SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
For Annual and Transition Reports Pursuant to Sections 13
or 15(d) of the Securities Exchange Act of 1934
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [FEE REQUIRED]
For the fiscal year ended September 30, 1998
--------------------------------------------
- or -
[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934 [NO FEE REQUIRED]
For the transition period __________________ to ____________________
Commission Number: 0-24648
FSF FINANCIAL CORP.
(Exact name of Registrant as specified in its Charter)
Minnesota 41-1783064
(State or other jurisdiction of incorporation (I.R.S. Employer)
or organization) Identification No.)
201 Main Street South, Hutchinson, Minnesota 55350-2573
(Address of principal executive offices) Zip Code
Registrant's telephone number, including area code: (320) 234-4500
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.10 per share
(Title of Class)
Indicate by check mark whether the Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period that the
Registrant was required to file such reports), and (2) has been subject to such
filling requirements for the past 90 days. YES X NO
---
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to the
best of the registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K.[X]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant, based on the average bid and asked price of the Registrant's
Common Stock as quoted on the National Association of Securities Dealers, Inc.,
Automated Quotations National Market on November 30, 1998 was $
35,477,505(2,365,167 shares at $ 15.00 per share).
As of November 30, 1998 there were issued and outstanding 2,972,513 shares
of the Registrant's Common Stock.
DOCUMENTS INCORPORATED BY REFERENCE
1. Portions of the Annual Report to Stockholders for the Fiscal Year Ended
September 30, 1998. (Parts I, II and IV)
2. Portions of the Proxy Statement for the Annual Meeting of Stockholders to
be held January 19, 1999. (Part III)
<PAGE>
INDEX
PART I Page
Item 1. Business.............................................................1
Item 2. Properties..........................................................20
Item 3. Legal Proceedings...................................................21
Item 4. Submission of Matters to a Vote of Security Holders.................21
PART II
Item 5. Market for Registrant's Common Equity and Related
Stockholder Matters................................................21
Item 6. Selected Financial Data ............................................21
Item 7. Management's Discussion of Financial Condition and
Results of Operations..............................................21
Item 7A. Quantitative and Qualitative Disclosure about Market Risk ..........21
Item 8. Financial Statements and Supplementary Data.........................21
Item 9. Change in and Disagreements with Accountants on Accounting and
Financial Disclosure...............................................21
PART III
Item 10. Directors and Executive Officers of the Registrant..................21
Item 11. Executive Compensation..............................................21
Item 12. Security Ownership of Certain Beneficial Owners and Management......22
Item 13. Certain Relationships and Related Transactions......................22
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.....22
<PAGE>
PART I
ITEM 1. BUSINESS
General
FSF Financial Corp. (the "Company"), a Minnesota Corporation, was organized in
May, 1994, and as of October 6, 1994, became the holding company for First
Federal fsb ("First Federal" or the "Bank"). First Federal is the resulting
institution of the merger of First State Federal Savings and Loan Association,
Hutchinson, MN ("Hutchinson"), and First Federal Savings and Loan Association of
Hastings, Hastings, MN ("Hastings"). The merger of the two institutions was
completed in September, 1994 ("Merger"). Hutchinson was organized as a state
chartered mutual savings and loan association in 1933 and received a federal
charter in 1934. Hastings was initially chartered in 1881 as the "Dakota County
Building and Loan Association" and obtained a federal charter in 1968. The
Company operates three wholly owned subsidiaries, Insurance Planners, Homeowners
Mortgage Corporation ("Homeowners") and the Bank. Insurance Planners (the
"Agency") is an independent property and casualty insurance agency located in
Hutchinson, MN. Homeowners is a mortgage banking company located in Vadnais
Heights, MN. The Agency was acquired by the Company on June 1, 1998. Homeowners
is the result of an acquisition on November 17, 1998.
First Federal's business consists primarily of attracting deposits from the
general public and using such deposits, together with borrowings and other
funds, to make mortgage loans secured by residential real estate located in
Minnesota. At September 30, 1998, First Federal operated 11 retail banking
offices in Minnesota.
First Federal is regulated by the Office of Thrift Supervision ("OTS"), and by
the Federal Deposit Insurance Corporation ("FDIC") which, through the Savings
Association Insurance Fund ("SAIF"), insures, up to certain legal limits, the
deposit accounts of institutions such as First Federal. First Federal is also a
member of the Federal Home Loan Bank ("FHLB") of Des Moines, which is one of the
twelve regional banks for federally insured savings institutions and certain
other residential lending entities comprising the Federal Home Loan Bank System.
Market Area
The Bank is authorized to make loans throughout the United States. First
Federal's primary market area consists of the ten Minnesota counties of Benton,
Carver, Dakota, McLeod, Meeker, Sherburne, Sibley, Stearns, Washington, and
Wright. The market area extends from the St. Cloud area northwest of the
Minneapolis/St Paul metropolitan area to the Mississippi River southeast of the
Minneapolis/St. Paul metropolitan area. The economic composition of the market
area is extremely diverse and contains agriculture, commercial, and
manufacturing enterprises. The market area is generally considered to be a
"bedroom" community for the Minneapolis/St. Paul metropolitan area.
<PAGE>
Lending Activities
General. The following table sets forth the composition of the Bank's loan
portfolio in dollars and in percentages of total loans at the dates indicated.
<TABLE>
<CAPTION>
At September 30,
----------------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
----------------------------------------------------------------------------------------------
Amount % Amount % Amount % Amount % Amount %
----------------------------------------------------------------------------------------------
Residential real estate: (Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
One-to-four family (1) $ 157,340 52.2 $ 170,422 60.3 $ 150,102 64.7 $ 121,034 64.6 $ 89,100 72.8
Residential construction 21,960 7.3 20,796 7.4 19,676 8.5 20,366 10.9 4,474 3.7
Multi-family 2,975 1.0 3,370 1.2 3,753 1.6 3,708 2.0 3,209 2.6
----------------------------------------------------------------------------------------------
182,275 60.4 194,588 68.9 173,531 74.8 145,108 77.4 96,783 79.1
Agricultural loans 22,959 7.6 - - - - - - - -
Land and commercial real estate 34,399 11.4 38,582 13.7 18,637 8.0 16,951 9.0 7,024 5.7
Commercial business 21,095 7.0 8,114 2.9 6,089 2.6 2,715 1.4 439 0.4
----------------------------------------------------------------------------------------------
260,728 86.4 241,284 85.4 198,257 85.4 164,774 87.9 104,246 85.1
Consumer:
Home equity and second mortgage 23,606 7.8 20,812 7.4 17,692 7.6 10,950 5.8 4,427 3.6
Automobile loans 9,670 3.2 11,596 4.1 10,080 4.3 8,399 4.5 6,950 5.7
Other 7,605 2.5 8,821 3.1 6,075 2.6 3,326 1.8 6,742 5.6
----------------------------------------------------------------------------------------------
Total loans 301,609 100.0 282,513 100.0 232,104 100.0 187,449 100.0 122,365 100.0
======== ======= ======== ======= =======
Less:
Loans in process (16,658) (20,364) (13,401) (15,010) (3,982)
Deferred fees (641) (703) (757) (613) (315)
Allowance for loan losses (1,035) (852) (776) (764) (748)
---------- ---------- ---------- ---------- ----------
Total loans, net $ 283,275 $ 260,594 $ 217,170 $ 171,062 $117,320
========== ========== ========== ========== ==========
</TABLE>
- -------------------------------------
(1) Includes loans held for sale in the amount of $2.7 million, $204,000,
$443,000, $230,000 and $729,000 as of September 30, 1998, 1997, 1996, 1995,
and 1994, respectively.
The following table sets forth the Bank's loan originations, loan purchases,
loan sales, and principal payments for the periods indicated:
<TABLE>
<CAPTION>
Years Ended September 30,
-----------------------------------------------------------------
1998 1997 1996 1995 1994
-----------------------------------------------------------------
(In Thousands)
<S> <C> <C> <C> <C> <C>
Total gross loans receivable at
end of period $ 301,609 $ 282,513 $ 232,104 $ 187,449 $ 122,365
Loans originated:
Residential real estate:
One-to-four family 56,768 55,144 53,801 45,988 42,462
Residential construction 23,007 12,968 12,975 21,996 5,064
Multi-family 240 190 -- 437 --
------------------------------------------------------------------
Total residential real estate 80,015 68,302 66,776 68,421 47,526
Land and commercial real estate 4,960 20,077 3,241 8,588 1,665
Commercial business 9,801 2,402 274 250 123
Agricultural 27,049 -- -- -- --
Consumer 25,740 28,465 27,270 17,465 13,438
------------------------------------------------------------------
Total loans orginated 147,565 119,246 97,561 94,724 62,752
Purchase of loans 10,832 8,528 17,447 20,993 --
Sale of loans (24,953) (6,661) (3,509) (810) (19,141)
Principal repayments (112,284) (72,035) (63,813) (49,651) (49,698)
Other (net) (2,064) 1,331 (3,031) (172) 2,530
------------------------------------------------------------------
Net loan activity $ 19,096 $ 50,409 $ 44,655 $ 65,084 $ (3,557)
==================================================================
</TABLE>
2
<PAGE>
Maturity of Loans. The following table sets forth the maturity of the Bank's
loans at September 30, 1998. The table does not include prepayments or scheduled
principal repayments. Prepayments and scheduled principal repayments on loans
totaled $112.0 million, $72.0 million, $63.8 million, $49.7 million, and $49.7
million for the years ended September 30, 1998, 1997, 1996, 1995 and 1994,
respectively. Adjustable-rate mortgage loans are shown as maturing based on
contractual maturities.
<TABLE>
<CAPTION>
Family Multi-Family Business,
Real Estate and Commercial Agriculture and
Mortgages Real Estate Construction Consumer Total
--------------------------------------------------------------------------------------------
Amounts Due: (In Thousands)
<S> <C> <C> <C> <C> <C>
Within 3 months $ 9,296 $ 2,878 $ 4,476 $ 39,089 $ 55,739
3 months to 1 year 16,749 6,443 17,484 8,714 49,390
--------------------------------------------------------------------------------------------
Total due before one year 26,045 9,321 21,960 47,803 105,129
--------------------------------------------------------------------------------------------
After 1 year:
1 to 3 years 10,742 13,985 12,784 37,511
-
3 to 5 years 26,708 9,187 18,276 54,171
-
5 to 10 years 38,753 3,242 5,071 47,066
-
10 to 20 years 41,327 1,639 1,001 43,967
-
Over 20 years 13,765 13,765
- - -
--------------------------------------------------------------------------------------------
Total due after one year 131,295 28,053 - 37,132 196,480
-
--------------------------------------------------------------------------------------------
Total amount due $ 157,340 $ 37,374 $ 21,960 $ 84,935 $ 301,609
============================================================================================
</TABLE>
The following table sets forth the dollar amount of all loans due after
September 30, 1999, which have predetermined interest rates and which have
floating or adjustable interest rates.
