note 15).
5. LOANS RECEIVABLE
Loans receivable are summarized as follows:
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The Company serviced loans for others in the amount of $42,922,000 and $21,175,000 as of June 30, 1997 and 1996, respectively.
As of June 30, 1997 and 1996, included in loans receivable are adjustable rate loans with principal balances of $347,974,000 and $107,696,000, respectively. Adjustable rate loans are indexed primarily to the Federal Home Loan Bank's Eleventh District cost of funds index and to various U.S. Treasury-related indices, particularly the U.S. Treasury One-Year Constant Maturities Index.
Activity in the allowance for estimated loan losses is summarized as follows:
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A summary of loan activities of executive officers and directors is as follows:
The majority of the Company's loans are collateralized by real estate in southern California.
Impairment of loans having recorded balances of $16,326,000 and $8,935,000 at June 30, 1997 and 1996, respectively, has been recognized in conformity with SFAS No. 114, as amended by SFAS No. 118. The average recorded investment in impaired loans during the years ended June 30, 1997 and 1996 was $16,247,000 and $8,257,000, respectively. The total allowance for loan losses related to these loans was $1,503,000 and $1,224,000 at June 30, 1997 and 1996, respectively. At June 30, 1997 and 1996, loans totaling $5,694,000 and $7,634,000, respectively, with specific reserves of $388,000 and $1,038,000, respectively, that the Company has classified as impaired, are performing in accordance with the terms of their contractual agreements. Interest income on impaired loans of $925,000 and $707,000 was recognized in the years ended June 30, 1997 and 1996, respectively.
Nonaccrual loans totaled $5,217,000, $1,301,000 and $2,281,000 as of June 30, 1997, 1996 and 1995, respectively. If nonaccrual loans had been performing in accordance with their original terms, the Company would have recorded interest income of $438,000, $124,000 and $177,000, instead of interest income actually recognized of $169,000, $83,000 and $100,000, for the years ended June 30, 1997, 1996 and 1995, respectively.
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6. ACCRUED INTEREST RECEIVABLE
Accrued interest receivable is summarized as follows:
7. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
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8. REAL ESTATE OWNED
Real estate owned is summarized as follows:
Activity in the allowance for estimated real estate losses is summarized as follows:
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Loss from real estate operations, net is summarized as follows:
9. DEPOSIT ACCOUNTS
Deposit accounts are summarized as follows:
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Certificate accounts are scheduled to mature as follows:
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10. ADVANCES FROM THE FEDERAL HOME LOAN BANK
At June 30, 1997, advances of $50,000,000 from the FHLB are scheduled to mature in 1998.
The following summarizes activities in advances from the FHLB:
11. OTHER BORROWINGS
From time to time, the Company enters into reverse repurchase and dollar reverse repurchase agreements on investment and mortgage-backed securities.
The Company enters into reverse repurchase and dollar reverse repurchase agreements only with primary government securities dealers. The lender maintains possession of the collateral securing these agreements.
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12. INCOME TAXES
Income taxes are summarized as follows:
A reconciliation from the statutory federal income tax rate to the consolidated effective income tax rate follows:
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At June 30, 1997, 1996 and 1995, the deferred components of the Company's total income tax liabilities (assets), as included in the consolidated statements of financial condition, are summarized as follows:
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Gross deferred tax assets are primarily expected to be realized in 1998 and 1999.
Valuation allowances under SFAS No. 109 have been provided for state purposes to the extent uncertainty exists as to the recoverability of the deferred tax assets. As of June 30, 1997, 1996 and 1995, valuation allowances were provided for a portion of the net deferred state tax assets. Future reductions in the valuation allowance will be dependent upon a more-likely-than-not expectation of recovery of tax benefits.
13. BENEFIT PLANS
DEFINED BENEFIT PLAN - The Bank maintains a noncontributory, defined-benefit pension plan covering all employees who meet both minimum age and length of service requirements and a nonqualified, supplemental benefit plan for certain qualified officers. The Company has determined to terminate the defined benefit plan. As a result of the termination, an additional $2,991,000 in expense was recorded as of June 30, 1997, including the acceleration of expense recognition of $1,236,000 in prepaid pension plan expense. Termination of the Plan is expected in fiscal year ended June 30, 1998. Costs under the defined-benefit pension plan are calculated and funded under the Projected Unit Credit Actuarial Cost Method, which includes amortization of past service costs. The Bank's funding policy is to fund pension costs within the minimum/maximum contribution permitted under Employment Retirement Income Security Act of 1974 ("ERISA"), as calculated by the actuaries.
