ITEM 1. BUSINESS
GENERAL
St. Francis Capital Corporation (the "Company") is a holding company incorporated under the laws of the State of Wisconsin and is engaged in the financial services business through its wholly-owned subsidiary, St. Francis Bank, F.S.B. (the "Bank"), a federally-chartered stock savings bank. For the majority of fiscal 1997, the Company also conducted operations through Bank Wisconsin, a wholly-owned state-chartered bank ("Bank Wisconsin") which was merged with and into the Bank in September, 1997. In June 1993, the Bank converted from a federally-chartered mutual savings institution to a stock savings institution. As part of the conversion, the Company acquired all of the outstanding common stock of the Bank. In November 1994, the Company completed the acquisition of the stock of Valley Bank East Central in Kewaskum, Wisconsin as well as the deposits and certain assets of the Hartford, Wisconsin branch of Valley Bank Milwaukee. The acquired bank offices were combined as a commercial bank named Bank Wisconsin. In February 1997, the Company completed the acquisition of Kilbourn State Bank in Milwaukee, Wisconsin. Kilbourn State Bank was merged into Bank Wisconsin after the acquisition was completed. As noted above, in September 1997, Bank Wisconsin was merged into the Bank, with the Bank being the surviving entity.
The Bank is headquartered in Milwaukee, Wisconsin. Its deposits are insured up to applicable limits by the Savings Association Insurance Fund ("SAIF"), administered by the Federal Deposit Insurance Corporation ("FDIC"). Originally chartered in 1923, the Bank serves southeastern Wisconsin with a network of nineteen full-service, two limited service and two loan production offices.
The Company's principal business is attracting retail deposits from the general public and investing those deposits, together with funds generated from other operations, primarily to originate mortgage, consumer and other loans within its primary market areas and to invest in mortgage-backed and related securities. Primary areas of lending include single-family and multi-family residential mortgages, home equity lines of credit, second mortgages, commercial real estate and commercial loans. The Company also purchases single-family mortgage loans, either by directly purchasing individual loans from other local mortgage lenders or by purchasing pools of single-family mortgage loans originated by other non-local lenders and secured by properties located outside the State of Wisconsin. The Company also invests a significant portion of its assets in mortgage-backed and related securities, and to a lesser extent, invests in debt and equity securities, including U.S. Government and federal agency securities, short-term liquid assets and other marketable securities. The Company also invests in affordable housing
projects throughout the State of Wisconsin. The Company's revenues are derived principally from interest on its loan portfolio, interest on mortgage-backed and related securities and interest and dividends on its debt and equity securities. The affordable housing projects do not provide a significant source of income before taxes but rather, provide income in the form of income tax credits which reduce the Company's income tax liability. The Company's principal sources of funds are from deposits, including brokered deposits, repayments on loans and mortgage-backed and related securities and advances from the Federal Home Loan Bank - Chicago ("FHLB").
MARKET AREA AND COMPETITION
The Company offers a variety of deposit products, services and mortgage loan offerings primarily within the metropolitan Milwaukee area. The Company's main office is located at 13400 Bishops Lane, Suite 350, Brookfield, Wisconsin. The Company's primary market area consists of Milwaukee and Waukesha counties, and portions of Ozaukee, Washington, Walworth and Kenosha counties. With the exception of the downtown Milwaukee branch office, all full service branches of the Bank are located in areas that generally are characterized as residential neighborhoods, containing predominantly one- and two-family residences.
The Company has significant competition in its mortgage, consumer and commercial lending business, as well as in attracting deposits. The Company's competition for loans is principally from other thrift institutions, savings banks, mortgage banking companies, insurance companies and commercial banks. However, its most direct competition for deposits historically has come from other thrifts, savings banks, commercial banks and credit unions. The Company has faced additional competition for funds from a number of institutions, including the availability of short-term money market funds and other corporate and government securities funds offered by other financial service companies, such as brokerage firms and insurance companies.
LENDING ACTIVITIES
GENERAL
The Company's largest component of the gross loan portfolio, which totaled $784.8 million at September 30, 1997, was first mortgage loans secured by owner-occupied one- to four-family residences. At September 30, 1997, one- to four-family mortgage loans totaled $240.5 million or 30.7% of gross loans. Of the total one- to four-family mortgage loans, $196.4 million or 81.7% were ARMs. Of the remaining loans held at September 30, 1997, 15.4% were in consumer loans, 14.7% were home equity loans, 12.9% were in multi-family mortgage loans, 11.2% were in commercial real estate, 9.2% were in commercial and agricultural and 5.9% were in residential construction. As part of its strategy to manage interest rate risk, the Company originates primarily ARM loans or fixed rate loans which have shorter maturities for its own loan portfolio. However, the Company also offers longer term fixed rate mortgage loans, many of which are sold in the secondary market.
The Company has been actively growing its loan portfolio which in addition to its traditional one- to four-family lending, includes consumer, commercial, multi-family and commercial real estate lending. One of the Company's strategies will be to attempt to diversify its loan portfolio through lending efforts in all of the above categories. The acquisitions of Bank Wisconsin and Kilbourn State Bank have led to the establishment of a commercial lending function at the Company. In addition, the Bank has been actively growing its consumer and home equity loan portfolios in recent years. Areas of lending other than one- to four-family generally have higher levels of credit risk and higher yields than one- to four-family lending. In addition, the Company may purchase loans in the above categories in addition to originating the loans on its own. Purchased loans involve different types of underwriting than loans originated directly by the Company and as such represent a different level of risk.
Levels of originations of various lending categories may vary from year-to-year and result from levels of interest rates, market demand for loans and emphasis by the Company on various types of loans. The Company will adjust its lending emphasis occasionally in accordance with its view of the relative returns and risks available at that time in each category of lending. Although there is likely to be activity in all areas in which the Company makes loans in any given year, the amount will vary given the above factors.
COMPOSITION OF LOAN PORTFOLIO
The following table sets forth the composition of the Company's loan portfolio in dollar amounts and in percentages of the respective portfolios at the dates indicated.
The following table sets forth the Company's loan originations and loan purchases, sales and principal repayments for the years indicated. Mortgage loans held for sale are included in the totals.
LOAN MATURITY AND REPRICING
The following table shows the maturity of the Company's loan portfolio at September 30, 1997. The table does not include prepayments or scheduled principal amortization. Prepayments and scheduled principal amortization on mortgage loans totaled $111.9 million, $125.3 million and $87.0 million for the years ended September 30, 1997, 1996 and 1995.
(1) Includes some residential construction lending.
The following table sets forth at September 30, 1997 the dollar amount of all loans and mortgage-backed and related securities due after September 30, 1998, and whether such loans have fixed interest rates or adjustable interest rates.
(1) Includes some residential construction lending.
ONE- TO FOUR-FAMILY MORTGAGE LENDING
A significant portion of the Company's lending activity is the origination of first mortgage loans secured by one- to four-family, owner occupied residences within the Company's primary market area. Long-term 15- and 30- year fixed-rate loans are generally originated to be sold in the secondary market, as are five and seven year balloon loans. Shorter-term ARM loans are originated both for sale in the secondary market and for the Company's loan portfolio. In addition, loans made under special loan terms or programs, principally originated within the purposes of the Community Reinvestment Act of 1977, as amended ("CRA") are retained for the Company's own loan portfolio. The Company follows FNMA underwriting guidelines for most one- to four-family mortgage loans.
The lending policy of the Company generally allows for mortgage loans to be made in amounts of up to 100% of the appraised value of the real estate to be mortgaged to the Company. Loans that are to be sold in the secondary market are made at 80% or less of appraised value under underwriting guidelines of the major mortgage secondary market makers. Loans retained in the Company's portfolio are made at levels of up to 100% of appraised value and may have private mortgage insurance or no mortgage insurance in some cases. With respect to those loans made at levels of up to 100% of appraised value, other underwriting criteria, such as debt service ability and credit history are given greater emphasis than lending involving lower loan to value ratios. In addition, loans with higher loan to value ratios generally are made at higher interest rates than other loans and may have a higher level of risk of default.
The Company makes loans under various governmental programs including the Federal Housing Authority ("FHA"), the federal and state Veterans Administration ("VA"), the Wisconsin Housing and Economic Development Authority ("WHEDA") and other City of Milwaukee-sponsored mortgage loan programs, and sells these loans. See "-Loan Sales and Purchases."
Included in mortgage loans held by the Company as part of its loan portfolio are ARM loans. Current one-year ARM loans typically adjust by a maximum of two percentage points per year with a lifetime cap approximating six percentage points above the interest rate established at the origination date of the ARM loan. Monthly payments of principal and interest are adjusted when the interest rate adjusts, in order to maintain full amortization of the mortgage loan within a maximum 30-year term. The initial rate offered on ARM loans fluctuates with general interest rate changes, and are determined by secondary market pricing, competitive conditions and the Company's yield requirements. Currently, the Company primarily utilizes the one-year Constant Maturity Treasury rate in order to determine the interest rate payable upon the adjustment date of its ARM loans outstanding. Most of the ARM loans are granted with conversion capabilities which provide terms under which the borrower may convert the mortgage loan to a fixed rate mortgage loan for a limited period during the early term of the ARM loan. The terms at which the ARM may be converted to a fixed rate loan are established at the date of loan origination and are set at a level allowing the Company to immediately sell the ARM loan at the date of conversion.
The Company offers balloon loan programs under which the interest rate and monthly payments are fixed for the first five or seven years of the mortgage loan and, thereafter, provided certain conditions are met, the loan would adjust to then current rates at the end of the fifth or seventh year, at which time the loan balance is then amortized for the full remaining term of the loan, based upon interest rates and appropriate principal and interest payments then in effect.
At September 30, 1997, the Company had $240.5 million in one- to four-family mortgage loans or 30.7% of the gross loan portfolio compared with $270.6 million or 40.5% of the portfolio at September 30, 1996. The decrease in the dollar amount of the portfolio was largely the result of the lower interest rate environment in effect during the course of the year. The larger decline in the percent of one- to four-family loans to total loans also was due to the increasing levels of other types of lending at the Bank. During periods of lower interest rates, such as experienced during the last year, many of the Company's one- to four-family loan customers prefer loans with fixed rates which the Company originates and sells in the secondary market in connection with interest rate risk management. Consequently, the lower volume of adjustable rate loan originations may not then be enough to offset the amount of repayments and prepayments taking place within the Company's loan portfolio. In such environments, the Company's level of gains on mortgage loans may be higher due to the increased percentage of loans being originated which are subsequently sold in lieu of being retained in the Company's portfolio. The volume of one- to
four-family mortgage loans is highly dependent on the relative levels of interest rates, although the Company has been expanding its one- to four-family lending capacity and the Company anticipates that as a result total originations will continue to increase assuming continuing interest rate levels.* In addition, one- to four-family lending is subject to numerous competitors which can result in lower origination totals if the competitors are willing to make loans at lower rates than the Company.
RESIDENTIAL CONSTRUCTION LENDING
Residential construction loans are made to individuals who have signed construction contracts with a home builder. Loan proceeds are disbursed in increments as construction of the residence progresses. These loans have loan to value ratios up to 95%. When the loan to value ratio exceeds 80%, private mortgage insurance is generally required which insures payment of the principal balance and reduces the Company's exposure to 75% loan to value or less. Single family residential construction loans are structured to allow the borrower to pay interest only on the funds advanced during the first nine months of the loan. Thereafter, the borrower is required to begin making principal and interest payments based on an amortization schedule of 351 months or less. Single family residential construction loan programs typically offered by the Company are one- or three-year ARM loans or certain balloon loans amortized over a 351-month period after the nine month interest only period.
The Company does not engage in construction lending for large tract developments. However, from time to time, the Company will consider multi-family residential construction lending. The loan to value on these loans does not exceed 80%. Multi-family construction loans typically offered by the Company are ARM loans amortized over 348 months after allowing for interest only payments during a twelve month construction period. Loan proceeds are advanced in increments as construction of the project progresses.
At September 30, 1997, the Company had $46.3 million in residential construction mortgage loans or 5.9% of the gross loan portfolio compared with $32.2 million or 4.8% of the portfolio at September 30, 1996. A significant portion of the Company's construction lending results in a permanent mortgage loan that is either retained in the mortgage loan portfolio or sold in the secondary market.
MULTI-FAMILY LENDING
The Company originates multi-family loans which it holds in its loan portfolio. Over the last five years, the Company has increased its emphasis in multi-family lending and has offered both adjustable- and fixed-rate loans. Multi-family loans generally have shorter maturities than one- to four-family mortgage loans, though the Company will make multi-family loans with terms of up to 30 years. The rates charged on the Company's fixed rate and ARM multi-family loans are typically higher than on one- to four-family residential properties. Multi-family ARM loans typically adjust in a manner similar to that of the Company's other ARM loans, although generally at a slightly higher rate. Multi-family loans generally are underwritten in amounts of up to 80% of the lesser of the appraised value or purchase price of the underlying property.
At September 30, 1997, the largest aggregate amount of loans outstanding to any one borrower consisted of a loan on a multi-family project in Madison, Wisconsin, of $8.1 million. This loan does not exceed the regulatory "loans to one borrower" limitation at September 30, 1997 of $18.6 million. See "-Regulation." Loans secured by multi-family real estate generally involve a greater degree of credit risk than one- to four-family loans and carry larger loan balances. The increased credit risk is the result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income-producing properties and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced, the borrower's ability to repay the loan may be impaired. In some instances, the risk level is mitigated by obtaining individual guarantees which may increase the level of collateral supporting the loan. Despite the risks inherent in multi-family lending, the Company's delinquent multi-family loans as a percentage of gross loans has been minimal.
At September 30, 1997, the Company had $101.3 million in multi-family mortgage loans or 12.9% of the gross loan portfolio compared with $103.3 million or 15.4% of the portfolio at September 30, 1996. The Company is continuing its efforts to increase the amount of the multi-family loans in the loan portfolio as these loans generally offer a greater yield than single-family loans, which the Company believes justifies the increased credit risk.
COMMERCIAL REAL ESTATE LENDING
The current lending policy of the Company includes originating or purchasing non-residential mortgage loans on a variety of commercial properties, including small office buildings, warehouses, small industrial/manufacturing buildings, motel properties and other improved non-residential properties. At September 30, 1997, the balance of such loans held by the Company was $88.0 million. As of September 30, 1997, the largest loans outstanding to any one borrower relating to commercial real estate consisted of two loans totaling $7.6 million on an office building and a shopping center in Madison, Wisconsin. Commercial real estate loans generally are underwritten in amounts up to 75% of the lesser of the appraised value or purchase price of the underlying property. However, loans secured by commercial real estate properties still involve a greater degree of credit risk than residential mortgage loans and generally carry large loan balances, and payments on loans secured by commercial real estate are often susceptible to adverse conditions in the real estate market or the economy. Despite the risks inherent in commercial real estate lending, the Company's delinquent commercial real estate loans as a percentage of gross loans has been minimal.
At September 30, 1997, the Company had $88.0 million in commercial real estate mortgage loans or 11.2% of the gross loan portfolio compared with $46.4 million or 6.9% of the portfolio at September 30, 1996. The Company is continuing its efforts to increase the amount of commercial real estate loans in the loan portfolio as these loans generally offer a better interest rate than single-family loans, which the Company believes justifies the increased credit risk.
HOME EQUITY LENDING
The Company has increased its emphasis in originating home equity loans secured by one- to four-family residences within its primary market area. These loans currently are originated with an interest rate indexed to the prime rate and adjustable monthly. The home equity loans are revolving lines of credit which are granted for a five-year term, renewable at the sole discretion of the Company for additional five-year periods. The maximum amortization to repay home equity loans is based on 1.5% of the outstanding balance. Typically, an origination fee is charged upon the origination of the loan and an annual service fee is charged thereafter. Home equity lines of credit may be made at up to a 100% loan-to-value level including any outstanding prior liens against the property which serves as collateral for the mortgage loan. For loans over 80% loan-to-value, the Company may obtain private mortgage insurance. The Company is usually in a second lien position on home equity loans. At September 30, 1997, the Company held $115.3 million in home equity loans or 14.7% of the gross loan portfolio compared with $90.6 million or 13.5% of the portfolio at September 30, 1996. Home equity loans offer the Company an asset that adjusts with current rates of interest as part of the Company's management of its interest rate risk.
CONSUMER LENDING
The Company has been expanding its consumer lending portfolio because higher yields can be obtained, the Company believes there is strong consumer demand for such loan products, and the Company historically has experienced relatively low delinquency and few losses on such products except for losses on sub-prime auto loans described further herein. Management also believes that offering consumer loan products helps to expand and create stronger customer relationships. At September 30, 1997, consumer loans totaled $121.3 million or 15.4% of gross loans compared to $100.4 million or 15.0% of gross loans at September 30, 1996. The increase in the portfolio has been primarily in the area of indirect auto lending through dealers located in the Company's primary market area and fixed term installment loans the Company makes that are secured by second mortgages in residential properties.
The Company originates a variety of secured consumer loans, including home improvement loans, automobile loans, educational loans, fixed term installment loans and interim financing loans, as well as loans secured by
savings accounts and unsecured loans. Consumer loan terms vary according to the type of collateral, term of the loan and creditworthiness of the borrower.
During fiscal 1995 and through January 1996, the Company purchased sub-prime automobile loans originated throughout the United States under a warehouse financing agreement. The intent was to warehouse the loans until the originator could originate sufficient quantities to securitize the loans to sell to institutional investors. The loans were serviced by an independent third party servicer and had various levels of insurance and also guarantees from the originator. The level of delinquencies and defaults on these loans increased significantly during fiscal 1996 and the Company ceased purchasing such loans. The Company currently has no intent to enter into any similar arrangement but does intend to continue to originate or purchase automobile loans in its primary market areas. The balance of the purchased automobile loans was $1.1 million at September 30, 1997.
Consumer loans may entail greater risk than residential mortgage loans, particularly in the case of unsecured loans or loans secured by rapidly depreciating assets such as automobiles. In such case, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be affected by adverse personal circumstances. Furthermore, the application of various federal and state laws, including bankruptcy and insolvency laws, may limit the amount which can be recovered on such a loan. Although the delinquencies and net charge-offs in the Company's consumer loan portfolio generally have been low, there can be no assurance that the level of delinquencies and charge-offs will not increase in the future.
COMMERCIAL AND AGRICULTURE LENDING
The Company originates a variety of commercial and agriculture loans, including inventory and receivable financing, equipment loans, agriculture production loans and interim financing loans, as well as loans secured by corporate or farm assets and unsecured loans. Commercial and agriculture loans involve a greater degree of risk than most other types of loans, and payments on commercial and agriculture loans are often susceptible to adverse employment and economic conditions. Also, the repayment of loans secured by commercial business assets is typically dependent upon the successful operation of the business and the eventual cash flows of the business. The Company anticipates commercial and agriculture lending to continue to increase as management believes this type of lending is an important component of a balanced loan portfolio. Typically, the Company targets smaller businesses with which to establish commercial banking relationships. These relationships may include secured or partially secured real estate, business or cash flow loans and inventory lending. Collateral can take many forms, such as real estate, inventory, equipment or may include personal guarantees of business owners or personal or other collateral of the business owner. The Company takes into account all cash flows attributable to the business plus collateral when making the lending decision. Despite the risks inherent in commercial lending, the Company's delinquent commercial loans as a percentage of gross loans has been minimal.
At September 30, 1997, the Company had $72.1 million in commercial loans or 9.2% of the gross loan portfolio compared with $25.2 million or 3.9% of the portfolio at September 30, 1996. $18.7 million in commercial loans were purchased as part of the Kilbourn State Bank acquisition. At September 30, 1997, the largest commercial loan outstanding was a $5.9 million lease financing arrangement and the largest outstanding line of credit was a $9.0 million line on a manufacturing facility. Beginning with the purchase of Bank Wisconsin, the Company has begun to build a commercial loan portfolio as one of the components of its loan portfolio. The Company intends to continue to increase its involvement in commercial lending and expects that this portfolio will grow as a percentage of the total loan portfolio.*
CREDIT ENHANCEMENT PROGRAMS
The Company has entered into agreements whereby, for an initial and annual fee, it would guarantee payment of an industrial revenue bond issue ("IRB"). The IRB's were issued by municipalities to finance real estate owned by a third party. The Company has not pledged any collateral for purposes of these agreements. At September 30, 1997, the amount of the IRB's for which the Company has guaranteed payment was $11.2 million.
LOAN SALES AND PURCHASES
SALE OF MORTGAGE LOANS
The Company makes loans under various governmental programs including FHA, VA, WHEDA and other City of Milwaukee-sponsored mortgage loan programs. All loans made under the various governmental agency programs are underwritten to and must meet all requirements of the appropriate city, state or federal agency. Most of the Company's loans granted under governmental agency programs are sold either to secondary market purchasers of such loans or, in the case of WHEDA loans, sold directly to WHEDA, all on a non-recourse basis. Except for loans sold to WHEDA, servicing of the loans is typically released to the purchaser of such loans. For the year ended September 30, 1997, the Company originated $10.2 million of loans under these various governmental programs.
In recent years, the Company has sold a significant amount of its originated residential mortgage loans to secondary marketing agencies, principally FNMA, primarily on a non-recourse basis. All mortgage loans, upon commitment, are immediately categorized either as to be held for investment or held for sale. Mortgage loans originated and sold to the secondary market totaled $116.8 million with gains of $1.6 million for the year ended September 30, 1997, and totaled $62.6 million with gains of $1.1 million for the year ended September 30, 1996. The level of mortgage loan sales is dependent on the amount of sellable loans being originated by the Company. Depending on factors such as interest rates, levels of refinancings and competitive factors in the Company's primary market area, the amount of mortgage loan originations ultimately sold can vary significantly. The Company is subject to interest rate risk on fixed rate loans in its pipeline from the point in time that the rate is locked with the borrower until the actual swap of the loan and sale of the related security. The Company utilizes various financial techniques to mitigate such interest rate risk, including short call/put option strategies, long put options and forward sales commitments. Any one or all of these strategies may be used depending upon management's determination of interest rate volatility, the amount of loans currently in the pipeline and current market conditions for mortgage-backed securities. See "Management's Discussion and Analysis of Financial Condition and Results of Operations-Asset/Liability Management."
Loan commitments are issued as soon as possible upon completion of the underwriting process, and mortgage loans are closed as soon as all title clearance and other required procedures have been completed. Because of the frequency of both the issuance of commitments and the scheduled closing dates of the loans, the amount of loan commitments outstanding will vary. At September 30, 1997, the Company had outstanding mortgage commitments totaling $27.7 million.
The Company retains servicing of the majority of mortgage loans sold, receiving a servicing fee, which represents the difference between the mortgage rate on the loans sold and the yield at which such loans are sold. The servicing yield earned by the Company on such transactions is typically between .25% and .375% of the total balance of the loan serviced. The origination of a high volume of mortgage loans and the related sales of the loans with servicing retained provides the Company with additional sources of non-interest income through loan servicing income and gains on the sales of loans. Mortgage loans serviced for others totaled $311.7 million at September 30, 1997.