<TABLE>
<CAPTION>
Fixed- Balloon Adjustable
rates Rates Rates Total
--------------- -------------- -------------- -------------
(In Thousands)
<S> <C> <C> <C> <C>
One-to four-family real estate and construction $ 76,315 $ 9,354 $ 45,626 $131,295
Land, multi-family and commercial real estate 11,601 5,144 11,308 28,053
Commercial business, agricultural and consumer 30,848 6,284 37,132
-
--------------- -------------- ------------- -------------
Total $ 118,764 $ 14,498 $ 63,218 $196,480
=============== ============== ============= =============
</TABLE>
One- to Four-Family Mortgage Loans. The largest portion of the Bank's loans are
made for the purpose of enabling borrowers to purchase one- to four-family
residences secured by first liens on the properties. The Bank originates balloon
mortgage loans, ARM loans and fixed-rate mortgage loans secured by one- to
four-family residences with loan terms up to 30 years. The Bank also offers FHA
and VA loans that are originated and then sold, servicing released, in the
secondary market. Borrower demand for balloon and ARM loans versus fixed-rate
mortgage loans depends on various factors, including, but not limited to,
interest rates offered, the expectations of changes in the short- and long-term
levels of interest rates and loan fees charged. The relative amount of
fixed-rate mortgage loans, balloon loans and ARM loans that can be originated at
any time is largely determined by the demand for each in a competitive
environment. The Bank sells substantially all of its fixed-rate loans to the
secondary market and retains servicing on loans sold to the Federal Home Loan
Mortgage Corporation ("FHLMC").
The Bank originates three-, five- and seven-year balloon mortgage loans, the
majority of which are three-year balloon mortgages. These mortgages contain no
contractual assurances that the loan will be renewed. At maturity the loan is
generally rewritten and re-recorded; however, if the borrower's loan payment
history is satisfactory, a new appraisal is not required. Management believes
that balloon loans have a pricing characteristic that helps offset the
detrimental effect that rising rates could have on net interest income because
the balloon loans do not contain interest rate adjustment caps. At September 30,
1998, balloon mortgages were $35.2 million, or 11.4% of the Bank's loan
portfolio.
The Bank offers ARM loans that adjust every year, with the initial adjustment
coming one, three, five, seven or ten years after origination. The loans have
terms from 10 to 30 years and the interest rates on these loans are generally
based on treasury bill indices. The annual interest rate cap (the maximum amount
by which the interest rate may be increased in a year) on the Bank's ARM loans
is generally 2.0% and the lifetime cap is generally 6.0% over the initial rate
of the loan. The Bank considers market factors and competitive rates on loans as
well as its own cost of funds when determining the rates on the loans it offers.
The Bank does not originate loans with negative amortization.
Residential Construction Lending. The Bank originates residential construction
loans to qualified borrowers for construction of one-to-four family residential
properties located in the Bank's market area. Construction loans are made to
builders on a pre-
3
<PAGE>
sold, speculative and model home basis and to owners for construction of their
primary residence on a construction/permanent basis. Such loans generally have
terms from six to nine months. Loans for speculative housing construction are
made to area builders only after a thorough background check has been made. The
background check includes an analysis of the builder's financial statements,
credit reports and reference checks with sub-contractors and suppliers. The Bank
usually will have no more than two speculative or model home construction loans
outstanding at any time to any single builder. Loan proceeds are disbursed in
increments as construction progresses and only after a physical inspection of
the project is made by a Bank representative. Accrued interest on loan
disbursements is paid monthly.
Loans involving construction financing present a greater level of risk than
loans for the purchase of existing homes because collateral value and
construction costs can only be estimated at the time the loan is approved. The
Bank has sought to minimize the risk by limiting construction lending to
qualified borrowers in the Bank's market area, by limiting the number of
construction loans for speculative purposes outstanding at any time, and by
installing a system to inspect the property and to monitor the loan
disbursements.
Land Acquisition and Development Loans, Commercial Real Estate and Multi-Family
Lending. The Bank originates land loans on residential properties located in the
Bank's primary market area. Land lending generally involves additional risks to
the lender as compared with residential mortgage lending. These risks are
attributable to the fact loan funds are advanced upon the security of land under
development, and predicated on the future value of the property upon completion
of development. Loans on undeveloped land may run the risk of adverse zoning
changes, environmental or other restrictions on future use. Because of these
factors, the analysis of land loans requires an expertise that is different in
significant respects from that which is required for residential lending.
Commercial real estate loans are permanent loans secured by improved property
such as office buildings, retail-wholesale facilities, industrial buildings and
other non-residential buildings. Commercial real estate loans may be originated
in amounts up to 80% of the appraised value of the mortgaged property as
determined by a certified or licensed independent appraiser.
Multi-family residential real estate loans are permanent loans secured by
apartment buildings. Of primary concern in multi-family residential real estate
lending is the borrower's creditworthiness, feasibility and cash flow potential
of the project. Loans secured by income properties generally are larger and
involve greater risks than residential mortgage loans because payments on loans
secured by income properties are often dependent on the successful operation or
management of the properties. As a result, repayment of such loans may be
subject to a greater extent than residential real estate loans to adverse
conditions in the real estate market or the economy. In order to monitor cash
flows on income properties, the Bank requires borrowers and loan guarantors, if
any, to provide annual financial statements and rent rolls on multi-family
loans. At September 30, 1998, the five largest land acquisition and development,
commercial real estate and multi-family loans ranged from $2.5 million to $5.1
million with an average committed outstanding balance of $3.8 million. All such
loans were current and have performed in accordance with their terms.
Commercial Business Lending. The Bank's commercial business loans are for a
variety of purposes including working capital, accounts receivable, inventory,
equipment and acquisitions. The Bank has no energy or foreign loans.
Unlike residential mortgage loans, which generally are made on the basis of the
borrower's ability to make repayment from his or her employment and other income
and which are secured by real property with a value that tends to be more easily
ascertainable, commercial business loans typically are made on the basis of the
borrower's ability to make repayment from the cash flow of the borrower's
business. As a result, the availability of funds for the repayment of commercial
business loans may be substantially dependent on the success of the business
itself (which is likely to be dependent upon the general economic environment.)
The Bank's commercial business loans are sometimes, but not always, secured by
business assets, such as accounts receivable, equipment and inventory, as well
as real estate. However, the collateral securing the loans may depreciate over
time, may be difficult to appraise, and may fluctuate in value based on the
success of the business.
The Bank recognizes the generally increased risks associated with commercial
business lending. The Bank's commercial business lending policy emphasizes (1)
credit file documentation, (2) analysis of the borrower's character, (3)
analysis of the borrower's capacity to repay the loan, (4) adequacy of the
borrower's capital and collateral, and (5) evaluation of the industry conditions
affecting the borrower. Analysis of the borrower's past, present and future cash
flows is also an important aspect of the Bank's credit analysis. The Bank plans
to continue to expand its commercial business lending, subject to market
conditions.
The Bank generally obtains annual financial statements from borrowers for
commercial business loans. These statements are analyzed to monitor the quality
of the loan. As of September 30, 1998, the five largest commercial business
loans ranged from $1.4 million to $5.5 million, with an average committed
balance outstanding of $3.3 million. All such loans are current and have
performed in accordance with their terms.
Agricultural Lending. The Bank originates loans to finance the purchase of
farmland, livestock, farm machinery and equipment, seed, fertilizer and for
other farm related products. Agricultural operating loans are originated at
either an adjustable or fixed
4
<PAGE>
rate of interest for up to a one year term or, in the case of livestock, upon
sale. Most agricultural operating loans have terms on one year or less. Such
loans provide for payments of principal and interest at least annually, or a
lump sum payment upon maturity in the original term is less than one year. Loans
secured by agricultural machinery are generally originated as fixed-rate loans
with terms of up to five years.
Agricultural real estate loans are frequently originated with adjustable rates
of interest. Generally, such loans provide for a fixed rate of interest for the
first three years, adjusting annually thereafter. In addition, such loans
generally provide for a ten year term based on a 20 year amortization schedule.
Adjustable-rate agricultural real estate loans are generally limited to 80% of
the value of the property securing the loan.
Agricultural lending affords the Bank the opportunity to earn yields higher than
those obtainable on one- to four-family residential lending. Nevertheless,
agricultural lending involves a greater degree of risk than one- to four-family
residential mortgage loans because of the typically larger loan amount. In
addition, payments on loans are dependent on the successful operation or
management of the farm property securing the loans or for which an operating
loan is utilized. The success of the loan may also be affected by many factors
outside the control of the farm borrower.
Weather presents one of the greatest risks as hail, drought, floods, or other
conditions, can severely limit crop yields and thus impair loan repayments and
the value of the underlying collateral. This risk can be reduced by the farmer
with multi-peril crop insurance which can guarantee set yields to provide
certainty of repayment. Unless the circumstances of the borrower merit
otherwise, the Bank generally does not require its borrowers to procure
multi-peril crop or hail insurance. However, recent changes in government
support programs generally require that farmers procure multi-peril crop
insurance to be eligible to participate in such programs.
Grain and livestock prices also present a risk as prices may decline prior to
sale resulting in a failure to cover production costs. These risks may be
reduced by the farmer with the use of futures contracts or options to provide a
"floor" below which prices will not fall. The Bank does not monitor or require
the use by borrowers of future contracts or options.
Another risk is the uncertainty of government programs and other regulations.
Some farmers rely on the income from government programs to make loan payments
and if these programs are discontinued or significantly changed, cash flow
problems or defaults could result.
Finally, many farms are dependent on a limited number of key individuals whose
injury or death may result in an inability to successfully operate the farm. At
September 30, 1998, the five largest agricultural loans ranged from $660,000 to
$4.6 million, with an average committed outstanding balance of $1.6 million. All
such loans are in the Bank's market area, are current and have performed in
accordance with their terms.
Consumer and Other Loans. The Bank offers consumer and other loans in the form
of home equity and second mortgage loans, automobile loans and loans for other
purposes. Federal regulations permit federally chartered thrift institutions to
make secured and unsecured consumer loans up to 35% of an institution's assets.
The Bank originates consumer loans in order to provide a wide range of financial
services to its customers and because the shorter terms and normally higher
interest rates on such loans help maintain a profitable spread between its
average loan yield and the Bank's cost of funds.