Net pension cost consists of the following:
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The following table sets forth the funded status of the Defined Benefit Plan:
The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 6.4% in 1997 and 7.5% in 1996 and 1995. The expected long-term rate of return on assets was 8.5% in 1997, 1996 and 1995.
EMPLOYEE STOCK OWNERSHIP PLAN AND TRUST - The Company established for eligible employees an Employee Stock Ownership Plan and Trust (ESOP) which became effective upon the conversion of the Bank from a mutual to a stock association (the Conversion). Eligible full-time and eligible part-time employees employed with the Bank who have been credited with at least 1,000 hours during a 12-month period and who have attained age 21 are eligible to participate.
The ESOP subscribed for 7% (or 462,875) of the shares of common stock issued in the Conversion pursuant to the subscription rights granted under the ESOP plan. On June 30, 1995, the ESOP borrowed $3,703,000 from the Company in order to fund the purchase of common stock. The loan to the ESOP will be repaid principally from the Company's contributions to the ESOP over a period of
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ten years and the collateral for the loan is the common stock purchased by the ESOP. The interest rate for the ESOP loan is 9%. At June 30, 1997 and 1996, the outstanding balance of the loan was $2,962,400 and $3,332,700 and a total of 100,231 and 46,288, respectively, shares of common stock were cumulatively allocated to employee accounts.
Shares purchased by the ESOP will be held in a suspense account for allocation among participants as the loan is repaid. Contributions to the ESOP and shares released from the suspense account in an amount proportional to the repayment of the ESOP loan will be allocated among participants on the basis of compensation in the year of allocations. Benefits generally become 100% vested after an employee's five years of credited service. Prior to the completion of five years of credited service, a participant who terminates employment for reasons other than death, retirement or disability will not receive any benefit. Benefits are payable upon death, retirement or disability.
The expenses related to the ESOP for the year ended June 30, 1997 and 1996 were approximately $708,000 and $665,000, respectively. At June 30, 1997 and 1996, unearned compensation related to the ESOP approximated $2,651,000 and $3,147,000, respectively, and is shown as a reduction of stockholders' equity in the accompanying consolidated statements of financial condition.
DEFERRED COMPENSATION PLAN - The Bank maintains a nonqualified deferred compensation plan (Deferred Compensation Plan) with certain directors, whereby such directors may defer all or a portion of compensation otherwise currently payable in exchange for the receipt at the time they cease to serve as directors of the Bank, with a benefit at the time of retirement as provided for in the Plan. Amounts deferred under this program will earn interest, compounded annually, based on the highest certificate account rate (excluding accounts requiring deposits of $100,000 or more) in effect on January 1 of each year of the deferral or distribution period. Directors may defer compensation for any number of years, designated in advance. The Deferred Compensation Plan provides that benefits are to be paid in a lump sum or annual installments over a period of years determined by the Bank, at its discretion. The Deferred Compensation Plan also provides that directors may elect to have their deferred compensation, or any portion thereof, invested in stock of the Company. Included in accounts payable and other liabilities at June 30, 1997 and 1996 are $332,000 and $524,000, respectively, of deferrals related to the Deferred Compensation Plan.
DIRECTORS' RETIREMENT PLAN - The Bank and Company maintain a retirement plan for those directors who have completed ten years of service or who have both attained the age of 65 and had five years of consecutive service as a director (Directors' Retirement Plan). The Directors' Retirement Plan provides that a participant will receive monthly benefits until death, equal to 60% of the basic monthly director's fee such participant received for the last month in which they served as director. Upon the retired participant's death, 50% of their benefit shall continue to be paid to their surviving spouse for the balance of the spouse's life. If the participant dies while still serving as a director, 50% of the monthly retirement benefit that said participant would have received had they retired the day
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immediately preceding the date of their death shall be paid to their surviving spouse for the balance of the spouse's life. The Directors' Retirement Plan was terminated effective March 31, 1995, and consequently, no new directors will be entitled to benefits under this plan.
Net pension cost for the Director's Retirement Plan consists of the following:
The following table sets forth the funded status of the Directors' Retirement Plan:
The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5% in 1997, 1996 and 1995.