PURCHASE OF MORTGAGE LOANS
The Company, as a regular part of its mortgage lending activities, purchases single-family mortgage loans originated in its primary market area by other lenders, primarily mortgage bankers and brokers. The types of loans purchased are generally newly originated loans with the same characteristics as the loans normally originated by the Company in its regular lending operations. This includes both fixed and adjustable rate mortgage loans which may or may not be sold in the secondary market. The Company pays a fee to the originating mortgage banker or broker which is amortized over the life of the loan for loans retained in the portfolio or which becomes an adjustment to the gain or loss recognized on loans sold in the secondary market. The Company maintains the same underwriting standards on these loans as it does on the loans it originates directly. During the fiscal year ended September 30, 1997, the Company purchased $21.5 million of loans from other originators compared to $15.5 million of loans purchased during the fiscal year ended September 30, 1996. As part of the Company's plans to diversify its single-family loan production, it is expected that purchases of loans from other originators will continue in future years.*
The Company also has purchased pools of single-family loans originated by other lenders in other parts of the country. The loans purchased have generally been adjustable rate loans with interest rate adjustment features of one month to one year and are indexed to both current indexes such as the one-year treasury or to lagging indexes such as the 11th district cost of funds. The loans are originated in other parts of the country, primarily California, where adjustable rate lending is more prevalent. As part of its interest rate risk management, the Company occasionally purchases adjustable rate assets because the availability of similar loan products within its primary market area is limited and competition for that limited demand may force interest rates to levels considered too low compared to other available instruments. The Company generally does not make a significant amount of short-term adjustable rate loans in its home market. Of the $21.5 million one- to four-family mortgage loans purchased during the year ended September 30, 1997, $728,000 were loans secured by properties located outside the state of Wisconsin. Purchased loans can result in a higher level of risk due to the Company not being involved in the original lending process. Efforts taken to mitigate the additional risk include underwriting efforts by the Company prior to purchase, review of the historical payment and credit history of the loans being purchased, and purchasing the loans with yields that offer additional yield for the risks taken.
LOAN ORIGINATION, SERVICING AND OTHER FEES
In addition to interest earned on loans, the Company receives income through fees in connection with loan originations, loan sales, loan modifications, late payments and for miscellaneous services related to its loans, including loan servicing. Income from these activities varies from period to period with the volume and type of loans originated.
In connection with the origination of mortgage loans, the Company typically charges fees for processing and closing in addition to requiring borrower reimbursement for out-of-pocket fees for costs associated with obtaining independent appraisals, credit reports, title insurance, private mortgage insurance and other items. The Company also may charge points for the origination of loans in exchange for a lower interest rate on the loan itself; however, since the availability of zero point mortgage loans in recent years, most borrowers typically accept a slightly higher interest rate and pay zero points. Commitment fees are paid by the applicant at the time of loan commitment, whereas the origination and discount fees are paid at time of closing. Commitment fees are periodically collected on commercial real estate or multi-family mortgage loans but are rarely collected as part of the origination of single-family mortgage loans.
DELINQUENCIES, NON-PERFORMING ASSETS AND CLASSIFIED ASSETS
DELINQUENT LOANS
When a borrower fails to make a required payment by the end of the month in which the payment is due, the Company generally initiates collection procedures. The Company will send a late notice, and in most cases, delinquencies are cured promptly. However, if a loan has been delinquent for more than 60 days, the Company contacts the borrower directly, to determine the reason for the delinquency and to effect a cure, and where it believes appropriate, reviews the condition of the property and the financial position of the borrower. At that time the Company may (i) accept a repayment program for the arrearage; (ii) seek evidence of efforts by the borrower to sell the property; (iii) request a deed in lieu of foreclosure; or (iv) initiate foreclosure proceedings. When a loan, secured by a mortgage, is delinquent for three or more monthly installments, the Company generally will initiate foreclosure proceedings. With respect to delinquencies on FHA, VA or other governmental loan program mortgage loans, the Company follows the appropriate notification and foreclosure procedures prescribed by the respective agencies.
On mortgage loans or loan participations purchased by the Company, the Company receives monthly reports from its loan servicers with which it monitors the loan portfolio. Based upon servicing agreements with the servicers of the loan, the Company relies upon the servicer to contact delinquent borrowers, collect delinquent amounts and initiate foreclosure proceedings, when necessary, all in accordance with applicable laws, regulations and the terms of the servicing agreements between the Company and its servicing agents.
NON-PERFORMING ASSETS
Loans are placed on nonaccrual status when, in the judgment of Company management, the probability of collection of principal or interest is deemed insufficient to warrant further accrual of interest. The Company discontinues the accrual of interest on loans when the borrower is delinquent as to a contractually due principal or interest payment by 90 days or more. When a loan is placed on nonaccrual status, all of the accrued interest on it is reversed by way of a charge to interest income. Interest income is recorded on nonaccrual loans when cash payments of interest are received. Accrual of interest on a nonaccrual loan is resumed when all contractually past due payments are current and when management believes the outstanding loan principal and contractually due interest is no longer doubtful of collection.
Property acquired by the Company as a result of a foreclosure or by deed in lieu of foreclosure is classified as foreclosed property. Foreclosed property is recorded at the lower of the unpaid principal balance of the related loan or the fair market value of the real estate acquired less the estimated costs to sell the real estate. The amount by which the recorded loan balance exceeds the fair market value of the real estate acquired less the estimated costs to sell the real estate is charged against the allowance for loan losses at the date title is received. Any subsequent reduction in the carrying value of a foreclosed property, along with expenses incurred to maintain or dispose of a foreclosed property, is charged against current earnings. At September 30, 1997, the Company had a total of five one- to four-family loans in foreclosed properties with a carrying value of $416,000.
Non-performing loans include loans placed on nonaccrual status and troubled debt restructurings. Non-performing assets include non-performing loans and foreclosed properties. The following table sets forth non-performing loans and assets:
Non-performing assets as of September 30, 1997 and 1996 included $1.1 million and $3.6 million, respectively, of purchased auto loans which are past due or in default or are expected to become past due. The auto loans were purchased in 1995 and 1996 under a warehouse financing arrangement the Company had with an originator of sub-prime automobile loans. The intent of the financing was to warehouse the loans until the originator could originate sufficient quantities to securitize the loans and sell to institutional investors. At that time, the loans would be sold back to the originator. The loans were serviced by an independent third party servicer and the loans had various levels of insurance and in addition were guaranteed as to principal and interest payments by the originator of the loans. The maximum amount that the Company had outstanding at any point in time was a balance of $14.6 million during February 1996. The Company has not funded any loans since that time and as of September 30, 1997, the carrying amount of the sub-prime auto loan portfolio was $1.1 million. Actions have been taken to repossess the collateral on the delinquent loans and to enforce the guarantee of the originator of these loans; however, it is anticipated that some portion of these loans will ultimately result in a charge-off due to the possible inability of the originator to perform under its guaranty.* In addition, the level of insurance collected on policies paying for credit losses on the loans has been lower than anticipated. The Company recorded $2.0 million in net charge-offs in fiscal 1997, which includes $1.9 million due to the aforementioned auto loans. Also included in non-performing assets in 1997 is a single $850,000 commercial real estate loan on a shopping center.
Non-performing assets as of September 30, 1995 and 1994 included a single $5.7 million multi-family construction loan on a 104-unit apartment complex. During the year ended September 30, 1995, the loan was transferred from nonaccrual to foreclosed properties. The property was sold during 1996 at a gain of $684,000.
CLASSIFICATION OF ASSETS
Federal regulations require that each insured financial institution classify its assets on a regular basis. In addition, in connection with examinations of insured institutions by regulatory authorities, regulatory examiners have authority to identify problem assets as Substandard, Doubtful or Loss. Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the Company will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of Substandard assets, with the additional characteristics that the weaknesses make collection or liquidation in full, on the basis of currently existing facts, conditions and values, questionable, and there is a high possibility of loss. An asset classified as Loss is considered uncollectible and of such little value that continuance as an asset of the Company is not warranted. Assets classified as Substandard or Doubtful require the Company to establish prudent general allowances for loan losses. Assets classified as Loss must either be charged off or must have a specific allowance established for 100% of the asset classified as a Loss. At September 30, 1997, the Company had assets classified as Substandard of $4.7 million, $899,000 classified as Doubtful and none classified as Loss. The amounts in the Substandard classification primarily consist of the previously discussed sub-prime auto loans and real estate-related loans with minor credit concerns. Most of the real estate-related loans are current as to principal and interest, but have some weaknesses that are being monitored by the Company.
Except for the aforementioned loans included in non-performing assets, the classified assets principally consist of residential mortgage or consumer loans and foreclosed properties. None of these remaining classified assets are considered to represent either individually or in the aggregate any material loss to the Company; however, such risk has been considered in establishing the allowance for loan losses.
ALLOWANCE FOR LOAN LOSSES
Under federal regulations, when an insured institution classifies problem assets as either Substandard or Doubtful, it is required to establish general allowances for loan losses in an amount deemed prudent by management. In addition to general valuation allowances, the Company may establish specific loss reserves against specific assets in which a loss may be realized. General allowances represent loss allowances which have been established to recognize the inherent risks associated with lending activities, but which, unlike specific allowances, have not been allocated to recognize probable losses on particular problem assets. The Company's determination as to its classification of assets and the amount of its specific and general valuation allowances are subject to review by the Company's regulators which can order the establishment of additional general or specific loss allowances.
The allowance for loan losses is a material estimate that is particularly susceptible to significant changes in the near term and is established through a provision for loan losses based on management's evaluation of the risk inherent in its loan portfolio and the general economy. Such evaluation, which includes a review of all loans on which full collectibility may not be reasonably assured, considers, among other matters, the estimated net realizable value of the underlying collateral, economic conditions, historical loan loss experience and other factors that warrant recognition in providing for an adequate loan loss allowance.
A summary of activity in the allowance for losses on loans follows:
It is not anticipated that charge-offs during the year ending September 30, 1998 will exceed the amount allocated to any individual category of loans.* Furthermore, there are no material loans about which management is aware that there exists serious doubts as to the ability of the borrower to comply with the loan terms, except for the subprime auto loans and the single commercial real estate loan previously discussed. The 1997 increase in the amount of the allowance for loan losses supports the growth in the loan portfolio and is primarily attributable to the $1.7 million allowance of the acquired Kilbourn State Bank. In addition, the increase in the allowance for loan losses supports the increase in loan types other than one- to four-family mortgage loans. Such loans may result in a higher level of charge-offs than the Company's more traditional lending products.
The following table shows the Company's total allowance for loan losses and the allocation to the various categories of loans at the dates indicated.
The increase in the allocated reserve on commercial real estate was due to the aforementioned shopping center loan, the increase in the reserve allocated on commercial loans was due to the increased volume of lending in that area along with the reserve that was part of the Kilbourn State Bank acquisition, while the decrease in the allocated reserve on consumer loans was due to the decrease in non-performing subprime auto loans.
INVESTMENT ACTIVITIES
GENERAL
The investment policy of the Company, which is established by the Board of Directors and implemented by the Asset/Liability Committee, is designed primarily to provide and maintain required liquidity, generate a favorable return on investments without incurring undue interest rate and credit risk and complement the Company's lending activities. The Company's investment policy permits investment in various types of liquid assets permissible under OTS regulations, which include U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposits of insured banks and savings institutions, certain bankers' acceptances and the purchase of federal funds. The Company also invests in corporate debt, asset-backed securities, mortgage-backed securities ("MBS's") and collateralized repurchase agreements, municipal securities, mortgage mutual funds, collateralized mortgage obligations ("CMO's"), real estate mortgage investment conduits ("REMIC's"), interest-only stripped securities ("IO's"), principal-only stripped securities ("PO's") and CMO residuals. At the time of purchase, all of the Company's investments are investment grade as rated by at least one of the major rating agencies.
The Company determines the appropriate classification of securities at the time of purchase and reevaluates such designations as of each statement of condition date based on regulatory and accounting guidelines. The Company has incorporated the requirements of those guidelines into the Company's investment policy and has categorized its investments in three separate categories: (i) Held to Maturity: debt and mortgage-backed and related securities are classified as held to maturity when the Company has the positive intent and ability to hold the securities to maturity. Held to maturity securities are carried at amortized cost; (ii) Available for Sale: debt and mortgage-back and related securities not classified as held to maturity or trading and marketable equity securities not classified as trading are classified as available for sale. Available for sale securities are stated at fair value, with the unrealized gains or losses, net of tax, reported as a separate component of shareholders' equity; and (iii) Trading: the Company maintains a separate portfolio of assets which are carried at market value and have been acquired for short term/trading purposes, to enhance the Company's financial results, with unrealized gains or losses recognized in current income.
The investment activities of the Company consist primarily of investments in mortgage-backed and related securities and other debt and equity securities, consisting primarily of securities issued or guaranteed by the United States Government or agencies thereof and corporate obligations. Typical investments include federally sponsored agency mortgage pass-throughs, private issue and senior-subordinated pass-throughs and federally sponsored agency and private issue CMO's.
MORTGAGE-BACKED AND RELATED SECURITIES
Mortgage-backed securities represent a participation interest in a pool of single-family or multi-family mortgage loans, the principal and interest payments on which are passed from the mortgage loan originators through intermediaries that pool and repackage the participation interest in the form of securities for sale to investors such as the Company. Such intermediaries which guarantee the payment of principal and interest to investors can be government sponsored enterprises such as FHLMC, FNMA and GNMA or private mortgage security conduits. Mortgage-backed securities issued by government sponsored enterprises generally increase the quality of the Company's assets by virtue of the guarantees that back them. When the intermediary is a private entity, neither the principal or interest on such securities is guaranteed. In addition, loans that back private mortgage-backed securities generally are non-conforming loans and consequently have a greater amount of credit risk. Private issue mortgage-backed securities generally will have a higher rate of interest than agency securities to compensate for the higher level of credit risk. In addition, mortgage-backed securities generally are more liquid than individual mortgage loans and may be used to collateralize borrowings or other obligations of the Company.
Mortgage-backed securities typically are issued with stated principal amounts and the securities are backed by pools of mortgage loans that include loans with interest rates that are within a range and have similar maturities. The underlying pool of mortgage loans can be composed of either fixed-rate mortgage loans or
ARM loans. Mortgage-backed securities generally are referred to as participation certificates or pass-through certificates. As a result, the interest rate risk characteristics of the underlying pool of mortgage loans, i.e., fixed-rate or adjustable-rate, as well as prepayment risk, are passed on to the certificate holder while the credit risk is not, if guaranteed. The average life of a mortgage-backed pass-through security is equal to the average lives of the underlying mortgage loans and is dependent on rates of prepayments which are significantly influenced by changes in the interest rate environment. The actual prepayments of the underlying mortgage loans depend upon many factors, including the type of mortgage loan, the coupon rate, the age of the mortgage loan, the geographical location of the real estate collateralizing the mortgage loan and general levels of market interest rates. Mortgage-backed securities may be either agency issued or private issued. Credit risk would tend to be higher for private issue securities which would generally be reflected in a higher rate of return.
CMO's and REMIC's typically are issued by a special purpose entity, which may be organized in a variety of legal forms, such as a trust, a corporation or a partnership. The entity aggregates pools of pass-through securities, which are used to collateralize the mortgage-related securities. Once combined, the cash flows can be divided into "tranches" or "classes" of individual securities, thereby creating more predictable average lives for each security than the underlying pass-through pools. Accordingly, under this security structure all principal paydowns from the various mortgage pools are allocated to a mortgage-related securities' class or classes structured to have priority until it has been paid off. Thus, these securities are intended to address the reinvestment concerns associated with mortgage-backed security pass-throughs, namely that they tend to pay off when interest rates fall. Although the CMO or REMIC structure is a legal entity on its own, the underlying collateral can be agency securities or individual loans. Thus, credit risk can vary depending upon the underlying collateral.
When purchased by the Company, these securities have credit ratings of A or better and meet the Federal Financial Institutions Examination Council definition of low-risk securities. At September 30, 1997, private-issue mortgage-backed securities, CMO's and REMIC's totaled $667.2 million, 74% of which had a credit rating of AAA, 21% of which had a credit rating of AA, 4% of which had a credit rating of A and 1% which had a credit rating of BBB. At September 30, 1996, private-issue mortgage-backed securities, CMO's and REMIC's totaled $567.4 million, 75% of which had a credit rating of AAA, 18% of which had a credit rating of AA, and 7% of which had a credit rating of A. During the year ended September 30, 1997, the Company incurred an impairment loss of $3.4 million on four private issue mortgage-backed securities with a carrying value prior to the impairment of $12.5 million. The new cost basis of these securities of $9.1 million is the Company's estimate of the fair value of these securities. This is the level at which the remaining cash flows should provide a return at a market rate of interest.* However, there can be no assurance that the write-down of these securities will be sufficient to cover all losses which the Company may in fact realize on such securities or that additional write-downs of these or other securities will not be necessary in the future. The four issues, two of which were rated "A" and two of which were rate "BBB", are collateralized by single-family loans relating to properties located primarily in California. The impairment loss was recognized because of reported delinquency, default and loss severity on the individual securities. It was determined that the various cash reserves and subordinate positions would not be adequate to fully protect the Company's investment and that the resultant cash flows to be received by the Company would be less than the carrying value of the securities. The Company is in the process of identifying and implementing additional procedures designed to provide earlier indications of issues relating to its' securities portfolio.
Private issue mortgage-backed securities and REMIC's have been an integral component of the Company's plan to increase earning assets by purchasing such securities and funding them with advances from the Federal Home Loan Bank or with brokered certificates of deposit. Investment and aggregate investment limitations and credit quality parameters of each class of investment are prescribed in the Company's investment policy. The Company performs analyses on mortgage related securities prior to purchase and on an ongoing basis to determine the impact on earnings and market value under various interest rate and prepayment conditions. In determining if declines in value in mortgage-backed and related securities are other than temporary, management estimates future cash flows to be generated by pools of loans
underlying the securities. Included in this evaluation are such factors as i) estimated loan prepayment rates, ii) a review of delinquencies, foreclosures, repossessions and recovery rates relative to the underlying mortgage loans collateralizing each security, iii) the level of available subordination or other credit enhancements, iv) an assessment of the servicer of the underlying mortgage portfolio, and v) the rating assigned to each security by independent national rating agencies.
At September 30, 1997, the aggregate securities of any single issuer (excluding securities of the U.S. government and U.S. government agencies and corporations) did not exceed 10% of the Company's shareholders' equity.
COMPOSITION OF THE COMPANY'S MORTGAGE-BACKED AND RELATED SECURITIES PORTFOLIO
Held to Maturity. At September 30, 1997, the Company held $66.8 million in its mortgage-backed and related securities held to maturity portfolio. The estimated market value of those securities at that date was $66.2 million. Of this amount, at September 30, 1997, 100% were fixed rate REMIC securities. At September 30, 1997, the mortgage-backed and related securities held to maturity portfolio represented 4.0% of the Company's total assets compared to $68.4 million or 4.9% of total assets at September 30, 1996.
The following table sets forth certain information regarding the amortized cost, weighted average yields and maturities of the Company's mortgage-backed and related securities held to maturity at September 30, 1997.
available for sale with a carrying and estimated market value of $620.7 million or 37.4% of total assets. Of these, $20.4 million were MBS's issued by various federal agencies, $224.9 million were private issue MBS's, $221.8 million were agency REMIC's, $153.7 million were private issue REMIC's and $37,000 were CMO residuals. At September 30, 1996, the Company's mortgage-backed and related securities held for sale were $519.8 million, representing 37.0% of total assets. Of these, $19.8 million were MBS's issued by various federal agencies, $197.3 million were private issue MBS's, $95.4 million were agency REMIC's, $206.4 million were private issue REMIC's, $842,000 were adjustable rate mortgage mutual fund investments and $68,000 were CMO residuals. The Company is utilizing its capital position to increase earning assets by increasing the level of mortgage-backed and related securities. During the past year, the emphasis has been on purchasing adjustable rate private issue mortgage-backed securities and adjustable rate REMIC's which the Company views as having favorable interest rate risk and pricing characteristics in comparison to other investment alternatives. Although there may various subordination levels within the MBS or REMIC structure or levels of collateral underlying the securities that should protect the Company's position in the securities, private issue securities represent an additional level of credit risk when compared with agency issue securities. The Company takes its perception of that additional credit risk into consideration when making the determination of whether to buy the security at the price and yield offered.
The following table sets forth certain information regarding the amortized cost, weighted average yields and maturities of the Company's mortgage-backed and related securities available for sale at September 30, 1997.
Held for Trading. At September 30, 1997 and 1996, the Company did not have any assets in its trading portfolio. The trading portfolio of the Company has typically carried various mortgage-backed or related securities that are purchased for short-term trading profits or securities that are required to be classified as such by regulatory definition. The Company may from time to time originate mortgage loans which are swapped for mortgage-backed securities backed by the original loans. These securities are required to be classified as trading securities. The Company expects to continue to sell mortgage loans by this method in future years.*
OTHER SECURITIES
The Company invests in various types of liquid assets that are permissible investments for federally chartered savings associations or state-chartered commercial banks, including U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, federal funds and, from time to time, repurchase agreements. Subject to various restrictions applicable to all federally chartered savings associations or state-chartered commercial banks, the Company also invests its assets in commercial paper, investment grade corporate debt securities, municipal securities, asset-backed securities and mutual funds, the assets of which conform to the investments the Company is otherwise authorized to make directly. Debt and equity securities are classified as either available-for-sale or held-to-maturity at the time of purchase and carried at market value if available-for-sale or at amortized cost if held-to-maturity. The Company's current investment policy permits purchases only of investments rated investment grade by a nationally recognized rating agency and does not permit purchases of securities of non-investment grade quality.
COMPOSITION OF THE COMPANY'S DEBT AND EQUITY SECURITIES PORTFOLIO
Held to Maturity. At September 30, 1997, the Company had debt securities with an amortized cost of $3.8 million and an estimated market value of $3.9 million. Of the total, $3.0 million were U.S. Treasury and agency obligations and $0.8 million were state and municipal obligations. The Company purchases debt securities that are in the top three investment grades (A or better) at the time that the investment is made.
The following table sets forth certain information regarding the amortized cost, weighted average yields and maturities of the Company's investment securities held to maturity at September 30, 1997. The yields on the municipal securities represent their taxable-equivalent yield.
Available for Sale. At September 30, 1997, the Company had securities available for sale with an amortized cost and estimated market value of $56.2 million. Of the total, $22.1 million were U.S. Treasury or agency obligations, $0.4 million were state and municipal securities, $5.5 million were corporate notes and bonds, $20.7 million were asset-backed securities and $7.5 million were marketable equity securities, primarily shares of mutual funds invested in bank or thrift eligible securities.
The following table sets forth certain information regarding the amortized cost, weighted average yields and maturities of the Company's investment securities available for sale at September 30, 1997. The yields on the municipal securities represent their taxable-equivalent yield.
AFFORDABLE HOUSING ACTIVITIES
The Company, through the Bank's subsidiary St. Francis Equity Properties ("SFEP"), invests in affordable housing properties throughout the State of Wisconsin. The properties qualify for tax credits under Section 42 of the Internal Revenue Code ("Code"). The Code provides a per state volume cap on the amounts of low-income housing tax credits that may be taken in each state. In order to claim a tax credit, a credit allocation must be received from the appropriate state or local housing development authority, which in Wisconsin is the Wisconsin Housing and Economic Development Authority ("WHEDA"). Typically, SFEP will commit to the equity funding of a specific property that a developer has submitted to WHEDA for approval and received. The developer then builds the property, generally with financing from the Bank, with final equity funding from SFEP coming at the completion of construction. Each property is structured as a limited liability partnership ("LLP") or limited liability corporation ("LLC"), with SFEP being a 98% or 99% partner or owner in each individual LLP or LLC.
The investment in the properties is treated as an equity investment for accounting purposes and the financial condition, results of operations and cash flows of each LLP or LLC is consolidated in the Company's financial statements. The operations of the properties are not expected to contribute significantly to the Company's net income before income taxes. However, the properties do contribute in the form of income tax credits, which lower the Company's effective tax rate. Once established, the credits on each property last for ten years and are passed through from the LLP or LLC to SFEP and reduce the consolidated federal tax liability of the Company. Gross revenues of SFEP were $3.4 million, $1.9 million and $1.1 million for the years ended September 30, 1997, 1996 and 1995 respectively. Gross expenses of SFEP were $3.9 million, $2.2 million and $1.4 million for each of the three years. The net operating loss of SFEP results in an income tax benefit which is then increased by the income tax credits which totaled $2.9 million, $1.6 million and $875,000 for the years ended September 30, 1997, 1996 and 1995, respectively.