In connection with consumer loan applications, the Bank verifies the borrower's
income and reviews credit bureau reports. In addition, the relationship of the
loan to the value of the collateral is considered. Consumer loans entail greater
risks than one-to- four family residential mortgage loans, particularly consumer
loans secured by rapidly depreciable assets such as automobiles or loans that
are unsecured. In such cases, any repossessed collateral for a defaulted loan
may not provide an adequate source of repayment of the outstanding loan balance,
since there is a greater likelihood of damage, loss or depreciation of the
underlying collateral. Further, consumer loan collections are dependent on the
borrower's continuing financial stability, and therefore are more likely to be
adversely affected by job loss, divorce, illness or personal bankruptcy.
Finally, the application of various federal and state laws, including federal
and state bankruptcy and insolvency laws, may limit the amount which can be
recovered on such loans in the event of a default. At September 30, 1998,
consumer loans 90 days or more delinquent totaled $69,000 or 0.18% of such
loans. Management believes that the Bank's level of consumer loan delinquencies
is relatively low in comparison to other financial institutions. No assurance
can be given, however, that the Bank's delinquency rate on consumer loans will
continue to remain low in the future.
Loan Approval Authority and Underwriting. First Federal's primary source of
mortgage loan applications is referrals from existing or past customers. The
Bank also solicits applications from real estate brokers, contractors, and
call-ins and walk-ins to its offices. First Federal advertises in local
newspapers for first mortgage and home equity loans.
Upon receipt of any loan application from a prospective borrower, a credit
report is ordered and verifications of specific information relating to the loan
applicant's employment, income and credit standing are requested. An appraisal
or valuation determination, subject to regulatory requirements, of the real
estate intended to secure the proposed loan is undertaken. First
5
<PAGE>
Federal utilizes the services of Board approved appraisers and two authorized
appraisers on staff at the Bank. In connection with the loan approval process,
First Federal's loan officers analyze the loan applications and the property
involved. All residential, home equity, multi-family, construction and
commercial real estate loans are underwritten and processed at First Federal's
main office by First Federal's loan servicing department, subject to the loan
underwriting policies as approved by the Board of Directors. The Chief Executive
Officer, President, and the Directors of Lending are authorized to approve all
one-to-four family applications. In general, loans in excess of $1.0 million
must be approved by the Board of Directors.
Loan applicants are promptly notified of the decision of the Bank by a letter
setting forth the terms and conditions of the decision. If approved, these terms
and conditions include the amount of the loan, interest rate basis, amortization
term, a brief description of real estate to be mortgaged to First Federal, and
the notice of requirement of insurance coverage to be maintained to protect the
Bank's interest. First Federal requires title insurance or a title opinion on
first mortgage loans and fire and casualty insurance on all properties securing
loans, which insurance must be maintained during the entire term of the loan.
The Bank also requires flood insurance, if appropriate, in order to protect
First Federal's interest in the property.
Loans-to-One Borrower. Under federal law, federally-chartered savings banks
have, subject to certain exemptions, aggregate lending limits to one borrower
equal to 15% of the institution's unimpaired capital and surplus. As of
September 30, 1998, First Federal's five largest lending relationships included
$5.1 million in land development loans to a local developer, a $5.0 million line
of credit to an unaffiliated mortgage-banking company, a $5.5 million commercial
line of credit participation loan, a $4.7 million commercial real estate loan,
and a $4.6 million agricultural line of credit participation loan, which is
approximately 15% of the total loan. At September 30, 1998, all of these loans
were within the loans to one borrower limitations, performing in accordance with
their terms, and at market rates of interest.
Loan Servicing. The Bank services substantially all of the loans which it
retains in its portfolio. Loan servicing includes collecting and remitting loan
payments, accounting for principal and interest, making advances to cover
delinquent payments, making inspections as required of mortgaged premises,
contacting delinquent mortgagors, supervising foreclosures and property
dispositions in the event of unremedied defaults and generally administering the
loans. Funds that have been escrowed by borrowers for the payment of
mortgage-related expenses, such as property taxes and hazard and mortgage
insurance premiums, are maintained in noninterest-bearing accounts at the Bank.
At September 30, 1998, the Bank had $274,000 deposited in escrow accounts for
its loans serviced for others.
The following table presents information regarding the loans serviced by the
Bank for others at the dates indicated.
September 30,
----------------------------------------
Mortgage loan portfolios serviced for: 1998 1997 1996
----------------------------------------
(In Thousands)
FHLMC $ 42,038 $ 38,137 $ 40,561
Other Investors 4,418 4,597 572
----------------------------------------
$ 46,456 $ 42,734 $ 41,133
========================================
The Bank receives fees for servicing mortgage loans, which generally amount to
0.25% per annum on the declining balance of mortgage loans. Such fees serve to
compensate the Bank for the costs of performing the servicing functions. Other
sources of loan servicing revenues include late charges. For the years ended
September 30, 1998, 1997 and 1996, the Bank earned gross fees of $234,000,
$204,000 and $194,000, respectively from loan servicing. The Bank retains a
portion of funds received from borrowers on the loans it services for others in
payment of its servicing fees received on loans serviced for others.
Non-Performing and Problem Assets
Loan Collections and Delinquent Loans. The Bank's collection procedures provide
that when a loan is 30 days or more delinquent, the borrower is contacted by
mail and telephone and payment is requested. If the delinquency continues,
subsequent efforts will be made to contact the delinquent borrower. In certain
instances, the Bank may modify the loan or grant a limited moratorium on loan
payments to enable the borrower to reorganize his financial affairs. Once a loan
delinquency exceeds 60 days it is classified as special mention and the Bank
attempts to work with the borrower to establish a repayment schedule to cure the
delinquency. If the borrower is unable to cure the delinquency, the Bank will
institute foreclosure actions. If a foreclosure action is taken and the loan is
not reinstated, paid in full or refinanced, the property is sold at a judicial
sale at which the Bank may be the buyer if there are no offers to satisfy the
debt. Any property acquired as the result of a foreclosure or by deed in lieu of
foreclosure is classified as foreclosed real estate until such time as it is
sold or otherwise disposed of by the Bank. At September 30, 1998, the Bank had
$502,000 of foreclosed real estate, consisting of two one-to-four family
residential loans and a commercial real estate loan. When foreclosed real estate
is acquired, it is recorded at the lower of the unpaid principal balance of the
related loan or its fair market value less related disposition costs. Any
writedown of the property is charged to the allowance for losses.
6
<PAGE>
Non-performing Assets. Loans are reviewed on a regular basis and are placed on
non-accrual status when, in the opinion of management, the collection of
additional interest is doubtful. Residential mortgage loans are placed on
non-accrual status when either principal or interest is 90 days or more past
due. Consumer loans are generally charged off when the loan becomes over 90 days
delinquent. Commercial business and real estate loans are generally placed on
non-accrual status when the loan is 90 days or more past due. Interest accrued
and unpaid at the time a loan is placed on non-accrual status is charged against
interest income. Subsequent payments are either applied to the outstanding
principal balance or recorded as interest income, depending on the assessment of
the ultimate collectibility of the loan. At September 30, 1998, the Bank had
approximately $1.3 million of loans that were more than 60 days delinquent.
The following table sets forth information with respect to the Bank's
non-performing assets for the periods indicated. During the periods indicated
the Bank had no restructured loans within the meaning of SFAS No. 15.
<TABLE>
<CAPTION>
At September 30,
------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
------------------------------------------------------------------------------------
(Dollars in Thousands)
Loans accounted for on a non-accrual basis:
Mortgage loans:
<S> <C> <C> <C> <C> <C>
Residential construction loans $ - $ 393 $ - $ 209 $ -
Permanent loans secured by one-to
four-family units 240 25 129 138 26
Permanent loans secured by non-
residential real estate - - - - -
Other - - - - 293
Non-mortgage loans:
Commercial and agricultural - - - - -
Consumer 69 82 90 33 21
------------------------------------------------------------------------------------
Total non-accrual loans 309 500 219 380 340
Foreclosed real estate and real estate
held for investment 502 72 - - 247
------------------------------------------------------------------------------------
Total non-performing assets $ 811 $ 572 $ 219 $ 380 $ 587
====================================================================================
Total non-performing loans to net loans 0.11% 0.19% 0.10% 0.22% 0.27%
====================================================================================
Total non-performing loans to total assets 0.07% 0.13% 0.06% 0.12% 0.11%
====================================================================================
Total non-performing assets to total assets 0.19% 0.15% 0.06% 0.12% 0.20%
====================================================================================
</TABLE>
During the years ended September 30, 1998, 1997, 1996, 1995 and 1994,
approximately $35,317, $22,833, $11,812, $11,593, and $6,109, respectively would
have been recorded on loans accounted for on a non-accrual basis if such loans
had been current according to the original loan agreements for the entire
period. These amounts were not included in the Bank's interest income for the
respective periods. No interest income on loans accounted for on a non-accrual
basis was included in income during any of these periods.
Classified Assets. Management, in compliance with regulatory guidelines, has
instituted an internal loan review program, whereby loans are classified as
special mention, substandard, doubtful or loss. When a loan is classified as
substandard or doubtful, management is required to establish a general valuation
reserve for loan losses in an amount that is deemed prudent. General allowances
represent allowances which have been established to recognize inherent risk
associated with lending activities, but which, unlike specific allowances, have
not been allocated to particular problem assets. When management classifies a
loan as "loss", a reserve equal to 100% of the loan balance may be established
or the loan is charged-off.
An asset is considered "substandard" if it is inadequately protected by the
paying capacity and net worth of the obligor or the collateral pledged, if any.
"Substandard" assets include those characterized by the "distinct possibility"
that the institution will sustain "some loss" if the deficiencies are not
corrected. Assets classified as "doubtful" have all of the weaknesses inherent
in those classified substandard, with the added characteristic that the
weaknesses present make "collection or liquidation in full," "highly
questionable and improbable," on the basis of currently existing facts,
conditions, and values. Assets classified as "loss" are those considered
"uncollectible" and of such little value that their continuance as assets
without the establishment of a specific loss reserve is not warranted. Assets
which do not currently expose the insured institution to a sufficient degree of
risk to warrant classification in one of the aforementioned categories but
possess credit deficiencies or potential weaknesses, including all loans over 60
days delinquent, are required to be designated "special mention" by management.
The OTS has promulgated regulations that discontinue the classification of
assets as special mention. However, the Bank continues to utilize this category.
