Item 1. Business
General
Harrington Financial Group, Inc. (the "Company") is an Indiana-chartered, registered thrift holding company for Harrington Bank, FSB (the "Bank"). The Bank is a federally chartered savings bank which conducts business through eight full-service offices located in Carmel, Fishers, Noblesville, Indianapolis, and Richmond, Indiana, and Mission, Kansas. In addition, the Bank opened its first full service banking facility in Chapel Hill, North Carolina in July of 1999.
The Company was organized in March 1988 in connection with its acquisition of the Bank. The Bank was originally organized in 1889 as an Indiana-chartered savings association under the name "The Peoples Home and Savings Association of Richmond, Indiana." In 1936, the Bank obtained federal insurance and in 1984 adopted a federal charter and changed its name to "Peoples Federal Savings Association." In 1985, the Bank converted from mutual to stock form and, in March 1994, changed its name to "Harrington Bank, FSB." On May 6, 1996, the Company sold 1,265,000 shares of common stock at $10.00 per share to investors in an initial public offering resulting in gross proceeds of $12,650,000 to the Company. Net proceeds to the Company after offering expenses were $11,437,000. At June 30, 1999, the Company had total consolidated assets of $471.3 million, total consolidated borrowings of $114.2 million, total consolidated deposits of $333.2 million, and total consolidated stockholders' equity of $19.1 million.
The Company was organized in March 1988 by certain principals of Smith Breeden Associates, Inc. ("Smith Breeden") for the sole purpose of acquiring the Bank. This investor group purchased the Bank with the intention of expanding the Bank's mortgage originations, investment and retail operations and improving the Bank's return on equity. The Company has contracted with Smith Breeden to provide investment advisory services and interest rate risk analysis. Certain stockholders and directors of the Company are also principals of Smith Breeden. Smith Breeden has a commercial loan outstanding with the Bank at June 30, 1999.
The Company's business strategy focuses on achieving attractive returns consistent with prudent risk management. The Company has sought to implement this strategy by (1) expanding its banking locations and product offerings in order to build a strong community banking franchise primarily through de novo branching; (2) controlling interest rate risk by matching the interest rate sensitivity of its assets to that of its liabilities; (3) controlling credit risk by maintaining a substantial portion of the Company's assets in mortgage-backed securities and single-family residential loans and by applying conservative underwriting standards and credit risk monitoring; and (4) utilizing excess capital balances through the management of a hedged investment portfolio.
Highlights of the principal elements of the Company's business strategy are as follows:
o Expand Banking Locations and Product Offerings. An integral part of the Company's strategy is to increase the Bank's emphasis on opportunistically expanding products, services and banking locations for business and retail customers in markets where the Company's management and directors have market knowledge and customer relationship potential. A total of seven new banking locations were opened since May 1994, with one being opened in fiscal year 1999. The Company's primary lending emphasis is on the origination (both directly and through correspondents) of loans secured by first liens on single-family (one-to-four units) residences. Originations of such loans have increased from $37.2 million during fiscal 1997 to $106.2 million during fiscal 1999. See "- Lending Activities." In addition, the Company's retail deposits (including transaction accounts and retail certificates of deposit) have increased from $123.5 million or 90.7% of total deposits at June 30, 1997 to $320.8 million or 96.3% of total deposits at June 30, 1999. See "- Sources of Funds - Deposits." The Company believes that single-family residential loan originations generally offer attractive risk adjusted returns and, with respect to direct originations, allow the Company to establish a relationship with the underlying borrower which the Company can utilize to cross-sell additional products and services. In addition, the Company believes that retail deposits are a cost-effective source of funds, provide an additional source of fee income, and also permit the further cross selling of additional products and services. Consequently, the Company expects to continue to focus on increasing its retail deposit base and its portfolio of single-family residential loans. Furthermore, the Company has developed a commercial lending division to provide funding to commercial borrowers and to increase business deposits. The Company also formed Harrington Wealth Management Company ("HWM") in February 1999. HWM is a strategic alliance between the Bank (51% owner) and Los Padres Bank (49% owner), a federally chartered savings bank located in California. HWM provides trust, investment management, and custody services for individuals and institutions.
o Control Interest Rate Risk. The Company attempts to manage its assets and liabilities in order to maintain a portfolio which produces positive returns in either an increasing or decreasing interest rate environment. The Company has sought to control interest rate risk both internally through the management of the composition of its assets and liabilities and externally through the utilization of interest rate contracts. Interest rate contracts, along with mortgage backed derivative securities, are purchased with the intention of protecting the market value of the Bank's portfolio and net interest income.
The Company marks a substantial portion of its assets and interest rate contracts to market in order to fully account for the market value changes in the Company's investment portfolio. This method of accounting is consistent with the Company's strategy of active portfolio management and provides the Company with the flexibility to quickly adjust the mix of its interest-earning assets in response to changing market conditions or to take advantage of community banking growth opportunities. The Company recognizes that marking substantially all of its assets to market subjects the Company to potential earnings volatility. Market value volatility is not unique to the Company as most unhedged financial institutions
have even greater volatility in market values. The difference is that the Company reflects the changes in market values directly in earnings, while most other institutions do not.
o Control Credit Risk. In order to limit the Company's credit exposure and as part of its strategy to earn a positive interest rate spread, the Company maintains a substantial portion of its assets in mortgage-backed and related securities, which are primarily issued or guaranteed by U.S. Government agencies or government sponsored enterprises, and single-family residential loans. At June 30, 1999, the Company's investment in mortgage-backed and related securities amounted to $180.1 million or 98.0% of the Company's securities portfolio (both held for trading and available for sale) and 38.2% of the Company's total assets. In addition, as of such date, the Company's investment in single-family residential loans amounted to $216.5 million or 45.9% of total assets. See "- Lending" and "- Investment Activities."
o Utilize Excess Capital Balances. The Company utilizes excess capital balances through the management of a hedged investment portfolio primarily consisting of mortgage backed securities. Although mortgage-backed securities often carry lower yields than traditional mortgage loans, such securities generally increase the quality of the Company's assets, as they have underlying insurance or guarantees, are more liquid than individual mortgage loans, and may be used to collateralize borrowings or other obligations of the Company. The funds invested in the securities portfolio can be quickly redeployed to pursue community bank expansion opportunities as they arise.
The Company's primary goal in fiscal years 1999 and 1998 was to improve the value of the banking franchise through profitable deposit, loan, market and business line expansion. The market expansion into Kansas and North Carolina and the establishment of the necessary infrastructure were substantially completed during fiscal years 1999 and 1998. The recent losses are due primarily to the underperformance of the investment portfolio combined with the necessary investment spending to complete the market expansion and develop the infrastructure to support continued growth into the future. With the foundation now in place for its community banks in Indiana, Kansas and North Carolina, the Company is making marked improvement in its core banking income (net interest income after provision for loan losses plus fees minus operating expenses). Net interest income has increased by $1.2 million over fiscal year 1998, which reflects the tremendous growth in the Company's loan portfolio and deposits. Furthermore, the core income deficit has been reduced from $1.1 million in the June 1998 quarter to $219,000 in the June 1999 quarter. Contributing to this margin improvement is a lower cost of deposits compared to initial promotional levels, falling from 5.50% at June 30, 1998 to 4.80% at June 30, 1999. The net interest margin also increased from 0.69% in the June 1998 quarter to 1.77% in the June 1999 quarter.
The Company, as a registered savings and loan holding company, is subject to examination and regulation by the Office of Thrift Supervision ("OTS") and is subject to various reporting and other requirements of the Securities and Exchange Commission ("SEC"). The Bank, as a federally chartered savings bank, is subject to comprehensive regulation and examination by the OTS, as its chartering authority and primary regulator, and by the Federal Deposit Insurance Corporation
("FDIC"), which administers the Savings Association Insurance Fund ("SAIF"), which insures the Bank's deposits to the maximum extent permitted by law. The Bank is a member of the Federal Home Loan Bank ("FHLB") of Indianapolis, which is one of the 12 regional banks which comprise the FHLB System. The Bank is further subject to regulations of the Board of Governors of the Federal Reserve System ("Federal Reserve Board") governing reserves required to be maintained against deposits and certain other matters. See "- Supervision and Regulation."
Investment Advisor
Smith Breeden is a money management and consulting firm providing investment management services to taxable and tax-exempt clients such as corporate, state and municipal pension funds, university endowments and mutual fund investors and consulting and investment advisory services to taxable financial institutions. Smith Breeden specializes in mortgage-backed and related securities, interest rate risk management, and the application of option pricing to loans and investments. Smith Breeden currently advises, or manages on a discretionary basis, assets totaling over $24 billion. Over the past 17 years, the firm has acted as a consultant to banks, thrifts and governmental agencies charged with the regulation of financial institutions and the resolution of troubled thrifts.
Smith Breeden was co-founded in 1982 by Douglas T. Breeden and Gregory Smith, who retired in 1988. Dr. Breeden is Chairman of the Board of the Company. He previously served on the faculty at Massachusetts Institute of Technology, the University of Chicago, Stanford University, where he obtained his Ph.D. in Finance, and Duke University's Fuqua School of Business. He is editor of the Journal of Fixed Income. - -----------------------
Since 1988, Smith Breeden and certain of its principals have made equity investments in financial institutions that apply the firm's approach to banking and investment management. Certain of the principals of Smith Breeden are investors in a number of banks and thrift institutions.
Smith Breeden is based in Chapel Hill, North Carolina, and employs approximately 85 people in its main office and its offices in Overland Park, Kansas; Dallas, Texas; Boulder, Colorado and Los Angeles, California.