SFEP has been increasing the number and dollar amount invested in affordable housing projects since first investing in 1993. At September 30, 1997 the amount invested in affordable housing projects was $51.5 million compared with $36.9 million at September 30, 1996. At September 30, 1997, SFEP was a equity partner in 25 projects compared with 20 at September 30, 1996.
The primary risk to the Company's results of operations from the affordable housing investments involves the maintenance of the tax credits. The Company has instituted several procedures which it believes will result in the maintenance of the tax credits. Those procedures include outside audit of the individual LLP or LLC including tenant compliance records, outside audit of the original development costs, review of the LLP or LLC and tenant compliance records by the Company's staff and review of audit and compliance records of the LLP or LLC performed by WHEDA. The Company believes that it has maintained compliance on all of its properties and that through September 30, 1997, no income tax credits are at risk.
Other risks of the affordable housing investments include the risks common to the owning and operating of apartment units, including, 1) length of time of initial lease up, 2) tenant vacancy factors, 3) operating costs of the properties, 4) unexpected or significant capital improvement costs, and 5) the market for the type of apartment unit in the area in which it resides. Although marketing studies are part of the initial development of the property, there can be no assurance that other similar properties might be built near any of the Company's properties at a later date and have an adverse effect upon the occupancy rate of the Company's units.
SOURCES OF FUNDS
GENERAL
The Company's primary sources of funds for use in lending, investing and for other general purposes are deposits, including brokered deposits, proceeds from principal and interest payment on loans, mortgage-backed and related securities and debt and equity securities, FHLB advances, and to a lesser extent, reverse repurchase agreements. Contractual loan payments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are significantly influenced by general market interest rates and economic conditions. Borrowings may be used on a short-term basis to compensate for seasonal or other reductions in normal sources of funds or for deposit inflows at less than projected levels, or they also may be used on a longer-term basis to support expanded lending or investment activities.* The Company utilizes advances from the FHLB and reverse repurchase agreements as sources for its borrowings. The Company is currently utilizing its capital position to increase assets by investing in primarily mortgage-backed or REMIC securities with adjustable rates or short and medium terms and financing the purchases with advances from the FHLB that generally match the expected maturity duration of the respective securities. At September 30, 1997 and 1996, the Company had advances from the FHLB of $385.1 million or 23.2% of total assets and $373.6 million or 26.6% of total assets, respectively. At September 30, 1997, the Company had reverse repurchase agreements outstanding of $22.5 million or 1.4% of total assets. The Company had no outstanding reverse repurchase agreements at September 30, 1996. Of the Company's outstanding FHLB advances at September 30, 1997, $95.0 million will mature before September 30, 1998. Based on sources and uses of funds projections, it is anticipated that all of the maturing advances, which represent 24.7% of the total FHLB advances outstanding, will be repaid upon their maturity dates.*
DEPOSITS
The Company offers a variety of deposit accounts having a range of interest rates and terms. The Company's deposits principally consist of demand accounts (non-interest bearing checking, NOW, MMDA and passbook) and certificates of deposit. The flow of deposits is influenced significantly by general economic conditions, changes in prevailing interest rates and competition. The Company's deposits are obtained primarily from the areas in which its branches are located, and the Company relies principally on customer service, marketing programs and long-standing relationships with customers to attract and retain these deposits. Various types of advertising and promotion to attract and retain deposit accounts also are used. Deposit promotions may involve the use of specific advertising for a type of deposit or it may include some form of pricing incentive, either a deposit product with a higher rate than currently offered by most competitors in the Company's market area or a temporary pricing concession for a limited period of time. For several years, the Company also has used brokered deposits as a funding source for its business activities. The brokered deposits are used to fund both general operating activities of the Company and to fund the Company's leverage program. At September 30, 1997, the Company had $140.8 million of brokered deposits, representing 12.9% of total deposits, compared to $138.6 million or 15.8% of total deposits at September 30, 1996. Maturities of brokered certificates range from three months to longer term certificates and include certificates that are callable at the option of the Company. The Company has used brokered deposits to fund some operational activities when such funds offer a better or quicker funding source than retail deposits or FHLB advances.
Management monitors the Company's certificate accounts and, based on historical experience, management believes it will retain a large portion of such accounts upon maturity. However, management believes that the likelihood for retention of brokered certificates of deposit is more a function of the rate paid on such accounts as compared to retail deposits which may be established due to branch location or other intangible reasons. Management considers Company profitability, the matching of term lengths with assets, the attractiveness to customers and rates offered by competitors in deposit offerings and promotions. The Company has been competitive in the types of accounts and interest rates it has offered on its deposit products. The Company intends to continue its efforts to attract deposits as a primary source of funds for supporting its lending and investing activities.
At September 30, 1997, the Company had outstanding $48.6 million in certificates of deposit in amounts of $100,000 or more maturing as follows:
The following table sets forth the distribution of the Company's deposit accounts at the dates indicated and the weighted average nominal interest rates on each category of deposits presented. Management does not believe that the use of year-end balances instead of average balances resulted in any material difference in the information presented. In this table, brokered deposits are included with certificates.
BORROWINGS AND OTHER FINANCING TRANSACTIONS
Although deposits are the Company's largest source of funds, the Company's policy has been to utilize borrowings as an alternative or less costly source of funds. The Company utilizes borrowings as part of its asset/liability investment strategy. Borrowings are collateralized when management believes it can profitably re-invest those funds for the benefit of the Company. The Company obtains advances from the FHLB. These advances are collateralized by the capital stock of the FHLB held by the Company and certain of its mortgage loans and mortgage-backed and related securities. Such advances are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. Additionally, the Company is currently utilizing its capital position to increase assets by investing primarily in mortgage-backed REMIC securities with adjustable rates or short and medium terms and financing the purchases with advances from the FHLB that generally match the expected maturity duration of the respective securities. The maximum amount the FHLB will advance to member institutions for purposes other than meeting withdrawals fluctuates from time to time in accordance with policies of the OTS and the FHLB. At September 30, 1997, the Company's FHLB advances totaled $385.1 million, representing 25.1% of total liabilities, up from the $373.6 million outstanding at September 30, 1996. At September 30, 1997, the Company had a borrowing capacity available of $199.2 million from the FHLB; however, additional securities may have to be pledged as collateral.
The Company's borrowings from time to time include reverse repurchase agreements. The form of reverse repurchase agreement used by the Company involves the sales of securities owned by the Company with a commitment to repurchase the same or substantially the same securities at a predetermined price at a future date, typically within 30 days to six months. These transactions are treated as borrowings collateralized by the securities sold and are therefore included as other borrowings on the Company's Consolidated Financial Statements. These transactions are authorized by the Company's Investment Policy and are governed by agreements with primary government dealers under PSA Master Repurchase Agreements. At September 30, 1997 and 1996, the Company had $22.5 million and zero, respectively, of reverse repurchase agreements.
The Bank line of credit was established by the Company for purposes of funding activities of the Company. These typically include dividends, share repurchases and acquisitions for cash such as the Kilbourn State Bank acquisition. Dividends received from the Bank are used as the primary source of cash to pay principal and interest on the line of credit. The line of credit has a maximum borrowing amount of $20.0 million and is collateralized by the stock of the Bank. At September 30, 1997, the Company had $11.0 million outstanding on the line of credit. The line was not in existence at September 30, 1996.
While increases in borrowings and changes in the collateralization levels due to market interest rate changes could require the Company to add collateral to secure its borrowings, the Company does not anticipate having a shortage of qualified collateral to pledge against its borrowings.
The following table sets forth certain information regarding the Company's FHLB advances, borrowed funds and reverse repurchase agreements at or for the years ended on the dates indicated.
(1) Computed on the basis of average daily balances.
SUBSIDIARY ACTIVITIES
During the fiscal year ended September 30, 1997, the Bank had four wholly-owned subsidiaries: St. Francis Insurance Corp. ("S-F Insurance"), St. Francis Equity Properties, Inc. ("S-F Equity"), S-F Mortgage Corp. ("S-F Mortgage") and SF Investment Services ("SF Investment").
S-F Insurance. S-F Insurance offers credit life and disability insurance on consumer and mortgage loans sold exclusively through licensed agents who also are employees of the Bank. The Bank is reimbursed by S-F Insurance for administration and sales services provided by the Bank. At September 30, 1997, the Bank's total investment in S-F Insurance was approximately $186,000 and S-F Insurance's assets of $186,000 consisted primarily of cash.
S-F Equity Properties. S-F Equity Properties ("SFEP") is a Wisconsin corporation incorporated in February 1993 to own, operate and develop multi-family rental property, either as a limited partner or through other ownership status, for investment and subsequent resale. Properties include projects for low-
to-moderate income housing, which would qualify for tax credits under Section 42 of the Internal Revenue Code (the "Code"). SFEP is currently a limited partner in 25 projects within the state of Wisconsin. Additionally, the Bank has provided financing to 24 of the projects. However, the primary return to the Company on these projects is in the form of tax credits earned over the first ten years of the projects life. At September 30, 1997, the Bank had loans outstanding to such projects of $28.8 million. At September 30, 1997, the Bank's total investment in S-F Equity was approximately $2.5 million and S-F Equity's assets of $53.5 million consisted primarily of its interests in the properties developed.
S-F Mortgage. S-F Mortgage is presently an inactive subsidiary which has not engaged in business during the past five years. The Company has no current plans to activate S-F Mortgage. At September 30, 1997, the Bank's total investment in S-F Mortgage was approximately $190,000 and S-F Mortgage's assets of $190,000 consisted primarily of cash.
SF Investment. SF Investment is a company incorporated in Nevada for the purpose of managing a portion of the Bank's investment portfolio. At September 30, 1997, the Bank's total investment in SF Investment was approximately $239.8 million and the assets consisted primarily of mortgage-related securities.
PERSONNEL
As of September 30, 1997, the Company had 310 full-time employees and 90 part-time employees. The employees of the Company are not represented by a collective bargaining unit and the Company believes its relationship with its employees to be good.
FEDERAL TAXATION
GENERAL
The following discussion of tax matters is intended to be a summary of the material tax rules applicable to the Company and does not purport to be a comprehensive description of all applicable tax rules.
BAD DEBT RESERVES
For the taxable years beginning before 1996, savings institutions, such as the Bank, which meet certain definitional tests primarily relating to their assets and the nature of their business ("qualifying thrifts"), are permitted to establish a reserve for bad debts and to make annual additions thereto, which additions may, within specified formula limits, be deducted in arriving at their taxable income. Each year the Bank would review the most favorable way to calculate the deduction attributable to an addition to the bad debt reserve.
For the taxable years beginning before 1996, earnings appropriated for bad debt reserves and deducted for federal income tax purposes cannot be used by the Bank to pay cash dividends to the Company without the payment of income taxes by the Bank at the then current income tax rate on the amount deemed distributed, which would include the amount of any federal income taxes attributable to the distribution. Thus, any dividends to the Company that would reduce amounts appropriated to the Bank's bad debt reserves and deducted for federal income tax purposes could create a tax liability for the Company. The Bank does not intend to pay dividends that would result in a recapture of its bad debt reserves.
On August 20, 1996, the President signed the Small Business Job Protection Act of 1996 ("the Act"). The Act repealed the reserve method of accounting for bad debts by thrift institutions, effective for taxable years beginning after 1995. Thrift institutions such as the Bank with more than $500 million in assets are now required to use the specific charge-off method. The Act also grants partial relief from the bad debt reserve recapture "recapture" which occurs in connection with the change in method of accounting. The pre-1988 reserves are not required to be included in income in connection with the change in method of accounting. In addition, the Act suspends recapture of post-1987 reserves for a period of two years, conditioned on the institution's compliance with certain residential loan requirements. Institution's can meet this residential loan requirement if the principal amount of residential loans made during a taxable year was not less than the "base amount" for such year. The base amount is determined on an institution-by-institution basis, and constitutes the average of the principal amounts of residential loans made by an
institution during the six most recent taxable years. Notwithstanding the foregoing, institutions will be required to pay for recaptured post-1987 bad debt reserves ratably over a six-year period starting in 1998. Since provisions for deferred income tax have been provided for on post-1987 bad debt reserves, there will not be any additional income tax expense to the Bank on recapture.
CORPORATE ALTERNATIVE MINIMUM TAX
For taxable years beginning after December 31, 1986, the Internal Revenue Code imposes an alternative minimum taxable income ("AMTI") which is imposed at a rate of 20%. For the taxable years beginning before 1996, the excess of the bad debt reserve deduction using the percentage of taxable income method, over the deduction that would have been allowable under an experience method is treated as a preference item for purposes of computing the AMTI. Only 90% of AMTI can be offset by net operating losses. For taxable years beginning after December 31, 1989, the adjustment to AMTI based on book income will be an amount equal to 75% of the amount by which a corporation's adjusted current earnings exceeds its AMTI (determined without regard to this preference and prior to reduction for net operating losses). In addition, for taxable years beginning after December 31, 1986 and before January 1, 1996, an environmental tax of .12% of the excess of AMTI (with certain modifications) over $2.0 million is imposed on corporations, including the Company, whether or not an Alternative Minimum Tax ("AMT") is paid. From time to time the Company may be subject to AMT tax. The Company was subject to an environmental tax liability for the year ended September 30, 1996, which was not material.
DISTRIBUTIONS
To the extent that (i) the Company's reserve for losses on qualifying real property loans exceeds the amount that would have been allowed under an experience method and (ii) the Company makes "non-dividend distributions" to shareholders that are considered to result in distributions from the excess bad debt reserve or the supplemental reserve for losses on loans ("Excess Distributions"), then an amount based on the amount distributed will be included in the Company's taxable income. Non-dividend distributions include distributions in excess of the Company's current and accumulated earnings and profits, distributions in redemption of stock and distributions in partial or complete liquidation. However, dividends paid out of the Company's current or accumulated earnings and profits, as calculated for federal income tax purposes, will not be considered to result in a distribution from the Company's bad debt reserves.
The amount of additional taxable income created from an Excess Distribution is an amount that when reduced by the tax attributable to the income, is equal to the amount of the distribution. Thus, if certain portions of the Bank's accumulated tax bad debt reserve are used for any purpose other than to absorb qualified bad debt loans, such as for the payment of dividends or other distributions with respect to the Company's capital stock (including distributions upon redemption or liquidation), approximately one and one-half times the amount so used would be includable in gross income for federal income tax purposes, assuming a 35% corporate income tax rate (exclusive of state taxes). See and "-Regulation" for limits on the payment of dividends of the Bank and the Company.
STATE TAXATION
The State of Wisconsin imposes a tax on the Wisconsin taxable income of corporations, including savings institutions, at the rate of 7.9%. Wisconsin taxable income is generally similar to federal taxable income except that interest from state and municipal obligations is taxable, no deduction is allowed for state income taxes and net operating losses may be carried forward but not back. Wisconsin law does not provide for filing of consolidated state income tax returns.
REGULATION
The Company is a savings and loan holding company registered with and subject to regulation by the Office of Thrift Supervision (the "OTS") under the Home Owners' Loan Act of 1993, as amended (the "HOLA"). Prior to the consummation of the merger of Bank Wisconsin with and into the Bank (the "Merger"), the Company was also a bank holding company registered with and subject to regulation by the Board of Governors of the Federal Reserve System (the "FRB") under the Bank Holding Company Act of 1956, as amended (the "BHCA"). The Company is required to file certain reports and otherwise comply with the rules and regulations of the OTS, the FRB, and the Securities and Exchange Commission (the "SEC") under the federal securities laws. The Bank, as a federally chartered savings bank, is subject to regulatory oversight by its primary regulator, the OTS. Bank Wisconsin, as a state chartered commercial bank, was formerly subject to regulatory supervision by the Wisconsin Department of Financial Institutions, Division of Banking (the "Division") and the Federal Deposit Insurance Corporation, (the "FDIC"), its primary federal regulator. Since the Merger was consummated near the end of this past fiscal year, a brief summary of those regulations applicable to Bank Wisconsin and the Company by virtue of its status as a bank holding company is included in the discussion below.
HOLDING COMPANY REGULATIONS
The Company must obtain approval from the OTS before acquiring control of more than 5% of the voting shares of any other SAIF - insured institution. Such acquisitions generally are prohibited if they result in a multiple savings and loan holding company controlling savings institutions in more than one state. However, such interstate acquisitions are permitted based on specific state authorization or in a supervisory acquisition of a failing savings institution.
The BHCA required the Company to obtain prior FRB approval before it could acquire substantially all of the assets of any bank, or ownership or control or any voting shares of any bank, if, after such acquisition, it would own or control, directly or indirectly, more than 5% of the voting shares of such bank.
The BHCA limits the activities of bank holding companies to managing, controlling and servicing their subsidiary banks and to engaging in certain non-banking activities determined by the FRB to be so "closely related" to banking as to be a "proper incident" thereto. With the exception of such closely related activities, bank holding companies are prohibited from acquiring direct or indirect ownership of more than 5% of the voting stock of any company which is not a bank. The FRB has also permitted bank holding companies to engage in certain additional activities on a case-by-case basis.
REGULATION OF FEDERAL SAVINGS BANKS
The OTS has extensive regulatory and supervisory authority over the operations of the Bank. This regulation and supervision established a comprehensive framework of activities in which the Bank can engage and is intended primarily for the protection of the insurance fund and depositors. The regulatory structure also gives the regulatory authorities extensive discretion in connection with their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes.
The OTS also has enforcement authority over the Bank and the Company, and their affiliated parties. This enforcement authority includes, among other things, the ability to assess civil money penalties, issue cease-and-desist or removal orders and initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws or regulations or for unsafe or unsound practices. Other actions or inaction may provide the basis for enforcement actions, including misleading or untimely reports filed with the OTS.
The Bank is required to file periodic reports with the OTS Regional Director and is subject to periodic examinations by the OTS and the FDIC. When these examinations are conducted, examiners may, among
other things, require the Bank to provide for higher general or specific loan loss reserves or write down the value of certain assets. The last regular examination by the OTS was in July 1997.
ASSESSMENTS
Savings institutions are required by OTS regulations to pay assessments to the OTS to fund the operations of the OTS. The general assessment, paid on a semiannual basis, is computed upon the savings institution's total assets, including consolidated subsidiaries, as reported in the institution's latest quarterly Thrift Financial Report. The Bank's OTS assessment for the six month period ended June 30, 1997 was $126,000, based on the Bank's assets as of March 31, 1997 of $1.4 billion and the current OTS assessment rate.
QUALIFIED THRIFT LENDER REQUIREMENT
In order for the Bank to exercise the powers granted to SAIF-insured institutions and maintain full access to Federal Home Loan Bank ("FHLB") advances, it must qualify as a qualified thrift lender ("QTL"). Under the HOLA and OTS regulations, savings institutions are required to maintain a level of qualified thrift investments equal to at least 65% of its "portfolio assets" (as defined by statute) on a monthly basis for nine out of twelve months per calendar year. Qualified thrift investments for purposes of the QTL test consist primarily of the residential mortgages and related investments. As of September 30, 1997, the Company maintained 88.0% of its portfolio assets in qualified thrift investments and therefore met the QTL test.
WISCONSIN COMMERCIAL BANK REGULATION
As a Wisconsin chartered commercial bank, Bank Wisconsin was authorized to make loans and investments, provided that the total liabilities of any person, partnership, corporation or bank did not exceed 20% of the capital of the bank with certain exceptions.
Bank Wisconsin was also permitted to invest funds in certain types of debt and equity securities, including obligations of local governments and agencies. Investment of debt securities in local government units could not exceed 50% of the capital of the bank, and temporary borrowings of any local government unit maturing within one year from date of issue could not exceed 60% of the bank's capital and surplus. Bank Wisconsin could also invest in equity positions, such as profit-participation projects, in an amount determined by the Division.
The Division examined the affairs of Bank Wisconsin on an annual basis. The Division was permitted to assess Bank Wisconsin fees in connection with any examination, as well as an annual assessment for maintenance of the Division's office.
FEDERAL REGULATIONS
The Bank is and Bank Wisconsin formerly was subject to federal regulations which address various issues including, but not limited to, insurance of deposits, capital requirements, and community reinvestment requirements.
o INSURANCE OF DEPOSITS
The Bank's deposits are insured up to applicable limits under the Savings Association Insurance Fund ("SAIF") of the FDIC. Bank Wisconsin's deposits were insured up to applicable limits under the Bank Insurance Fund ("BIF") of the FDIC. The FDIC regulations assign institutions to a particular capital group based on the level of an institution's capital -- "well capitalized," "adequately capitalized," and "undercapitalized". These three groups are then divided into three subgroups which reflect varying levels of supervisory concern, from those which are considered to be healthy to those which are considered to be of substantial supervisory concern. The matrix so created results in nine assessments risk classifications, with reduced insurance rates paid by well capitalized, financially sound institutions and higher rates paid by undercapitalized institutions that pose a substantial risk of loss to the insurance fund unless effective corrective action is taken.
Under the Federal Deposit Insurance Act (the "FDI Act"), insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the Division. Management of the Company does not know of any practice, condition or violation that might lead to the termination of deposit insurance. See, "Management's Discussion and Analysis of Financial Condition and Results of Operations--Recent Regulatory Legislative Developments."
o CAPITAL REQUIREMENTS
FDIC REGULATION
Bank Wisconsin was required to follow FDIC capital adequacy guidelines which prescribe minimum levels of capital and require that institutions meet certain risk-based and leverage capital requirements. Under the FDIC capital regulations, Bank Wisconsin had to meet the following capital standards: (i) "Tier 1 capital" in an amount not less than 3% of total assets; (ii) "Tier 1 capital" in an amount not less than 4% of risk-weighted assets; and (iii) "total capital" in an amount not less than 8% of risk-weighted assets. At the time of the Merger, Bank Wisconsin exceeded all of the FDIC capital requirements.
OTS REGULATION
The OTS capital regulations require savings institutions to meet three capital standards: (i) "core capital" in an amount not less than 3% of adjusted total assets; (ii) "tangible capital" in an amount not less than 1.5% of adjusted total assets; and (iii) "risk-based capital" of at least 8% of risk-weighted assets. Savings institutions must meet all of the standards in order to comply with the capital requirements.
The following table summarizes the Bank's capital ratios and the ratios required by federal regulations at September 30, 1997:
The minimum core capital requirement is 3% of adjusted total assets (the "leverage limit" requirement). Core capital is defined to include common stockholders' equity (including retained earnings), noncumulative perpetual preferred stock and any related surplus, and minority interests in equity amounts of consolidated subsidiaries, less any unidentifiable intangible assets (other than limited amounts of purchased mortgage servicing rights, supervisory goodwill and other intangibles that meet certain salability and market valuation tests); and equity and debt investments in subsidiaries which are not "includable subsidiaries." Includable subsidiaries are defined as subsidiaries engaged solely in activities permissible for a national bank, engaged in activities impermissible for a national bank but only as an agent for its customers, or engaged solely in mortgage-banking activities.
Each savings institution must also maintain total capital equal to at least 8% of risk-weighted assets. Total capital consists of the sum of core and supplementary capital, provided that supplementary capital cannot exceed core capital, as defined above. Supplementary capital includes permanent capital instruments such as, cumulative perpetual preferred stock, perpetual subordinated debt, and mandatory convertible subordinated debt, maturing capital instruments such as, subordinated debt, intermediate-term preferred stock and mandatory redeemable preferred stock, subject to an
amortization schedule, and general valuation loan and lease loss allowances up to 1.25% of risk-weighted assets. The OTS risk-based capital regulation assigns each balance sheet asset held by a savings institution to one of five risk categories based on the amount of credit risk associated with that particular class of asset.
COMMUNITY REINVESTMENT ACT
Under the Community Reinvestment Act of 1977, as amended (the "CRA"), a depository institution has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution's discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the federal regulators to assess the institution's record of meeting with the credit needs of its community and to take such record into account in its evaluation of certain applications by such institution. The CRA also requires all institutions to make public disclosure of their CRA ratings and requires an institution's primary regulator to provide a written evaluation of an institution's performance. The Bank's latest CRA rating, received in May 1996, was "Outstanding."