Management's evaluation of the classification of assets and the adequacy of the
reserve for loan losses is reviewed by regulatory agencies as part of their
periodic examinations. At September 30, 1998, First Federal had total classified
assets of $1.7 million of which $789,000 were considered substandard, and no
assets were classified as doubtful or loss. Special mention assets totaled
$925,000 at September 30, 1998.
7
<PAGE>
Allowance for Loan and Lease Losses and Foreclosed Real Estate. In making loans,
First Federal recognizes that credit losses will be experienced and that the
risk of loss will vary with, among other things, the type of loan being made,
the creditworthiness of the borrower over the term of the loan, and in the case
of a secured loan, the quality of the collateral for the loan. First Federal's
management evaluates the need to establish reserves against losses on loans and
other assets each quarter based on estimated losses on specific loans and on any
real estate held for sale or investment when a finding is made that a loss is
estimable and probable. Such evaluation includes a review of all loans for which
full collectibility may not be reasonably assured and considers, among other
matters, the estimated market value of the underlying collateral of problem
loans, prior loss experience, economic conditions and overall portfolio quality.
While management recognizes and charges against the allowance for loan losses
accounts which are determined to be uncollectible, experience indicates that at
any point in time, possible losses may exist in the loan portfolio which are not
specifically identifiable. Therefore, based upon management's best estimate,
each year an amount may be charged to earnings to maintain the allowance for
loan losses at a level sufficient to recognize potential risk.
Impaired loans, including all loans that are restructured in a troubled debt
restructuring involving a modification of terms, are measured at the present
value of expected future cash flows discounted at the loan's initial effective
interest rate. The fair value of the collateral of an impaired
collateral-dependent loan or an observable market price, if one exists, may be
used as an alternative to discounting. If the measure of the impaired loan is
less than the recorded investment in the loan, impairment is recognized through
the allowance for loan losses. A loan is considered impaired when, based on
current information and events, it is probable that the Bank will be unable to
collect all amounts due according to the contractual terms of the loan
agreement.
First Federal believes it has established its existing allowance for loan losses
in accordance with GAAP. However, there can be no assurance that banking
regulators, in reviewing the Bank's loan portfolio, will not request First
Federal to significantly increase its allowance for loan losses, or that a
deteriorating real estate market or other unforeseen economic changes, may cause
First Federal to significantly increase its allowance for loan losses, therefore
negatively affecting First Federal's financial condition and earnings.
8
<PAGE>
The following table sets forth information with respect to the Bank's allowance
for loan losses at the dates indicated:
<TABLE>
<CAPTION>
At September 30,
-----------------------------------------------------------------------------------
1998 1997 1996 1995 1994
-----------------------------------------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
Total loans outstanding $ 301,609 $282,513 $ 232,104 $ 187,449 $ 122,365
===================================================================================
Average loans outstanding $ 276,730 $237,475 $ 193,202 $ 142,711 $ 119,133
===================================================================================
Allowance balance (beginning of period) $ 852 $ 776 $ 764 $ 748 $ 721
-----------------------------------------------------------------------------------
Provision (credit):
Residential - - - - 27
Commercial real estate 2 40 - - -
Land and commercial/agricultural business 293 - - - -
Consumer 7 80 42 24 6
-----------------------------------------------------------------------------------
Total provision 302 120 42 24 33
Charge-off:
Residential 45 13 - - -
Commercial real estate - - - - -
Consumer 87 37 34 20 6
-----------------------------------------------------------------------------------
Total charge-offs 132
50 34 20 6
Recoveries:
Residential - - - - -
Commercial real estate - - - - -
Consumer 13 6 4 12 -
-----------------------------------------------------------------------------------
Total recoveries 13 6 4 12 -
-----------------------------------------------------------------------------------
Net charge-offs 119 44 30 8 6
-----------------------------------------------------------------------------------
Allowance balance (at end of period) $ 1,035 $ 852 $ 776 $ 764 $ 748
===================================================================================
Allowance as percent of total loans 0.34% 0.30% 0.33% 0.41% 0.61%
Net loans charged off as a percent of
average loans 0.04% 0.02% 0.02% 0.01% 0.01%
</TABLE>
To further monitor and assess the risk characteristics of the loan portfolio,
loan delinquencies are reviewed to consider any developing loan problems. Based
upon the procedures in place, First Federal's experience regarding charge-offs
and recoveries and the current risk elements in the portfolio, management
believes the allowance for loan losses at September 30, 1998, is adequate.
However, assessment of the adequacy of the allowance for loan losses involves
subjective judgments regarding future events and thus there can be no assurance
that additional provisions for loan losses will not be required in future
periods.
The following table sets forth the breakdown by loan category of the allowance
for loan losses.
<TABLE>
<CAPTION>
September 30,
--------------------------------------------------------------------------------------------
1998 1997 1996 1995 1994
--------------------------------------------------------------------------------------------
Percent Percent Percent Percent Percent
of Total of Total of Total of Total of Total
Amount Loans Amount Loans Amount Loans Amount Loans Amount Loans
--------------------------------------------------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Real estate loans $ 368 60.4% $ 413 68.9% $ 426 74.8% $ 675 77.5% $ 675 79.1%
Consumer and commercial business, land,
commercial real estate and agricultural 667 39.6% 439 31.1% 350 25.2% 89 22.5% 73 20.9%
--------------------------------------------------------------------------------------------
$1,035 100.0% $ 852 100.0% $ 776 100.0% $ 764 100.0% $ 748 100.0%
============================================================================================
</TABLE>
Investment and Mortgage-backed Securities Activities
General. Federally-chartered thrift institutions have the authority to invest in
various types of liquid assets, including United States Treasury obligations,
securities of various Federal agencies, certain certificates of deposit of
insured banks and savings institutions, certain bankers' acceptances, repurchase
agreements, and loans on Federal Funds. To supplement lending activities,
subject to various restrictions, First Federal invests a portion of its assets
in commercial paper, corporate debt
9
<PAGE>
securities and asset-backed securities (e.g., mortgage-backed securities). A
significant portion of First Federal's income during recent years has been
attributable to interest income on such securities. The Corporation does not
have the same investment limitations as the Bank.
Mortgage-backed and Related Securities. First Federal invests in residential
mortgage-backed securities guaranteed by participation certificates issues by
FHLMC and Government National Mortgage Association ("GNMA"). The mortgage-backed
securities portfolio as of September 30, 1998, consisted primarily of Real
Estate Mortgage Investment Conduits ("REMICs") ($53.3 million).
At September 30, 1998, the carrying value of mortgage-backed and related
securities held to maturity totaled $36.4 million, or 8.7% of total assets. The
market value of such securities totaled approximately $35.4 million at September
30, 1998. First Federal also held $16.6 million of mortgage-backed and related
securities that were classified available for sale.
Mortgage-backed securities 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 quasi-governmental agencies) that pool and repackage the
participation interest in the form of securities to investors such as the Bank.
Such quasi-governmental agencies, which guarantee the payment of principal and
interest to investors, primarily include FHLMC, FNMA, and 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
underlying pool of mortgages is primarily composed of either fixed-rate
mortgages or ARM loans. Mortgage-backed securities are generally referred to as
mortgage participation certificates or pass-through certificates. As a result,
the interest rate risk 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 life of a mortgage-backed pass-through security
is equal to the life of the underlying mortgages. Mortgage-backed securities
issued by FHLMC, FNMA, and GNMA make up a majority of the pass-through market.
Mortgage-backed securities provide for monthly payments of principal and
interest and generally have contractual maturities ranging from five to thirty
years. In periods of declining interest rates, payments on many mortgages is
received faster than the contractual amount required, causing the estimated
lives of mortgage-related securities to be significantly shorter than expected.
REMICs are typically issued by a special-purpose entity (the "issuer"), which
may be organized in a variety of legal forms, such as a trust, a corporation, or
a partnership. The entity aggregates pools of pass-through securities, which are
used to collateralize the mortgage related securities. Once combined, the cash
flows can be divided into "tranches" or "classes" of individual securities,
thereby creating more predictable average duration for each security than the
underlying pass-through pools. Accordingly, under this security structure all
principal pay downs from the various mortgage pools are allocated to a
mortgage-related class or classes structured to have priority until it has been
paid off. Thus, these securities are intended to address the reinvestment
concerns associated with mortgage-backed securities pass-through, namely that
(i) they tend to pay off when interest rates fall, thereby taking their
relatively high coupon with them, and (ii) their expected average life may vary
significantly among the different tranches.
Some REMIC instruments are more like traditional debt instruments because they
have stated principal amounts and traditionally defined interest rate terms.
Purchasers of certain other REMIC securities are entitled to the excess, if any,
of the issuer's cash inflows, including reinvestment earnings, over the cash
outflows for debt service and administrative expenses. These mortgage related
instruments may include instruments designated as residual interests, and are
riskier in that they could result in the loss of a portion of the original
investment. Cash flows from residual interests are very sensitive to prepayments
and, thus, contain a high degree of interest-rate risk. Residual interests
represent an ownership interest in the underlying collateral, subject to the
first lien of the REMICs investors.
The REMICs held by First Federal at September 30, 1998, consisted of
floating-rate tranches. The interest rate of all of the Bank's floating-rate
securities adjusts monthly and provides the institution with net interest margin
protection in an increasing market rate environment. The securities are backed
by mortgages on one- to four-family residential real estate and have contractual
maturities up to 30 years. None of the securities are deemed to be "High Risk"
according to OTS guidelines. The securities are primarily companion tranches to
"PACs" and "TACs". PACs and TACs (Planned and Targeted Amortization Classes) are
designed to provide a specific principal and interest cash-flow. Principal
payments that are received in excess of the amount needed for the PACs and TACs
are allocated to the companion tranches. When the PACs and TACs are repaid in
full, all principal is then used to pay the companion tranches. Although the
timing of principal payments may be impacted by the amount of prepayments (the
higher the level of prepayments, the sooner the principal will be received), all
of the principal and interest payments are guaranteed.
Investment Securities. First Federal is required under federal regulations to
maintain a minimum amount of liquid assets which may be invested in specified
short-term securities and certain other investments. Liquidity levels may be
increased or
10
<PAGE>
decreased depending upon the yields on investment alternatives and upon
management's judgment as to the attractiveness of the yields then available in
relation to other opportunities and its expectations of future yield levels, as
well as management's projections as to the short-term demand for funds to be
used in First Federal's loan origination and other activities. At September 30,
1998, the carrying value of debt securities held to maturity totaled $24.4
million, or 5.9% of total assets. The market value of such securities totaled
$24.0 million at September 30, 1998. These securities consisted mainly of U.S.
Government Securities and U.S. government agency obligations. The Bank also held
available for sale debt and equity securities with a market value of $3.0
million and $19.5 million respectively, at September 30, 1998.