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RETIREMENT RESTORATION PLAN - The Bank has implemented a nonqualified retirement plan to provide any qualifying executive with additional retirement benefits. The Company has determined to terminate the Retirement Restoration Plan. As a result of the termination, an additional $9,000 in expense was recorded as of June 30, 1997. Termination of the Retirement Restoration Plan is expected in fiscal year ended June 30, 1998. The benefits provided under such Plan will make up the benefits lost to the participant due to application of limitations on compensation and maximum benefits applicable to the Bank's tax-qualified, defined-benefit plan. Benefits will be provided under the Retirement Restoration Plan at the same time and in the same form as the benefits will be provided under the Bank's tax-qualified, defined-benefit plan.
Net pension cost for the Retirement Restoration Plan consists of the following:
The following table sets forth the funded status of the Retirement Restoration Plan:
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The weighted average discount rate used in determining the actuarial present value of the projected benefit obligation was 7.5% in 1997 and 1996.
STOCK BENEFIT PLANS - The Company maintains the amended and restated HF Bancorp, Inc. Stock-Based Incentive Plan (the Plan), which amends the HF Bancorp, Inc. 1995 Master Stock Option Plan and the 1995 Hemet Federal Savings & Loan Association 1995 Master Stock Compensation Plan, which were both adopted on January 11, 1996.
The Company applies Accounting Principles Board (APB) Opinion No. 25 and related interpretations in accounting for the Plan. Under APB No. 25, compensation cost for stock options is measured as the excess, if any, of the fair market value of the Company's stock at the date of grant over the amount the director or employee must pay to acquire the stock. Because the Plan provides for the issuance of options at a price of no less than the fair market value at the date of grant, no compensation cost has been recognized for the stock option components of the Plan.
Had compensation costs for the stock option components of the Plan been determined based upon the fair value at the date of grant consistent with SFAS No. 123, Accounting For Stock Based Compensation, the Company's net (loss) income and (loss) earnings per share would have been (increased) reduced to the pro forma amounts indicated below:
STOCK OPTION COMPONENT OF THE PLAN - Pursuant to the terms of the Plan, 661,250 shares of HF Bancorp, Inc. common stock are reserved for issuance under the stock option components of the Plan. Of these 661,250 shares, 547,550 are reserved for grant as Incentive Stock Options and 113,700 shares are reserved for grant as Nonstatutory Stock Options. To the extent that options are granted under the Plan, the shares underlying such options are unavailable for any other use including future grants under the Plan, except that options which terminate, expire, or are forfeited without having been exercised may be recycled into new grants.
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NONSTATUTORY STOCK OPTIONS - Nonstatutory Stock Options may be granted to employees and outside directors. The exercise price of each Nonstatutory Stock Option is determined by the Board of Directors; and may not be less than the fair market value of HF Bancorp, Inc. common stock on the date of grant. The term of each Nonstatutory Stock Option shall be determined by the Board of Directors, but in no case shall such term exceed 10 years from the date of grant. Nonstatutory Stock Options vest and are exercisable as determined by the Board of Directors. However, all Nonstatutory Options granted will be immediately vested and exercisable in the event the optionee terminates his employment due to death, disability, or a change in control of Hemet Federal Savings & Loan or HF Bancorp, Inc. In the event optionee's employment is terminated for cause, all optionee rights under the optionee's Nonstatutory Options expire immediately. In the event optionee terminates his employment due to reasons other than death, disability, a change in control, and termination for cause, optionee's Nonstatutory Stock Options shall be exercisable only to the extent that such options were exercisable at the date of termination, and for a period of three months following termination except in the case of retirement, which provides for an exercise period of twelve months following termination.
The Nonstatutory Stock Options do not provide for the granting of stock appreciation rights; however, all options were granted in tandem with limited stock appreciation rights exercisable in the event of a change in control of Hemet Federal Savings & Loan or HF Bancorp, Inc., as defined by the Plan.
INCENTIVE STOCK OPTIONS - Incentive Stock Options may be granted to employees. The exercise price of each Incentive Stock Option is determined by the Board of Directors, but may not be less than the fair market value of HF Bancorp, Inc. common stock on the date of grant. The term of each Incentive Stock Option shall be determined by the Board of Directors, but in no case shall such term exceed 10 years from the date of grant. Incentive Stock Options vest and are exercisable as determined by the Board of Directors. The Board of Directors may select various conditions or performance goals which must be satisfied prior to the Incentive Stock Options' becoming exercisable. Incentive Stock Options are designed to comply with Section 422 of the Internal Revenue Code (IRC). However, any Incentive Stock Options failing to qualify under the IRC are converted to Nonstatutory Stock Options.