On May 4, 1995, the federal banking regulators adopted a final rule ("Final CRA Rule") governing compliance with CRA. The Final CRA Rule eliminates the previous CRA regulation's twelve assessment factors and substitutes a performance based evaluation system. The Final CRA Rule was phased in over a period of time and became fully effective July 1, 1997. Under the Final CRA Rule, an institution's performance in meeting the credit needs of its entire community, including low- and moderate-income areas, as required by the CRA, will generally be evaluated under three assessment tests relating to lending, investment and service. Management of the Company does not anticipate that the new CRA regulations will adversely affect the Bank.
FEDERAL HOME LOAN BANK SYSTEM
The Federal Home Loan Bank System, consisting of twelve FHLBs, is under the jurisdiction of the Federal Housing Finance Board ("FHFB"). The designated duties of the FHFB are to supervise the FHLBs; ensure that the FHLBs carry out their housing finance mission; ensure that the FHLBs remain adequately capitalized and able to raise funds in the capital market; and ensure that the FHLBs operate in a safe and sound manner.
Members of the FHLB-Chicago are required to acquire and hold shares of capital stock in the FHLB-Chicago in an amount equal to 1% of the aggregate outstanding principal amount of residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year. Further, at no time shall advances (borrowings) from the FHLB-Chicago exceed 20 times the amount paid by such member for FHLB-Chicago capital stock. The Bank is in compliance with these requirements with a total investment in FHLB-Chicago stock of $20.8 million at September 30, 1997.
Among other benefits, the FHLBs provide a central credit facility primarily for member institutions. It makes advances to members in accordance with policies and procedures established by the FHFB and the Board of Directors of the FHLB-Chicago. At September 30, 1997, the Bank had $385.1 million in advances from the FHLB-Chicago. See "Business of the Company."
RESERVE REQUIREMENTS
Regulation D, promulgated by the FRB, imposes reserve requirements on all depository institutions which maintain transaction accounts or non-personal time deposits. Checking accounts, NOW accounts and certain other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any non-personal time deposits (including certain money market deposit accounts). Under Regulation D, a depository institution must maintain average daily reserves equal to 3% on the first $49.3 million of transaction accounts. There
has been a 0% reserve requirement on non-personal deposits since December 27, 1990. In addition, the first $4.4 million of otherwise reservable liabilities are exempt from the reserve requirement. These percentages and tranches are subject to adjustment by the FRB. As of September 30, 1997, the Bank met Regulation D reserve requirements.
OTHER FEDERAL LAWS
RESTRICTIONS ON LOANS TO INSIDERS
Federal regulations establish limits on the total amount an institution may lend to its executive officers, directors, and principal shareholders, and their related interests (collectively referred to in this section as "insiders"). Generally, an insider may borrow an aggregate amount not exceeding 15% of the institution's unimpaired capital and unimpaired surplus on an unsecured basis and an additional 10% on a secured basis. The regulations limit, with certain exceptions, the aggregate amount a depository institution may lend to its insiders as a class to an amount not exceeding the institution's unimpaired capital and unimpaired surplus.
When extending credit to an insider, an institution must apply underwriting policies and procedures no less stringent than those applied for comparable transactions with non-insiders. Generally, all loans to insiders must be approved by a majority of the institution's disinterested directors. Any credit extension to an executive officer must be reported to the board of directors, include a current financial statement of the borrower, and include a demand feature which permits the institution to call the loan if the officer's borrowings from other institutions aggregated with the loan exceeds applicable limits. An insider cannot knowingly receive, or permit a related interest to receive, a loan that violates applicable regulations. The Bank has not been significantly affected by such restrictions on loans to insiders.
TRANSACTIONS WITH AFFILIATES
The Bank is required and Bank Wisconsin was required to comply with Sections 23A and 23B of the Federal Reserve Act ("Sections 23A and 23B") relative to transactions with affiliates. Generally, Sections 23A and 23B limit the extent to which the insured institution or its subsidiaries may engage in certain covered transactions with an affiliate to an amount equal to 10% of such institution's capital and surplus, place an aggregate limit on all such transactions with affiliates to an amount equal to 20% of such capital and surplus, and require that all such transactions be on terms substantially the same, or at least as favorable to the institution or subsidiary, as those provided to a non-affiliate. The term "covered transaction" includes the making of loans, purchase of assets, issuance of a guaranty and similar other types of transactions. Exemptions from 23A or 23B may be granted only by the Federal Reserve Board. The Company has not been significantly affected by such restrictions on transactions with affiliates.
FEDERAL SECURITIES LAWS
The Company's Common Stock is registered with the SEC under Section 12(g) of the Exchange Act. The Company is subject to the information, proxy solicitation, insider trading restrictions and other restrictions and other requirements of the SEC under the Exchange Act.
ITEM 2.
ITEM 2. PROPERTIES
The Company conducts its business through 19 full-service locations, two limited service offices in residential retirement communities and two loan production offices. Nine of the full-service branches are located in Milwaukee County, five are in Waukesha County, three are in Washington County, one in Ozaukee County, and one is in Walworth County. Management believes the current facilities are adequate to meet the present and immediately foreseeable needs of the Company. The total net book value of property owned by the Company was $17.4 million at September 30, 1997.
ITEM 3.
ITEM 3. LEGAL PROCEEDINGS
The Company is involved as a plaintiff or defendant in various legal actions arising in the normal course of its business. While the ultimate outcome of these various legal proceedings cannot be predicted with certainty, it is the opinion of management that the resolution of these legal actions should not have a material effect on the Company's consolidated financial condition or results of operations.
ITEM 4.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
No matters were submitted to a vote of shareholders during the three months ended September 30, 1997.
Executive Officers of the Registrant Who Are Not Directors
The following information as to the business experience during the past five years is supplied with respect to executive officers of the Company who do not serve on the Company's Board of Directors. There are no arrangements or understandings between the persons named and any other person pursuant to which such officers were selected, nor are there any family relationships among them.
JAMES C. HAZZARD, age 52, is an Executive Vice President of the Bank. Mr. Hazzard has held his position with the Bank since September 1997. From November 1994 to September 1997, Mr. Hazzard was President of Bank Wisconsin, a subsidiary of the Company that was merged into the Bank during 1997. Prior to joining Bank Wisconsin, Mr. Hazzard served as President and Chief Executive Officer of Associated Bank/F&M Bank Menomonee Falls, Wisconsin.
WILLIAM R. HOTZ, age 52, is Secretary and is an Executive Vice President of the Company and of the Bank. Mr. Hotz joined the Company in those positions in May 1997 and was appointed an Executive Vice President of the Bank in September 1997. Prior to joining the Company and the Bank, Mr. Hotz was a shareholder of the law firm of von Briesen, Purtell & Roper, s.c.
BRUCE R. SHERMAN, age 52, is an Executive Vice President of the Company and of the Bank. Mr. Sherman became Executive Vice President of the Company and the Bank in September 1997. Mr. Sherman had been a Vice President of the Company since June 1993 and Senior Vice President and Treasurer of the Bank since 1984.
BRADLEY J. SMITH, age 42, is an Executive Vice President of the Bank. Mr. Smith became Executive Vice President of the Bank in January 1997. Prior to joining the Bank, Mr. Smith was a Senior Vice President of Provident Bank in Cincinnati, Ohio from 1993 to 1996 and a Vice President prior to 1993.
JON D. SORENSON, age 42, is Chief Financial Officer and Treasurer and is an Executive Vice President of the Company and of the Bank. Mr. Sorenson became Chief Financial Officer and Treasurer of the Company in November 1992, and of the Bank in September 1997. From December 1992 to September 1997, Mr. Sorenson was a Senior Vice President of the Bank and prior to that he was a Vice President of the Bank.
PART II
ITEM 5.
ITEM 5. MARKET FOR THE REGISTRANT'S COMMON STOCK AND RELATED SECURITY HOLDER MATTERS
The Company's common stock is currently being traded on the National Association of Securities Dealers Automated Quotation ("NASDAQ") National Market System over-the-counter exchange under the symbol of STFR. Information required by this item is incorporated by reference to the "Quarterly financial information (Unaudited)" shown in Note 19 to Notes to Consolidated Financial Statements and the "Earnings per share" Note 13 to Notes to Consolidated Financial Statements included under Item 8 of this Annual Report on Form 10-K.
As of October 31, 1997, there were approximately 1,300 holders of record and approximately 3,100 beneficial holders owning a total of 5,226,998 shares.
The Company paid quarterly dividends of $0.10 per share starting in November 1995, increased the dividend to $0.12 per share in November 1996 and increased it again to $0.14 per share in November 1997. No dividends were paid prior to November 1995. While there can be no assurance of the payment of future dividends, the Company anticipates that future dividends, if paid, would be paid on a quarterly basis in February, May, August and November. Future payments of dividends will be subject to determination and declaration by the Company's Board of Directors, which will take into account the Company's financial condition, results of operations, tax considerations, industry standards, economic conditions and other factors, including regulatory restrictions which affect the payment of dividends by the Company's subsidiaries to the Company.
On September 25, 1997, the Company's Board of Directors adopted a shareholders' rights plan (the "Rights Plan"). Under the terms of the Rights Plan, the Board of Directors declared a dividend of one preferred share purchase right for each outstanding share of common stock. Upon becoming exercisable, each right entitles shareholders to buy one one-hundredth of a share of the Company's preferred stock at an exercise price of $150. Rights do not become exercisable until eleven business days after any person or group has acquired, commenced, or announced its intention to commence a tender or exchange offer to acquire 15% or more of the Company's common stock, or in the event a person or group owning 10% or more of the Company's common stock is deemed to be "adverse" to the Company. If the rights become exercisable, holders of each right, other than the acquiror, upon payment of the exercise price, will have the right to purchase the Company's common stock (in lieu of preferred shares) having a value equal to two times the exercise price. If the Company is acquired in a merger, share exchange or other business combination or 50% or more of its consolidated assets or earning power are sold, rights holders, other than the acquiring or adverse person or group, will be entitled to purchase the acquiror's shares at a similar discount. If the rights become exercisable, the Company may also exchange rights, other than those held by the acquiring or adverse person or group, in whole or in part, at an exchange ratio of one share of the Company's common stock per right held. Rights are redeemable by the Company at any time until they are excercisable at the exchange rate of $.01 per right. Issuance of the rights has no immediate dilutive effect, does not currently affect reported earnings per share, is not taxable to the Company or its shareholders, and will not change the way in which the Company's shares are traded. The rights expire in ten years.
On November 11, 1997, the Company's current share repurchase plan expired. The plan was in effect from November 11, 1996 to November 11, 1997 and allowed for the purchase of up to 538,100 shares over the twelve month period. The Company actually purchased 275,000 shares during that time period at an average cost of $32.07 per share. On October 31, 1997 the Company announced that, subsequent to the expiration of its current share repurchase program, it had adopted a share repurchase program for its common stock. The Company plans to purchase up to 10%, or approximately 523,000 shares over a twelve month period commencing November 18, 1997 depending on market conditions. The repurchased shares will become treasury shares and will be used for general corporate purposes.
ITEM 6.
ITEM 6. SELECTED FINANCIAL DATA
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
Set forth below are selected consolidated financial and other data. The financial data is derived in part from, and should be read in conjunction with, the Consolidated Financial Statements and notes thereto presented elsewhere in this Annual Report on Form 10-K.
(1) Other operating income for the year ended September 30, 1997 included the effects of a $3,400,000 write-down of mortgage-backed securities for other than temporary impairment.
(2) General and administrative expenses for the year ended September 30, 1996 include a one-time special SAIF assessment of $4.2 million.
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA (CONT.)
- ------------------------------------------------
(1) Net interest spread represents the difference between the weighted average yield on interest-earning assets and the weighted average cost of interest-bearing liabilities. Net interest margin represents net interest income as a percentage of average interest-earning assets.
(2) Non-performing loans consist of nonaccrual loans and troubled debt restructurings. Non-performing assets consist of non-performing loans and foreclosed properties, which consist of real estate acquired by foreclosure or deed-in-lieu thereof.
(3) Capital ratios are those of St. Francis Bank, F.S.B. only for 1993 through 1997.
(4) Performance ratios for the year ended September 30, 1996 include the effects of the one-time special SAIF assessment of $4.2 million.
ITEM 7.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
GENERAL
St. Francis Capital Corporation (the "Company") is a bank holding company incorporated under the laws of the State of Wisconsin and is engaged in the financial services business through its wholly-owned subsidiary, St. Francis Bank, F.S.B. (the "Bank"), a federally-chartered savings bank. In June 1993, the Bank converted from a federally-chartered mutual savings institution to a stock savings institution. As part of the conversion, the Company acquired all of the outstanding common stock of the Bank. In February 1997, the Company completed the acquisition of the stock of Kilbourn State Bank, which subsequently merged into Bank Wisconsin. The Company merged the operations of its St. Francis Bank and Bank Wisconsin bank subsidiaries in September 1997 and currently operates with one subsidiary, St. Francis Bank.
The earnings of the Company depend primarily on its level of net interest income, which is the difference between interest earned on interest-earning assets, consisting primarily of mortgage, consumer and commercial loans, mortgage-backed and related securities and other investment securities, and the interest paid on interest-bearing liabilities, consisting primarily of deposits and borrowings from the Federal Home Loan Bank of Chicago (the "FHLB"). Net interest income is a function of the Company's net interest spread, which is the difference between the average yield earned on interest-earning assets and the average rate paid on interest-bearing liabilities, as well as a function of average ratio of interest-earning assets as compared to interest-bearing liabilities. The Company's earnings also are affected by the level of its other income, including loan servicing fees, deposit charges and fees and gains on trading assets and sales of loans and securities, as well as its level of non-interest expenses, including employee compensation and benefits, occupancy and equipment costs and federal deposit insurance premiums.
The Company's operating results are significantly affected by general economic conditions and the monetary, fiscal and regulatory policies of governmental agencies. Lending activities are influenced by the demand for and supply of housing competition among lenders, the level of interest rates and the availability of funds. Deposit flows and costs of funds likewise are heavily influenced by prevailing market rates of interest on competing investment alternatives, account maturities and the levels of personal income and savings in the Company's market areas.
Advances and changes in available technology can significantly impact the business and operations of the Company. The Company is in the process of conducting a review of its computer systems and its third-party systems to identify those that could be affected by the "Year 2000" issue and is developing an implementation plan to resolve the issue. The Year 2000 problem is the result of computer programs being written using two digits rather than four to define the applicable year. Any of the Company's programs or programs of third-party providers that have time-sensitive software may recognize a date using "00" as the year 1900 rather than the year 2000. If not corrected, Year 2000 issues could result in a major system failure or miscalculations and material costs to the Company. The Company presently believes that, with modifications to existing software and converting to new software, the Year 2000 problem will not pose significant operational problems for the Company's computer systems as so modified and converted, nor will compliance with the Year 2000 problem result in a material cost.* However, if such modifications and conversions are not completed timely, the Year 2000 problem may have a material impact on the operations of the Company.
FINANCIAL CONDITION
Total assets of the Company increased $256.5 million to $1.66 billion at September 30, 1997 from $1.40 billion at September 30, 1996. The increase was primarily in loans receivable, including loans held for sale, which increased $106.3 million, and mortgage-backed and related securities, including securities available for sale, which increased $99.4 million. At September 30, 1997, the Company's statement of financial condition also includes the assets and liabilities of Kilbourn State Bank since the acquisition was consummated on February 28, 1997. The acquisition of Kilbourn State Bank added $93.0 million to total assets, including additions of $62.6 million to net loans and $67.8 million to deposits. The increase in
loans receivable was partially due to increases in mortgage loan originations. The growth in assets was funded primarily by an increase in deposits of $209.5 million and an increase in advances and other borrowings of $45.2 million.
Mortgage-backed and related securities, including securities available for sale, increased to $687.6 million at September 30, 1997 from $588.2 million at September 30, 1996, which represented 41.4% and 41.9% of total assets, respectively. The increase was the result of purchasing short- and medium-term REMIC's. These securities were financed primarily with advances from the Federal Home Loan Bank of Chicago (the "FHLB") and deposit growth. The Company is utilizing its capital position to increase earning assets by investing primarily in REMIC securities with short and medium terms of two to five years and financing the purchases with FHLB advances that generally match the expected average lives of the respective securities. The Company purchases mortgage-backed securities that are guaranteed by both government sponsored enterprises such as FHLMC, FNMA and GNMA as well as securities that are issued by private mortgage security conduits. These securities have credit ratings of A or better at the time of purchase and meet the Federal Financial Institutions Examination Council definition of low-risk securities. Mortgage-backed securities issued by government sponsored enterprises generally increase the quality of the Company's assets by virtue of the guarantees that back them. When the intermediary is a private entity, neither the principal or interest on such securities is guaranteed. In addition, loans that back private mortgage-backed securities generally are non-conforming loans and consequently have a greater amount of credit risk and generally will have a higher yield. The Company has been an active purchaser of adjustable rate mortgage-backed securities as well as short-term mortgage-related securities because of their lower level of interest rate risk and low credit risk in relation to the interest earned on such securities.
At September 30, 1997, the Company recorded declines in fair value judged to be other than temporary on four of its private issue mortgage-backed securities. The Company believes that these four securities, two of which were rated "A" and the other two of which were rated "BBB" at September 30, 1997, were impaired at September 30, 1997. Therefore, in accordance with generally accepted accounting principles, these securities were written down to fair value and the impairment loss was recorded in the Company's income statement. Prior to the adjustment, the Company's cost basis in these securities was $12.5 million. The impairment loss resulted in a new cost basis of $9.1 million for these four issues. The four issues under impairment are private issue mortgage-backed securities backed by single-family loans relating to properties located primarily in California. The underlying loans have experienced significant delinquencies and foreclosures and the Company learned that recoveries on these loans were less than previously realized and that the various subordinate and cash positions within the mortgage-backed structures may no longer protect the Company's position in the securities. The Company has written the securities down to fair value which is a level where the remaining cash flows should provide a return at a market rate of interest income on the remaining cost basis.
Subsequent to September 30, 1997, the Company has conducted a review of its mortgage-backed and related securities portfolio and its debt and equity securities portfolio relating primarily to the levels of credit and interest rate risk within the portfolios. Credit issues reviewed included global portfolio issues such as the amount of various securities with ratings other than "AAA", the highest of the investment grade ratings and security specific issues such as the collateral level of individual securities. Interest rate risk issues included review of maturity and repricing characteristics of the securities and of the portfolio as a whole. Primarily as a result of the Company's view of the current external credit risk and external interest rate risk cycles and the Company's internal view of its investment management position, selected securities from the mortgage-backed securities and debt and equity securities portfolios have been sold subsequent to year-end. From October 1, 1997 through December 19, 1997, the Company has sold securities totaling $122.1 million at a net gain of $493,000. The net gain consisted of gross gains of $2.1 million and gross losses of $1.6 million. The net gain will be reflected in the Company's results of operations during the first quarter of its fiscal year ending September 30, 1998. Other activity, including sales during the remaining part of the quarter, may result in a final amount different than that discussed above.
Total loans, including loans held for sale, increased to $737.5 million at September 30, 1997 from $631.2 million at September 30, 1996, primarily due to the aforementioned Kilbourn State Bank acquisition. Mortgage loans increased to $476.1 million during the year compared to $452.5 million in 1996. The Company increased loan origination activity during the year, originating $223.2 million of first mortgage loans compared to $173.1 million in the prior year. Additional activity in loans included mortgage loans sold for the year ended September 30, 1997 of $116.8 million, up from $62.6 million for the year ended September 30, 1996, and mortgage loans purchased during the year ended September 30, 1997 of $24.7 million, down from $56.2 million for the year ended September 30, 1996. Long-term 15- and 30- year fixed-rate loans are generally originated to be sold in the secondary market as are five and seven year balloon loans. Shorter-term ARM loans are originated both for sale in the secondary market and for the Company's loan portfolio. Additionally, the Company has increased its emphasis on commercial and consumer lending, which are primarily retained in the Company's loan portfolio. For the year ended September 30, 1997, the Company originated approximately $144.2 million of consumer and home equity loans, purchased $888,000 and sold $12.2 million of these same types of loans, compared with originations of $126.5 million, purchases of $12.8 million and sales of $15.1 million for the year ended September 30, 1996. Exclusive of the Kilbourn State Bank acquisition, the Company originated $33.4 million of commercial loans during the year ended September 30, 1997 compared with $14.0 million of originations for the year ended September 30, 1996. Consumer and commercial lending represent a different level of risk than mortgage lending which is primarily collateral based lending. Consumer and commercial loans are primarily based on the assessment of the cash flow and repayment ability of the customer or business to which funds have been lent.
Debt and equity securities, including those available for sale, decreased $6.1 million to $60.1 million at September 30, 1997, from $66.2 million at September 30, 1996. Debt and equity securities are comprised primarily of U.S. Treasury Notes, tax-exempt obligations, asset-backed securities, mutual fund investments and commercial paper.
Real estate held for investment increased $14.6 million to $51.5 million at September 30, 1997, from $36.9 million at September 30, 1996. Real estate held for investment consists of affordable housing projects in which a subsidiary of the Bank invests, which qualify for tax credits under Section 42 of the Internal Revenue Code. The subsidiary currently is a limited partner in 25 projects all within the state of Wisconsin. Additionally, the Bank has provided financing or committed to provide financing to 24 of the projects. However, the primary return to the Company on these projects is in the form of income tax credits earned over the first ten years of the project.
Deposits increased $209.5 million to $1.09 billion at September 30, 1997 from $877.7 million at September 30, 1996. The increase in deposits was primarily due to an increase of $67.8 million from the Kilbourn State Bank acquisition as well as increases of $88.5 million in money market demand account deposits and $62.3 million in certificates of deposit. The Company has continued to offer new deposit products in an effort to attract new deposits and maintain current relationships with customers. Significant new deposit products offered which have contributed to the increase include certificates of deposit and a money market demand account with an interest rate tied to a nationally recognized money market index. At September 30, 1997, the Company had approximately $140.8 million in brokered certificates of deposit compared with $138.6 million at September 30, 1996. The brokered deposits are generally of terms from three months to ten years in maturity with interest rates that approximate the Company's retail certificate rates. At September 30, 1997, $89.9 million of the brokered deposits having longer maturities are callable within one to two years. Although the Company has experienced growth in its deposit liabilities during 1997, there can be no assurance that this trend will continue in the future, nor can there be any assurance the Company will retain the deposits it now has.* The level of deposit flows during any given period is heavily influenced by factors such as the general level of interest rates as well as alternative yields that investors may obtain on competing instruments, such as money market mutual funds.
Advances and other borrowings increased to $420.2 million at September 30, 1997, from $375.0 million at September 30, 1996. This increase is due primarily to the Company's previously discussed leveraging
strategy to increase its earning assets through the purchase of short- and medium-term mortgage-related securities using FHLB advances as a funding source.
At September 30, 1997, the Company had $163.0 million in interest rate swaps outstanding compared with $55.0 million at September 30, 1996. The swaps are designed to offset the changing interest payments of some of the Company's borrowings and brokered certificates. Fixed pay-floating receive swaps totaled $55.0 million at September 30, 1997 and were entered into to hedge interest rates on borrowings from the FHLB used to fund purchases of fixed rate securities. Fixed pay-floating receive swaps will provide for a lower interest expense (or interest income) in a rising rate environment while adding to interest expense in a falling rate environment. Fixed receive-floating pay swaps totaled $108.0 million at September 30, 1997 and were entered into to hedge interest rates on brokered deposits used to fund the purchase of floating rate securities. Fixed receive-floating pay swaps will provide for a lower interest expense (or interest income) in a falling rate environment while adding to interest expense in a rising rate environment. During the year ended September 30, 1997, the Company recorded a net reduction of interest expense of $752,000 as a result of the Company's interest rate swap agreements.