The Investment Policy of First Federal, which is established by the Board of
Directors, is designed to provide and maintain liquidity, to generate favorable
return on investments without incurring undue interest rate and credit risk, and
to compliment First Federal's lending activity. The policy currently provides
for investments held to maturity and investments available for sale.
The amount of short-term securities in excess of regulatory requirements
reflects management's strategy to provide interest rate adjustments for
securities that are shorter than their maturity. It is the intention of
management to maintain a repricing structure in the Bank's investment portfolio
that better matches the interest rate sensitivities of its assets and
liabilities. However, during periods of rapidly declining interest rates, such
investments also decline at a faster rate than the yields on fixed-rate
investments. Investment decisions are made within policy guidelines established
by the Board of Directors. Unless loan demand increases, the Bank intends to
maintain its investments at current levels.
Investment and Mortgage-backed Securities Portfolio. The following table sets
forth the carrying value of First Federal's investment securities portfolio,
short-term investments, FHLB stock, and mortgage-backed and related securities
at the dates indicated. At September 30, 1998, the market value of the debt and
equity securities portfolio (including securities available for sale) and
mortgage-backed and related securities portfolio (including mortgage-backed
securities available for sale) was $46.4 and $51.9 million, respectively.
<TABLE>
<CAPTION>
September 30,
---------------------------------------------------
1998 1997 1996
------------ ------------- ------------
(In Thousands)
Investment securities:
<S> <C> <C> <C>
Debt securities $ 24,412 $ 37,876 $ 44,349
Debt securities available for sale 3,010 1,000 -
FHLB Stock 7,363 6,692 5,736
Equity securities available for sale 12,096 12,619 12,495
----------- ----------- -----------
Total investment securities 46,881 58,187 62,580
Interest-bearing deposits 17,370 3,645 9,392
Federal funds sold
- - -
Mortgage-backed and related securities:
Mortgage-backed and related securities 36,418 38,539 38,557
Mortgage-backed and related securities
available for sale 16,574 16,699 16,336
----------- ----------- -----------
Total mortgage-backed and related securities 52,992 55,238 54,893
----------- ----------- -----------
Total investments $ 117,243 $ 117,070 $ 126,865
=========== =========== ============
</TABLE>
11
<PAGE>
The following table sets forth certain information regarding the carrying
values, weighted average yields and maturities of the Bank's investment
portfolio at September 30, 1998.
<TABLE>
<CAPTION>
September 30, 1998
------------------------------------------------------------------------------------------------------------
One Year One to Five to More than
Adjustable or Less Five Years Ten Years Ten Years Total Investment Securities
-------------- --------------- ------------- -------------- -------------- ---------------------------
Carry- Carry- Carry- Carry- Carry- Carry-
ing Average ing Average ing Average ing Average ing Average ing Average Market
Value Yield Value Yield Value Yield Value Yield Value Yield Value Yield Value
----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- ----- -----
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C> <C>
U.S. Government
and Federal
Agency Obligations
held to maturity $ -- -- % $3,502 2.89% $ 7,628 5.26% $7,065 3.69% $6,217 7.48% $ 24,412 4.97% $ 23,953
Federal Agency
Obligations
available for sale -- -- -- -- 3,010 6.30 -- -- -- -- 3,010 6.30 3,010
Equity Securities
available for sale 12,096 5.52 -- -- -- -- -- -- -- -- 12,096 5.52 12,096
FHLB Stock N/A N/A N/A N/A N/A N/A N/A N/A N/A N/A 7,363 7.00 7,363
Mortgage-backed
and related securities
held to maturity 36,369 5.33 -- -- 3 6.50 23 7.60 23 17.00 36,418 5.33 35,369
Mortgage-backed and
related securities
available for sale 16,574 5.15 -- -- -- -- -- -- -- -- 16,574 5.15 16,574
Interest-bearing
deposits 17,370 5.08 -- -- -- -- -- -- -- -- 17,370 5.80 17,370
------- ------ ------- ------ ------ ----- -------- --------
Total $82,409 5.26% $3,502 2.89% $10,641 5.55% $7,088 3.70% $6,240 7.49% $117,243 5.40% $115,735
======= ====== ======= ====== ====== ======== ========
</TABLE>
12
<PAGE>
Deposits and Other Sources of Funds
General. Deposits are the major source of First Federal's funds for lending and
other investment purposes. In addition to deposits, the Bank derives funds from
loan and mortgage-backed securities principal payments, interest on investment
securities, proceeds from the maturity of mortgage-backed securities and
investment securities and borrowings. Loan and mortgage-backed securities
payments are a relatively stable source of funds, while deposit inflows are
significantly influenced by general interest rates and money market conditions.
Borrowings may be used on a short-term basis to compensate for reductions in the
availability of funds from other sources. They also may be used on a longer-term
basis for general business purposes.
Deposits. First Federal offers a wide variety of deposit accounts. It constantly
strives to meet consumers' needs by offering new products. This, in addition to
interest rate risk management and asset/liability ratios, is taken into
consideration prior to offering new products. Deposit account terms vary,
primarily as to the required minimum balance amount, the amount of time that the
funds must remain on deposit and the applicable interest rate.
First Federal's current deposit products include regular savings, demand
deposits, NOW, money market and certificates of deposit accounts ranging in
terms from ninety-one days to five years including certificates of deposit with
negotiable interest rates and balances in excess of $100,000 (jumbo
certificates), and Individual Retirement Accounts (IRAs). All checking and
savings accounts are eligible for an Express Teller ATM card. This card can be
used at any Express Teller, Fastbank, or Instant Cash ATM in Minnesota and
surrounding states. With the addition of the Plus and Cirrus network automated
banking system, First Federal's Express Teller ATM card can be used at thousands
of ATM locations throughout the United States and the world.
Deposits are obtained primarily from residents in the Minnesota counties of
McLeod, Dakota, Meeker, Sibley, Carver, Wright, Benton, Sherburne, Stearns and
Washington. First Federal attracts deposit accounts by offering a wide variety
of products, competitive interest rates, and convenient locations and service
hours. The Bank uses traditional methods of advertising to attract new customers
and deposits, including radio and print media advertising.
First Federal pays interest on its deposits which are competitive in its market.
Interest rates on deposits are set weekly, based on a number of factors,
including: (1) the previous week's deposit flow; (2) a current survey of a
selected group of competitors' rates for similar products; (3) external data
which may influence interest rates; (4) investment opportunities and loan
demand; and (5) scheduled maturities.
The following table shows the amounts of First Federal's deposits by type of
account at the dates indicated.
September 30,
-----------------------------------------------
1998 1997 1996
-----------------------------------------------
(In Thousands)
NOW Accounts $ 22,136 $ 24,740 $ 22,416
Commercial Demand 8,163 3,319 5,185
Savings Accounts 53,984 47,847 48,334
-----------------------------------------------
84,283 75,906 75,935
-----------------------------------------------
Certificates of Deposit:
3.00 to 4.00% 3,744 4,204 422
4.01 to 5.00% 17,925 14,796 28,155
5.01 to 6.00% 52,303 50,460 64,367
6.01 to 7.00% 62,462 56,604 13,693
7.01 to 8.00% 3,143 - 6,502
8.01% and over 2,682 6,276 -
-----------------------------------------------
142,259 132,340 113,139
-----------------------------------------------
Total deposits $ 226,542 $ 208,246 $ 189,074
===============================================
13
<PAGE>
The following table sets forth the amount and maturities of time deposits at
September 30, 1998.
<TABLE>
<CAPTION>
Amount Due
--------------------------------------------------------------------------------
Less than 1 - 2 2 - 3 Greater than
One Year Years Years 3 years Total
--------------------------------------------------------------------------------
Interest Rate (In Thousands)
<S> <C> <C> <C> <C> <C>
2.01 - 4.00% $ 3,681 $ 38 $ 25 $ - $ 3,744
4.01 - 6.00% 52,035 13,350 2,299 2,544 70,228
6.01 - 8.00% 23,886 29,699 9,880 2,140 65,605
Over 8.00% 2,143 539 - - 2,682
-----------------------------------------------------------------------------------
$ 81,745 $43,626 $ 12,204 $ 4,684 $ 142,259
================================================================================
</TABLE>
The following table indicates the amount of the Bank's certificates of deposit
of $100,000 or more by time remaining until maturity as of September 30, 1998.
Certificates
of
Maturity Period Deposits
- --------------------- ------------------
(In Thousands)
Within three months $ 2,850
Three through six months 4,410
Six through twelve months 11,179
Over twelve months 5,872
------------------
$ 24,311
==================
Borrowings. Savings deposits are the primary source of funds for First Federal's
lending and investment activities and for its general business purposes. The
Bank, if the need arises, may rely upon advances from the FHLB of Des Moines to
supplement its supply of lendable funds and to meet deposit withdrawal
requirements. Advances from the FHLB of Des Moines are typically secured by
First Federal's stock in the FHLB and a portion of First Federal's residential
mortgage loans and other assets (principally securities which are obligations of
or guaranteed by the U.S. Government). First Federal has an Open Line of Credit
("LOC") in the amount of $12.5 million with the FHLB, which had an outstanding
balance of $12.5 million. The LOC requires an annual review and a commitment fee
of 0.05%. The LOC is reviewed for renewal annually. The LOC is maintained in
order to help meet on-going liquidity and cash flow needs of First Federal.
Advances have been utilized when adequate spreads can be obtained and the risk
(credit risk, interest rate risk, and market risk) in the transaction minimized.
Advances have been used to purchased mortgage-backed and related securities and
to purchase single family residential mortgages originated by other financial
institutions within the state of Minnesota.
The following table sets forth certain information as to the Bank's FHLB
advances at the date indicated.
As of and for the Years Ended
September 30,
-------------------------------------------------
1998 1997 1996
-------------------------------------------------
(Dollars in Thousands)
Maximum balance $ 147,234 $113,839 $ 114,693
Average balance 145,459 120,093 90,408
Balance at end of period 144,177 133,817 114,693
Weighted average rate:
at end of period 5.42% 5.83% 5.88%
during the period 5.79% 5.83% 5.91%
It is First Federal's policy to fund loan demand and investment opportunities
out of current loan and mortgage-backed securities repayments, investment
maturities and new deposits. However, the Bank has, in recent periods, increased
its utilization of FHLB advances to supplement these sources. This policy may
change in the future as investment opportunities are presented or loan demand
increases.
Subsidiary Activity
As of September 30, 1998, the Company had two directly owned subsidiaries: the
Bank and the Agency.