Lending Activities
General. At June 30, 1999, the Bank's net loan portfolio totaled $259.7 million, representing approximately 55.1% of the Company's $471.3 million of total assets at that date. In addition to utilizing option-adjusted pricing analysis in order to manage the Company's investment portfolio, the Company also uses such analysis to price its loan originations and ascertain the net spread expected to be earned with respect to the Bank's loan portfolio. The Bank's primary focus with respect to its lending operations continues to be in the direct origination and servicing of single-family residential mortgage loans. Since fiscal 1995, the Bank has also been active in originating whole residential mortgage loans through correspondents which meet its pricing and credit quality objectives. In the latter part of fiscal year 1998, the Company initiated the development of a commercial loan division. The Company's origination of commercial mortgage and commercial and industrial loans provides further diversification of business lines and fulfills a critical component of the Company's community banking strategy. Currently, approximately 83.5% of the Bank's loan portfolio consists of conventional loans, which are loans that are neither insured by the Federal Housing Administration nor partially guaranteed by the Department of Veterans Affairs.
The risks associated with residential mortgage lending are well defined and controllable. Credit risk is controlled through the adherence, with few exceptions, to secondary market underwriting guidelines. In addition, the commercial real estate loans and collateralized commercial loans are underwritten to comply with stringent internal guidelines. A strong internal loan review program monitors compliance with the Bank's underwriting standards, which is reflected by the low level of non-performing assets. See - "Asset Quality - Non-Performing Assets." Market risk is controlled by a disciplined approach to pricing and by regular monitoring and hedging of the institution's overall sensitivity to interest rate changes.
As a federally chartered savings institution, the Bank has general authority to originate and purchase loans secured by real estate located throughout the United States. Notwithstanding this nationwide lending authority, the Company estimates that at June 30, 1999, approximately 86% of the loans in the Bank's portfolio are to customers located in the immediate market areas of its offices in Richmond and Indianapolis, Indiana as well as Mission, Kansas and Chapel Hill, North Carolina.
Although the Bank has historically originated loans with lesser dollar balances than the maximum permitted by federal regulations, current loans-to-one borrower limitations may restrict its ability to do business with certain customers. A savings institution generally may not make loans to any one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable securities. At June 30, 1999, the Bank's regulatory limit on loans-to-one borrower was $5.0 million and its five largest loans or groups of loans-to-one borrower, including related entities, aggregated $2.8 million, $2.8 million, $2.6 million, $2.3 million and $2.0 million. All five of the Bank's largest loans or groups of loans are secured primarily by commercial real estate or commercial business assets and were performing in accordance with their terms at June 30, 1999.
Loan Portfolio Composition. The following table sets forth the composition of the Bank's loan portfolio by type of loan at the dates indicated.
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(1) Includes single-family residential construction loans. At June 30, 1999, the Bank had $545,000 in single-family residential and $1.2 million in commercial real estate construction loans in process.
(2) Includes $63,000, $224,000, $258,000, $291,000, and $321,000 of mortgage revenue bonds secured by commercial real estate at each of the respective dates.
(3) Reflects the balance of the fair value adjustments made on the loan portfolio as a result of the completion in September 1988 of the Company's acquisition of the Bank, which acquisition was accounted for under the purchase method of accounting.
(4) Includes undisbursed funds relating to construction loans.
Contractual Principal Repayments and Interest Rates. The following table sets forth certain information at June 30, 1999 regarding the dollar amount of loans maturing in the Bank's total loan portfolio, based on the contractual terms to maturity, before giving effect to net items.
The following table sets forth the dollar amount of all loans, before net items, due after one year from June 30, 1999, which have fixed interest rates or which have floating or adjustable interest rates.
Origination, Purchase and Sale of Loans. The lending activities of the Bank are subject to the written, non-discriminatory underwriting standards and loan origination procedures established by the Bank's Board of Directors and management. Loan originations are obtained by a variety of sources, including referrals from real estate brokers, builders, existing customers, walk-in customers, loan officers and advertising. In its marketing, the Bank emphasizes its community ties, customized personal service, competitive rates, and an efficient underwriting and approval process. Property valuations are performed by independent outside appraisers approved by the Bank's Board of Directors. The Bank requires title, hazard and, to the extent applicable, flood insurance on all security property.
Mortgage loan applications are reviewed by Bank employees who have approval authority up to designated limits. All loans in excess of an individual's designated limits are referred to the Bank's Loan Committee, which has approval authority for all loans up to $1.0 million. Any loans exceeding $1.0 million (of which, at June 30, 1999, there were nine) must be approved by the Board of Directors of the Bank. In addition, the Board of Directors of the Bank ratifies all loans originated and purchased by the Bank.
The single-family residential loans originated by the Bank are generally made on terms, conditions and documentation which permit the sale to the Federal Home Loan Mortgage Corporation ("FHLMC"), the Federal National Mortgage Association ("FNMA") and other institutional investors in the secondary market. From fiscal 1991 to fiscal 1993, the Bank sold substantially all of its fixed-rate single-family residential loans to FNMA in the secondary market as a means of generating fee income as well as providing additional funds for lending, investing and other purposes. Sales of loans were generally under terms which did not provide any recourse to the Company by the purchaser in the event of default on the loan by the borrower. With respect to such loan sales, the Company generally retained responsibility for collecting and remitting loan payments, inspecting the properties, making certain insurance and tax payments on behalf of borrowers and otherwise servicing the loans it sold, and received a fee for performing these services. At June 30, 1999, the Company was servicing $2.0 million of loans for others.
During fiscal year 1994, the Bank initiated programs to increase its portfolio of single-family residential loans in accordance with its community banking expansion. In addition, during fiscal 1995, the Bank began originating single-family residential loans through correspondent mortgage banking companies. Currently, the Bank is utilizing mortgage banking companies located in Indianapolis, Indiana and Overland Park, Kansas. The Bank requires that all loans originated through correspondents be underwritten in accordance with its underwriting guidelines and standards. The Bank reviews the loans for adherence to its underwriting standards prior to acceptance from the correspondent. Such loans are obtained with servicing released.
The following table sets forth the loan origination activity of the Company during the periods indicated.
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(1) Consisted solely of single-family residential loans.
Single-Family Residential Real Estate Loans. Historically, savings institutions such as the Bank have concentrated their lending activities on the origination of loans secured primarily by first mortgage liens on existing single-family residences. At June 30, 1999,
$216.5 million or 83.5% of the Bank's total loan portfolio consisted of single-family residential real estate loans, substantially all of which are conventional loans.
The Bank offers fixed-rate single family residential loans with terms of 10 to 30 years. Such loans are amortized on a monthly basis with principal and interest due each month. Generally, the value of fixed-rate loans fluctuates inversely with changes in interest rates. Consequently, if left unhedged, long-term fixed-rate single-family residential loans would increase the Bank's interest rate risk. However, the Bank believes that its sophisticated asset and liability management techniques provide the Bank with a competitive advantage and allow for the Bank to continue to offer fixed-rate residential mortgage loans over a variety of interest rate scenarios.
Since the early 1980s, the Bank has also been offering adjustable-rate single-family residential mortgage loans. Such loans generally have up to 30-year terms and an interest rate which adjusts after one, three or five years in accordance with a designated index (the weekly average yield on U.S. Treasury securities adjusted to a constant comparable maturity of one year, as made available by the Federal Reserve Board). Such loans currently have a 2% cap on the amount of any increase or decrease in the interest rate per year, and a 6% limit on the amount by which the interest rate can increase or decrease over the life of the loan. In addition, the Bank's adjustable-rate loans are currently not convertible into fixed-rate loans and do not contain prepayment penalties. Approximately 12.4% of the single-family residential loans in the Bank's loan portfolio at June 30, 1999 had adjustable interest rates.
Adjustable-rate mortgage loans decrease but do not eliminate the risks associated with changes in interest rates. Because periodic and lifetime caps limit the interest rate adjustments, the value of adjustable-rate mortgage loans also fluctuates inversely with changes in interest rates. In addition as interest rates increase, the required payments by the borrower increase, thus increasing the potential for default.
The demand for adjustable-rate loans in the Bank's primary market area has been a function of several factors, including the level of interest rates, the expectations of changes in the level of interest rates and the difference between the interest rates and loan fees offered for fixed-rate loans and adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate residential loans that can be originated at any time is largely determined by the demand for each in a competitive environment.
Pursuant to underwriting guidelines adopted by the Board of Directors, the Bank will generally lend up to 95% of the appraised value of the property securing a single-family residential loan. However, the Bank generally obtains private mortgage insurance on the principal amount that exceeds 80% of appraised value of the security property.
Although the Bank does not emphasize the origination of residential construction loans, in recent years the Bank has occasionally originated loans in its primary market area to construct single-family residences. At June 30, 1999, the Bank had $545,000 in single-family residential and $1.2 million in commercial real estate construction loans in process.
Commercial Real Estate Loans. At June 30, 1999, $16.7 million or 6.4% of the Bank's total loan portfolio consisted of loans secured by commercial real estate. At June 30, 1999, the Bank's commercial real estate loan portfolio included term loans secured by commercial buildings located within the Company's primary market areas.
Commercial real estate lending entails different and significant risks when compared to single-family residential lending because such loans typically involve large loan balances to single borrowers and because the payment experience on such loans is typically dependent on the successful operation of the project or the borrower's business. During the latter part of the 1998 fiscal year, the Bank developed a commercial lending division by implementing the necessary policies, operating procedures, loan systems and hiring support personnel. These loans are made in conformance with strict underwriting guidelines and adherence to the Bank's policies.
Collateralized Commercial Loans. At June 30, 1999, $17.1 million or 6.6% of the Bank's total loan portfolio consisted of collateralized commercial loans. These collateralized loans consist of both term loans as well as lines of credit which are secured by business assets or stock.
As previously mentioned, the Bank's recent development of the commercial lending division allows for the origination of non-real estate business loans in strict compliance with the Bank's underwriting standards. Collateralized commercial lending also entails different and significant risks in relation to single-family residential lending.