At September 30, 1997, the Company had $30.0 million in interest rate corridors outstanding compared with none at September 30, 1996. The Company uses interest rate corridors to help protect its net interest margin in various interest rate environments. $20.0 million of the interest rate corridors pay the Company the range difference or a full 1.0% when the three-month LIBOR rate is within the corridor strike rates. There are no payments due to the Company when three-month LIBOR rates are outside of the corridor strike rates. $10.0 million of the interest rate corridors pay the Company the difference between the three-month LIBOR and the low limit of the corridor strike rate up to the full amount of the corridor strike rate. There are no payments due to the Company when three-month LIBOR rates are below the corridor strike rate. When rates are above the corridor strike rate, the corridor pays the Company the full corridor range of 1.0%.
There are certain risks associated with swaps and corridors, including the risk that the counterparty may default and that there may not be an exact correlation between the indices on which the swap agreements are based and the terms of the hedged liabilities. In order to offset these risks, the Company generally enters into swap and corridor agreements only with nationally recognized securities firms and monitors the credit status of counterparties, the level of collateral for such swaps and corridors and the correlation between the hedged liabilities and indices utilized.
During the year, the Company's Board of Directors adopted a shareholders' rights plan (the "Rights Plan"). Under the terms of the Rights Plan, the Board of Directors declared a dividend of one preferred share purchase right for each outstanding share of common stock. If the rights become exercisable, holders of each right, other than the acquiror, upon payment of the exercise price, will have the right to purchase the Company's common stock (in lieu of preferred shares) having a value equal to two times the exercise price. Rights are redeemable by the Company at any time until they are excercisable at the exchange rate of $.01 per right. Issuance of the rights has no immediate dilutive effect, does not currently affect reported earnings per share, is not taxable to the Company or its shareholders, and will not change the way in which the Company's shares are traded. The rights expire in ten years.
COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED SEPTEMBER 30, 1997 AND 1996
GENERAL
Net income for the year ended September 30, 1997 increased $1.2 million or 12.0% to $11.7 million from $10.5 million for the year ended September 30, 1996. The recent results include the operations of Kilbourn State Bank since its acquisition on February 28, 1997. The prior year results were significantly affected by a one-time industry-wide assessment of $2.5 million, after tax, for the recapitalization of the Savings Association Insurance Fund ("SAIF"). The increase in net income was primarily the result of an increase in earning assets, which resulted in a $3.1 million increase in net interest income and a $1.4 million decrease in income tax expense, partially offset by a $2.0 million decrease in other income and a $1.3 million increase in general and administrative expenses. The decrease in other income was primarily
due to a $3.4 million writedown to reflect an impairment loss in the Company's mortgage-backed securities portfolio.
NET INTEREST INCOME
Net interest income before provision for loan losses increased $3.1 million or 8.7% to $38.8 million for the year ended September 30, 1997 compared to $35.7 million for the year ended September 30, 1996. The increase was due to an increase of $217.3 million in average earning assets, partially offset by a decrease in the net interest margin to 2.73% in 1997 from 2.97% in 1996. While the Company has adopted interest rate risk policies in an effort to protect net interest income from significant increases in interest rates, the Company's net income could still be affected by a narrowing of its net interest rate spread.
Total interest income increased $16.0 million or 17.4% to $108.1 million for the year ended September 30, 1997 compared to $92.1 million for the year ended September 30, 1996. The increase in interest income was primarily the result of a $10.1 million increase in interest on loans and a $4.1 million increase in interest on mortgage-backed and related securities. The increase in interest on loans was due to increases in the average balance of loans to $677.9 million for the year ended September 30, 1997, compared to $553.7 million for the year ended September 30, 1996, partially offset by a decrease in the average yield on loans, which decreased to 8.50% for the year ended September 30, 1997, from 8.58% for the year ended September 30, 1996. The increase in the average balance of loans is due primarily to the Company's recent efforts to emphasize commercial, consumer and home equity lending in addition to the Kilbourn State Bank acquisition. However, such loans, while potentially resulting ultimately in higher yields for the Company, may result in a higher level of credit risk than conventional mortgage loans. The decrease in the average yield is primarily due to the Company now selling substantially all new originations of initially higher yielding long-term, fixed-rate single-family mortgage loans in the secondary market and retaining new originations of initially lower yielding adjustable-rate single-family mortgage loans. The increase in interest income on mortgage-backed and related securities was due to an increase in the average balance of such securities to $627.4 million for the year ended September 30, 1997 from $559.5 million for the year ended September 30, 1996, partially offset by a decrease in the average yield on such securities to 6.90% for the year ended September 30, 1997 from 7.00% for the year ended September 30, 1996. The Company has purchased significant amounts of adjustable rate and short- and medium-term securities during the past two years as part of its efforts to increase earning assets, funding those purchases with FHLB advances, whose terms generally match the securities purchased.
Total interest expense increased $13.0 million or 23.0% to $69.4 million for the year ended September 30, 1997 compared to $56.4 million for the year ended September 30, 1996. Interest expense on deposits increased $9.4 million or 24.9% to $47.0 million for the year ended September 30, 1997 compared to $37.6 million for the year ended September 30, 1996. The increase in interest expense was the result of increases in the average balances and costs on deposits and advances and other borrowings. The average balances of deposits increased to $934.9 million for the year ended September 30, 1997, from $757.3 million for the year ended September 30, 1996. The increases in the balances of deposits are due to the Company's offering of additional deposit products, the use of brokers to sell certificates of deposit and the Kilbourn State Bank acquisition. The average cost of deposits increased to 5.03% for the year ended September 30, 1997, from 4.97% for the year ended September 30, 1996. Brokered deposits increased to $140.8 million during the year compared to $138.6 million in 1996 at weighted average stated rates of 6.49% and 5.35%, respectively. The higher cost of the brokered certificates reflects the use of longer-term callable brokered deposits to fund the Company's leverage program. The Company then, in effect, lowers the cost of the deposits through the use of interest rate swaps to rates approximating short-term rates. This funding then matches the interest rate characteristics of the related asset, which is generally a short-term adjusting mortgage-backed security. The average cost of deposits increased even though overall market rates of interest were slightly lower for the year ended September 30, 1997 compared with the prior year. The Company will generally meet its local competition in the pricing of deposit products which may mean that its cost of funds may not correlate exactly with national market rates such as treasury rates or LIBOR. As part of a continuing strategy, the Company continues to offer deposit products that compete more effectively with money market funds and other non-financial deposit products. Such accounts have
generally changed the Company's traditional mix of deposit accounts to one that is more adjustable to current interest rates such as the money market demand account. This has resulted in passbook and certificate of deposit accounts representing a lower percentage of the Company's total deposit portfolio. Interest expense on advances and other borrowings increased $3.6 million or 19.0% to $22.3 million for the year ended September 30, 1997 from $18.8 million for the year ended September 30, 1996. The average balance of advances and other borrowings increased to $399.8 million for the year ended September 30, 1997, from $341.2 million for the year ended September 30, 1996, while the average cost of advances and other borrowings increased to 5.59% for the year ended September 30, 1997, from 5.50% for the year ended September 30, 1996. The increase in the average balance of borrowings was a result of the aforementioned leveraging program with most of the borrowings being adjustable-rate advances which are indexed to three-month LIBOR rates which have increased modestly over the current year.
PROVISION FOR LOAN LOSSES The provision for loan losses remained unchanged at $1.3 million for the years ended September 30, 1997 and 1996. A significant portion of the provision for the year ended September 30, 1997 includes a provision to recognize the potential loss on a commercial real estate loan while the prior year includes a provision of $1.0 million for loan losses related to purchased auto loans. The commercial real estate loan is on a shopping center property located in Wisconsin. The allowance for loan losses totaled $6.2 million and $5.2 million at September 30, 1997 and 1996, respectively, representing 0.79% and 0.78% of total loans, respectively. Net charge-offs were $2.0 million during the year ended September 30, 1997 and $159,000 during the year ended September 30, 1996. Defaults of purchased subprime auto loans and related repossessed autos sold during the year resulted in charge-offs of $1.9 million. It is anticipated that as more of the auto loans default and repossessed autos are sold, additional charge-offs will be incurred, but in lower amounts than in 1997.* The provision for loan loss is established based on management's evaluation of the risk inherent in its loan portfolio and the general economy. Such evaluation, which includes a review of all loans on which full collectibility may not be reasonably assured, considers, among other matters, the estimated net realizable value of the underlying collateral, economic conditions, historical loan loss experience and other factors that warrant recognition in providing for an accurate provision for loan losses.
OTHER OPERATING INCOME Other operating income decreased $2.0 million or 18.4% to $8.6 million for the year ended September 30, 1997 compared to $10.6 million for the year ended September 30, 1996. The decrease was primarily due to a $3.4 million writedown to fair value on four of the Company's private issue mortgage-backed securities and decreases in gains on investments and mortgage-backed and related securities, partially offset by increases in gains on mortgage loans held for sale, gains on trading account activity and increased income from the Company's affordable housing subsidiary. During the year ended September 30, 1997, the Company recorded declines in fair value judged to be other than temporary on four of its private issue mortgage-backed securities. The Company believes that these four securities, two of which were rated "A" and the other two of which were rated "BBB" at September 30, 1997, were impaired during the year. Therefore, in accordance with generally accepted accounting principles, these securities were written down to fair value and the impairment loss was recorded in the Company's income statement. Management's decision to write down these issues reflects a decline in value resulting from the deterioration of the collateral securing the loans within the REMIC structures. That decision is a result of the level of delinquencies, foreclosures, repossessions and recovery rates on the underlying loans. The securities have been written down to $9.1 million at September 30, 1997 compared to an original amortized cost basis of $12.5 million. This is a level at which the remaining estimated cash flows should result in a market yield on the securities.*
Gains on investments and mortgage-backed and related securities were $1.3 million for the year ended September 30, 1997, compared to $3.3 million for the year ended September 30, 1996. The gains recognized were primarily due to declining interest rates and the Company's continuing review of its mortgage-backed securities portfolio. During the year the Company will sell securities from its mortgage-backed securities portfolio and replace them with similar securities with more favorable interest rate and
maturity characteristics. This is generally done when, in the opinion of management, a security being held in portfolio appears to be overvalued and the Company will receive greater economic value by selling the security rather than retaining it. The Company does not consider gains on the sales of securities as a predictable source of earnings as such sales are based on the Company's aforementioned review of individual securities within the Company's available for sale portfolio whereby securities may be sold and replaced with ones that offer a better combination of interest income, interest rate risk or credit risk than the security sold. Gain/(loss) on foreclosed properties decreased to a loss of $22,000 from a gain of $865,000 for the years ended September 30, 1997 and 1996, respectively. For the year ended September 30, 1996, the gain was the result of the sale of one foreclosed property which had a carrying value of $5.8 million. The gain on sale of this property was $684,000. Gains from the trading account increased to $726,000 from $109,000 for the years ended September 30, 1997 and 1996, respectively. The increase in trading gains was the result of the sale of mortgage-backed securities which the Company had exchanged for its own mortgage loans ("loan swaps"). This method of selling the Company's salable mortgage production is required, under accounting rules, to be accounted for as a "trading" activity, and as such, the resulting realized and unrealized gains or losses are classified as trading income. The level of trading gains may fluctuate due to the volume of originations of single-family mortgage loans which in turn can fluctuate due to changes in interest rates. Sales of loans as opposed to loan swaps are recorded as sales of mortgage loans in the income statement. Income from the operations of the Company's affordable housing subsidiary (which represents primarily rental income) increased to $3.4 million from $1.9 million for the years ended September 30, 1997 and 1996, respectively. The Company currently has 23 properties fully in operation compared to 15 in the prior year.
GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses increased $1.3 million or 4.1% to $32.9 million for the year ended September 30, 1997, compared to $31.6 million for the year ended September 30, 1996. The prior year included a one-time charge of $4.2 million for the recapitalization of the Savings Association Insurance Fund. General operating expenses of the Company have increased for various reasons, including; 1) costs associated with the Kilbourn State Bank acquisition, 2) the opening of four new branches, 3) the establishment of a centralized call center, 4) expansion of the Company's lending areas and 5) other increased activity connected with the Company's higher level of earning assets. Expense categories significantly affected by the above items include compensation and benefits which were $15.6 million for the year ended September 30, 1997 compared with $13.2 million for the prior year, occupancy and furniture and equipment expenses which combined were $5.0 million for the year ended September 30, 1997 compared with $4.0 million for the prior year, and telephone and postage expense which was $1.0 million for the year ended September 30, 1997 compared with $724,000 for the prior year. In addition, the affordable housing subsidiary showed an increase in operating expenses to $3.9 million compared with $2.2 million in the prior year, primarily as a result of the Company currently having 23 properties fully in operation compared to 15 in the prior year. Amortization of intangible assets increased to $834,000 for the year ended September 30, 1997 compared with $446,000 during the prior year due to the purchase of Kilbourn State Bank during the year.
INCOME TAX EXPENSE
Income tax expense decreased by $1.4 million or 47.0% to $1.5 million for the year ended September 30, 1997 compared to $2.9 million for the year ended September 30, 1996. The decrease was primarily the result of income tax credits received from investments in the low-income housing. The Company's effective tax rate was 11.6% for the year ended September 30, 1997, compared to 21.8% for the year ended September 30, 1996. The decrease in effective rates reflects the effect of the tax credits earned by the Company's affordable housing subsidiary. Income tax credits increased to $2.9 million for the year ended September 30, 1997, compared to $1.7 million in the prior year.
COMPARISON OF OPERATING RESULTS FOR THE YEARS ENDED SEPTEMBER 30, 1996 AND 1995 GENERAL Net income for the year ended September 30, 1996 before a one-time significant charge increased $300,000 or 2.4% to $13.0 million from $12.7 million for the year ended September 30, 1995. The significant charge was a one-time industry-wide assessment of $2.5 million, after tax, for the recapitalization of the Savings Association Insurance Fund ("SAIF"). The Company reported actual net income of $10.5 million for the year ended September 30, 1996. The change was primarily the result of an increase in earning assets, which resulted in a $2.1 million increase in net interest income, a $2.3 million increase in other income and a $3.4 million decrease in income tax expense, partially offset by a $1.1 million increase in provision for loan losses and a $8.9 million increase in general and administrative expenses.
NET INTEREST INCOME Net interest income before provision for loan losses increased $2.1 million or 6.3% to $35.7 million for the year ended September 30, 1996 compared to $33.6 million for the year ended September 30, 1995. The increase was due to an increase of $96.6 million in average earning assets, partially offset by a decrease in the net interest margin to 2.97% in 1996 from 3.04% in 1995.
Total interest income increased $8.3 million or 9.9% to $92.1 million for the year ended September 30, 1996 compared to $83.8 million for the year ended September 30, 1995. The increase in interest income was primarily the result of a $5.5 million increase in interest on loans and a $2.5 million increase in interest on mortgage-backed and related securities. The increase in interest on loans was due to increases in the average balance of loans to $553.7 million for the year ended September 30, 1996, as compared to $502.6 million for the year ended September 30, 1995, and an increase in the average yield on loans, which increased to 8.58% for the year ended September 30, 1996, from 8.35% for the year ended September 30, 1995. The increase in the yields and average balances of loans is consistent with the Company's recent efforts to emphasize higher yielding loans, such as those made in consumer and home equity lending and an increase in the level of loan purchases. Such loans while resulting in higher yields for the Company may result in a higher level of credit risk than conventional mortgage loans. The increase in interest income on mortgage-backed and related securities was due to an increase in the average balance of such securities to $559.5 million for the year ended September 30, 1996, from $516.9 million for the year ended September 30, 1995, however, the average yield on such securities decreased to 7.00% for the year ended September 30, 1996, from 7.10% for the year ended September 30, 1995. The Company has purchased significant amounts of adjustable rate and short- and medium-term securities during the past two years as part of its efforts to increase earning assets, funding those purchases with FHLB advances, whose terms generally match the securities purchased.
Total interest expense increased $6.2 million or 12.4% to $56.4 million for the year ended September 30, 1996 compared to $50.2 million for the year ended September 30, 1995. Interest expense on deposits increased $6.8 million or 22.1% to $37.6 million for the year ended September 30, 1996 compared to $30.8 million for the year ended September 30, 1995. The increase in interest expense was the result of increases in the average balances and costs on deposits and advances and other borrowings. The average balances of deposits increased to $757.3 million for the year ended September 30, 1996, from $654.7 million for the year ended September 30, 1995. The increases in the balances of deposits are due to the Company's offering of additional deposit products and the use of brokers to purchase certificates of deposit. The average cost of deposits increased to 4.97% for the year ended September 30, 1996, from 4.70% for the year ended September 30, 1995. Brokered deposits increased to $138.6 million during the year compared to $38.0 million in 1995 at weighted average stated rates of 5.35% and 6.24%, respectively. The average cost of deposits increased even though overall market rates of interest were slightly lower for the year ended September 30, 1996 compared with the prior year. The Company has been emphasizing deposit accounts such as its prime CD and its market investor account because of the deposit growth it believes these accounts can bring over the other products the Company offers. However, these accounts also tend to have a higher rate of interest than the average of other deposit accounts offered by the Company. Interest expense on advances and other borrowings decreased $645,000 or 3.3% to $18.8 million for the year ended
September 30, 1996 from $19.4 million for the year ended September 30, 1995. The average balance of advances and other borrowings increased to $341.2 million for the year ended September 30, 1996, from $339.8 million for the year ended September 30, 1995, while the average cost of advances and other borrowings decreased to 5.50% for the year ended September 30, 1996, from 5.71% for the year ended September 30, 1995. The increase in the average balance of borrowings was a result of the aforementioned leveraging program with most of the borrowings being adjustable-rate advances which have repriced downwards as market rates of interest have decreased.
PROVISION FOR LOAN LOSSES The provision for loan losses increased to $1.3 million for the year ended September 30, 1996 compared to a provision for loan losses of $240,000 for the year ended September 30, 1995. For the year ended September 30, 1996, the Company recorded an additional provision of $1.0 million for loan losses on a pool of auto loans purchased by the Company. The allowance for loan losses totaled $5.2 million and $4.1 million at September 30, 1996 and 1995, respectively, representing 0.78% and 0.77% of total loans, respectively. Net charge-offs were $159,000 during the year ended September 30, 1996 and $293,000 during the year ended September 30, 1995. Included in the net charge-offs for the year ended September 30, 1995 was a $210,000 charge-off for the settlement of a loan on a multi-family property in Houston, Texas. The provision for loan loss is established based on management's evaluation of the risk inherent in its loan portfolio and the general economy. Such evaluation, which includes a review of all loans on which full collectibility may not be reasonably assured, considers, among other matters, the estimated net realizable value of the underlying collateral, economic conditions, historical loan loss experience and other factors that warrant recognition in providing for an accurate provision for loan losses.
OTHER OPERATING INCOME Other operating income increased $2.3 million or 27.4% to $10.6 million for the year ended September 30, 1996 compared to $8.3 million for the year ended September 30, 1995. The increases were due primarily to gains on investments and mortgage-backed and related securities, gains on mortgage loans held for sale, gains on foreclosed properties and real estate held for sale and increased income from the Company's affordable housing subsidiary. Gains on investments and mortgage-backed and related securities were $3.3 million for the year ended September 30, 1996, compared to $2.6 million for the year ended September 30, 1995. The gains recognized were primarily due to declining interest rates and the Company's repositioning of its existing leverage portfolio. The Company sold securities from the leverage portfolio and replaced them with similar securities with more favorable interest rate and maturity characteristics. One of the Company's asset/liability management techniques utilizes options which provide it with a practical floor and cap on portfolio market values for moderately adverse interest rate movements. However, during periods of rapidly rising interest rates, the strategy may not prevent a market value loss from being recognized overall, and also may result in additional losses incurred on the options themselves. Gains on sales of mortgage loans held for sale increased to $1.1 million for the year ended September 30, 1996 compared to $261,000 for the year ended September 30, 1995. Gain/(loss) on foreclosed properties and real estate held for sale, net increased due to the Company recording a gain of $684,000 in 1996 on the cash sale of a foreclosed multi-family property acquired in August, 1995. The operations of the Company's affordable housing subsidiary had increases in income (which represents primarily rental income) for the year ended September 30, 1996 of $806,000 from the previous year.
GENERAL AND ADMINISTRATIVE EXPENSES General and administrative expenses increased $8.9 million or 39.2% to $31.6 million for the year ended September 30, 1996, compared to $22.7 million for the year ended September 30, 1995. General and administrative expenses were higher primarily because of increased compensation and other costs associated with the Company's expansion of various lines of business, including an increased emphasis on commercial banking, higher levels of mortgage and consumer loan originations, the opening of two new branches and the establishment of a centralized call center. FDIC premiums increased $4.2 million due to the one-time charge for recapitalization of the Savings Association Insurance Fund ("SAIF"). A reduction in FDIC premium rates are expected to favorably impact general and administrative expenses in fiscal
1997.* The expenses related to the operation of the Company's affordable housing subsidiary increased $744,000 for the year ended September 30, 1996.
INCOME TAX EXPENSE Income tax expense decreased by $3.4 million or 53.6% to $2.9 million for the year ended September 30, 1996 compared to $6.3 million for the year ended September 30, 1995. The decrease was a result of a decrease in income before income tax expense, income tax credits received from investment in the low-income housing units and increased municipal interest and dividends. The Company's effective tax rate was 21.8% for the year ended September 30, 1996, compared to 33.1% for the year ended September 30, 1995.
AVERAGE BALANCE SHEET The following table sets forth certain information relating to the Company's consolidated average statements of financial condition and the consolidated statements of income for the years ended September 30, 1997, 1996 and 1995, and reflects the average yield on assets and average cost of liabilities for the years indicated. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the years shown. Average balances are derived principally from average daily balances and include non-accruing loans. The yields and costs include fees which are considered adjustments to yields. The amount of interest income resulting from the recognition of loan fees was $159,000, $457,000 and $465,000 for the years ended September 30, 1997, 1996 and 1995, respectively. Interest income on non-accruing loans is reflected in the year that it is collected. Such amounts are not material to net interest income or net change in net interest income in any year. Non-accrual loans are included in the average balances and do not have a material effect on the average yield. Tax-exempt investments are immaterial and the tax-equivalent method of presentation is not included in the schedule. Interest rate swaps, which are accounted for as a hedge of the cost of various liabilities, are included in the category of liability being hedged.
RATE/VOLUME ANALYSIS Net interest income represents the difference between income on interest-earning assets and expense on interest-bearing liabilities. Net interest income depends upon the volumes of interest-earning assets and interest-bearing liabilities and the interest rate earned or paid on them.
The following table presents the extent to which changes in interest rates and changes in the volume of interest-earning assets and interest-bearing liabilities have affected the Company's interest income and interest expense during the periods indicated. Information is provided in each category with respect to (i) changes attributable to changes in volume (changes in volume multiplied by prior rate), (ii) changes attributable to changes in rate (changes in rate multiplied by prior volume), (iii) changes attributable to the combined impact of volume and rate (changes in the rate multiplied by the changes in the volume) and (iv) the net change.
ASSET/LIABILITY MANAGEMENT The Company's profitability, like that of most financial institutions, depends to a large extent upon its net interest income, which is the difference between interest earned on its interest-earning assets, such as loans and investments, and its interest expense paid on interest-bearing liabilities, such as deposits and borrowings.
The Company maintains a high level of short-term savings deposits, including passbook savings, NOW checking accounts and money market deposit accounts. These accounts typically react more quickly to changes in market interest rates than the Company's investments in mortgage-backed and related securities and mortgage loans because of the shorter maturity and repricing characteristics of deposits. As a result, sharp increases in interest rates may adversely affect earnings while decreases in interest rates may beneficially affect earnings.