All Incentive Stock Options granted will be immediately vested and exercisable in the event the optionee terminates his employment due to death, disability, or a change in control of Hemet Federal Savings & Loan or HF Bancorp, Inc. In the event the optionee's employment is terminated for cause, all optionee rights under the optionee's Incentive Stock Options expire immediately. In the event the optionee terminates his employment due to reasons other than death, disability, a change in control, and termination for cause, optionee's Incentive Stock Options shall be exercisable only to the extent that such options were exercisable at the date of termination, and for a period of three months following termination except in the case of retirement, which provides for an exercise period of twelve months following termination (although, in the event of retirement, exercising after three months will result in a loss of incentive stock option treatment under the IRC). The Incentive Stock Options do not provide for the granting of stock appreciation rights; however, all options were granted in tandem with limited stock appreciation rights exercisable in the event of a change in control of Hemet Federal Savings & Loan or HF Bancorp, Inc., as defined by the Plan.
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The Stock Option components of the Plan as of June 30, 1997 and 1996, and changes during the years then ended, consist of the following:
Options to purchase 138,065 and 65,910 shares were available for future grants as of June 30, 1997 and June 30, 1996, respectively.
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At the July 24, 1997 Board of Directors meeting, 99,000 options for the purchase of shares were issued at the then-current market price of HF Bancorp, Inc. common stock ($14.34), leaving 39,065 shares available for future option grants.
STOCK AWARD COMPONENT OF THE PLAN - The Company established the stock award component of the Plan as a method of providing directors, officers, and employees with a proprietary interest in the Company in a manner designed to encourage such persons to remain with the Company and to improve the performance of the Company. The Company contributed $1,983,750 from available liquid assets on February 28, 1996 to purchase 198,375 shares in the open market at an average cost of $10.00 per share. This contribution represents deferred compensation which is initially recorded as a reduction in stockholders' equity and then is ratably charged to compensation expense over the vesting period of the actual stock awards.
The Plan provides for two types of stock awards: time-based grants and performance-based grants. Outside directors of the Company receive time-based grants, which vest on a straight-line basis over the applicable period, as determined by the Board of Directors. Employees are eligible for both time-based grants and performance-based grants. Vesting of performance-based grants is dependent upon achievement of the criteria established by the Board of Directors for each stock award.
All stock awards granted will be immediately vested and exercisable in the event the award recipient terminates his employment due to death, disability, or a change in control of Hemet Federal Savings & Loan or HF Bancorp, Inc. In the event the award recipient terminates his employment due to any reason other than death, disability, or a change in control, all unvested stock awards become null and void.
During the fiscal years ended June 30, 1997 and 1996, the Company recorded $354,000 and $198,000, respectively, in compensation expense related to the stock award component of the Plan. During the fiscal year ended June 30, 1995, no compensation expense was recorded related to the Plan.
A summary of the status of the stock award component of the Plan as of June 30, 1997 and 1996, and changes during the years ended on those dates, is presented below:
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At the July 24, 1997 Board of Directors meeting, 33,300 shares were granted, leaving 5,894 shares available for future stock awards.
14. COMMITMENTS AND CONTINGENCIES
The Company is a party to financial instruments with off-balance sheet risk in the normal course of business, in order to meet the financing needs of its customers. These financial instruments represent commitments to fund loans. Commitments are issued following the Company's evaluation of each applicant's creditworthiness on a case-by-case basis. At June 30, 1997, the Company had outstanding loan funding commitments of $10,129,000, substantially all of which were adjustable rate commitments. Commitments to fund loans are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Also, external market forces impact the probability of commitments being exercised; therefore, total commitments outstanding do not necessarily represent future cash requirements.
As of June 30, 1997, minimum future operating lease commitments of the Company for real and personal property are as follows:
Included in general and administrative expenses are rents and other leasehold expenses which approximated $928,000, $520,000 and, $468,000 for the years ended June 30, 1997, 1996 and 1995, respectively.
The Company is involved in litigation concerning various transactions entered into during the normal course of business. Management does not believe that settlement of such litigation will have a material effect on the Company's financial position or results of operations.