Consumer Loans. The Bank is authorized to make loans for a wide variety of personal or consumer purposes. The Bank has been originating consumer loans in recent years in order to provide a wider range of financial services to its customers and because such loans generally have higher interest spreads than mortgage loans. The consumer loans offered by the Bank include home equity loans and lines of credit, home improvement loans and deposit account secured loans. At June 30, 1999, $9.0 million or 3.5% of the Bank's total loan portfolio consisted of consumer loans.
Home equity loans and lines of credit are originated by the Bank for up to 90% of the appraised value, less the amount of any existing prior liens on the property. The Bank also offers home improvement loans in amounts up to 95% of the appraised value, less the amount of any existing prior liens on the property, provided the loan is guaranteed by an approved insurer. Home equity loans and home improvement loans have a maximum term of twenty years and carry fixed interest rates. Home equity lines of credit have a maximum repayment term of 10 years, a five-year term with respect to draws, and carry interest rates which adjust monthly in accordance with a designated prime rate. The Bank will secure each of these types of loans with a mortgage on the property (generally a second mortgage) and will originate the loan even if another institution holds the first mortgage. At June 30, 1998, home equity loans and lines of credit and home improvement loans totaled $5.4 million or 60.2% of the Bank's total consumer loan portfolio.
The Bank currently offers loans secured by deposit accounts, which amounted to $426,000 or 4.7% of the Bank's total consumer loan portfolio at June 30, 1999. Such loans
are originated for up to 95% of the deposit account balance, with a hold placed on the account restricting the withdrawal of the account balance.
During fiscal year 1998, the Bank expanded its consumer loan products to include automobile and personal loans. As of June 30, 1999, these other loans amounted to $3.2 million or 35.1% of the Bank's total consumer loan portfolio.
Consumer loans generally have shorter terms and higher interest rates than mortgage loans but generally involve more credit risk than mortgage loans because of the type and nature of the collateral. In addition, consumer lending collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness and personal bankruptcy. The Bank believes that the generally higher yields earned on consumer loans compensate for the increased credit risk associated with such loans, and the Company intends to continue to offer consumer loans in order to provide a full range of services to its customers.
Asset Quality
Loan Delinquencies. When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and seeking payment. Contacts are generally made following the fifteenth day after a payment is due, at which time a late payment is assessed. In most cases, deficiencies are cured promptly. If a delinquency extends beyond 15 days, the loan and payment history is reviewed and efforts are made to collect the loan. While the Bank generally prefers to work with borrowers to resolve such problems, when the account becomes 90 days delinquent, the Bank does institute foreclosure or other proceedings, as necessary, to minimize any potential loss.
Non-Performing Assets. All loans are reviewed on a regular basis and are placed on non-accrual status when, in the opinion of management, the probability of collection of additional interest is deemed insufficient to warrant further accrual. As a matter of policy, the Bank does not accrue interest on loans past due 90 days or more except when the estimated value of the collateral and collection efforts are deemed sufficient to ensure full recovery. The Bank provides an allowance for the loss of uncollected interest on all non-accrual loans. Impaired loans covered under Statement of Financial Accounting Standards ("SFAS") No. 114 and No. 118 are defined by the Company to consist of non-accrual commercial loans which have not been collectively evaluated for impairment. The allowance is established by a charge to interest income equal to all interest previously accrued, and income is subsequently recognized only to the extent that cash payments are received until, in management's judgment, the borrower's ability to make periodic interest and principal payments returns to normal, in which case the loan is returned to accrual status.
Real estate acquired through foreclosure is carried at the lower of the loan's unpaid principal balance (cost) or fair value less estimated selling expenses at the date of transfer. A loan charge-off is recorded for any write-down in the loan's carrying value to fair value at the date of transfer. Real estate loss provisions are recorded if the properties' fair value subsequently declines below the value determined at the recording date. In determining the
lower of cost or fair value at acquisition, costs relating to development and improvement of property are considered. Costs relating to holding real estate acquired through foreclosure, net of rental income, are charged against earnings as incurred.
Automobiles acquired through repossession are carried at the lower of the loan's unpaid principal balance (cost) or fair value based on current National Automobile Dealers Association valuation, adjusted for any damage or vandalism. A loan charge-off is recorded for any write-down in the loan's carrying value to fair value at the date of transfer. Loss provisions are recorded if the fair value of the automobile subsequently declines below the value determined at the recording date. After repossession, costs relating to holding the automobile are charged against earnings as incurred.
The following table sets forth the amounts and categories of the Bank's non-performing assets at the dates indicated. The Bank did not have any troubled debt restructuring at any of the periods presented.
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(1) Consists of a non-agency participation certificate. See "- Classified Assets."
The interest income that would have been recorded during the years ended June 30, 1999, 1998, 1997, 1996 and 1995 if the Bank's non-accrual loans at the end of such periods had been current in accordance with their terms during such periods was $1,000, $15,000, $6,000, $6,000 and $13,000, respectively.
Classified Assets. Federal regulations require that each insured savings institution classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: "substandard," "doubtful" and "loss." Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic 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 loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. Another category designated "special mention" also must be established and maintained for assets which do not currently expose an insured institution to a sufficient degree of risk to warrant classification as substandard, doubtful or loss. Assets classified as substandard or doubtful require the institution to establish general allowances for loan losses. If an asset or portion thereof is classified loss, the insured institution must either establish specific allowances for loan losses in the amount of 100% of the portion of the asset classified loss, or charge-off such amount. General loss allowances established to cover possible losses related to assets classified substandard or doubtful may be included in determining an institution's regulatory capital, while specific valuation allowances for loan losses do not qualify as regulatory capital.
The Bank's classified assets at June 30, 1999 consisted of $1.1 million of assets classified as substandard (including $612,000 of loans and $502,000 of securities) and one loan in the amount of $2,000 was classified as doubtful. In addition, at June 30, 1999, $4.3 million of the Bank's loans were designated special mention.
The $502,000 of securities classified as substandard at June 30, 1999 relates to a single non-agency participation certificate which was purchased by the Bank during fiscal 1991. The security was issued by a savings institution located in Huntington Beach, California and the underlying mortgages consist of six-month adjustable-rate notes (priced off of LIBOR) which are secured by single-family properties located in southern California. As of June 30, 1999, approximately 9.0% of the underlying mortgages were at least 30 days past due and/or in foreclosure or already foreclosed upon by the servicer. The security was structured into both senior and subordinate classes and the Bank owns only senior classes. As of June 30, 1999, the pool had cumulative realized losses of $23.5 million which were initially absorbed by certain credit supports and subsequently absorbed by subordinate certificate holders. Currently, senior certificate holders (such as the Bank) are having to absorb the losses. The credit supports, which totaled $11.0 million at the date of issuance, had been depleted as of June 30, 1999. The security is currently held in the Bank's available for sale portfolio and its $502,000 carrying value at June 30, 1999 reflects $41,000 of net unrealized gains as of such date as well as $414,000 and $253,000 of write-downs with respect to such security which were recognized by the Bank during fiscal 1995 and 1994, respectively.
Allowance for Loan Losses. It is management's policy to maintain an allowance for estimated losses on loans based upon the estimated net realizable value of the underlying collateral, general economic conditions, particularly as they relate to the Bank's market area, historical loss experience, and other factors related to the collectibility of the loan portfolio. Although management believes that it uses the best information available to make such determinations, future adjustments to the allowance may be necessary, and net income could be significantly affected, if circumstances differ substantially from the assumptions used in making the initial determinations.
Effective December 21, 1993, the OTS, in conjunction with the Office of the Comptroller of the Currency, the FDIC and the Federal Reserve Board, issued an Interagency
Policy Statement on the Allowance for Loan and Lease Losses ("Policy Statement"). The Policy Statement includes guidance (1) on the responsibilities of management for the assessment and establishment of an adequate allowance and (2) for the agencies' examiners to use in evaluating the adequacy of such allowance and the policies utilized to determine such allowance. The Policy Statement also sets forth quantitative measures for the allowance with respect to assets classified substandard and doubtful and with respect to the remaining portion of an institution's loan portfolio. Specifically, the Policy Statement sets forth the following quantitative measures which examiners may use to determine the reasonableness of an allowance: (1) 50% of the portfolio that is classified doubtful; (2) 15% of the portfolio that is classified substandard and (3) for the portions of the portfolio that have not been classified (including loans designated special mention), estimating credit losses over the upcoming twelve months based on facts and circumstances available on the evaluation date. While the Policy Statement sets forth this quantitative measure, such guidance is not intended as a "floor" or "ceiling."
The following table sets forth an analysis of the Bank's allowance for loan losses during the periods indicated.
The Bank established provisions (recoveries) for loan losses of $509,000, $147,000, $93,000, $(1,000) and $15,000 during the years ended June 30, 1999, 1998, 1997, 1996 and 1995, respectively. During such periods, loan charge-offs (net of recoveries) amounted to $(1,000), $0, $0, $0 and $0, respectively. The increases in the provision for loan losses during the periods presented were due to substantial growth in the Company's mortgage, consumer and commercial loan portfolios.
The following table sets forth information concerning the allocation of the Bank's allowance for loan losses by loan categories at the dates indicated.