In an attempt to manage vulnerability to interest rate changes, management closely monitors the Company's interest rate risks. The Company has established its investment strategies through an Asset/Liability Committee which reports to the Board of Directors. The Committee generally meets monthly and reviews the Company's interest rate risk position, maturing securities and borrowings, interest rates and programs for raising deposits, including retail and brokered and nonbrokered wholesale deposits, and originating and purchasing of loans, and develops policies dealing with these issues. The Company primarily seeks to manage its interest rate risk through structuring its balance sheet by investing in a variety of different types of financial instruments in order to reduce its vulnerability to changes in interest rates and to enhance its income. The Company's assets and liabilities maturing and repricing within one year generally result in a negative one-year gap, which is when the level of liabilities maturing or repricing within one year are greater than the level of assets maturing or repricing within the same period of time. If interest rates were to rise significantly, and for a prolonged period, the Company's operating results could be adversely affected. The Company attempts to maintain a negative one-year gap of less than 15% of total assets. If in the estimation of management, the one-year gap exceeded or was soon to exceed that limit, actions would be taken to reduce the Company's exposure to rising interest rates. These steps could include the sale of longer-term assets, the obtaining of longer-term deposits or other liabilities and the use of interest rate swaps or other off-balance sheet instruments that would reduce the Company's overall interest rate risk position.
Generally, the Company uses the following strategies to reduce its interest rate risk: (i) the Company seeks to originate and hold a variety of ARMs or other mortgage loans with short- to medium-term average lives or terms and invests in primarily adjustable-rate mortgage-backed and related securities with short- to medium-term average lives; (ii) the Company seeks to lengthen the maturities of deposits when deemed cost effective through the pricing and promotion of certificates of deposit with terms of one to five years, and periodically utilizes deposit marketing programs offering maturity and repricing terms structured to complement the repricing and maturity characteristics of the existing asset/liability mix; (iii) the Company has utilized longer term borrowings, principally secured from the FHLB, in order to manage its assets and liabilities and enhance earnings; and (iv) the Company is utilizing its capital position to increase earning assets by investing primarily in agency or private issue REMIC securities with short and medium terms of two to five years and financing the purchases with FHLB advances or brokered deposits that generally match the expected average lives of the respective securities.
By originating and purchasing ARM loans and other mortgage loans with short to medium terms and by investing in primarily variable-rate, short- to medium-term securities, the Company has been able to reduce interest rate risk by more closely matching the terms and repricing characteristics of its assets and liabilities. In addition, because of the relative liquidity of mortgage-backed and related securities, the Company can restructure its interest-earning asset portfolio more quickly and effectively in a changing interest rate environment. Although the Company has continued its emphasis upon originating ARM loans and has been developing other types of mortgage loans with shorter average lives, customer demands for fixed rate mortgage and consumer loans and the level of the Company's portfolio of fixed rate mortgage loans and investments with longer average lives continues to affect its gap position. The Company's ARM loans and ARM mortgage-backed and related securities also typically have annual and lifetime caps on interest rate increases, which reduces the extent to which they protect the Company against interest rate risk.
The Company continues to closely monitor its interest rate risk as that risk relates to its strategies. At September 30, 1997, total interest-bearing liabilities maturing or repricing within one year exceeded total interest-earning assets maturing or repricing in the same period by $179.4 million, representing a negative cumulative one year gap ratio of 10.8%, compared to a negative cumulative one year gap ratio of 9.7% at September 30, 1996. With a negative gap position, during periods of rising interest rates it is expected that the cost of the Company's interest-bearing liabilities will rise more quickly than the yield on its interest-earning assets, which will have a negative effect upon its net interest income. Although the opposite effect on net interest income would occur in periods of falling interest rates, the Company could experience substantial prepayments of its fixed-rate mortgage loans and mortgage-backed and related securities in periods of falling interest rates, which results in the reinvestment of such proceeds at market rates which are lower than current rates.
The following table sets forth the amounts of interest-earning assets and interest-bearing liabilities outstanding at September 30, 1997:
(1) Adjustable and floating rate assets are included in the period in which interest rates are next scheduled to adjust rather than in the period in which they are due, and fixed rate assets are included in the periods in which they are scheduled to be repaid based on scheduled amortization, in each case adjusted to take into account estimated prepayments utilizing the Company's historical prepayment statistics, modified for forecasted statistics using the Public Securities Association model of prepayments.* For fixed rate mortgage loans and mortgage-backed and related securities, annual prepayment rates ranging from 8% to 30%, based on the loan coupon rate, were used.
(2) Balances have been reduced for undisbursed loan proceeds, unearned insurance premiums, deferred loan fees, purchased loan discounts and allowances for loan losses, which aggregated $47.3 million at September 30, 1997.
(3) Although the Company's negotiable order of withdrawal ("NOW") accounts, passbook savings accounts and money market deposit accounts generally are subject to immediate withdrawal, management considers a certain portion of such accounts to be core deposits having significantly longer effective maturities based on the Company's retention of such deposits in changing interest rate environments. NOW accounts, passbook savings accounts and money market deposit accounts are assumed to be withdrawn at annual rates of 37%, 17% and 88%, respectively, of the declining balance of such accounts during the period shown. The withdrawal rates used are higher than the Company's historical rates but are considered by management to be more indicative of expected withdrawal rates in a rising interest rate environment. If all the Company's NOW accounts, passbook savings accounts and money market deposit accounts had been assumed to be repricing within one year, the one-year cumulative deficiency of interest-earning assets to interest-bearing liabilities would have been $316.1 million or 19.0% of total assets.
(4) Adjustable and floating rate borrowings are included in the period in which their interest rates are next scheduled to adjust rather than in the period in which they are due.
Certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets, such as ARM loans and mortgage-backed and related securities, have features which restrict changes in interest rates on a short-term basis and over the life of the asset. In addition, the proportion of ARM loans and mortgage-backed and related securities in the Company's portfolios could decrease in future periods if market interest rates remain at or decrease below current levels due to the exercise of conversion options and refinance activity. Further, in the event of a change in interest rates, prepayment and early withdrawal levels would likely deviate significantly from those assumed in the table. Finally, the ability of many borrowers to service their debt may decrease in the event of an interest rate increase.
From time to time, the Company has utilized a variety of financial instruments and strategies to manage the interest rate risk associated with its interest rate sensitive assets and liabilities. Techniques that have been utilized include interest rate swaps and caps, financial futures and options and forward commitments. At various points in time, the Company, responding to changing interest rate, prepayment, credit and market value risk environments, may emphasize one strategy or financial instrument over another in its endeavor to achieve the desired interest rate and market value risk profile.
The Company has entered into various off-balance sheet transactions that are not yet, or never may be, reflected on the balance sheet. The transactions, while not affecting the balance sheet, may have some effect on earnings. Due to the possible balance sheet and earnings effect of these items, there is some potential credit, interest rate and market value price risk inherent in these transactions. The Company has been primarily utilizing these items to manage the interest rate and market value risk relating to mortgage-backed securities that result from the MBS loan swap program. These mortgage-backed securities are then ultimately sold either through forward commitments or option contracts. As a result, the majority of held for sale off-balance sheet transactions do not impact the balance sheet. The Asset/Liability Committee recommends aggregate limits which may change from time to time, as specifically authorized by the Board of Directors.
The Company enters into interest rate exchange agreements ("swaps") from time to time in order to reduce the interest rate risk associated with certain assets and liabilities. The agreements have been both fixed-pay, floating-receive swaps whereby the Company pays interest at a fixed rate and receives interest at a floating rate based on a notional amount of principal, locking in a fixed cost of funds and fixed-receive, floating-pay swaps whereby the Company receives interest at a fixed rate and pays interest at a floating rate based on a notional amount of principal, locking in a floating cost of funds. The net interest income or expense resulting from the differential between exchanging floating rate and fixed rate interest payments is recorded on a current basis. There are certain risks associated with swaps, including the risk that the counterparty may default and that there may not be an exact correlation between the indices on which the swap agreements are based and the terms of the hedged liabilities. In order to offset these risks, the Company generally enters into swap agreements only with nationally recognized securities firms and monitors the credit status of counterparties, the level of collateral for such swaps and the correlation between the hedged liabilities and indices utilized. Generally, the swaps have been designed to more accurately match the interest cash flows of certain liabilities used to fund specific assets to the interest rate characteristics of those assets. However, there is no assurance that in the event interest rates change, the swaps will move on the same basis or in the same amounts as its cost of funds. At September 30, 1997 and 1996, the Company had interest rate swaps outstanding with a notional amount of $163.0 million and $55.0 million, respectively. $163.0 million is the largest aggregate notional amount of the Company's interest rate swaps at any one time over the past five years.
The agreements consist of the following:
For the years ended September 30, 1997, 1996 and 1995, the Company realized net interest income on interest rate exchange agreement activity of $752,000, $413,000 and $628,000, respectively. While this activity resulted in net interest income in fiscal years 1997, 1996 and 1995, the Company effectively matched the related funding costs of certain assets with the interest rate characteristics of those assets. The Company's Investment Policy limits the notional amount of outstanding interest rate exchange agreements to $250.0 million. Any notional amounts of interest rate exchange agreements in excess of $250.0 million must be approved by the Company's Board of Directors.
The Company also has begun to use interest rate corridors to help protect its net interest margin in various interest rate environments. The corridors are of two general types. One type of corridor pays 1.0% per annum of the notional amount over its life only when the three-month LIBOR rate is between the corridor strike rates (inclusive of the strike rates). There are no payments due to the Company when the three-month LIBOR rate is outside the corridor strike rates. The other type of corridor pays the Company a percent per annum equal to the three-month LIBOR rate minus the lower corridor strike rate on the notional amount when three-month LIBOR is within the corridor strike rates. When the three-month LIBOR rate is above the upper strike rate (equal to 1.0% above the lower strike rate), the corridor pays the Company 1.0% per annum.
The interest rate corridors consist of the following:
The Company also utilizes financial futures or options to manage anticipated increases in interest rates and the resulting decline in the market prices of its mortgage loan production. Option contracts represent a right (not the obligation) for the owner of the contract to purchase or sell specified securities at some specified future (forward) date at a specified price. Options can be purchased and owned (long), or sold and owned by a counterparty (short). A long put position represents the right to sell, while a long call represents the right to purchase. A short put position represents the right of the counterparty to sell securities to the Company, resulting in a purchase. A short
call option position represents the right of the counterparty to purchase from the Company, resulting in a sale. These options when exercised become commitments to purchase or sell securities. These options are over-the-counter options to purchase or sell mortgage-backed securities and exchange-trade options on U.S. Treasury futures. The options provide a practical floor and cap on portfolio market values for moderate interest rate movements while the forward contracts are used to offset actual and anticipated on- and off-balance sheet positions of the Company. These options result in a certain amount of potential interest rate and market value risk exposure for the Company. The amount of the actual exposure is determined by the exercise of these options. The Company generally sells options for settlement no more than four months forward. An option's likelihood of exercise is dependent upon the relation of the market price of the underlying security to the strike price of the option. The strategy is not meant to offset losses that could be incurred during a substantial interest rate move and actually may result in additional losses on the instruments themselves which is beyond the losses the Company would have incurred had the management techniques not been utilized. The combined effect of the Company's option, forward commitment and loan swap activity is included in the income statement as part of gain (loss) on debt and equity and mortgage-backed and related securities. For the years ended September 30, 1997, 1996 and 1995, the Company realized gains on that combined activity of $844,000, $203,000 and $335,000, respectively. At September 30, 1997 and 1996, the notional amount of outstanding short put options (which if exercised could result in a purchase) were zero and $4.0 million, respectively. As of September 30, 1997 and 1996, the notional amount of outstanding short call options (which if exercised could result in a sale) were $2.0 million and $4.0 million, respectively. The notional amount of options and forward contracts outstanding varies and is a function of the current lending activity of salable mortgage loans. In order to limit the risks which may be associated with such financial options or futures, the Company's Investment Policy limits the amount of outstanding sold puts or calls used to manage the Company's available for sale portfolio to $40.0 million; the amount of financial futures or purchased options used to manage Company's held for sale portfolio to $20.0 million; and the amount of financial options used to manage the Company's trading portfolio to $20.0 million. Any amounts of outstanding financial options or futures in excess of these amounts must be approved by the Company's Board of Directors.
The following table sets forth the amounts of estimated cash flows for the various interest-earning assets and interest-bearning liabilities outstanding at September 30, 1997.
LIQUIDITY AND CAPITAL RESOURCES The Company's primary sources of funds are deposits, borrowings from the FHLB, proceeds from principal and interest payments on loans and principal and interest payments on mortgage-backed and related securities and on debt and equity securities. Although maturities and scheduled amortization of loans are predictable sources of funds, deposit flows, mortgage prepayments and prepayments on mortgage-backed and related securities are influenced significantly by general interest rates, economic conditions and competition. Mortgage loan and mortgage security prepayments slowed during 1995 and 1996 because of the generally higher level of interest rates, but have generally been higher during 1997 because of the generally lower level of interest rates throughout the year.
The Bank is required to maintain minimum levels of liquid assets as defined under OTS regulations. These requirements, which may be changed by the OTS depending upon economic conditions and deposit flows, is based upon a percentage of deposits and short-term borrowings. The required ratio of liquid assets to deposits and short-term borrowings is currently 5.0%. The Bank's liquidity ratio was 7.1% at both September 30, 1997 and 1996. The Bank adjusts its liquidity levels in order to meet various funding needs and to meet its asset and liability management objectives.
The Bank's most liquid assets are cash and cash equivalents and highly liquid, short-term investments. The levels of these assets are dependent on the Bank's operating, financing, lending and investing activities during any given period. At September 30, 1997 and 1996, liquid assets of the Bank (as defined in the OTS regulations) were $81.9 million and $57.3 million, respectively. Liquidity levels are reviewed regularly and decisions are made as to how excess liquid funds are to be invested. During periods in which the Bank is unable to originate a sufficient amount of loans that it intends to retain, such as ARM loans and other loans with shorter durations or terms, and during periods of high principal prepayments, the Bank will increase liquid assets with remaining amounts invested in mortgage-backed and related securities which are not liquidity-qualifying under OTS regulations.
Liquidity management for the Company is both an ongoing and long-term function of the Company's asset/liability management strategy. Excess funds generally are invested in short-term investments such as federal funds or overnight deposits at the FHLB. The Company has found brokered certificates of deposit to be an efficient source and a cost-effective method, relative to local retail market deposits, of meeting the Company's funding needs. Management recognizes that the likelihood for retention of brokered certificates of deposits is more a function of the rate paid on such accounts as compared to retail deposits which may be established due to branch location or other intangible reasons. Management believes that a significant portion of its retail deposits will remain with the Company, and in the case of brokered deposits, may be replaced with similar type accounts even should the level of interest rates change. However, in the event of a significant increase in market interest rates, the cost of obtaining replacement brokered deposits would increase as well. Whenever the Company requires funds beyond its ability to generate them internally, additional sources of funds are available and obtained from borrowings from the FHLB. Funds also may be available through reverse repurchase agreements wherein the Company pledges mortgage-backed securities. The Company utilizes its borrowing capabilities on a regular basis. At September 30, 1997, FHLB advances totaled $385.1 million or 25.1% of total liabilities and at September 30, 1996, FHLB advances were $373.6 million or 29.2% of total liabilities. At September 30, 1997, the Company had a borrowing capacity available of $199.2 million from the FHLB; however, additional securities may have to be pledged as collateral. At September 30, 1997, reverse repurchase agreements totaled $22.5 million or 1.5% of total liabilities compared with zero at September 30, 1996. The Company's reverse repurchase agreements are generally short-term, with maturities of less than 90 days. In a rising interest rate environment, such short-term borrowings present the risk that upon maturity, the borrowings will have to be replaced with higher rate borrowings. The Company generally has matched such borrowings to specific assets and has relatively little liquidity risk due to the fact that the assets and borrowings mature at approximately the same time.
The amount of principal repayments on loans and mortgage securities are heavily influenced by the general level of interest rates in the economy. Funds received from principal repayments on mortgage securities for the years ended September 30, 1997 and 1996, were $92.4 million and $68.2 million, respectively. Funds received from principal repayments on loans for the years ended September 30, 1997 and 1996, were $153.2 million and $172.0 million, respectively. In addition to principal repayments, the Company sells mortgage loans to government agencies
(primarily FNMA) and to institutional investors. Total mortgage loan sales to FNMA and others were $174.2 million and $62.6 million for the years ended September 30, 1997 and 1996, respectively.
Through both origination and purchase, the Company primarily reinvests funds received back into loans receivable and mortgage-backed and related securities. Loan originations totaled $400.7 million and $313.6 million for the years ended September 30, 1997 and 1996, respectively. Purchases of mortgage-backed and related securities totaled $306.4 million and $324.6 million for the years ended September 30, 1997 and 1996, respectively. During the years ended September 30, 1997 and 1996, the Company repurchased approximately 387,000 and 608,000 shares of its common stock in share repurchase programs at a total cost of approximately $11.8 million and $15.5 million, respectively.
At September 30, 1997 and 1996, the Company had outstanding loan commitments including lines of credit of $164.7 million and $159.2 million, respectively. The Company had no commitments to purchase loans outstanding at either of these dates. At September 30, 1997 and 1996, the Company had commitments to purchase $1.9 million and $12.8 million, respectively, of mortgage-backed and related securities. The Company anticipates it will have sufficient funds available to meet its current loan commitments, including loan applications received and in process prior to the issuance of firm commitments. Certificates of deposit, including brokered certificates, which are scheduled to mature in one year or less at September 30, 1997 and 1996, were $401.5 million and $358.3 million, respectively. Management believes that a significant portion of such deposits will remain with the Company.
IMPACT OF INFLATION AND CHANGING PRICES The Consolidated Financial Statements and Notes thereto presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars without considering the change in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Company's operations. Unlike most industrial companies, nearly all the assets and liabilities of the Company are monetary in nature. As a result, interest rates have a greater impact on the Company's performance than do the effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to the same extent as the prices of goods and services.
RECENT REGULATORY LEGISLATIVE DEVELOPMENTS The deposits of thrift institutions such as the Bank are insured up to applicable limits under the Savings Association Insurance Fund ("SAIF") of the Federal Deposit Insurance Corporation ("FDIC"). Deposits of commercial banks are insured under the Bank Insurance Fund ("BIF") of the FDIC. Insured institutions pay assessments to the applicable fund based on assessment rate schedules determined by the law and FDIC regulation.
Premium levels for the BIF and the SAIF are set in order to permit the funds to be capitalized at a level equal to 1.25% of total fund deposits. As the funds reach their designated ratios, the FDIC has authority to lower fund premium assessments to rates sufficient to maintain the designated reserve ratio. Historically, BIF and SAIF assessment schedules had been identical. In May 1995, the BIF achieved its designated ratio and the FDIC lowered BIF premium rates for most BIF-insured institutions. In November 1995, the FDIC reduced assessment rates by four cents per $100 of deposits for all BIF-insured institutions, producing a premium rate schedule ranging from zero (i.e. whereby such institutions are subject only to a $2,000 minimum annual premium) to 27 cents per $100 of deposits depending on the institution's risk-based premium category. Based on these assessment rate modifications, the majority of BIF members pay only a $2,000 minimum annual premium. The SAIF has not achieved its designated reserve ratio and is not anticipated to do so prior to year 2001. Premium rates for SAIF-insured members were being paid at an average of 23.4 cents per $100 of deposits. As a result of the modified assessment rate provisions, SAIF member institutions such as the Bank were placed at a competitive disadvantage based on higher deposit insurance premium obligations.
The "Deposit Insurance Funds Act of 1996" (the "DIF Act") addressed the deposit insurance premium disparity. Pursuant to the terms of the DIF Act, the FDIC was directed to impose a special assessment on SAIF-assessable
deposits at a rate that would cause the SAIF to achieve its designated reserve ratio of 1.25% of SAIF-insured deposits as of October 1, 1996. The DIF Act required that the special assessment be applied against the SAIF-assessable deposits held by institutions as of March 31, 1995. Pursuant to the final rule issued by the FDIC, the special assessment rate was determined to be 65.7 basis points. The amount of the assessment to the Bank was $4.2 million with an after-tax effect on income of $2.5 million or $0.45 cents per share for the year ended September 30, 1996. With the recapitalization of the SAIF, BIF and SAIF premiums will be comparable and FDIC premium expense for the Bank will therefore be reduced in future periods.
The FDIC published a proposed rule on October 16, 1996, under which a permanent base assessment schedule for the SAIF would be established, setting assessment rates at a range of 4 to 31 basis points. The proposed rule also called for an adjusted assessment schedule reducing these rates by 4 basis points to reflect current conditions, producing an effective SAIF assessment range of 0 to 27 basis points, beginning October 1, 1996. This assessment range is comparable to the current schedule for BIF-institutions. A special interim rate schedule ranging from 18 to 27 basis points applied to the majority of SAIF-member savings associations for the last quarter of 1996, reflecting the fact that assessments related to certain bond obligations of the Financing Corporation ("FICO") were included in the SAIF rates for these institutions during that period.
The DIF Act addressed other matters which will affect the Bank. Obligations pursuant to the FICO bonds, which were issued to ameliorate the savings and loan crisis in the 1980's, have been shared by all insured depository institutions since December 31, 1996. This obligation had previously been the sole responsibility of SAIF-insured institutions and had been funded through SAIF assessments. The DIF Act eliminated the statutory link between FICO's assessments and amounts authorized to be assessed by the SAIF. Effective January 1, 1997, all insured institutions are now paying an annual assessment to fund interest payments on the FICO bonds. BIF-member institutions will pay one-fifth the rate to be paid by SAIF members, for the first three years. After January 1, 2000, BIF and SAIF members will share the FICO payments on a pro-rata basis, which will be assessed at 2.4 basis points, until the bonds mature in 2017.
In addition, the DIF Act provides for the merger of BIF and SAIF into a single Deposit Insurance Fund. This provision will be effective January 1, 1999, assuming that no insured depository institution is a savings association on that date. This legislation contemplates that the savings association charter will be phased out over that period of time. The DIF Act also calls for the Secretary of the Treasury to undertake a study concerning the development of a common charter for all insured depository institutions and the abolition of separate and distinct charters for banks and savings associations.
After payment of the one-time assessment described above, the Bank has continued to exceed all the regulatory minimum capital levels. Although management is unable to predict the ultimate effect on Company operations of the FICO bond assessments, the merger of the BIF and SAIF, and the potential abolition of separate and distinct charters for banks and savings associations, management does not presently anticipate that these provisions will have a material impact on the financial condition of the Company in future periods.
CURRENT ACCOUNTING DEVELOPMENTS In February 1997, Financial Accounting Standards Board (FASB) issued SFAS No. 128, "Earnings per Share," which is effective for financial statements issued for periods ending after December 15, 1997. This statement simplifies the standards for computing earnings per share previously found in APB No. 15. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic EPS 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. Earlier application of this statement is not permitted. The Company has determined that the impact of adoption will not have a material effect on the earnings per share of the Company.
In June 1997, FASB issued SFAS No. 130, "Reporting Comprehensive Income," which is effective for fiscal years beginning after December 15, 1997. This statement establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose
financial statements. This statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements.
In June 1997, FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which is effective for fiscal years beginning after December 15, 1997. This statement establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers.
ITEM 7A
ITEM 7A QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
The information contained in the section captioned "Management's Discussion and Analysis of Financial Condition and Results of Operations" is incorporated herein by reference.
ITEM 8.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
INDEPENDENT AUDITORS' REPORT
The Board of Directors St. Francis Capital Corporation:
We have audited the accompanying consolidated statements of financial condition of St. Francis Capital Corporation and Subsidiary (the "Company") as of September 30, 1997 and 1996, and the related consolidated statements of income, changes in shareholders' equity and cash flows for each of the years in the three year period ended September 30, 1997. These consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these consolidated 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 audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe 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 St. Francis Capital Corporation and Subsidiary as of September 30, 1997 and 1996, and the results of their operations and their cash flows for each of the years in the three year period ended September 30, 1997 in conformity with generally accepted accounting principles.