The Company has negotiated employment agreements with its chief executive and operating officers. The employment agreements provide for the payment of severance benefits upon termination.
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15. INTEREST RATE RISK MANAGEMENT - OFF-BALANCE SHEET ACTIVITIES
From 1987 to 1993, the Company entered into various interest rate exchange agreements in order to reduce the interest rate risk associated with long-term fixed-rate mortgages and short-term liabilities. These agreements were designated as hedges of short-term liabilities, specifically deposit accounts with no specified maturity date or with maturity dates of less than one year which were expected to be renewed or replaced with other deposits upon their maturity.
The Company pays a fixed rate and earns a variable rate, three-month LIBOR on interest rate swap agreements with notional amounts of $35,000,000 as of June 30, 1997 and 1996, and $110,000,000 as of June 30, 1995. The agreements are due to mature on various dates through 1999. At June 30, 1997, 1996 and 1995, the weighted average fixed-payment rate and variable-payment received rate were 8.72% and 5.85%, 8.72% and 5.49% and 9.17% and 6.15%, respectively.
At June 30, 1997, outstanding notional amounts and maturity dates of interest rate exchange agreements are summarized as follows:
Net interest expense (income) recorded by the Company on interest rate swap, cap and floor agreements is summarized as follows:
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There are certain risks associated with swaps, floors and caps, including the risk that the counterparty may default and that there may not be an exact correlation between the indices on which the interest-rate swap agreements are based and the terms of the hedged liabilities. In order to offset these risks, the Company generally enters into interest-rate swap, floor and cap agreements only with nationally recognized securities firms and monitors the credit status of counterparties, the level of collateral for such swaps and caps, and the correlation between the hedged liabilities and indices utilized. There is no assurance that, in the event interest rates change, the swaps, floors and caps will move on the same basis or in the same amounts as its cost of funds.
On July 10, 1995, the Company terminated four interest-rate swap agreements with an aggregate outstanding notional amount of $60,000,000. At June 30, 1995, the weighted average fixed-payment rate and variable-payment received rate were 9.53% and 6.11%, respectively. The Company paid a termination fee of $4,856,000 which has been deferred and is being amortized over the remaining terms of the respective swap agreements.
16. FAIR VALUE OF FINANCIAL INSTRUMENTS
The following disclosures of the estimated fair value of financial instruments is made in accordance with the requirements of SFAS No. 107, Disclosures about Fair Value of Financial Instruments. The estimated fair value amounts have been determined by the Company, using available market information and appropriate valuation methodologies. However, considerable judgment is necessarily required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange.
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The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts.
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The estimated fair values of investment securities and mortgage-backed securities are based on quoted market prices or dealer quotes. If quoted market prices are not available, estimated fair values are based on quoted market prices of comparable instruments.
The fair value of loans receivable is estimated by discounting the future cash flows using the current rates at which similar loans would be made to borrowers with similar credit ratings and for the same remaining maturities. The fair value of nonperforming loans with a principal balance of approximately $5,217,000 and $1,301,000 at June 30, 1997 and 1996, respectively, was not estimated because it is not practicable to reasonably assess the credit adjustment that would be applied in the marketplace for such loans. These nonperforming loans have a weighted average interest rate of 8.32% and 8.84% as of June 30, 1997 and 1996, respectively, and are due at various dates through 2025.
The estimated fair value of Federal Home Loan Bank stock is based on its redemption value.
The fair value of term deposit accounts is estimated using the rates currently offered for deposits of similar remaining maturities. The estimated fair value of other deposit accounts is the amount payable on demand at June 30, 1997 and 1996.
Rates currently available to the Company for debt with similar terms and remaining maturities are used to estimate the fair value of advances from the Federal Home Loan Bank.
The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For fixed-rate loan commitments, the estimated fair value also considers the difference between current levels of interest rates and the committed rates.
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The fair value of interest-rate swap agreements is the estimated amount that the Company would receive or pay to terminate the interest-rate swap agreements at the reporting date, taking into account current interest rates and the current creditworthiness of the swap counterparties.
The fair value of accrued interest receivable and accrued interest payable is estimated at book value.
The fair value estimates presented herein are based on pertinent information available to management as of June 30, 1997 and 1996. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively re-evaluated for purposes of these consolidated financial statements since that date, and therefore, current estimates of fair value may differ significantly from the amounts presented herein.