14
<PAGE>
First Federal is permitted to invest up to 2% of its assets in the capital stock
of, in secured or unsecured loans to, subsidiary corporations, with an
additional investment of 1% of assets when such additional investment is
utilized primarily for community development purposes. Under such limitations,
as of September 30, 1998, First Federal was authorized to invest up to
approximately $8.3 million in the stock of service corporations (based upon the
2% limitation). First Federal has one wholly-owned subsidiary, Firstate
Services, Inc. ("FSI"). FSI was incorporated in the State of Minnesota in
August, 1983, and is engaged in the sale, on an agency basis, of mutual funds,
annuities and life, credit life and disability insurance products. As of
September 30, 1998, the net book value of First Federal's investment in stock,
unsecured loans, and conforming loans in its subsidiary was $196,587. For the
fiscal year ended September 30, 1998, FSI had net income of $44,610.
Insurance Planners ("the Agency") was incorporated in the state of Minnesota in
August, 1983, and is engaged in the sale, on an agency basis, of property and
casualty insurance products. As of September 30, 1998, the net book value of
First Federal's investment in stock , unsecured loans, and conforming loans in
its subsidiary was $660,703. For the four month period ended September 30, 1998,
the Agency had net income of $19,234.
On November 17, 1998, the Company acquired, in a transaction that was a
combination of stock and cash, all of the outstanding shares of Homeowners
Mortgage Corporation ("Homeowners"). Homeowners was organized in 1988, and
originates residential mortgage loans from three locations in Minnesota.
Personnel
As of September 30,1998, First Federal had 85 full-time employees and 44
part-time employees, representing a total of 102.0 full-time equivalents. The
employees are not represented by a collective bargaining agreement. First
Federal believes its relationship with its employees is satisfactory.
Competition
First Federal faces strong competition in its attraction of savings deposits,
which are its primary source of funding for lending, and in the origination of
real estate loans. The Bank's competition for savings deposits and loans
historically has come from other savings institutions and commercial banks
located in First Federal's market area. However, in recent years, mortgage
bankers have captured a larger share of the mortgage market. The size and number
of mortgage bankers, as well as their decreased costs due to less regulatory
oversight, has contributed to their growth. First Federal also faces competition
for investor funds from credit unions, investment firms and insurance companies.
First Federal competes for loans and deposits by charging competitive interest
rates and loan fees, remaining efficient, marketing aggressively and providing a
wide range of services to its customers. First Federal offers all consumer
banking services such as checking accounts, certificates of deposits, retirement
accounts, consumer and mortgage loans and ancillary services such as convenient
offices and drive-up facilities, automated teller machines and overdraft
protection.
Bank Regulation
General
First Federal is a federally chartered savings bank and a member of the FHLB of
Des Moines. First Federal's deposits are insured by the FDIC through the SAIF.
First Federal is subject to examination and regulation by the OTS and the FDIC
with respect to most of its business activities, including, among others,
lending activities, capital standards, general investment authority, deposit
taking and borrowing authority, mergers and other business combinations,
establishment of branch offices, and permitted subsidiary investments and
activities. The OTS's operations, including examination activities, are funded
by assessments levied on its regulated institutions.
First Federal is further subject to regulations of the Board of Governors of the
Federal Reserve System (the "Federal Reserve Board") concerning reserves
required to be maintained against deposits and certain other matters. Financial
institutions, including the Bank, may also be subject, under certain
circumstances, to potential liability under various statutes and regulations
applicable to property owners generally, including statutes and regulations
relating to the environmental condition of real property and the remediation
thereof.
The descriptions of the statutes and regulations applicable to the Company and
First Federal set forth below and elsewhere herein do not purport to be complete
descriptions of such statutes and regulations and their effects on the Company
and First Federal. Such descriptions also do not purport to identify every
statute and regulation that may apply to the Company or the Bank.
The FDIC may terminate the deposit insurance of any insured depository
institution if the FDIC determines, after a hearing, that the institution has
engaged or is engaging in unsafe or unsound practices, is in an unsafe or
unsound condition to continue
15
<PAGE>
operations or has violated any applicable law, regulation or order or any
condition imposed in writing by the FDIC. In addition, FDIC regulations provide
that any insured institution that falls below a 2% minimum leverage ratio will
be subject to FDIC deposit insurance termination proceedings unless it has
submitted, and is in compliance with, a capital plan with its primary federal
regulator and the FDIC. The FDIC may also suspend deposit insurance temporarily
during the hearing process if the institution has no tangible capital.
Federal Home Loan Bank System
As a member of the FHLB System, First Federal is required to own capital stock
in its regional FHLB, the FHLB of Des Moines, in an amount at least equal to the
greater of 1% of the aggregate principal amount of its unpaid residential
mortgage loans, home purchase contracts and similar obligations at the end of
each year, or 5% of its outstanding borrowings from the FHLB of Des Moines.
First Federal was in compliance with this requirement, with an investment of
$7.4 million in FHLB of Des Moines stock at September 30, 1998. The FHLB of Des
Moines serves as a reserve or central bank for the member institutions within
its assigned region, the Eighth FHLB District. It is funded primarily from
proceeds derived from the sale of consolidated obligations of the FHLB System.
It makes advances to members in accordance with policies and procedures
established by the Federal Housing Finance Board and the Board of Directors of
the FHLB of Des Moines.
Current law requires each FHLB to transfer a certain portion of its reserves and
undivided profits to the Resolution Funding Corporation ("REFCORP"), the entity
established to raise funds to resolve troubled thrift cases, to fund the
principal and a portion of the interest on bonds issued by the REFCORP and
certain other obligations. In addition, each FHLB is required to transfer 5% of
its annual net earnings to fund certain affordable housing programs. That amount
is scheduled to increase to at least 10% of its annual net income in 1997 and
subsequent years. As a result of these requirements and other factors, the FHLB
of Des Moines has experienced reduced earnings since these provisions became
effective in 1989. It is anticipated that this may continue and that First
Federal will continue to receive a reduced level of dividends on its FHLB of Des
Moines stock in future periods. During 1998, 1997, and 1996, First Federal
recorded dividend income of $491,888, $417,929, and $328,853, respectively, on
its FHLB of Des Moines stock.
Insurance of Accounts
The FDIC administers two separate deposit insurance funds. Generally, the Bank
Insurance Fund (the "BIF") insures the deposits of commercial banks and the SAIF
insures the deposits of savings institutions. The FDIC is authorized to increase
deposit insurance premiums if it determines such increases are appropriate to
maintain the reserves of either the SAIF or BIF or to fund the administration of
the FDIC. In addition, the FDIC is authorized to levy emergency special
assessments on BIF and SAIF members.
Community Reinvestment Act. The Community Reinvestment Act ("CRA") requires each
savings institution, as well as commercial banks and certain other lenders, to
identify the communities served by the institution and assess the credit needs
of those communities. The CRA also requires the OTS to assess an institution's
performance in meeting the credit needs of its identified communities as part of
its examination of the institution, and to take such assessments into
consideration in reviewing applications with respect to branches, mergers and
other business combinations, and savings and loan holding company acquisitions.
An unsatisfactory CRA rating may be the basis for denying such an application
and community groups have successfully protested applications on CRA grounds.
The OTS assigns CRA ratings of "outstanding, satisfactory, need to improve, or
substantial noncompliance". First Federal was rated "satisfactory" in its last
CRA examination in May, 1998.
Regulatory Capital Requirement. The following table reflects, in both dollars
and ratios, First Federal's regulatory capital position as of September 30,
1998, as well as the requirements at that date.
<TABLE>
<CAPTION>
Required
First Federal fsb minimum Excess
regulatory capital regulatory regulatory
---------------------------------------------
Amount Percent (1) capital capital
--------------------------------------------------------------------------------------
(Dollars in Thousands)
<S> <C> <C> <C> <C>
Tangible equity $ 37,456 9.1% $ 6,168 $ 31,288
Tier 1 (Core) capital 37,456 9.1% 16,457 $ 20,999
Tier 1 risk-based capital 37,456 15.5% 9,645 $ 27,811
Total risk-based capital 38,491 16.0% 19,290 $ 19,201
</TABLE>
- -----------------------------
(1)Based upon a percentage of adjusted total assets for tangible and core
capital and a percentage of risk-adjusted assets for risk-based capital.
OTS regulated institutions are required to maintain additional risk-based
capital equal to one-half of the amount by which the decline in its "net
portfolio value" that would result from a hypothetical 200 basis point change
(up or down, depending on which
16
<PAGE>
would result in the greater reduction in net portfolio value) in interest rates
on its assets and liabilities exceeds 2% of the estimated "economic value" of
its assets. The one exception to this general rule is that if the three month
Treasury bond equivalent yield falls below 4%, an institution would measure the
hypothetical downward change at one-half of that Treasury yield. An
institution's "net portfolio value" is defined for this purpose as the
difference between the aggregate expected future cash inflows from an
institution's assets and the aggregate expected cash outflows on its
liabilities, plus the net expected cash flows from existing off-balance sheet
contract, each discounted to present value. The estimated "economic value" of an
institution's assets is defined as the discounted present value of the estimated
future cash flows from its assets. Both the "net portfolio value" and the
"economic value" include, as specified in the regulation, the book value of
assets and liabilities that are not interest rate sensitive. The OTS has stated
that implementation of this amendment to its regulations will require additional
capital to be maintained only by institutions having "above normal" interest
rate risk. Based on the assets and liabilities comprising First Federal's
statement of financial condition as of September 30, 1998, there was no
additional increase required in First Federal's minimum capital requirement.
Prompt Corrective Action. The Federal Deposit Insurance Corporation Improvement
Act of 1989 ("FDICIA"), among other things, established a system of prompt
corrective action to resolve problems of undercapitalized institutions. Under
this system, the banking regulators are required to take certain supervisory
actions against undercapitalized institutions, the severity of which depends
upon the institution's degree of capitalization. Under the OTS final rule
implementing the prompt corrective action provisions, an institution shall be
deemed to be (i) "well capitalized" if it has total (risk-based) capital of
10.0% or more, has a Tier I (risk-based) capital ratio of 6.0% or more, has Tier
1 (core) capital 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, (ii) "adequately capitalized" if it has a total (risk-based) capital
ratio of 8.0% or more, Tier I (risk-based) ratio of 4.0% or more and a Tier 1
(core) capital ratio of 4.0% or more (3.0% under certain circumstances) and does
not meet the definition of well capitalized, (iii) "undercapitalized" if it has
a total (risk-based) capital ratio that is less than 6.0%, a Tier I (risk-based)
capital ratio that is less than 4.0% or a Tier 1 (core) capital ratio that is
less than 4.0% (3.0% in certain circumstances), (iv) "significantly
undercapitalized" if it has a total (risk-based) capital ratio that is less than
6.0%, a Tier I (risk-based) capital ratio that is less than 3.0% or a Tier 1
(core) capital ratio that is less than 3.0% and (v) "critically
undercapitalized" if it has a ratio of tangible equity to total assets that is
equal to or less than 2.0%. In addition, under certain circumstances, 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 OTS may not reclassify a significantly
undercapitalized institution as critically undercapitalized). At September 30,
1998 First Federal was a "well capitalized institution" as defined in the prompt
corrective action regulations and as such is not subject to any prompt
corrective action measures.