KPMG PEAT MARWICK LLP
Milwaukee, Wisconsin November 13, 1997
ST. FRANCIS CAPITAL CORPORATION AND SUBSIDIARY Consolidated Statements of Financial Condition
See accompanying Notes to Consolidated Financial Statements
ST. FRANCIS CAPITAL CORPORATION AND SUBSIDIARY Consolidated Statements of Income
See accompanying Notes to Consolidated Financial Statements
ST. FRANCIS CAPITAL CORPORATION AND SUBSIDIARY Consolidated Statements of Changes in Shareholders' Equity
See accompanying Notes to Consolidated Financial Statements
ST. FRANCIS CAPITAL CORPORATION AND SUBSIDIARY Consolidated Statement of Cash Flows
See accompanying Notes to Consolidated Financial Statements
ST. FRANCIS CAPITAL CORPORATION AND SUBSIDIARY Consolidated Statement of Cash Flows
See accompanying Notes to Consolidated Financial Statements
(1) SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accounting and reporting policies of St. Francis Capital Corporation and subsidiary (the "Company") conform to generally accepted accounting principles and to general practice within the banking industry. The Company provides a full range of banking and related financial services to individual and corporate customers through its network of bank affiliates. The Company is subject to competition from other financial institutions and is regulated by federal and state banking agencies and undergoes periodic examinations by those agencies. The following is a description of the more significant of those policies that the Company follows in preparing and presenting its consolidated financial statements. In preparing the consolidated financial statements in conformity with generally accepted accounting principles, management is required to make estimates and assumptions that affect the amounts reported in the financial statements and accompanying notes. Actual results could differ from those estimates.
(a) Principles of Consolidation
The consolidated financial statements include the accounts of the Company, its wholly-owned subsidiary, St. Francis Bank, F.S.B. ("Bank"), the Bank's subsidiaries, SF Investment Corp. ("SF Investment"), St. Francis Development Corp. (liquidated September 30, 1995), St. Francis Insurance Services Corp., S-F Mortgage Corp. and St. Francis Equity Properties ("SFEP") and limited partnerships which are all more than 50% owned by SFEP. All significant intercompany accounts and transactions have been eliminated in consolidation.
(b) Statements of Cash Flows
For purposes of the consolidated statements of cash flows, cash and cash equivalents include cash on hand, interest- bearing deposits with the FHLB and other financial institutions and federal funds sold.
(c) Trading Account Securities
Trading account securities include debt securities which are held for resale in anticipation of short-term market movements. Trading account securities are stated at fair value. Gains and losses, both realized and unrealized, are included in trading securities gains and commitment fees, net.
(d) Securities Held to Maturity and Available For Sale
Management determines the appropriate classification of debt and equity securities at the time of purchase and reevaluates such designations as of each statement of condition date. Debt securities are classified as held-to- maturity when the Company has the positive intent and ability to hold the securities to maturity. Held to maturity securities are stated at amortized cost.
Debt securities not classified as held to maturity or trading and marketable equity securities not classified as trading are classified as available for sale. Available for sale securities are stated at fair value, with the unrealized gains and losses, net of tax, reported as a separate component of shareholders' equity.
The cost of debt securities classified as held to maturity or available for sale is adjusted for amortization of premiums and accretion of discounts to maturity, or in the case of mortgage-backed and related securities, over the estimated life of the security. Such amortization is based on a level-yield method and is included in interest income from the respective security. Interest and dividends are included in interest and dividend income from investments. Realized gains are included in net gains and losses from sales of investments and mortgage-backed and related securities. The cost of securities sold is based on the specific identification method.
In determining if declines in value in mortgage-backed and related securities are other than temporary, management estimates future cash flows to be generated by pools of loans underlying the securities. Included in this evaluation are such factors as i) estimated loan prepayment rates, ii) a review of delinquencies, foreclosures, repossessions and recovery rates relative to the underlying mortgage loans collateralizing each security, iii) the level of available subordination or other credit enhancements, iv) an assessment of the servicer of the underlying mortgage portfolio and v) the rating assigned to each security by independent national rating agencies.
(e) Loans Held For Sale
Mortgage loans held for sale generally consist of current production of certain fixed-rate and adjustable-rate first mortgage loans. Mortgage loans held for sale are carried at the lower of cost (less principal payments received) or market value, as determined by outstanding commitments from investors or current quoted investor yield requirements on an aggregate basis.
(f) Loans and Fees and Income on Loans
Loans are carried at the outstanding principal amount reduced by purchased discount, deferred fees, unearned insurance premiums, loans in process and the allowance for loan losses. Loans sold with recourse are derecognized at the time of sale. The estimated liability related to recourse provisions is periodically evaluated with increases charged to expense. Loans for which management has the intent and ability to hold for the foreseeable future or until maturity or repayment are carried at their unpaid principal balances. Interest on loans is recorded as income in the period earned.
Loans are normally placed on non-accrual status when contractually past due 90 days or more as to interest or principal payments. Additionally, whenever management becomes aware of facts or circumstances that may adversely impact on the collectibility of principal or interest on loans, it is management's practice to place such loans on non-accrual status immediately, rather than delaying such action until the loans become 90 days past due. Previously accrued and uncollected interest on such loans is reversed, amortization of related loan fees is suspended, and income is recorded only to the extent that interest payments are subsequently received in cash and a determination has been made that the principal balance of the loan is collectible. If collectibility of the principal is in doubt, payments received are applied to loan principal.
Loan origination and commitment fees and certain direct loan origination costs are deferred and the net amounts amortized as an adjustment of the related loan's yield. These amounts are amortized to income using the level yield method, over the contractual life of the related loans. Discounts on purchased loans are amortized using a method which approximates level yield. Unamortized discounts on purchased loans which prepay are amortized immediately.
Loan origination fees and costs associated with loans sold are deferred and recognized at the time of sale as a component of gain or loss on the sale of loans. Fees for the servicing of loans are recognized as income when earned.
(g) Mortgage Servicing Rights
The value of mortgage servicing rights is amortized in relation to the servicing revenue expected to be earned. The evaluation of mortgage servicing rights for impairment takes into consideration certain risk characteristics including loan type, note rate, prepayment trends and external market factors.
The FASB issued SFAS No. 125, "Accounting for Transfers and Servicing of Financial Assets and Extinguishment of Liabilities," which was effective for transactions occurring after December 31, 1996. This statement provides accounting and reporting standards for transfers and servicing of financial assets and extinguishments of liabilities based on consistent application of a financial-components approach that focuses on control. This statement was adopted on January 1, 1997. The effect of adopting this statement was not material to the Company's results of operations or financial condition.
(h) Allowance for Loan Losses
The allowance for loan losses is a material estimate that is particularly susceptible to significant change in the near term. The allowance for loan losses is maintained at a level adequate to provide for loan losses through charges to operating expense. The allowance is based upon past loan loss experience and other factors which, in management's judgment, deserve current recognition in estimating loan losses. Such other factors considered by management include growth and composition of the loan portfolio, the relationship of the allowance for loan losses to outstanding loans and economic conditions. In connection with the determination of the allowance for loan losses, management obtains independent appraisals for significant properties which collateralize loans. With respect to loans which are deemed impaired, the calculation of reserve levels is based upon the discounted present value of expected cash flows received from the debtor or other measures of value such as market prices or collateral values.
Management believes that the allowance for loan losses is adequate. While management uses available information to recognize losses on loans, future additions to the allowance may be necessary based on changes in economic conditions. In addition, various regulatory agencies, as an integral part of their examination process, periodically review the Company's allowance for losses on loans. Such agencies may require the Company to recognize additions to the allowance based on their judgments about information available to them at the time of their examination.
(i) Financial Options
Interest rate swaps, forward and future commitments and contracts and option contracts purchased or sold may be used from time to time to manage interest rate exposure by hedging specific assets or liabilities. Realized and unrealized gains and losses on these instruments are deferred and amortized over the life of the hedged assets and liabilities. Financial instruments which do not meet the criteria for hedge accounting are marked to market in aggregate and any gains or losses are recognized in the income statement line item trading securities gains and commitment fees, net.
Fees received on options written are deferred at the time the fees are received and recognized in other operating income at the earlier of the settlement or the expiration of the contract.
(j) Foreclosed Properties
Foreclosed properties (which were acquired by foreclosure or by deed in lieu of foreclosure) are initially recorded at the lower of the carrying value of the related loan balance or the fair market value of the real estate acquired less the estimated costs to sell the real estate at the date title is received. Costs relating to the development and improvement of the property are capitalized. Income and expenses incurred in connection with holding and operating the property are charged to expense. Valuations are periodically performed by management and independent third parties and an allowance for loss is established by a charge to expense if the carrying value of a property exceeds its fair value less estimated costs to sell.
(k) Real Estate Held for Investment
Real estate held for investment is multi-family rental property (affordable housing projects) that SFEP, a wholly-owned subsidiary of the Bank, owns, operates and develops as a limited partner. The properties are recorded at cost less accumulated depreciation. The Company evaluates the recoverability of the carrying value on a regular basis. If the recoverability was determined to be in doubt, a valuation allowance would be established by way of a charge to expense. Depreciation expense is provided on a straight-line basis over the estimated useful life of the assets. Expenditures for normal repairs and maintenance are charged to expense as incurred.
(l) Premises and Equipment
Premises and equipment are recorded at cost less accumulated depreciation and amortization. Depreciation and amortization expense are provided on a straight-line basis over the estimated useful lives of the assets. The cost of leasehold improvements is amortized on the straight-line basis over the lesser of the term of the respective lease or the estimated economic life of the improvements.
Expenditures for normal repairs and maintenance are charged to expense as incurred. When properties are retired or otherwise disposed of, the related cost and accumulated depreciation are removed from the respective accounts and the resulting gain or loss is recorded in income.
(m) Federal Home Loan Bank Stock
The Company's investment in Federal Home Loan Bank stock meets the minimum amount required by current regulation and is carried at cost which is its redeemable (fair) value since the market for this stock is limited.
(n) Income Taxes
The Company and its subsidiaries file consolidated Federal income tax returns. Federal income tax expense is allocated to each subsidiary based on an intercompany tax sharing agreement. Each subsidiary files separate state and local income or franchise tax returns.
Income taxes are accounted for using the asset and liability method. Under this method, deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to the differences between the financial statement carrying amount of assets and liabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax rates in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in the period that includes the enactment date.
Affordable housing tax credits are recognized as a reduction of income tax expense in the year they are available to be used in the Company's consolidated income tax returns.
(o) Stock-based Compensation Plans
The Company has various stock based compensation plans that authorize the granting of stock options, restricted stock, and other stock based awards to eligible employees. The Company has elected to not adopt the recognition provisions of SFAS No. 123, "Accounting for Stock Based Compensation", which requires a fair-value based method of accounting for stock options and equity awards, but will continue to follow APB No. 25, "Accounting for Stock Issued & Employees", and related interpretations to account for its stock based compensation plans. Pursuant to the disclosure requirements of SFAS No. 123, the Company has included in Note 15 the effect of the fair value of employee stock-based compensation plans on net income and earnings per share on a pro-forma basis as if the fair value based method of accounting defined in SFAS No. 123 was applied.
(p) Pending Accounting Changes
In February 1997, the Financial Accounting Standards Board ("FASB") issued SFAS No. 128, "Earnings per Share," which is effective for financial statements issued for periods ending after December 15, 1997. This statement simplifies the standards for computing earnings per share previously found in APB No. 15. It replaces the presentation of primary EPS with a presentation of basic EPS. It also requires dual presentation of basic EPS 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. Earlier application of this statement is not permitted. The Company has determined that the impact of adoption will not have a material effect on the earnings per share of the Company.
In June 1997, FASB issued SFAS No. 130, "Reporting Comprehensive Income," which is effective for fiscal years beginning after December 15, 1997. This statement establishes standards for reporting and display of comprehensive income and its components (revenues, expenses, gains and losses) in a full set of general-purpose financial statements. This statement requires that all items that are required to be recognized under accounting standards as components of comprehensive income be reported in a financial statement that is displayed with the same prominence as other financial statements.
In June 1997, FASB issued SFAS No. 131, "Disclosures about Segments of an Enterprise and Related Information," which is effective for fiscal years beginning after December 15, 1997. This statement establishes standards for the way that public business enterprises report information about operating segments in annual financial statements and requires that those enterprises report selected information about operating segments in interim financial reports issued to shareholders. It also establishes standards for related disclosures about products and services, geographic areas, and major customers.
(q) Reclassification
Certain amounts for prior years have been reclassified to conform to the 1997 presentation.
(2) ACQUISITIONS
In February 1997, the Company completed the acquisition of Kilbourn State Bank for $25.3 million cash. Under the terms of the agreement, the Company acquired all of the outstanding shares of Kilbourn State Bank, with the acquisition being accounted for as a purchase. The related accounts and results of operations are included in the Company's consolidated financial statements from the date of acquisition. The acquisition of Kilbourn State Bank added $93.0 million in assets, including additions of $62.6 million to net loans and $67.8 million to deposits.
The excess of cost over the fair value of assets acquired is accounted for as goodwill and will be amortized over fifteen years using the straight-line method. The amount of goodwill recorded due to the acquisition was $9.1 million.
(3) DEBT AND EQUITY SECURITIES
The following is a summary of available for sale and held to maturity debt and equity securities:
The amortized cost and estimated fair value of debt and equity securities available for sale and held to maturity at September 30, 1997, by contractual maturity, are as follows:
During the years ended September 30, 1997, 1996 and 1995, proceeds from the sale of available for sale debt and equity securities were $47.2 million, $33.9 million and $1.1 million, respectively. The gross realized gains on such sales totaled $65,000, $614,000 and $52,000 in 1997, 1996 and 1995, respectively. The gross realized losses on such sales totaled $24,000, $126,000 and $32,000 in 1997, 1996 and 1995, respectively. There were no sales of held to maturity debt securities in 1997, 1996 and 1995.
Under implementation guidance for SFAS 115 provided by the Financial Accounting Standards Board, the Company, at December 31, 1995, reclassified securities from its held-to-maturity portfolio to available-for-sale that had an amortized cost basis of $28.9 million and a fair value of $29.1 million at the time of the transfer.
(4) MORTGAGE-BACKED AND RELATED SECURITIES
The following is a summary of available for sale mortgage-backed and related securities and held to maturity mortgage-backed and related securities:
During the years ended September 30, 1997, 1996 and 1995, proceeds from the sale of available for sale mortgage-backed and related securities were $112.3 million, $178.6 million and $135.1 million, respectively. The gross realized gains on such sales totaled $1.3 million, $2.8 million and $3.1 million in 1997, 1996 and 1995, respectively. The gross realized losses on such sales totaled $28,000, $10,000 and $422,000 in 1997, 1996 and 1995, respectively. There were no sales of held to maturity mortgage-backed and related securities in 1997, 1996 and 1995.
During the year ended September 30, 1997, the Company recorded an impairment loss of $3.4 million to reflect other than temporary impairment of the carrying value of certain private issue mortgage-backed securities. The securities, carried at $12.5 million prior to the writedown, were adjusted to fair value of $9.1 million. Based on the new carrying value, estimated future cash flows on the securities should reflect a market rate of interest.
At September 30, 1997 and 1996, $267.7 million and $240.4 million, respectively, of mortgage-related securities were pledged as collateral for FHLB advances.
Under implementation guidance for SFAS 115 provided by the Financial Accounting Standards Board, the Company, at December 31, 1995, reclassified mortgage-backed and related securities from its held-to-maturity portfolio to available- for-sale with an amortized cost basis of $88.4 million and a fair value of $88.6 million.
(5) LOANS RECEIVABLE
Loans receivable are summarized as follows:
Activity in the allowance for loan losses is as follows:
Recoveries are insignificant in all years. Non-performing loans, which include loans on which the accrual of interest has been discontinued, and troubled debt restructurings totaled approximately $3.0 million and $3.9 million at September 30, 1997 and 1996, respectively. Non-performing loans at September 30, 1997 and 1996 include $1.1 million and $3.6 million, respectively of purchased auto loans which are past due or in default. Also included in non-performing assets in 1997 is a single $850,000 commercial real estate loan collateralized by a shopping center mortgage. Impaired loans totaled $1.9 million and $3.6 million at September 30, 1997 and 1996, respectively. These loans had associated impairment reserves of $782,000 and $1.1 million at September 30, 1997 and 1996, respectively. During 1997 and 1996, the average balance of impaired loans was $4.1 million and $1.4 million, respectively, and no interest income was recorded. Interest income on impaired loans is recognized only to the extent that payments are expected to exceed the amount of principal due on the loans.
The effect of non-performing loans on interest income is as follows:
Capitalized mortgage servicing rights total $1.8 million and $701,000 at September 30, 1997 and 1996, respectively. The Company recorded gains of $1.1 million and $634,000, respectively; and amortization expense of $48,000 and $23,000, respectively, for the years ended September 30, 1997 and 1996. The fair value approximates the amount of capitalized mortgage servicing rights at September 30, 1997 and 1996.
Mortgage loans serviced for others are not included in the accompanying consolidated statements of financial condition. The unpaid principal balances of these loans are summarized as follows:
(6) ACCRUED INTEREST RECEIVABLE
Accrued interest receivable is summarized as follows:
(7) PREMISES AND EQUIPMENT
A summary of premises and equipment, at cost, follows:
(8) DEPOSITS
Deposit accounts are summarized as follows:
The certificates category above includes approximately $140.8 million and $138.6 million of brokered deposits at weighted average stated rates of 6.49% and 5.35% at September 30, 1997 and September 30, 1996, respectively.
Aggregate annual maturities of certificate accounts at September 30, 1997 are as follows:
Certificates include approximately $48.6 million and $31.7 million in denominations of $100,000 or more at September 30, 1997 and 1996, respectively.
Interest expense on deposits is as follows:
Accrued interest payable on deposits totaled approximately $3.6 million and $3.5 million at September 30, 1997 and 1996, respectively.
(9) SHORT AND LONG TERM BORROWINGS
Advances and other borrowings consist of the following:
The Company is required to maintain as collateral unencumbered mortgage loans and mortgage-related securities such that the outstanding balance of Federal Home Loan Bank ("FHLB") advances does not exceed 60% of the book value of this collateral. In addition, these notes are collateralized by all FHLB stock. At September 30, 1997 and 1996, $234.2 million and $262.0 million, respectively, of mortgage loans and $287.6 million and $240.4 million, respectively, of mortgage-related securities were pledged as collateral for FHLB advances. The variable rate advances are tied to the one-month and three-month LIBOR indices. FHLB advances are subject to a prepayment penalty if they are repaid prior to maturity. The maximum amount of borrowings at any month end during the years ended September 30, 1997 and 1996 was approximately $422.6 million and $375.0 million, respectively. The approximate average amount outstanding was $388.8 million and $344.8 million for those same years. The weighted average interest rate was 5.67% and 5.43% during those years. The Federal Reserve Bank advances are
collateralized by U.S. Treasury bills with a carrying value of $2.0 million and $1.0 million at September 30, 1997 and 1996, respectively.
Securities sold under agreements to repurchase averaged $5.4 million and $703,000 based on average daily balances during the years ended September 30, 1997 and 1996, respectively. The maximum amount outstanding at any month-end was $22.5 million and zero during those years, respectively. The average balances are calculated based on daily balances. Securities sold under agreements to repurchase were delivered for escrow to the broker-dealer who arranged the transactions.
The Bank line of credit averaged $5.6 million for the year ended September 30, 1997 with a maximum amount outstanding at any month-end of $12.0 million. There was no line of credit outstanding at any time for the year ended September 30, 1996. The line of credit allows for individual advances of one to six months at rates tied to equivalent term LIBOR indices and is collateralized by the stock of the Bank. The line of credit allows for up to $20.0 million in borrowings.
(10) OTHER GENERAL AND ADMINISTRATIVE EXPENSES
Other general and administrative expenses are as follows:
(11) INCOME TAXES
Income tax expense (benefit) in the consolidated statements of income consists of the following:
Actual income tax expense differs from the "expected" income tax expense computed by applying the statutory Federal corporate tax rate to income before income tax expense, as follows:
Included in other assets is a deferred tax asset of $ 2.6 million and $2.3 million at September 30, 1997 and 1996, respectively. The tax effects of temporary differences that give rise to significant portions of deferred tax assets and deferred tax liabilities are presented below:
At September 30, 1997 and 1996, deferred tax assets include approximately $11.5 million and $5.4 million of various state net operating loss carry forwards respectively, which begin to expire in 1999 and are reduced by the valuation allowance to the extent full realization is in doubt.
(12) SHAREHOLDERS' EQUITY
In accordance with federal regulations, at the time the Bank converted from a federal mutual savings bank to a federal stock savings bank, the Bank established a liquidation account equal to its retained earnings of $63.0 million to provide a limited priority claim for the benefit of qualifying depositors who maintain their deposit accounts at the Bank after conversion. The liquidation account is reduced annually to the extent that eligible account holders have reduced their qualifying deposits. Subsequent increases will not restore an eligible account holder's interest in the liquidation account. In the unlikely event of a complete liquidation of the Bank, and only in such event, each eligible account holder would receive from the liquidation account a liquidation distribution based on his or her proportionate share of the then remaining qualifying deposits. At September 30, 1997, the balance of the liquidation account was approximately $24.2 million. Under current regulations, the Bank is not permitted to pay dividends on its stock if the effect would reduce its regulatory capital below the liquidation account.
Office of Thrift Supervision ("OTS") regulations also provide that an institution that exceeds all fully phased-in capital requirements before and after a proposed capital distribution could, and after prior notice but without approval by the OTS, make capital distributions during the calendar year of up to 100% of its net income 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. Any additional capital distributions would require prior regulatory approval. During the year ended September 30, 1997, the Bank paid dividends to the Company totaling $11.5 million. As of September 30, 1997, retained earnings of the Bank of approximately $21.3 million were free of restriction and available for dividend payments.
Unlike the Bank, the Company is not subject to these regulatory restrictions on the payment of dividends to its shareholders. However, the Company's source of funds for future dividends may depend upon dividends from the Bank.
Under the Internal Revenue Code and the Wisconsin Statutes, for tax years beginning before 1996, the Company was permitted to deduct an annual addition to a reserve for bad debts. This amount differed from the provision for loan losses recorded for financial accounting purposes. Under prior law, bad debt deductions for income tax purposes were included in taxable income of later years only if the bad debt reserves were used for purposes other than to absorb bad debt losses. Because the Company did not intend to use the reserve for purposes other than to absorb losses, no deferred income taxes were provided. Shareholders' equity at September 30, 1997 includes approximately $21.9 million for which no federal or state income taxes were provided. Under SFAS No. 109, deferred income taxes have been provided on certain additions to the tax reserve for bad debts.
The Small Business Job Protection Act of 1996 repealed the bad debt reserve method for tax years beginning after 1995. The Bank will not be required to recapture into income any of the restricted amounts previously deducted except in the unlikely event of a partial or complete liquidation of the Bank or if nondividend distributions to shareholders exceed current and accumulated earnings and profits.
The Company and the Bank are 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 Company's and the Bank's financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Company and the Bank must meet specific capital guidelines that involve quantitative measures of the Company's and the Bank's assets, liabilities, and certain off-balance-sheet items as calculated under regulatory accounting practices. The Company's and 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 Company and the Bank to maintain minimum amounts and ratios of total and Tier 1 capital (as defined in the regulations) to risk-weighted assets (as defined), and of Tier 1 capital (as defined) to average assets (as defined).
Management believes, as of September 30, 1997, that the Company and the Bank meet all capital adequacy requirements to which they are subject.
As of September 30, 1997, the most recent notification from the OTS categorized the Bank as well-capitalized under the regulatory framework for prompt corrective action. A well-capitalized institution significantly exceeds the required minimum level for each relevant capital measure. There are no conditions or events since that notification that management believes have changed the institution's category.