Investment Activities
General. The Company's securities portfolio is managed by investment officers in accordance with a comprehensive written investment policy which addresses strategies, types and levels of allowable investments and which is reviewed and approved by the Bank's Board of Directors on an annual basis. The management of the securities portfolio is set in accordance with the direction of the Bank's Investment Committee. In addition, the Bank has entered into an agreement with Smith Breeden whereby Smith Breeden has been appointed as investment advisor with respect to the management of the Bank's securities portfolio. With the assistance of Smith Breeden, the Bank's Chief Executive Officer and Chief Investment Officer execute various transactions with respect to the portfolio and are responsible for informing the Investment Committee of the types of investments available, the status and performance of the portfolio and current market conditions. The investment officers are authorized to: purchase or sell any securities as well as commitments to hedge eligible investments; purchase or sell eligible investments under repurchase or reverse repurchase agreements; execute hedging strategies approved by the Investment Committee; pledge securities owned as collateral for public agency deposits or repurchase accounts or agreements; and lend securities to approved dealers in government securities or approved commercial banks. Any one investment officer has the authority to purchase or sell securities up to $5.0 million in any one transaction and acting together, two members of the Investment Committee have authority to purchase or sell securities up to $10.0 million in any one transaction. For purchases or sales greater than $10.0 million, the prior approval of a majority of the Investment Committee is required. Investment officers are also authorized to invest excess liquidity in approved liquid investment vehicles. In addition, both the Investment Committee and the Board of Directors of the Bank ratify all securities purchased and sold by the Bank.
The Company invests in a portfolio of mortgage-backed securities, mortgage-backed derivative securities, interest rate risk management contracts, equity securities and municipal bonds. In selecting securities for its portfolio, the Company employs option-adjusted pricing analysis with the assistance of Smith Breeden in order to ascertain the net risk-adjusted spread expected to be earned with respect to the various investment alternatives. The nature of this analysis is to quantify the costs embedded in the yield of an investment, such as the duration matched funding cost, the costs of the options embedded in the investment's cash flows (such as a borrower's ability to prepay a mortgage) and servicing costs. The objective of the Company's investment management process is to select investments with the greatest net spreads and actively manage the underlying risks of these investments.
The Company actively manages its securities portfolio in order to enhance net interest and net market value on a risk-adjusted basis. As a result, the Company continuously monitors the net risk-adjusted spreads of its investments and compares them with the spreads available with respect to other securities in the market. Accordingly, as market conditions fluctuate (e.g., as risk-adjusted spreads narrow), the Company will sell individual securities prior to their maturity and reinvest the proceeds into new investments which generally carry wider risk-adjusted spreads. The Company's securities portfolio also contains various interest rate risk management contracts (such as interest
rate swaps, collars, caps, floors, options and futures) which are primarily utilized to hedge the Company's interest rate exposure in the trading portfolio and which require active management in order to respond to changing prepayment rates on the mortgage securities. The investment portfolio, although hedged for interest rate risk, is still susceptible to adverse changes in the spreads between the yields on mortgage securities and the related Treasury and LIBOR based hedges with the potential for significant earnings volatility from net mark-to-market changes. That is, the Company designates substantially all of the investment portfolio as securities held for trading and, therefore, reflects the market value changes of these investments, net of hedges, in the statement of operations.
In recognition of the Company's business strategy of actively managing its securities portfolio, during fiscal 1994, the Company reclassified substantially all of its securities as held for trading. Pursuant to SFAS No. 115, securities classified as trading securities are reported at fair value with unrealized gains and losses included in earnings, and securities classified as available for sale are similarly reported at fair value, but with unrealized gains and losses excluded from earnings and instead reported as a separate component of stockholders' equity.
Mortgage-Backed and Related Securities. At June 30, 1999, the Company's mortgage-backed and related securities portfolio (including $12.2 million of mortgage-backed derivative securities) amounted to $180.1 million or 98.0% of the Company's securities portfolio (both held for trading and available for sale) and 38.2% of the Company's total assets. By investing in mortgage-backed and related securities, management seeks to achieve a targeted option-adjusted spread over applicable funding costs.
The Company invests in mortgage-backed and related securities, including mortgage participation certificates, which are insured or guaranteed by U.S. Government agencies and government sponsored enterprises, and CMOs and real estate mortgage investment conduits ("REMICs"). Mortgage-backed securities (which also are known as mortgage participation certificates or pass-through certificates) represent a participation interest in a pool of single-family or multi-family mortgages, the principal and interest payments on which are passed from the mortgage originators, through intermediaries (generally U.S. Government agencies and government sponsored enterprises) that pool and repackage the participation interests in the form of securities, to investors such as the Company. Such U.S. Government agencies and government sponsored enterprises, which guarantee the payment of principal and interest to investors, primarily include the FHLMC, the FNMA and the Government National Mortgage Association ("GNMA").
Mortgage-backed securities typically are issued with stated principal amounts, and the securities are backed by pools of mortgages that have loans with interest rates that are within a range and have varying maturities. The characteristics of the underlying pool of mortgages, (i.e., fixed-rate or adjustable-rate) as well as prepayment risk, are passed on to the certificate holder. The term of a mortgage-backed pass-through security thus approximates the term of the underlying mortgages.
The Company's mortgage-backed derivative securities include CMOs, which include securities issued by entities which have qualified under the Internal Revenue Code as REMICs. CMOs and REMICs (collectively CMOs) have been developed in response to investor concerns regarding the uncertainty of cash flows associated with the prepayment option of the underlying mortgagor and are typically issued by governmental agencies, government sponsored enterprises and special purpose entities, such as trusts, corporations or partnerships, established by financial institutions or other similar institutions. A CMO can be collateralized by loans or securities which are insured or guaranteed by FNMA, FHLMC or GNMA. In contrast to pass-through mortgage-backed securities, in which cash flow is received pro rata by all security holders, the cash flow from the mortgages underlying a CMO is segmented and paid in accordance with a predetermined priority to investors holding various CMO classes. By allocating the principal and interest cash flows from the underlying collateral among the separate CMO classes, different classes of bonds are created, each with its own stated maturity, estimated average life, coupon rate and prepayment characteristics.
The Company's mortgage-backed derivative securities also include mortgage-backed residuals and interest-only and principal-only strips. Mortgage-backed residuals consist of certificates of particular tranches of a CMO whereby the principal repayments and prepayments with respect to the underlying pool of loans are generally not allocated to the residual until all other certificates or tranches have been fully paid and retired. Interest-only strips are a particular class of mortgage-backed derivative security which receives and pays only interest with respect to the underlying pool of loans, while principal-only strips receive and pay only principal repayments and prepayments. As a result of the foregoing, mortgage-backed derivative securities often exhibit elasticity and convexity characteristics (i.e., respond differently to changes in interest rates) which the Company can utilize to internally hedge other components of the Company's portfolio of assets against interest rate risk.
The OTS has issued a statement of policy which states, among other things, that mortgage derivative products (including CMOs and CMO residuals and stripped mortgage-backed securities such as interest-only and principal-only strips) which possess average life or price volatility materially different from benchmark fixed-rate 30-year mortgage-backed securities are "high risk mortgage securities," and must be carried in the institution's trading account or as assets held for sale, and therefore marked to market on a regular basis. At June 30, 1999, $12.0 million or 6.7% of the securities held in the Company's portfolio consisted of such "high risk mortgage securities," as defined in such policy statement. However, the Bank is in compliance with this OTS policy statement since all of such securities are held in the Company's trading account and marked to market on a regular basis in accordance with generally accepted accounting principles.
Like most fixed-income securities, mortgage-backed and related securities are subject to interest rate risk. However, unlike most fixed-income securities, the mortgage loans underlying a mortgage-backed or related security generally may be prepaid at any time without penalty. The ability to prepay a mortgage loan generally results in significantly increased price and yield volatility (with respect to mortgage-backed and related securities) than is the case with non-callable fixed-income securities. Furthermore, mortgage-backed derivative securities often are more
sensitive to changes in interest rates and prepayments than traditional mortgage-backed securities and are, therefore, even more volatile. Nevertheless, the Company attempts to hedge against both interest rate and prepayment risk. Although, as stated, no assurances can be given that these hedges will be effective.
Although mortgage-backed and related securities often carry lower yields than traditional mortgage loans, such securities generally increase the quality of the Company's assets by virtue of the securities' underlying insurance or guarantees, are more liquid than individual mortgage loans (which enhances the Company's ability to actively manage its portfolio) and may be used to collateralize borrowings or other obligations of the Company. At June 30, 1999, $65.6 million or 35.7% of the Company's mortgage-backed and related securities were pledged to secure various obligations of the Company (such as reverse repurchase agreements and interest rate swaps). In addition, in relation to the Company maintaining a substantial portion of its assets in mortgage-backed and related securities, the Company has been able to maintain a relatively low level of operating expenses. Furthermore, mortgage-backed derivative securities are often utilized by the Company to internally hedge its interest rate exposure and can be attractive alternatives to other hedge vehicles when their option-adjusted spreads are abnormally wide.
The following table sets forth information relating to the amortized cost and fair value of the Company's securities held for trading and securities available for sale portfolios.
The following table sets forth the fair value of the Company's securities activities (both held for trading and available for sale) for the periods indicated:
At June 30, 1999, the contractual maturity of substantially all of the Company's mortgage-backed or related securities was in excess of twenty years. The actual maturity of a mortgage-backed or related security is usually less than its stated maturity due to prepayments of the underlying mortgages. Prepayments that are faster than anticipated may shorten the life of the security and affect its yield to maturity. The yield to maturity is based upon the interest income and the amortization of any premium or discount related to the security. In accordance with generally accepted accounting principles, premiums and discounts are amortized over the estimated lives of the loans, which decrease and increase interest income, respectively. The prepayment assumptions used to determine the amortization period for premiums and discounts can significantly affect the yield of the mortgage-backed or related security, and these assumptions are reviewed periodically to reflect actual prepayments. Although prepayments of underlying mortgages depend on many factors, including the type of mortgages, the coupon rate, the age of mortgages, the geographical location of the underlying real estate collateralizing the mortgages and general levels of market interest rates, the difference between the interest rates on the underlying mortgages and the prevailing mortgage interest rates generally is the most significant determinant of the rate of prepayments. During periods of falling mortgage interest rates, if the coupon rate of the underlying mortgages exceeds the prevailing market interest rates offered for mortgage loans, refinancing generally increases and accelerates the prepayment of the underlying mortgages and the related security. At June 30, 1999, of the $180.1 million of mortgage-backed and related securities held by the Company, an aggregate of $146.8 million were secured by fixed-rate mortgage loans and an aggregate of $33.3 million were secured by adjustable-rate mortgage loans.