Dividend and Other Capital Distribution Limitations. OTS regulations require the
Bank to give the OTS 30 days advance notice of any proposed declaration of
dividends to the Holding Company, and the OTS has the authority under its
supervisory powers to prohibit the payment of dividends to the Holding Company.
In addition, the Bank may not declare or pay a cash dividend on its capital
stock if the effect thereof would be to reduce the regulatory capital of the
Bank below the amount required for the liquidation account established in
connection with its Conversion.
OTS regulations impose limitations upon all capital distributions by savings
institutions, such as cash dividends, payments to repurchase or otherwise
acquire its shares, payments to shareholders of another institution in a
cash-out merger and other distributions charged against capital. The rule
establishes three tiers of institutions, based primarily on an institution's
capital level. An institution that exceeds all fully phased-in capital
requirements before and after a proposed capital distribution ("Tier 1
institution") and has not been advised by the OTS that it is in need of more
than the normal supervision can, after prior notice but without approval of the
OTS, make capital distributions during a calendar year equal to the greater of
(i) 100% of its net income to date during the calendar year plus the amount that
would reduce by one-half its "surplus capital ratio" (the excess capital over
its fully phased-in capital requirements) at the beginning of the calendar year,
or (ii) 75% of its net income over the most recent four quarter period. Any
additional capital distributions require prior regulatory approval. An
institution is further limited in its ability to pay dividends as its capital
levels decrease below its regulatory requirement. As of September 30, 1998,
First Federal was a Tier 1 institution.
The OTS retains the authority to prohibit any capital distribution otherwise
authorized under the regulation if the OTS determines that the capital
distribution would constitute an unsafe or unsound practice. The regulation also
states that the capital distribution limitations apply to direct and indirect
distributions to affiliates, including those occurring in connection with
corporate reorganizations.
Qualified Thrift Lender Test. The Home Owners' Loan Act, as amended ("HOLA"),
requires savings institutions to meet a Qualified Thrift Lender ("QTL") test. If
an institution maintains an appropriate level of Qualified Thrift Investments
(primarily residential mortgages and related investments, including
mortgage-backed securities) ("QTIs") on a monthly basis in nine out of every 12
months and otherwise qualifies as a QTL, it will continue to enjoy full
borrowing privileges from the FHLB of Des Moines. The required percentage of
QTIs is 65% of portfolio assets (defined as all assets minus intangible assets,
property used by the institution in conducting its business and liquid assets
equal to 10% of total assets). Certain assets are subject to a
17
<PAGE>
percentage limitation of 20% of portfolio assets. In addition, savings
associations may include shares of stock of the FHLBs, FNMA and FHLMC as
qualifying QTIs. As of September 30, 1998, First Federal was in compliance with
its QTL requirement with 81.0% of assets invested in QTIs.
Loans-to-One Borrower. See "Lending Activities -- Loans-to-One Borrower."
Transactions with Affiliates. Generally, restrictions on transactions with
affiliates require that transactions between a savings association or its
subsidiaries and its affiliates be on terms as favorable to the Bank as
comparable transactions with non-affiliates. In addition, certain of these
transactions are restricted to an aggregate percentage of the Bank's capital;
collateral in specified amounts must usually be provided by affiliates to
receive loans from the Bank. Affiliates of the Bank include the Company and any
company which would be under common control with the Bank. In addition, a
savings association may not lend to any affiliate engaged in activities not
permissible for a bank holding company or acquire the securities of any
affiliate which is not a subsidiary. The OTS has the discretion to treat
subsidiaries of savings associations as affiliates on a case-by-case basis.
Branching by Federal Associations. Effective May 11, 1992, the OTS amended its
Policy Statement on Branching by Federal Savings Associations to permit
interstate branching to the full extent permitted by statute (which is
essentially unlimited). This permits savings associations with interstate
networks to diversify their loan portfolios and lines of business. The OTS
authority preempts any state law purporting to regulate branching by federal
associations. However, the OTS will evaluate a branch's record of compliance
with the CRA. A poor CRA record may be the basis for denial of a branching
application.
Federal Reserve System. The Federal Reserve Board requires all depository
institutions to maintain non-interest bearing reserves at specified levels
against their transaction accounts (primarily checking, NOW and Super NOW
checking accounts) and non-personal time deposits. The balances maintained to
meet the reserve requirements imposed by the Federal Reserve Board may be used
to satisfy the liquidity requirements that are imposed by the OTS. At September
30, 1998, the Bank was in compliance with all applicable requirements.
Savings associations have authority to borrow from the Federal Reserve Bank
"discount window," but Federal Reserve policy generally requires savings
associations to exhaust all other sources before borrowing from the Federal
Reserve System.
Holding Company Regulation
General. The Company is registered with the OTS as a unitary savings and loan
holding company. As such, the Company is required to register and file reports
with the OTS and is subject to regulation and examination by the OTS. In
addition, the OTS has enforcement authority over the Company and its non-savings
association subsidiaries, should such subsidiaries be formed, which also permits
the OTS to restrict or prohibit activities that are determined to be a serious
risk to the subsidiary savings association. This regulation and oversight is
intended primarily for the protection of the depositors of the Bank and not for
the benefit of stockholders of the Company. The Company also is required to file
certain reports with, and otherwise comply with, the rules and regulations of
the Securities and Exchange Commission ("SEC").
QTL Test. As a unitary savings and loan holding company, the Company generally
is not subject to activity restrictions, provided the Bank satisfies the QTL
test. If the Company acquires control of another savings association as a
separate subsidiary, it would become a multiple savings and loan holding
company, and the activities of the Company and any subsidiaries (other than the
Bank or any other SAIF-insured savings association) would become subject to
restrictions applicable to bank holding companies unless such other associations
each also qualify as a QTL and were acquired in a supervisory acquisition.
Restrictions on Acquisitions. The Company must obtain approval from the OTS
before acquiring control of any SAIF-insured association. Such acquisitions are
generally prohibited if they result in a multiple savings and loan holding
company controlling savings associations in more than one state. However, such
interstate acquisitions are permitted based on specific state authorization or
in a supervisory acquisition of a failing savings association.
Federal law generally provides that no "person," acting directly or indirectly
or through or in concert with one or more other persons, may acquire "control,"
as that term is defined in OTS regulations, of a federally insured savings
institution without giving at least 60 days' written notice to the OTS and
providing the OTS an opportunity to disapprove the proposed acquisition. Such
acquisitions of control may be disapproved if it is determined, among other
things, that (a) the acquisition would substantially lessen competition; (b) the
financial condition of the acquiring person might jeopardize the financial
stability of the savings institution or prejudice the interest of its
depositors; or (c) the competency, experience or integrity of the acquiring
person or the proposed management personnel indicates that it would not be in
the interest of the depositors or the public to permit the acquisitions of
control by such person.
18
<PAGE>
Subject to appropriate regulatory approvals, a bank holding company can acquire
control of a savings association, and it controls a savings association, merge
or consolidate the assets and liabilities of the savings association 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. Generally, federal savings associations can acquire or be
acquired by any insured depository institution.
Federal Securities Law. The Company's stock held by persons who are affiliates
(generally officers, directors, and principal shareholders) of the Company may
not be resold without registration or unless sold in accordance with certain
sale restrictions. If the Company meets specified current public information
requirements, each affiliate of the Company is able to sell in the public
market, without registration, a limited number of shares in any three-month
period.
19
<PAGE>
ITEM 2. PROPERTIES
The Bank operates from its main office located at 201 Main Street South,
Hutchinson, Minnesota. The Bank owns this 20,000 square feet office facility
which it built in 1985/86. The total investment in property and equipment at 201
Main Street South had a net book value of $1.4 million at September 30, 1998.
Additional offices, either owned or leased by the Bank, are set forth below with
information regarding net book value of the premises and equipment at such
facilities at September 30, 1998.
Year
Acquired or Net Book
Date Lease Value at Square
Location Expires September 30, 1998 Footage
- ------------------------------- --------------------------------------------
(Dollars in thousands)
14994 Glazier Avenue
Apple Valley, MN 55124 1989 $294 3,000
19 Central Avenue
Buffalo, MN 55313 1973 95 1,800
1002 Greeley Avenue
Glencoe, MN 55336 1999 (1) 36 1,100
1320 South Frontage Road
Hastings, MN 55033 1984 826 15,000
905 Highway 15 South,
Frontage Road
Hutchinson, MN 55350 1980 204 1,400
6505 Cahill Avenue
Inver Grove Heights, MN 55075 1979 310 3,000
501 North Sibley Avenue
Litchfield, MN 55355 1978 180 2,400
200 East Frontage Road,
Highway 5
Waconia, MN 55387 1985 257 2,400
122 East Second Street
Winthrop, MN 55396 1999 (2) 10 950
113 Waite Avenue South
Waite Park, MN 56387 2003 (3) 37 550
(1) One year lease expires in April, 1999 with option to renew for one year
terms thereafter. The Bank expects to renew the lease.
(2) Lease expires in July, 1999 with option to renew for one year terms. The
Bank expects to renew the lease.
(3) Lease expires in September, 2003 with options to renew for two additional
five year terms
The Bank leases approximately 5,713 square feet of the property in Hastings,
Minnesota to various tenants under three year operating leases. These leases
expire April 14, 2000 and April 30, 1999. The annual rents total $25,345 in
addition to each tenant's proportionate share of the operating expenses.
The Agency operates from its main office located at 135 3rd Avenue Southeast,
Hutchinson, Minnesota. The Agency leases this 1,200 square feet office facility.
The lease expires in September, 2001.
20
<PAGE>
ITEM 3. LEGAL PROCEEDINGS
First Federal, from time to time, is a party to legal proceedings in the
ordinary course of business when it enforces security interests in loans made by
it. The Bank is not engaged in any legal proceedings of a material nature at the
present time.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
None.