The following table summarizes the Bank's capital ratios and the ratios required by federal regulations at September 30, 1997:
The following table summarizes the Bank's capital ratios and the ratios required by federal regulations at September 30, 1996:
On September 25, 1997, the Company's Board of Directors adopted a shareholders' rights plan (the "Rights Plan"). Under the terms of the Rights Plan, the Board of Directors declared a dividend of one preferred share purchase right for each outstanding share of common stock. Upon becoming exercisable, each right entitles shareholders to buy one one-hundredth of a share of the Company's preferred stock at an exercise price of $150. Rights do not become exercisable until eleven business days after any person or group has acquired, commenced, or announced its intention to commence a tender or exchange offer to acquire 15% or more of the Company's common stock, or in the event a person or group owning 10% or more of the Company's common stock is deemed to be "adverse" to the Company. If the rights become exercisable, holders of each right, other than the acquiror, upon payment of the exercise price, will have the right to purchase the Company's common stock (in lieu of preferred shares) having a value equal to two times the exercise price. If the Company is acquired in a merger, share exchange or other business combination or 50% or more of its consolidated assets or earning power are sold, rights holders, other than the acquiring or adverse person or group, will be entitled to purchase the acquiror's shares at a similar discount. If the rights become exercisable, the Company may also exchange rights, other than those held by the acquiring or adverse person or group, in whole or in part, at an exchange ratio of one share of the Company's common stock per right held. Rights are redeemable by the Company at any time until they are exercisable at the exchange rate of $.01 per right. Issuance of the rights has no immediate dilutive effect, does not currently affect reported earnings per share, is not taxable to the Company or its shareholders, and will not change the way in which the Company's shares are traded. The rights expire in ten years.
(13) EARNINGS PER SHARE
Earnings per share of common stock for the years ended September 30, 1997, 1996 and 1995, have been determined by dividing net income for the year by the weighted average number of shares of common stock and common stock equivalents outstanding during the year. Stock options are regarded as common stock equivalents and are, therefore, considered in per share calculations. Common stock equivalents are computed using the treasury stock method. Total shares outstanding for earnings per share calculation purposes have been reduced by the ESOP shares that have not been committed to be released.
The computation of earnings per common share for the years ended September 30 is as follows:
Primary and fully diluted earnings per share for the years ended September 30, 1997, 1996 and 1995, respectively, are the same.
(14) STOCK REPURCHASE PROGRAM
On November 7, 1996, the Company announced it had adopted a share repurchase program for its common stock whereby the Company could purchase up to 10% of the outstanding stock, or approximately 538,100 shares, commencing November 11, 1996 and concluding before November 11, 1997, depending upon market conditions. The repurchased shares would become treasury shares and would be used for the exercise of stock options under the stock option plan and for general corporate purposes. At September 30, 1997, 275,000 shares had been repurchased at an average price of $32.07 per share. This is the seventh such repurchase program that the Company has undertaken, the most recent of which was completed November 7, 1996. At September 30, 1997, an aggregate of 2,207,952 shares had been repurchased in all such repurchase programs at an average price of $21.36. On October 31, 1997, the Company announced, subsequent to the expiration of the existing share repurchase program, a new program to repurchase up to 10% of the outstanding stock, or approximately 523,000 shares. The program is authorized for twelve months starting November 18, 1997.
(15) EMPLOYEE BENEFIT PLANS
DEFINED CONTRIBUTION PLANS:
The Company has a defined contribution pension plan which covers substantially all employees who are at least 21 years of age and have completed 1,000 hours or more of service each year. Company contributions are based on a set percentage of each participant's compensation for the plan year. Plan expense for the
years ended September 1997, 1996 and 1995 was approximately $427,000, $289,000 and $282,000, respectively. The Company funds the plan's costs.
The Company also has a defined contribution savings plan for substantially all employees. The plan is qualified under Section 401(k) of the Internal Revenue Code. Participation in the plan requires that an employee be at least 21 years of age and have a minimum of six months of full-time service. Participants may elect to defer a portion of their compensation (between 2% and 7%) and contribute this amount to the plan. Under the plan, the Company will match the contribution made by each employee up to fifty percent of 4% of the eligible employee's annual compensation. Plan expense for the years ended September 30, 1997, 1996 and 1995 was approximately $154,000, $111,000 and $95,000, respectively. The Company funds the plan's costs.
The aggregate benefit payable to any employee of both defined contribution plans is dependent upon the rates of contribution, the earnings of the fund and the length of time such employee continues as a participant.
OFFICER DEFERRED COMPENSATION PLAN:
The Company has deferred compensation plans covering certain officers of the Company. These arrangements provide for monthly payments to be made upon retirement or reaching certain age levels for periods of 10 to 15 years. A liability is recorded for the present value of the future payments under these agreements earned through September 30, 1997 and 1996 amounting to $618,000 and $591,000, respectively. The Company owns insurance policies on the lives of these officers which are intended to fund these benefits.
EMPLOYEE STOCK OWNERSHIP PLAN:
In conjunction with the conversion of the Bank to a stock savings bank, an employee stock ownership plan ("ESOP") was adopted covering all full-time employees of the Company who have attained age 21 and completed one year of service during which they work at least 1,000 hours. The ESOP borrowed $4.9 million from the Company and purchased 490,600 common shares issued in the conversion. The debt bears a variable interest rate based on the borrower's prime lending rate which was 8.50% at September 30, 1997. The balance of this loan was $3.8 million and $4.1 million at September 30, 1997 and 1996, respectively. The Bank makes annual contributions to the ESOP equal to the ESOP's debt service less dividends received by the ESOP. All dividends received by the ESOP are used to pay debt service. The ESOP shares initially were pledged as collateral for its debt. As the debt is repaid, shares are released from collateral and allocated to active employees, based on the proportion of debt service paid in the year. The Company accounts for its ESOP in accordance with Statement of Position 93-6. Accordingly, the debt of the ESOP is recorded as debt and the shares pledged as collateral are reported as unearned ESOP shares in the statement of financial position. As shares are released from collateral, the company reports compensation expense equal to the current market price of the shares. The excess of the current market price of shares released over the cost of those shares is credited to paid-in-capital. As shares are released they become outstanding for earnings-per-share computations. Dividends on allocated ESOP shares are recorded as a reduction of shareholders' equity; dividends on unallocated ESOP shares are recorded as a reduction of debt and accrued interest. ESOP compensation expense for the years ended September 30, 1997, 1996 and 1995 was $1.3 million, $932,000 and $764,000, respectively. The following is a summary of ESOP shares at September 30, 1997 and 1996:
STOCK OPTION AND INCENTIVE PLANS:
The Company has adopted stock option plans for the benefit of directors and officers of the Company. The option exercise price cannot be less than the fair value of the underlying common stock as of the date of the option grant, and the maximum term cannot exceed ten years. Stock options awarded to directors may be exercised at any time or on a cumulative basis over varying time periods, provided the grantee remains a director of the Company. The stock options awarded to officers are exercisable on a cumulative basis over varying time periods, depending on the individual option grant terms which may include provisions for acceleration of vesting periods.
At September 30, 1997, 68,487 shares were reserved for future grants. Further information concerning the options is as follows:
The following table summarizes information about stock options outstanding at September 30, 1997:
*Average contractual life remaining in years
For purposes of providing the pro-forma disclosures required under SFAS No. 123, "Accounting for Stock-Based Compensation", the fair value of stock options granted was estimated using the Black-Scholes option pricing model. The per share weighted-average fair value of stock options granted during 1997 was $7.18 on the date of grant with the following weighted-average assumptions: expected dividend yield of 1.47%, risk-free interest rate of 6.75%, an expected life of 10 years and expected volatility of 15%.
Had compensation cost for the Company's stock-based plans been determined in accordance with SFAS
No. 123, net income would have been $11.5 million in 1997. Earnings per share would have been $2.16 in 1997. This pro-forma net income reflects only options granted in 1997. Therefore, the full impact of calculating compensation cost under SFAS No. 123 is not reflected in the pro-forma net income amounts.
MANAGEMENT RECOGNITION AND RETENTION PLAN:
The Company and the Bank have a Management Recognition and Retention Plan ("MRP"). Pursuant to the MRP, 280,370 shares of common stock were awarded to directors and officers and are earned over three years. The aggregate purchase price of these shares, initially recorded as a reduction of shareholders' equity, were amortized as compensation expense as participants became fully vested. All participants became fully vested as of June 18, 1996. MRP expense for the years ended September 30, 1997, 1996 and 1995 was $-0-, $701,000 and $935,000, respectively.
(16) FINANCIAL INSTRUMENTS WITH OFF-BALANCE SHEET RISK AND OTHER COMMITMENTS
The Company is party to financial instruments with off-balance-sheet risk in the normal course of business to meet the financing needs of its customers and to reduce its own exposure to fluctuations in interest rates. These financial instruments include commitments to extend credit and involve, to varying degrees, elements of credit and interest rate risk in excess of the amounts recognized in the consolidated financial statements. The contractual or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.
The Company's exposure to credit loss in the event of nonperformance by the other party to the financial instrument for the commitments to extend credit is represented by the contractual notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for instruments reflected in the consolidated financial statements.
Commitments to extend credit 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 of 45 days or less or other termination clauses and may require a fee. Fixed-rate loan commitments as of September 30, 1997 have interest rates ranging from 6.625% to 9.00%. Because some commitments expire without being
drawn upon, the total commitment amounts do not necessarily represent cash requirements. The Company evaluates the creditworthiness of each customer on a case-by-case basis. The amount of collateral obtained if deemed necessary by the Company upon extension of credit is based on management's credit evaluation of the counterparty. The Company generally extends credit on a secured basis. Collateral obtained consists primarily of one- to four-family residences and other residential and commercial real estate.
Loans sold with recourse represent one- to four-family mortgage loans that are sold to secondary market agencies, primarily FNMA, with the servicing of these loans being retained by the Company. The Company receives a larger servicing spread on those loans being serviced then it would if the loans had been sold without recourse.
The Company has entered into agreements whereby, for an initial and annual fee, it will guarantee payment for an industrial development revenue bond issue ("IRB"). The IRBs are issued by municipalities to finance real estate owned by a third party. Potential loss on a guarantee is the notional amount of the guarantee less the value of the real estate collateral. Appraised values of the real estate collateral exceed the amount of the guarantee.
Interest rate swap agreements generally involve the exchange of fixed and variable rate interest payments without the exchange of the underlying notional amount on which the interest rate payments are calculated. The notional amounts of these agreements represent the amounts on which interest payments are exchanged between the counterparties. The notional amounts do not represent direct credit exposures. The Company is exposed to credit-related losses in the event of nonperformance by the counterparties on interest rate payments but does not expect any counterparty to fail to meet their obligations. The fixed pay-floating receive agreements were entered into as hedges of the interest rates on FHLB advances. The fixed receive-floating pay agreements were entered into as hedges of the interest rates on fixed rate brokered certificates. Interest receivable or payable on interest rate swaps is recognized using the accrual method. The use of interest rate swaps enables the Company to synthetically alter the repricing characteristics of designated interest-bearing liabilities.
The agreements at September 30, 1997 consist of the following:
The fair value of interest rate swaps, which is based on the present value of the swap using dealer quotes, represent the estimated amount the Company would receive or pay to terminate the agreements taking into account current interest rates and market volatility. The interest rate swaps are off-balance sheet items; therefore at September 30, 1997, the gross unrealized gains and losses of $328,000 and $710,000, respectively, equals the fair value loss of the interest rate swaps of $382,000. At September 30, 1996, the gross unrealized gains and losses of $599,000 and $0, respectively, equals the fair value of the interest rate swaps of $599,000.
The Company use interest rate corridors to help protect its net interest margin in various interest rate environments. The corridors are of two general types. One type of corridor pays 1.0% per annum of the notional amount over its life only when the three-month LIBOR rate is between the corridor strike rates (inclusive of the strike rate). There are no payments due to the Company when the three-month LIBOR rate is outside the corridor strike rates. The other type of corridor pays the Company a percent per annum equal to the three-month LIBOR rate minus the lower corridor strike rate on the notional amount when three-month LIBOR is within the corridor strike rates. When the three-month LIBOR rate is above the upper strike rate (equal to 1.0% above the lower strike rate), the corridor pays the Company 1.0% per annum.
The interest rate corridors consist of the following:
These instruments do not qualify as hedges and are accounted for in the trading portfolio, and therefore, are valued at fair value. The fair value of the interest rate corridors is $63,000 at September 30, 1997.
Commitments to buy/sell mortgage-backed securities are contracts which represent notional amounts to buy/sell mortgage-backed securities at a future date and specified price. Such commitments generally have fixed settlement dates.
The unused and open consumer lines of credit are conditional commitments issued by the Company for extensions of credit such as home equity, auto, credit card or other similar consumer type financing. Furthermore, the unused and open commercial lines of credit are also conditional commitments issued by the Company for extensions of credit such as working capital, agricultural production, equipment or other similar commercial type financing. The credit risk involved in extending lines of credit is essentially the same as that involved in extending loan facilities to customers. Collateral held for these commitments may include, but may not be limited to, real estate, investment securities, equipment, accounts receivable, inventory and Company deposits.
The open option contracts written represent the notional amounts to buy (short-put options) or sell (short-call options) mortgage-backed securities (GNMA or FNMA) at a future date and specified price. The Company receives a premium/fee for option contracts written which gives the purchaser the right, but not the obligation, to buy or sell mortgage-backed securities within a specified time period for a contracted price. Because these contracts can expire without being drawn upon, the total commitment amounts do not necessarily represent cash requirements. The expiration of the options range from seven to 44 days.
The commitments to fund equity investments represent amounts St. Francis Equity Properties ("SFEP"), a subsidiary of the Bank, is committed to invest in low-income housing projects, which would qualify for tax credits under Section 42 of the Internal Revenue Code (the "Code"). The investment in the low-income housing projects is included in the Company's balance sheet as real estate held for investment.
The Company's primary business activities include granting residential mortgage and consumer loans to customers located within the proximity of their branch locations, primarily within the State of Wisconsin. Approximately $4.3 million of commercial real estate and multi-family loans are outside Wisconsin as of September 30, 1997.
In the normal course of business, various legal proceedings involving the Company are pending. Management, based upon advice from legal counsel, does not anticipate any significant losses as a result of
these actions.
The Company leases 13 offices under agreements which expire at various dates through January 2030, with nine leases having renewable options. Rent expense under these agreements totaled approximately $468,000, $252,000 and $232,000 for the years ended September 30, 1997, 1996 and 1995, respectively.
The future minimum rental commitments as of September 30, 1997 under these leases for the next five years and thereafter, are as follows:
(17) FAIR VALUES OF FINANCIAL INSTRUMENTS
Statement of Financial Accounting Standards No. 107, Disclosures about Fair Value of Financial Instruments (SFAS No. 107), requires disclosure of fair value information about financial instruments, whether or not recognized in the balance sheet, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are materially affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. SFAS No. 107 excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent, and should not be interpreted to represent, the underlying value of the Company.
The following table presents the estimates of fair value of financial instruments at September 30, 1997:
* Amount is not material.
The following table presents the estimates of fair value of financial instruments at September 30, 1996:
* Amount is not material.
The following methods and assumptions were used by the Company in estimating its fair value disclosures for financial instruments:
CASH AND CASH EQUIVALENTS: The carrying amounts reported in the balance sheet for cash and short-term instruments approximate those assets' fair values.
DEBT AND EQUITY AND MORTGAGE-BACKED AND RELATED SECURITIES: Fair values for debt and equity and mortgage-backed and related securities are based on quoted market prices, where available. If quoted market prices are not available, fair values are based on quoted market prices of comparable instruments.
MORTGAGE LOANS HELD FOR SALE: The fair values for mortgage loans held for sale are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics.
LOANS RECEIVABLE: For variable-rate mortgage loans that reprice frequently and with no significant change in credit risk, fair values are based on carrying values. The fair values for residential mortgage loans are based on quoted market prices of similar loans sold in conjunction with securitization transactions, adjusted for differences in loan characteristics. The fair values for commercial real estate loans, rental property mortgage loans and consumer and other loans are estimated using discounted cash flow analyses, using interest rates currently being offered for loans with similar terms to borrowers of similar credit quality. The carrying amount of accrued interest approximates its fair value.
FEDERAL HOME LOAN BANK STOCK: Federal Home Loan Bank stock is carried at cost which is its redeemable (fair) value since the market for this stock is limited.
CERTIFICATE ACCOUNTS: The fair values of fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit. In accordance with SFAS No. 107, the fair value of liabilities cannot be less than the carrying value.
OTHER DEPOSITS: The fair values disclosed for other deposits, which include interest and non-interest checking accounts, passbook accounts and money market accounts, are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying value amounts).
FEDERAL HOME LOAN BANK AND OTHER BORROWINGS: The fair values of the Company's long-term borrowings are estimated using discounted cash flow analyses, based on the Company's current incremental borrowing rates for similar types of borrowing arrangements. In accordance with SFAS No. 107, the fair value of liabilities cannot be less than the carrying value.
OFF-BALANCE SHEET ITEMS: The fair value of the Company's off-balance sheet instruments are based on quoted market prices and fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the credit standing of the related counterparty.
The fair value of the interest rate swap agreements is based on the present value of the swap using dealer quotes. These values represent the estimated amount the Company would receive or pay to terminate the agreements, taking into account current interest rates and market volatility. The fair value of the interest rate corridors is based on dealer quotes at period end. The corridors are marked to market as a trading asset. The fair value of the commitment to fund equity investments is not determinable and is therefore not shown.
The fair value estimates are presented for on-balance sheet financial instruments without attempting to estimate the value of the Company's long-term relationships with depositors and the benefit that results from low-cost funding provided by deposit liabilities.
(18) FINANCIAL INFORMATION OF ST. FRANCIS CAPITAL CORPORATION (PARENT ONLY)
STATEMENT OF FINANCIAL CONDITION
STATEMENT OF INCOME
STATEMENT OF CASH FLOWS
(19) QUARTERLY FINANCIAL INFORMATION (UNAUDITED)
(1) Earnings per share of common stock have been determined by dividing net income for the period by the weighted average number of shares of common stock and common stock equivalents outstanding during the period.
Net income and earnings per share as reported above for the three-month period ended June 30, 1997 has been restated from the previously issued unaudited quarterly financial statements. The Company determined that it had not properly evaluated other than temporary impairment on private mortgage-backed securities during the quarter ended June 30, 1997. The net effect of the change was to decrease net income by $1.2 million or $.23 per share for the three months ended June 30, 1997.
The quarter ended September 30, 1997 contained the effect of an other than temporary impairment loss on private mortgage-backed securities. The loss was $1.35 million with an after-tax effect on net income of $790,000 or $0.15 per share for the quarter. The quarter also contained the effect of an additional provision for loan losses of $650,000 with an after-tax effect of $390,000 or $0.07 per share for the quarter, to provide for a potential default on a commercial real estate property.
The quarter ended September 30, 1996 contained the effect of a one-time assessment from the Federal Deposit Insurance Corporation for recapitalization of the Savings Association Insurance Fund. The assessment was $4.2 million with an after-tax effect on net income of $2.5 million or $0.45 per share for the quarter. The quarter also contained the effect of an additional provision for loan losses of $1.0 million with an after-tax effect of $600,000 or $0.11 per share for the quarter, to provide for potential losses on a pool of sub- prime auto loans.
On October 31, 1997, the Company declared a dividend of $0.14 per share on the Company's common stock for the quarter ended September 30, 1997, which was the ninth cash dividend payment since the Company became a publicly-held company in June 1993. The dividend was payable on November 21, 1997 to shareholders of record as of November 10, 1997. At November 28, 1997, the closing price of the Company's common stock was $38.25 per share.
EVENTS SUBSEQUENT TO YEAR END (UNAUDITED)
Subsequent to September 30, 1997, the Company has conducted a review of its mortgage-backed and related securities portfolio and its debt and equity securities portfolio as to the levels of credit and interest rate risk within the portfolios. From October 1, 1997 through December 19, 1997, the Company has sold securities totaling $122.1 million at a net gain of $493,000. The net gain consisted of gross gains of $2.1 million and gross losses of $1.6 million. The net gain will be reflected in the Company's results of operations during the first quarter of its fiscal year ending September 30, 1998. Other activity, including sales during the remaining part of the quarter, may result in a final amount different than that discussed above.
ITEM 9.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL DISCLOSURE
None.
PART III
ITEM 10.
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT
Information required by this item with respect to directors is included under the heading "Election of Directors" in the Company's definitive Proxy Statement, dated December 29, 1997, relating to the 1998 Annual Meeting of Shareholders currently scheduled for January 28, 1998, which is incorporated herein by reference. Information concerning executive officers who are not directors is contained in Part I of this Form 10-K pursuant to paragraph (b) of Item 401 of Regulation S-K in reliance on Instruction G(3).
ITEM 11.
ITEM 11. EXECUTIVE COMPENSATION
Information required by this item is included under the heading "Compensation of Executive Officers and Directors" in the Company's definitive Proxy Statement, dated December 29, 1997, relating to the 1998 Annual Meeting of Shareholders currently scheduled for January 28, 1998, which is incorporated herein by reference. However, the information set forth under the heading "Compensation Committee Report" in the Company's definitive Proxy Statement dated December 29, 1997, shall not be deemed to be incorporated by reference by any general statement into any filing and shall not otherwise be deemed to be filed under the Securities Act of 1933, as amended, or the Securities Exchange Act of 1934, as amended.
ITEM 12.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
Information required by this item is included under the heading "Security Ownership of Certain Beneficial Owners" in the Company's definitive Proxy Statement, dated December 29, 1997, relating to the 1998 Annual Meeting of Shareholders currently scheduled for January 28, 1998, which is incorporated herein by reference.
ITEM 13.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
Information required by this item is included under the heading "Indebtedness of Management and Certain Transactions" in the Company's definitive Proxy Statement, dated December 29, 1997, relating to the 1998 Annual Meeting of Shareholders currently scheduled for January 28, 1998, which is incorporated herein by reference.
ITEM 14.
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K
(a) (1) FINANCIAL STATEMENTS
The following financial statements and financial statement schedules are included under a separate caption "Financial Statements and Supplementary Data" in Part II, Item 8 hereof and are incorporated herein by reference:
Consolidated Statements of Financial Condition at September 30, 1997 and Consolidated Statements of Income for Years Ended September 30, 1997, 1996 and 1995 Consolidated Statements of Shareholders' Equity for Years Ended September 30, 1997, 1996 and 1995 Consolidated Statements of Cash Flows for Years Ended September 30, 1997, 1996 and 1995 Notes to Consolidated Financial Statements Independent Auditors' Report
(a) (2) FINANCIAL STATEMENT SCHEDULES
All financial statement schedules have been omitted as the required information is inapplicable or has been included in the Consolidated Financial Statements.
(a) (3) EXHIBITS:
(1) Incorporated by reference to exhibits filed with the Registrant's Form S-1 Registration Statement declared effective on April 22, 1993. (Registration Number 33-58680).
(2) Incorporated by reference to the Registrant's Annual Report on Form 10-K for the fiscal year ended September 30, 1995.
(3) Incorporated by reference to the Registrant's Annual Report on Form 10-K for the fiscal year ended September 30, 1996.
(4) Filed herewith.
(5) Filed in paper format pursuant to Rule 101(b)(1) of Regulation S-T.
(b) REPORTS ON FORM 8-K
A report on Form 8-K dated September 30, 1997 was filed by the Company during the three months ended September 30, 1997, relating to an Item 5 disclosure of the Company's adoption of a Shareholder Rights Plan.
(c) EXHIBITS
Reference is made to the exhibit index set forth above at (a)(3).
(d) FINANCIAL STATEMENT SCHEDULES
Reference is made to the disclosure set forth above at (a)(1 and 2).
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
ST. FRANCIS CAPITAL CORPORATION
By: /s/ Thomas R. Perz ----------------------------------- Thomas R. Perz, President and Chief Executive Officer (Duly Authorized Representative)
Date: December 11, 1997 -----------------------------------
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the registrants and in the capacities and on the dates indicated.