Other Securities. Other securities owned by the Company at June 30, 1999 include various interest rate risk management contracts, including interest rate swaps, collars, caps, floors, options and futures and equity securities. At June 30, 1999, the carrying value of the Company's interest rate contracts and equity securities amounted to $3.5 million and $134,000, respectively. See Note 2 to the Notes to Consolidated Financial Statements.
Sources of Funds
General. The Company will consider various sources of funds to fund its investing and lending activities and evaluates the available sources of funds in order to reduce the Company's overall funding costs. Deposits, securities sold under agreements to repurchase, advances from the FHLB of Indianapolis, notes payable, and sales, maturities and principal repayments on loans and securities have been the major sources of funds for use in the Company's lending and investing activities, and for other general business purposes. Management of the Company closely monitors rates and terms of competing sources of funds on a daily basis and utilizes the source which it believes to be cost effective.
Deposits. The Bank attempts to price its deposits in order to promote deposit growth and offers a wide array of deposit products in order to satisfy its customers' needs. The Bank's current deposit products include statement savings accounts, negotiable order of withdrawal ("NOW") and demand deposit accounts ("DDA"), money market deposit accounts, fixed-rate, fixed-maturity retail certificates of deposit ranging in terms from seven days to 10 years, individual retirement
accounts, and non-retail certificates of deposit consisting of jumbo (generally greater than $95,000) certificates, inverse variable-rate certificates and brokered certificates of deposit.
The Bank's retail deposits are generally obtained from residents in its primary market area. The principal methods currently used by the Bank to attract deposit accounts include offering a wide variety of value-added products and services and competitive interest rates. The Bank utilizes traditional marketing methods to attract new customers and savings deposits, including various forms of advertising. Management estimates that as of June 30, 1999, non-retail deposit accounts totaled $12.4 million or 3.7% of the Bank's total deposits. These non-retail deposits consist largely of jumbo certificates of deposit and inverse variable-rate certificates (which are obtained through brokers). The Bank's jumbo certificates of deposit and other deposits are also obtained through the posting of deposit rates on national computerized bulletin boards at no cost to the Bank. The Bank's inverse variable-rate certificates carry rates which fluctuate inversely with respect to the three month LIBOR rate. For example, if LIBOR rates of interest increase, the rates on the inverse variable-rate certificates would decrease, while if market rates of interest decrease, the rates on the inverse variable-rate certificates would increase. As a result, the Bank would generally be paying a higher rate on such certificates during a declining interest rate environment. The Bank offers inverse variable-rate certificates when they represent a lower cost source of funds to comparable duration funding sources. Retail deposits increased $154.0 million, from $166.8 million at June 30, 1998 to $320.8 million at June 30, 1999, primarily due to the Company's strategy of rapidly building a community banking franchise which included the opening of the Kansas branch in August of 1998.
The following table shows the distribution of and certain other information relating to the Bank's deposits by type as of the dates indicated.
The following table shows the distribution of and certain other information relating to the Bank's certificates of deposit as of the dates indicated.
- ------------------------------ (1) Of the Company's $11.7 million of non-retail certificates as of June 30, 1999, $4.9 million was scheduled to mature in six months or less, $2.8 million was scheduled to mature in 7-12 months, $2.4 million was scheduled to mature in 13-36 months and $1.6 million was scheduled to mature in over 36 months.
The following table presents the average balance of each deposit type and the average rate paid on each deposit type for the periods indicated.
The following table sets forth the deposit account activities of the Bank during the periods indicated.
Year Ended June 30, 1999 1998 1997 --------- --------- --------- (In Thousands) Deposits $ 878,151 $ 264,182 $ 208,032 Withdrawals 742,612 230,421 212,517 --------- --------- --------- Net increase (decrease) before interest credited 135,539 33,761 (4,485) Interest credited 19,395 8,375 5,517 --------- --------- ---------
Net increase in deposits $ 154,934 $ 42,136 $ 1,032 ========= ========= =========
The following table shows the interest rate and maturity information for the Bank's certificates of deposit at June 30, 1999.
The following table sets forth the maturities of the Bank's certificates of deposit having principal amounts of $100,000 or more at June 30, 1999.
Certificates of deposit maturing in quarter ending: Amount - ---------------------------------------------- -------------- (In Thousands)
September 30, 1999 $ 11,107 December 31, 1999 11,106 March 31, 2000 4,495 After March 31, 2000 4,481 -------- Total certificates of deposit with balances of $100,000 or more $ 31,189 ========
Borrowings. The following table sets forth certain information regarding the borrowings of the Company at or for the dates indicated.
The Company obtains both fixed-rate and variable-rate long-term and short-term advances from the FHLB of Indianapolis upon the security of certain of its residential first mortgage loans and other assets, provided certain standards related to creditworthiness of the Bank have been met. FHLB of Indianapolis advances are available for general business purposes to expand lending and investing activities. Borrowings have generally been used to fund the purchase of mortgage-backed and related securities or lending activities and have been collateralized with a blanket pledge agreement of the Bank's assets.
Advances from the FHLB of Indianapolis are made pursuant to several different credit programs, each of which has its own interest rate and range of maturities. The Company currently has one variable-rate advance from the FHLB of Indianapolis which matures in fiscal 2000. At June 30, 1999, the Company had a FHLB of Indianapolis advance in the amount of $40.0 million at a weighted average interest rate of 4.9%.
The Company also obtains funds from the sales of securities to investment dealers under agreements to repurchase ("reverse repurchase agreements"). In a reverse repurchase agreement transaction, the Company will generally sell a mortgage-backed security agreeing to repurchase
either the same or a substantially identical security (i.e., "dollar rolls") on a specified later date (generally not more than 90 days) at a price that is generally less than the original sales price. The difference in the sale price and purchase price is the spread between the mortgage cash flows and the implied financing rate. The mortgage-backed securities underlying the agreements are delivered to the dealers who arrange the transactions. For agreements in which the Company has agreed to repurchase substantially identical securities, the dealers may sell, loan or otherwise dispose of the Company's securities in the normal course of their operations; however, such dealers or third party custodians safe-keep the securities which are to be specifically repurchased by the Company. Reverse repurchase agreements represent a competitive cost funding source for the Company. Nevertheless, the Company is subject to the risk that the lender may default at maturity and not return the collateral. The amount at risk is the value of the collateral which exceeds the balance of the borrowing. In order to minimize this potential risk, the Company normally deals with large, established investment brokerage firms when entering into these transactions. Reverse repurchase transactions are accounted for as financing arrangements rather than as sales of such securities, and the obligation to repurchase such securities is reflected as a liability in the Consolidated Financial Statements.
In April 1993, the Company entered into a $10.0 million loan facility with an unrelated financial institution. This facility, as amended in 1997, includes a $10.0 million term loan (the "Refinancing Loan") and a non-revolving line of credit of $5.0 million. Proceeds from the Refinancing Loan were utilized to repay the unpaid balance of a $10.0 million loan that the Company obtained in 1988 in connection with its acquisition of the Bank, reduce the average interest rate paid on such indebtedness and increase the capitalization of the Bank. The loan facility matures in June 2000 and carries an interest rate equal to the prime rate published in the Wall Street Journal. The loan facility requires quarterly interest-only repayments with the unpaid principal balance outstanding payable in full at maturity. The loan facility is secured by (1) a general pledge agreement between the parties pursuant to which the Company has pledged 100% of the outstanding stock of the Bank; (2) a security agreement between the parties pursuant to which the Company has provided a blanket security interest in all of its assets; and (3) the assignment of life insurance policies on Messrs. Breeden and Cerny by the Company in the aggregate amount of $1.25 million. At June 30, 1999, the total balance of the loan facility was $14.0 million.
Subsidiaries
In February 1999, the Bank formed Harrington Wealth Management Company ("HWM"), which provides trust, investment management, and custody services for individuals and institutions. HWM is a strategic alliance between the Bank (51% owner) and Los Padres Bank (49% owner), a federally chartered savings bank located in California. HWM is an operating subsidiary of the Bank and, as such, is restricted to engage in activities that the Bank can engage in directly. As of June 30, 1999, HWM administered 69 trust/fiduciary accounts, with aggregate assets of approximately $29.8 million at such date, a portion of which were formerly administered by Harrington Investment Management and Trust Services, a separate division of the Bank. The Bank's investment in HWM is not material to its operations or financial condition. The accompanying consolidated balance sheet includes 100 percent of the assets and liabilities of HWM, and the ownership of Los Padres Bank is recorded as "Minority interest." The results of operations include 100 percent of the revenues and expenses of HWM from the date of formation, and the ownership of Los Padres Bank is recorded as "Minority interest" net of income taxes. See Note 1 to the Notes to Consolidated Financial Statements.
The Bank is permitted to invest up to 2% of its assets in the capital stock of, or secured or unsecured loans to, service corporations, with an additional investment of 1% of assets when such additional investments is utilized primarily for community development purposes. The Bank's only service corporation, Pine Tree Mortgage Corp., is an inactive corporation formed in 1987 to originate mortgage loans in North Carolina and has conducted no business since 1988. The Bank's investment in the service corporation is not material to its operations or financial condition.
Supervision and Regulation
Set forth below is a brief description of those laws and regulations which, together with the descriptions of laws and regulations contained elsewhere herein, are deemed material to an investor's understanding of the extent to which the Company and the Bank are regulated. The description of the laws and regulations hereunder, as well as descriptions of laws and regulations contained elsewhere herein, does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.
The Company
General. The Company is a registered savings and loan holding company within the meaning of the Home Owners' Loan Act ("HOLA"), and is subject to OTS regulations, examinations, supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank is subject to certain restrictions in its dealings with the Company and affiliates thereof.