17. BUSINESS ACQUISITIONS
In September 1996, the Company acquired Palm Springs Savings Bank ("Palm Springs") for approximately $16,300,000. The Company acquired all outstanding shares of common stock of Palm Springs, including total deposits of $164,687,000 as well as other items for four branches in the Coachella Valley communities. The acquisition was accounted for under the purchase accounting method. In conjunction with the acquisition, the Company recorded a core deposit intangible of $9,808,000. The intangible balance is included in intangible assets on the consolidated statement of financial condition. Amortization is calculated on a straight-line basis, over seven years, with total amortization of $1,030,000 recorded for the year ended June 30, 1997.
The following unaudited pro forma financial information presents the combined results of operations as if the acquisition had taken place on July 1, 1995, after giving effect to purchase accounting adjustments.
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The weighted average number of shares used in the calculation of earnings per share was 5,755,859 (1997) and 5,953,823 (1996).
The results of operations since the date of the acquisition is included in the accompanying consolidated statement of operations.
During June 1996, the Company acquired deposit accounts totaling approximately $185,189,000 and certain other assets of three branches in San Diego County. A premium of approximately $6,642,000 was paid, all of which was allocated to core deposit intangible to be amortized, on a straight-line basis, over seven years. The balance is included in intangible assets in the accompanying consolidated statements of financial condition. Amortization of $949,000 was recorded for the year ended June 30, 1997 and no amortization was recorded for the year ended June 30, 1996.
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Intangible assets are summarized as follows:
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18. PARENT COMPANY FINANCIAL INFORMATION
The following presents the unconsolidated financial statements of the parent company only, HF Bancorp, Inc. (Note 1).
HF BANCORP, INC. (PARENT COMPANY ONLY)
STATEMENTS OF FINANCIAL CONDITION
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HF BANCORP, INC. (PARENT COMPANY ONLY)
SUMMARY STATEMENTS OF CASH FLOWS
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19. QUARTERLY RESULTS OF OPERATIONS (UNAUDITED)
The following is a summary of quarterly results:
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURES
None. PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
The information relating to Directors and Executive Officers of the Registrant is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on October 28, 1997, on pages 6 through 8. Information concerning executive officers who are not directors is contained in Part I of this report pursuant to paragraph (b) of Item 401 of Regulation S-K in reliance on Instruction G.
ITEM 11. EXECUTIVE COMPENSATION
The information relating to executive compensation is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on October 28, 1997, on pages 11 through 19 (excluding the Report of the Compensation Committee on pages 11 through 13 and the Stock Performance Graph on page 14).
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information relating to security ownership of certain beneficial owners and management is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on October 28, 1997, on page 4 and 6 through 8.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information relating to certain relationships and related transactions is incorporated herein by reference to the Registrant's Proxy Statement for the Annual Meeting of Stockholders to be held on October 28, 1997, on page 19.
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULES, AND REPORTS ON FORM 8-K
(a) 1. Financial Statements
These documents are listed in the Index to Consolidated Financial Statements under Item 8.
2. Financial Statement Schedules
Financial Statement Schedules have been omitted because they are not applicable or the required information is shown in the Consolidated Financial Statements or Notes thereto.
(b) Reports on Form 8-K Filed During the Quarter Ended June 30, 1997
None
(c) Exhibits Required by Securities and Exchange Commission Regulation S-K
Exhibit Number - --------------
3.1 Amended Certificate of Incorporation of HF Bancorp, Inc.*
3.2 Bylaws of HF Bancorp, Inc.*
4.0 Stock Certificate of HF Bancorp, Inc.*
10.1 Form of Employment Agreement entered into between the Association and Mr. Cupp
10.2 Form of Employment Agreement entered into between the Company and Mr. Cupp
10.3 Form of Employment Agreement entered into between the Association and Mr. Agnes
10.4 Form of Employment Agreement entered into between the Company and Mr. Agnes
10.5 Hemet Federal Savings and Loan Association Employee Stock Ownership Plan and Trust*
10.6 Hemet Federal Savings and Loan Association Retirement Restoration Plan**
10.7 Hemet Federal Savings and Loan Association Directors Deferred Fee Stock Unit Plan**
10.8 Hemet Federal Savings and Loan Association Management Deferred Compen- sation Plan**
10.9 HF Bancorp, Inc. 1995 Master Stock Option Plan***
21 Subsidiaries of HF Bancorp, Inc. See "Part II - Item 7