Activities Restrictions. Although there are generally no restrictions on the activities of a savings and loan holding company which holds only one subsidiary savings institution under
applicable OTS regulations, the Company may be considered to be a multiple savings and loan holding company because principals and affiliates of Smith Breeden may be deemed for regulatory purposes to control both the Company and Harrington West Financial Group, a savings and loan holding company which owns all of the outstanding common stock of Los Padres Savings Bank, F.S.B., Los Padres, California.
Multiple savings and loan holding companies are subject to restrictions which do not apply to unitary savings and loan holding companies. Among other things, no multiple savings and loan holding company or subsidiary thereof which is not a savings institution shall commence or continue for a limited period of time after becoming a multiple savings and loan holding company or subsidiary thereof any business activity, upon prior notice to, and no objection by the OTS, other than: (1) furnishing or performing management services for a subsidiary savings institution; (2) conducting an insurance agency or escrow business; (3) holding, managing, or liquidating assets owned by or acquired from a subsidiary savings institution; (4) holding or managing properties used or occupied by a subsidiary savings institution; (5) acting as trustee under deeds of trust; (6) engaging in those activities authorized by regulation as of March 5, 1987 to be permissible for multiple savings and loan holding companies; or (7) unless the Director of the OTS by regulation prohibits or limits such activities for savings and loan holding companies, those activities authorized by the Federal Reserve Board as permissible for bank holding companies. Those activities described in (7) above also must be approved by the Director of the OTS prior to being engaged in by a multiple savings and loan holding company. The Company does not believe that if the OTS designates it as a multiple thrift holding company, such a designation will limit its ability to conduct its normal business operations.
In addition, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings institution, the Director may impose such restrictions as deemed necessary to address such risk, including limiting (1) payment of dividends by the savings institution; (2) transactions between the savings institution and its affiliates; and (3) any activities of the savings institution that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings institution.
Limitations on Transactions with Affiliates. Transactions between savings institutions and any affiliate are governed by Sections 23A and 23B of the Federal Reserve Act. An affiliate of a savings institution is any company or entity which controls, is controlled by or is under common control with the savings institution. In a holding company context, the parent holding company of a savings institution (such as the Company) and any companies which are controlled by such parent holding company are affiliates of the savings institution. Generally, Sections 23A and 23B (1) limit the extent to which the savings institution or its subsidiaries may engage in "covered transactions" with any one affiliate to an amount equal to 10% of such institution's capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus and (2) 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
guarantee and other similar transactions. In addition to the restrictions imposed by Sections 23A and 23B, no savings institution may (1) loan or otherwise extend credit to an affiliate, except for any affiliate which engages only in activities which are permissible for bank holding companies, or (2) purchase or invest in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for affiliates which are subsidiaries of the savings institution.
In addition, Sections 22(h) and (g) of the Federal Reserve Act places restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer and to a greater than 10% stockholder of a savings institution, and certain affiliated interests of either, may not exceed, together with all other outstanding loans to such person and affiliated interests, the savings institution's loans to one borrower limit (generally equal to 15% of the institution's unimpaired capital and surplus). Section 22(h) also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons unless the loans are made pursuant to a benefit or compensation program that (1) is widely available to employees of the institution and (2) does not give preference to any director, executive officer or principal stockholder, or certain affiliated interests of either, over other employees of the savings institution. Section 22(h) also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a savings institution to all insiders cannot exceed the institution's unimpaired capital and surplus. Furthermore, Section 22(g) places additional restrictions on loans to executive officers. At June 30, 1999, the Bank was in compliance with the above restrictions.
Restrictions on Acquisitions. Except under limited circumstances, savings and loan holding companies are prohibited from acquiring, without prior approval of the Director of the OTS, (1) control of any other savings institution or savings and loan holding company or substantially all the assets thereof or (2) more than 5% of the voting shares of a savings institution or holding company thereof which is not a subsidiary. Except with the prior approval of the Director of the OTS, no director or officer of a savings and loan holding company or person owning or controlling by proxy or otherwise more than 25% of such company's stock, may acquire control of any savings institution, other than a subsidiary savings institution, or of any other savings and loan holding company.
The Director of the OTS may only approve acquisitions resulting in the formation of a multiple savings and loan holding company which controls savings institutions in more than one state if (1) the multiple savings and loan holding company involved controls a savings institution which operated a home or branch office located in the state of the institution to be acquired as of March 5, 1987; (2) the acquirer is authorized to acquire control of the savings institution pursuant to the emergency acquisition provisions of the Federal Deposit Insurance Act ("FDIA"); or (3) the statutes of the state in which the institution to be acquired is located specifically permit institutions to be acquired by the state-chartered institutions or savings and loan holding companies located in the state where the acquiring entity is located (or by a holding company that controls such state-chartered savings institutions).
Under the Bank Holding Company Act of 1956, the Federal Reserve Board is authorized to approve an application by a bank holding company to acquire control of a savings institution. In addition, a bank holding company that controls a savings institution may merge or consolidate the assets and liabilities of the savings institution with, or transfer assets and liabilities to, any subsidiary bank which is a member of the BIF with the approval of the appropriate federal banking agency and the Federal Reserve Board. As a result of these provisions, there have been a number of acquisitions of savings institutions by bank holding companies in recent years.
The Bank
General. The OTS has extensive authority over the operations of federally chartered savings institutions. As part of this authority, savings institutions are required to file periodic reports with the OTS and are subject to periodic examinations by the OTS. The last regulatory examination of the Bank by the OTS was conducted beginning on November 2, 1998. The Bank was not required to make any material changes to its operations as a result of such examination. The investment and lending authority of savings institutions are prescribed by federal laws and regulations, and such institutions are prohibited from engaging in any activities not permitted by such laws and regulations. Those laws and regulations generally are applicable to all federally chartered savings institutions and may also apply to state-chartered savings institutions. Such regulation and supervision is primarily intended for the protection of depositors.
The OTS' enforcement authority over all savings institutions and their holding companies includes, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the OTS.
Insurance of Accounts. The deposits of the Bank are insured to the maximum extent permitted by the SAIF, which is administered by the FDIC, and are backed by the full faith and credit of the U.S. Government. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action.
Both the SAIF and Bank Insurance Fund ("BIF") are statutorily required to be capitalized to a ratio of 1.25% of insured reserve deposits. The BIF met its required capitalization levels in 1995 and, as a result, most BIF insured banks have been paying significantly lower premiums than SAIF institutions. The legislation enacted by the U.S. Congress, which was signed by the President on September 30, 1996, has recapitalized the SAIF by a one-time charge of $0.657 for each $100 of assessable deposits held at March 31, 1995. Although this resulted in pre-tax expense of $830,000 recognized in the Company's earnings in fiscal year 1997, future earnings will be enhanced due to lower insurance premiums. The Bank's insurance premiums, which had amounted to $0.23 for
every $100 of assessable deposits, were reduced to $0.065 for every $100 of assessable deposits beginning on January 1, 1997.
The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices or is in an unsafe or unsound condition to continue operations, or if the insured depository institution or any of its directors or trustees have violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which would result in termination of the Bank's deposit insurance.
Regulatory Capital Requirements. OTS capital regulations require savings instituions to satisfy minimum capital standards: risk-based capital requirements, a leverage requirement and a tangible capital requirement. Savings institutions must meet each of these standards in order to be deemed in compliance with OTS capital requirements. In addition, the OTS may require savings institutions to maintain capital above the minimum capital levels.
All savings institutions are required to meet a minimum risk-based capital requirement of total capital (core capital plus supplementary capital) equal to 8% of risk-weighted assets (which includes the credit risk equivalents of certain off-balance sheet items). In calculating total capital for purposes of the risk-based requirement, supplementary capital may not exceed 100% of core capital. Under the leverage requirement, a savings institution is required to maintain core capital equal to a minimum of 3% of adjusted total assets. (In addition, under the prompt corrective action provisions of the OTS regulations, all but the most highly-rated institutions must maintain a minimum leverage ratio of 4% in order to be adequately capitalized. See "--Prompt Corrective Action.") A savings institution is also required to maintain tangible capital in an amount at least equal to 1.5% of its adjusted total assets.
The foregoing capital requirements are viewed as minimum standards by the OTS, and most institutions are expected to maintain capital levels well above the minimum. In addition, the OTS regulations provide that minimum capital levels higher than those provided in the regulations may be established by the OTS for individual savings institutions, upon a determination that the savings institution's capital is or may become inadequate in view of its circumstances. The OTS regulations provide that higher individual minimum regulatory capital requirements may be appropriate in circumstances where, among others: (1) a savings institution has a high degree of exposure to interest rate risk, prepayment risk, credit risk, concentration of credit risk, certain risks arising from nontraditional activities, or similar risks or a high proportion of off-balance sheet risk; (2) a savings institution is growing, either internally or through acquisitions, at such a rate that supervisory problems are presented that are not dealt with adequately by OTS regulations; and (3) a savings institution may be adversely affected by activities or condition of its holding company,
affiliates, subsidiaries or other persons or savings institutions with which it has significant business relationships. The Bank is not subject to any such individual minimum regulatory capital requirement.
In March 1999, the federal banking agencies amended their risk-based and leverage capital standards to make uniform their regulations. In particular, the agencies made risk-based capital treatments for construction loans on pre-sold residential properties, real estate loans secured by junior liens on 1-to 4-family residential properties, and investments in mutual funds consistent among the agencies, and simplified and made uniform the agencies' Tier 1 leverage capital standards. The most highly-rated institutions must maintain a minimum Tier 1 leverage ratio of 3.0 percent, with all other institutions required to maintain a minimum leverage ratio of 4.0 percent. The OTS regulations now state that higher-than-minimum capital levels may be required if warranted, and that institutions should maintain capital levels consistent with their risk exposures.
Any savings institution that fails any of the capital requirements is subject to possible enforcement actions by the OTS or the FDIC. Such actions could include a capital directive, a cease and desist order, civil money penalties, the establishment of restrictions on the institution's operations (including growth), termination of federal deposit insurance and the appointment of a conservator or receiver. The OTS' capital regulation provides that such actions, through enforcement proceedings or otherwise, could require one or more of a variety of corrective actions.
Prompt Corrective Action. Under Section 38 of the Federal Deposit Insurance Act ("FDIA"), each federal banking agency was required to implement a system of prompt corrective action for institutions which it regulates. The federal banking agencies, including the OTS, adopted substantially similar regulations to implement Section 38 of the FDIA, effective as of December 19, 1992. Under the regulations, an institution is deemed to be (1) "well capitalized" if it has total risk-based capital of 10.0% or more, has a Tier 1 risk-based capital ratio of 6.0% or more, has a Tier 1 leverage capital ratio of 5.0% or more and is not subject to any order or final capital directive to meet and maintain a specific capital level for any capital measure, (2) "adequately capitalized" if it has a total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital ratio of 4.0% or more and a Tier 1 leverage capital ratio of 4.0% or more (3.0% under certain circumstances) and does not meet the definition of "well capitalized," (3) "undercapitalized" if it has a total risk-based capital ratio that is less than 8.0%, a Tier 1 risk-based capital ratio that is less than 4.0% or a Tier 1 leverage capital ratio that is less than 4.0% (3.0% under certain circumstances), (4) "significantly undercapitalized" if it has a total risk-based capital ratio that is less than 6.0%, a Tier 1 risk-based capital ratio that is less than 3.0% or a Tier 1 leverage capital ratio that is less than 3.0% and (5) "critically undercapitalized" if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%. Section 38 of the FDIA and the regulations promulgated thereunder also specify circumstances under which a federal banking agency may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution or an undercapitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized instituion as critically undercapitalized).
An institution generally must file a written capital restoration plan which meets specified requirements with an appropriate federal banking agency within 45 days of the date that the institution receives notice or is deemed to have notice that it is undercapitalized, significantly undercapitalized or critically undercapitalized. A federal banking agency must provide the institution with written notice of approval or disapproval within 60 days after receiving a capital restoration plan, subject to extensions by the agency.
An institution which is required to submit a capital restoration plan must concurrently submit a performance guaranty by each company that controls the institution. Such guaranty shall be limited to the lesser of (1) an amount equal to 5.0% of the institution's total assets at the time the institution was notified or deemed to have notice that it was undercapitalized or (2) the amount necessary to restore the relevant capital measures of the institution to the levels required for the institution to be classified as adequately capitalized. Such a guarantee shall expire after the federal banking agency notifies the institution that it has remained adequately capitalized for each of four consecutive calendar quarters. An institution which fails to submit a written capital restoration plan within the requisite period, including any required performance guarantee(s), or fails in any material respect to implement a capital restoration plan, shall be subject to the restrictions in Section 38 of the FDIA which are applicable to significantly undercapitalized institutions.
Immediately upon becoming undercapitalized, an institution shall become subject to the provisions of Section 38 of the FDIA (1) restricting payment of capital distributions and management fees, (2) requiring that the appropriate federal banking agency monitor the condition of the institution and its efforts to restore its capital, (3) requiring submission of a capital restoration plan, (4) restricting the growth of the institution's assets and (5) requiring prior approval of certain expansion proposals. The appropriate federal banking agency for an undercapitalized instituiton also may take any number of discretionary supervisory actions if the agency determines that any of these actions is necessary to resolve the problems of the institution at the least possible long-term cost to the deposit insurance fund, subject in certain cases to specified procedures. These discretionary supervisory actions include requiring the institution to raise additional capital; restricting transactions with affiliates; restricting interest rates paid by the institution on deposits; requiring replacement of senior executive officers and directors; restricting the activities of the institution and its affiliates; requiring divestiture of the institution or the sale of the institution to a willing purchaser; and any other supervisory action that the agency deems appropriate. These and additional mandatory and permissive supervisory actions may be taken with respect to significantly undercapitalized and critically undercapitalized institutions.
At June 30, 1999, the Bank was deemed a "well capitalized" institution for purposes of the above regulations and as such was not subject to the above mentioned restrictions.
Liquidity Requirements. The Bank is required under applicable federal regulations to maintain specified levels of "liquid" investments as defined by the OTS. As of November 24, 1997, the required level of such liquid investments was changed from 5% to 4% of certain liabilities as defined by the OTS. In addition to the change in the percentage of required level of liquid assets, the OTS also modified its definition of investments that are considered liquid. As a
result of this change, the level of assets eligible for regulatory liquidity calculations increased considerably. At June 30, 1999, the Bank's liquidity ratio was 16.7%.
Capital Distributions. OTS regulations govern capital distributions by savings institutions, which include cash dividends, stock redemptions or repurchases, cash-out mergers, interest payments on certain convertible debt and other transactions charged to the capital account of a savings institution to make capital distributions.
In January 1999, the OTS amended its capital distribution regulation to bring such regulations into greater conformity with the other bank regulatory agencies. Under the regulation, certain savings institutions would not be required to file with the OTS. Specifically, savings institutions that would be well capitalized following a capital distribution would not be subject to any requirement for notice or application unless the total amount of all capital distributions, including any proposed capital distribution, for the applicable calendar year would exceed an amount equal to the savings institution's net income for that year to date plus the savings institution's retained net income for the preceding two years. Because the Bank is a subsidiary of the Company, the regulation, however, would require the Bank to provide notice to the OTS of its intent to make a capital distribution, unless an application is otherwise required. The Bank does not believe that the regulation will adversely affect its ability to make capital distributions.
Loans to One Borrower. The permissible amount of loans-to-one borrower now generally follows the national bank standard for all loans made by savings institutions, as compared to the pre-FIRREA rule that applied that standard only to commercial loans made by federally chartered savings institutions. The national bank standard generally does not permit loans-to-one borrower to exceed 15% of unimpaired capital and unimpaired surplus. Loans in an amount equal to an additional 10% of unimpaired capital and unimpaired surplus also may be made to a borrower if the loans are fully secured by readily marketable securities. If a savings institution's aggregate lending limitation is less than $500,000, then, notwithstanding the aforementioned aggregate limitation, such savings institution may have total loans and extensions of credit, for any purpose, to one borrower outstanding at one time not to exceed $500,000. For information about the largest borrowers from the Bank, see "- Lending Activities."
Branching by Federal Savings Institutions. OTS policy permits interstate branching to the full extent permitted by statute (which is essentially unlimited). Generally, federal law prohibits federal savings institutions from establishing, retaining or operating a branch outside the state in which the federal institution has its home office unless the institution meets the IRS' domestic building and loan test (generally, 60% of a thrift's assets must be housing-related) ("IRS Test"). The IRS Test requirement does not apply if, among other things, the law of the state where the branch would be located would permit the branch to be established if the federal savings institution were chartered by the state in which its home office is located. Furthermore, the OTS will evaluate a branching applicant's record of compliance with the Community Reinvestment Act of 1977 ("CRA"). An unsatisfactory CRA record may be the basis for denial of a branching application.
Qualified Thrift Lender Test. All savings institutions are required to meet a QTL test to avoid certain restrictions on their operations. Under Section 2303 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996, a savings association can comply with the QTL test by either meeting the QTL test set forth in the HOLA and implementing regulations or qualifying as a domestic building and loan association as defined in Section 7701(a)(19) of the Internal Revenue Code of 1986, as amended ("Code"). The QTL test set forth in the HOLA requires a thrift institution to maintain 65% of portfolio assets in Qualified Thrift Investments ("QTIs"). Portfolio assets are defined as total assets less intangibles, property used by a savings institution in its business and liquidity investments in an amount not exceeding 20% of assets. Generally, QTIs are residential housing related assets. At June 30, 1999, the qualified thrift investments of the Bank were approximately 84.5% of its portfolio assets.
A savings institution that does not meet the QTL test must either convert to a bank charter or comply with the following restrictions on its operations: (1) the institution may not engage in any new activity or make any new investment, directly or indirectly, unless such activity or investment is permissible for a national bank; (2) the branching powers of the institution shall be restricted to those of a national bank; (3) the institution shall not be eligible to obtain any advances from its FHLB; and (4) payment of dividends by the institution shall be subject to the rules regarding payment of dividends by a national bank. Upon the expiration of three years from the date the savings institution ceases to be a QTL, it must cease any activity and not retain any investment not permissible for a national bank and immediately repay any outstanding FHLB advances (subject to safety and soundness considerations).
Accounting Requirements. Applicable OTS accounting regulations and reporting requirements apply the following standards: (1) regulatory reports will incorporate generally accepted accounting principles ("GAAP") when GAAP is used by federal banking agencies; (2) savings institution transactions, financial condition and regulatory capital must be reported and disclosed in accordance with OTS regulatory reporting requirements that will be at least as stringent as for national banks; and (3) the Director of the OTS may prescribe regulatory reporting requirements more stringent than GAAP whenever the Director determines that such requirements are necessary to ensure the safe and sound reporting and operation of savings institutions.
Federal Home Loan Bank System. The Bank is a member of the FHLB of Indianapolis, which is one of 12 regional FHLBs that administers the home financing credit function of savings institutions. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the Board of Directors of the FHLB. At June 30, 1999, the Company had a $40.0 million FHLB advance. See "Sources of Funds - Borrowings."
As a member, the Bank is required to purchase and maintain stock in the FHLB of Indianapolis in an amount equal to at least 1% of its aggregate unpaid residential mortgage loans, home purchase contracts or similar obligations at the beginning of each year. At June 30, 1999, the Bank had $4.9 million in FHLB stock, which was in compliance with this requirement.
The FHLBs are required to provide funds for the resolution of troubled savings institutions and to contribute to affordable housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have adversely affected the level of FHLB dividends paid in the past and could continue to do so in the future. These contributions also could have an adverse effect on the value of FHLB stock in the future.
Federal Reserve System. The Federal Reserve Board requires all depository institutions to maintain reserves against their transaction accounts (primarily NOW and Super NOW checking accounts) and non-personal time deposits. As of June 30, 1999, the Bank was in compliance with this requirement. Because required reserves must be maintained in the form of vault cash or a non-interest bearing account at a Federal Reserve Bank, the effect of this reserve requirement is to reduce an institution's earning assets.
Federal Taxation
General. The Company and Bank are subject to the generally applicable corporate tax provisions of the Code, and Bank is subject to certain additional provisions of the Code which apply to thrifts and other types of financial institutions. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters material to the taxation of the Company and the Bank and is not a comprehensive discussion of the tax rules applicable to the Company and Bank.
Year. The Company files a consolidated federal income tax return on the basis of a fiscal year ending on June 30. The Company's federal income tax returns for the tax years ended June 30, 1996 forward are open under the statute of limitations and are subject to review by the IRS.
Bad Debt Reserves. Prior to the enactment, on August 20, 1996, of the Small Business Job Protection Act of 1996 (the "Small Business Act"), for federal income tax purposes, thrift institutions such as the Bank, which met certain definitional tests primarily relating to their assets and the nature of their business, were permitted to establish tax reserves for bad debts and to make annual additions thereto, which additions could, within specified limitations, be deducted in arriving at their taxable income. The Bank's deduction with respect to "qualifying loans," which are generally loans secured by certain interest in real property, could be computed using an amount based on a six-year moving average of the Bank's actual loss experience (the "Experience Method"), or a percentage equal to 8.0% of the Bank's taxable income (the "PTI Method"), computed without regard to this deduction and with additional modifications and reduced by the amount of any permitted addition to the non-qualifying reserve.
Under the Small Business Act, the PTI Method was repealed and the Bank will be required to use the Experience Method of computing additions to its bad debt reserve for taxable years beginning with the Bank's taxable year beginning July 1, 1996. In addition, the Bank will be required to recapture (i.e., take into taxable income) over a six-year period, beginning with the
Bank's taxable year beginning July 1, 1996, the excess of the balance of its bad debt reserves (other than the supplemental reserve) as of June 30, 1996 over (a) the greater of the balance of such reserves as of June 30, 1988 or (b) an amount that would have been the balance of such reserves as of June 30, 1996 had the Bank always computed the additions to its reserves using the Experience Method. However, under the Small Business Act such recapture requirements will be suspended for each of the two successive taxable years beginning July 1, 1996 in which the Bank originates a minimum amount of certain residential loans during such years that is not less than the average of the principal amounts of such loans made by the Bank during its six taxable years preceding July 1, 1996. The Bank delayed the timing of this recapture for taxable years 1998 and 1997 as certain residential loan test requirements were met. The six year recovery period for the excess reserves began in taxable year 1999.
State Taxation
The State of Indiana imposes a franchise tax on the "adjusted gross income" of financial institutions at a fixed rate of 8.5% per annum. This franchise tax is imposed in lieu of the gross income tax, adjusted gross income tax, and supplemental net income tax otherwise imposed on certain corporate entities. "Adjusted gross income" is computed by making certain modifications to an institution's federal taxable income. Tax-exempt interest, for example, is included in the savings association's adjusted gross income and the bad debt deduction is limited to actual charge-offs for purposes of the financial institutions tax.
Item 2.
Item 2. Properties
The Company's principal executive office is located at 722 East Main Street, Richmond, Indiana, 47374. The following table sets forth certain information with respect to the offices and other properties of the Bank at June 30, 1999.
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(1) Includes leasehold improvements.
(2) Branch opened in May 1994.
(3) The lease expires in June 2008 and may be extended for an additional ten years provided that proper notice is timely given.
(4) Branch opened in December 1995.
(5) Branch opened in June 1997.
(6) Branch opened in December 1997
(7) Branch opened in January 1998.
(8) The lease expires in January 2003 and has three options for additional terms of five years each.
(9) Branch opened in February 1998.
(10) The lease expires in February 2001 and has three options for additional terms of five years each.
(11) Branch opened in August 1998.
(12) The lease expires in December 2010 and has four options for additional terms of five years each.
(13) Branch opened in July 1999.
(14) The lease expires in July 2004.
(15) The lease expires in March 2004.
Item 3.
Item 3. Legal Proceedings.
There are no material legal proceedings to which the Company is a party or to which any of their property is subject.
Item 4.
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
PART II
Item 5.
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
Shares of the Company's common stock are traded nationally under the symbol "HFGI" on the Nasdaq National Market. The following table sets forth the high, low and closing sales prices for the common stock as reported by the Nasdaq Stock Market, as well as the dividends paid, for fiscal years 1999 and 1998:
There have been no stock dividends, stock splits or reverse stock splits. Payment of future dividends is subject to a declaration by the Company's Board of Directors. Factors considered in determining the size of dividends are the amount and stability of profits, adequacy of capitalization and expected asset and liability growth of the Bank.
At September 16, 1999 the Company had approximately 64 stockholders of record.
Item 6.
Item 6. Selected Financial Data.
The information required herein is incorporated by reference from page 16 of the Registrant's 1999 Annual Report.
Item 7.
Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.
The information required herein is incorporated by reference from pages 17 to 31 of the Registrant's 1999 Annual Report.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information required herein is incorporated by reference from pages 18 to 22 of the Registrant's 1999 Annual Report.
Item 8.
Item 8. Financial Statements and Supplementary Data.
The information required herein is incorporated by reference from pages 32 to 59 of the Registrant's 1999 Annual Report.
Item 9.
Item 9. Changes in and Disagreements on Accounting and Financial Disclosure.
Not applicable.
PART III
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
The information required herein is incorporated by reference from pages 2 to 9, and 12 of the Registrant's Proxy Statement dated September 27, 1999 ("Proxy Statement").
Item 11.
Item 11. Executive Compensation.
The information required herein is incorporated by reference from pages 12 to 20 of the Registrant's Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management.
The information required herein is incorporated by reference from pages 9 to 12 of the Registrant's Proxy Statement.
Item 13.
Item 13. Certain Relationships and Related Transactions.
The information required herein is incorporated by reference from page 17 of the Registrant's Proxy Statement.
PART IV
Item 14.
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a) Document filed as part of this Report.
(1) The following documents are filed as part of this report and are incorporated herein by reference from the Registrant's 1999 Annual Report.
Independent Auditors' Report.
Consolidated Balance Sheets as of June 30, 1999 and 1998.
Consolidated Statements of Operations for the Years Ended June 30, 1999, 1998 and 1997.
Consolidated Statements of Changes in Stockholders' Equity for the Years Ended June 30, 1999, 1998 and 1997.
Consolidated Statements of Cash Flows for the Years Ended June 30, 1999, 1998 and 1997.
Notes to Consolidated Financial Statements.
(2) All schedules for which provision is made in the applicable accounting regulation of the Securities and Exchange Commission are omitted because they are not applicable or the required information is included in the Consolidated Financial Statements or notes thereto.
(3)(a) The following exhibits are filed as part of this Form 10-K, and this list includes the Exhibit Index.
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1/ Incorporated by reference from the Registration Statement on Form S-1 (Registration No. 333-1556) filed by the Registrant with the Securities and Exchange Commission ("SEC") on February 20, 1996, as amended.
2/ Incorporated by reference from the Form 10-K for the fiscal year ended June 30, 1996 filed by the Registrant with the SEC on September 30, 1996.
3/ Incorporated by reference from the Form 10-K for the fiscal year ended June 30, 1997 filed by the Registrant with the SEC on September 29, 1997.
4/ Incorporated by reference from the Form 10-K for the fiscal year ended June 30, 1998 filed by the Registrant with the SEC on September 28, 1998.
5/ Incorporated by reference from the Form 10-Q for the quarterly period ended March 31, 1999 filed by the Registrant with the SEC on May 17, 1999.
*/ Management contract or compensatory plan or arrangement.
(3)(b) Reports filed on Form 8-K.
None.
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.
HARRINGTON FINANCIAL GROUP, INC.
By: /s/ Craig J. Cerny ------------------- Craig J. Cerny President
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 Registrant and in the capacities and on the dates indicated.
/s/ Craig J. Cerny September 27, 1999 - ------------------------------------------ Craig J. Cerny President (Principal Executive Officer)
/s/ John E. Fleener September 27, 1999 - ------------------------------------------ John E. Fleener Principal Financial & Accounting Officer
/s/ Douglas T. Breeden September 27, 1999 - ------------------------------------------ Douglas T. Breeden Chairman of the Board
/s/ Russell Breeden III September 27, 1999 - ------------------------------------------ Russell Breeden III Director
/s/ William F. Quinn September 27, 1999 - ------------------------------------------ William F. Quinn Director
/s/ Daniel C. Dektar September 27, 1999 - ------------------------------------------ Daniel C. Dektar Director
/s/ Marianthe Mewkill September 27, 1999 - ------------------------------------------ Marianthe Mewkill Director
/s/ Michael J. Giarla September 27, 1999 - ------------------------------------------ Michael J. Giarla Director
/s/ Stephen A. Eason September 27, 1999 - ------------------------------------------ Stephen A. Eason Director
/s/ Sharon E. Fankhauser September 27, 1999 - ------------------------------------------ Sharon E. Fankhauser Director
/s/ David F. Harper September 27, 1999 - ------------------------------------------ David F. Harper Director
/s/ Stanley J. Kon September 27, 1999 - ------------------------------------------ Stanley J. Kon Director
/s/ John J. McConnell September 27, 1999 - ------------------------------------------ John J. McConnell Director