PART II
ITEM 5. MARKET FOR REGISTRANTS COMMON EQUITY AND RELATED STOCKHOLDERS MATTERS
In connection with the acquisitions of the Agency and HMC, the Company issued an
additional 116,800 shares of common stock. These shares were exempt from
registration under the Securities Act of 1933, as amended, pursuant to section 3
(a) (11) of the Securities Act (intra-state offerings). Such shares bear
restrictive legends as to transfer.
For additional information relating to the market for Registrant's common equity
and related stockholder matters, see "Corporate Profile and Stock Market
Information" in the Registrant's 1998 Annual Report to Stockholders on page 1,
and is incorporated herein by reference.
ITEM 6. SELECTED FINANCIAL DATA
The above-captioned information appears under "Selected Financial Data" in the
Registrant's 1998 Annual Report to Stockholders on page 2 and is incorporated
herein by reference.
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS
The above-captioned information appears under Management's Discussion and
Analysis of Financial Condition and Results of Operations in the Registrant's
1998 Annual Report to Stockholders on Pages 4 through 15 and is incorporated
herein by reference.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURE ABOUT MARKET RISK
The above information appears under Management's Discussion and Analysis of
Financial Condition and Results of Operations in the Registrant's 1998 Annual
Report to Stockholders on pages 4 through 7 and is incorporated herein by
reference.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA
The Consolidated Financial Statements of the Company and its subsidiary,
together with the report thereon by Bertram Cooper & Co., LLP appears in the
Bank's 1998 Annual Report to Stockholders on pages 16 through 40 and are
incorporated herein by reference.
Quarterly Results of Operations on page 41 of the 1998 Annual Report to
Stockholders is incorporated herein by reference.
ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES
None.
PART III
ITEM 10. DIRECTORS AND OFFICERS OF THE REGISTRANT
The information contained under the section captioned "Information with Respect
to Nominees for Director, Directors Continuing in Office, and Executive
Officers" at pages 3 to 8 the Registrant's definitive proxy statement for the
Company's Annual Meeting of Stockholders to be held on January 20, 1999 (the
"Proxy Statement"), which was filed with the Commission on December 8, 1998, and
incorporated herein by reference.
ITEM 11. EXECUTIVE COMPENSATION
The information relating to executive compensation is incorporated herein by
reference to the Registrant's Proxy Statement at pages 8 through 14.
21
<PAGE>
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information relating to security ownership of certain beneficial owners and
management is incorporated herein by reference to the Registrant's Proxy
Statement at pages 2 through 5.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information relating to certain relationships and related transactions is
incorporated herein by reference to the Registrant's Proxy Statement at page 15.
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K
(a) The following documents are filed as a part of this report:
(1) Consolidated Financial Statements of the Bank are incorporated by
reference to the following indicated pages of the 1998 Annual Report to
Stockholders.
PAGE
Independent Auditors' Report . . . . . . . . . . . . . . . . . . . . . . . 16
Consolidated Statements of Financial Condition as of
September 30, 1998 and 1997 . . . . . . . . . . . . . . . . . . . . . 17
Consolidated Statements of Income for the Years
Ended September 30, 1998, 1997 and 1996 . . . . . . . . . . . . . . . 18
Consolidated Statements of Changes in Stockholders' Equity for the
Years Ended September 30, 1998, 1997 and 1996 . . . . . . . . . . . . 19
Consolidated Statements of Cash Flows for the Years Ended
September 30, 1998, 1997 and 1996 . . . . . . . . . . . . . . . . . . 20
Notes to Consolidated Financial Statements . . . . . . . . . . . . . . . . 22
The remaining information appearing in the Annual Report to Stockholders is
not deemed to be filed as part of this report, except as expressly provided
herein.
(2) All schedules are omitted because they are not required or applicable,
or the required information is shown in the consolidated financial statements or
the notes thereto.
(3) Exhibits
(a) The following exhibits are filed as part of this report.
2.1 Plan of Conversion Merger of Hutchinson and Hastings *
2.2 Agreement of Merger *
3.1 Articles of Incorporation of FSF Financial Corp. *
3.2 Bylaws of FSF Financial Corp. *
4.0 Stock Certificate of FSF Financial Corp. *
10.1 Form of Employment Agreement with Donald A. Glas, George B. Loban and
Richard H. Burgart *
10.2 First Federal fsb Management Stock Plan**
10.3 FSF Financial Corp. 1996 Stock Option Plan**
10.4 FSF Financial Corp. 1998 Stock Compensation Plan***
11.0 Statement regarding computation of earnings per share
13.0 1998 Annual Report to Stockholders
21.0 Subsidiary Information
23.0 Consent of Accountant
27.0 Financial Data Schedule ****
- ---------------------
* Incorporated herein by reference into this document from the Exhibits to
Form S-1, Registration Statement, initially filed with the Commission, on
June 1, 1994, Registration No. 33-79570.
** Incorporated herein by reference into this document from the Registrant's
proxy statement for the Annual Meeting of Stockholders held on January 17,
1996, and filed with the Commission on December 13, 1994.
*** Incorporated herein by reference into this document from the Registrant's
proxy statement for the Annual Meeting of Stockholders held on January 20,
1998, and filed with the Commission on December 10, 1997.
**** Included with electronic filing only.
22
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 o4 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.
FSF Financial Corp.
Dated: December 11, 1998 By: /s/ Donald A. Glas
------------------
Donald A. Glas
Co-Chair of the Board and Chief
Executive Officer
(Duly Authorized Representative)
Pursuant to the requirement 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,
By: /s/ Donald A. Glas By: /s/ Richard H. Burgart
------------------ ----------------------
Donald A. Glas Richard H. Burgart
Co-Chair of the Board and Chief Financial Officer
Chief Executive Officer and Treasurer
(Principal Executive Officer) Principal Financial and
Accounting Officer)
Director
Date: December 11, 1998 Date: December 11, 1998
By: /s/ George B. Loban
-------------------
George B. Loban
Co-Chair of the Board and
President
Date: December 11, 1998
By: /s/ Sever B. Knutson By: /s/ Roger R. Stearns
-------------------- --------------------
Sever B. Knutson Roger R. Stearns
Director Director
Date: December 11, 1998 Date: December 11, 1998
By: /s/ James J. Caturia By: /s/ Jerome R. Dempsey
-------------------- ---------------------
James J. Caturia Jerome R. Dempsey
Director Director
Date: December 11, 1998 Date:
December 11, 1998
23
EXHIBIT 11
<PAGE>
See Note 12 to the Consoldiated Financial Statements in the 1998
Annual Report to Stockholders
EXHIBIT 13
<PAGE>
FSF FINANCIAL CORP.
1998 ANNUAL REPORT
- --------------------------------------------------------------------------------
TABLE OF CONTENTS
- --------------------------------------------------------------------------------
Corporate Profile and Stock Market Information............................1
Selected Financial and Other Data.........................................2
Letter to Stockholders....................................................3
Management's Discussion and Analysis of
Financial Condition and Results of Operations...........................4
Independent Auditors' Report.............................................16
Consolidated Statements of Financial Condition...........................17
Consolidated Statements of Income........................................18
Consolidated Statements of Changes in Stockholders' Equity...............19
Consolidated Statements of Cash Flows....................................20
Notes to Consolidated Financial Statements...............................22
Selected Quarterly Financial Data........................................41
Office Locations.........................................................42
Corporate Information....................................................43
<PAGE>
FSF FINANCIAL CORP.
Corporate Profile and Related Information
FSF Financial Corp. (the "Corporation") is a Minnesota corporation organized in
1994 at the direction of First Federal fsb (the "Bank") to acquire all of the
capital stock of the Bank upon its conversion from the mutual to stock form of
ownership. The Bank resulted from the merger of First Federal Savings and Loan
Association of Hastings, Hastings, Minnesota, with and into First State Federal
Savings and Loan Association, Hutchinson, Minnesota, on September 30, 1994. On
October 6, 1994, the Bank completed its mutual-to-stock conversion
("Conversion") and is currently chartered by the Office of Thrift Supervision
("OTS") as a federally-chartered stock savings bank. The Corporation is a
unitary savings and loan holding company which, under existing laws, generally
is not restricted in the types of business activities in which it may engage
provided that the Bank retains a specified amount of its assets in
housing-related investments.
The Corporation purchased all of the capital stock of the Bank with one-half of
the net proceeds from the Conversion. The Corporation also provided a loan to
the Bank's Employee Stock Ownership Plan ("ESOP") to enable the ESOP to purchase
shares of the Corporation's common stock in the initial public offering. The
note bears an interest rate and has terms and conditions which prevailed in the
marketplace at the time it was originated. The Corporation has not engaged in
any business activities to date other than the loan to the ESOP.
The Company operates two wholly owned subsidiaries, Insurance Planners and the
Bank. Insurance Planners (the "Agency") is an independent property and casualty
insurance agency located in Hutchinson, MN. The Agency was acquired by the
Company on June 1, 1998. Furthermore, on November 17, 1998, the Company acquired
Homeowners Mortgage Corporation ("Homeowners"), Vadnais Heights, MN. Homeowners
is a mortgage banking company.
The Bank conducts its business from its main office in Hutchinson, Minnesota,
and ten additional full service offices located in the Minnesota counties of
McLeod, Dakota, Meeker, Sibley, Carver, Stearns and Wright. The Bank also
operates ten automated teller machines ("ATMs"). The Bank's deposits have been
federally insured since 1934 and are currently insured up to the maximum
allowable by law as administered by the Federal Deposit Insurance Corporation
(the "FDIC"). The Bank is a community oriented savings institution offering a
variety of financial services to meet the needs of the communities it serves.
The Bank attracts deposits from the general public and uses such deposits,
together with borrowings and other funds, primarily to originate and purchase
residential real estate, commercial real estate, multi-family loans,
construction loans, agricultural loans, commercial business loans, and consumer
loans.
Stock Market Information
Since its issuance in October 1994, the Corporation's common stock has been
traded on the Nasdaq National Market. The daily stock quotation for FSF
Financial Corp. is listed in the Nasdaq National Market published in The Wall
Street Journal, the St Paul Pioneer Press and Dispatch, and other leading
newspapers under the trading symbol of "FFHH". For a listing of the stock price
as published by the Nasdaq statistical report, see "Selected Quarterly Financial
Data."
The number of stockholders of record of common stock as of the record date of
November 30, 1998, was approximately 511. This does not reflect the number of
persons or entities who held stock in nominee or "street" name through various
brokerage firms. At November 30, 1998, there were 2,972,513 shares issued and
outstanding.
The Corporation's ability to pay dividends to stockholders is dependent upon the
dividends it receives from the Bank. The Bank may not declare or pay a cash
dividend on any of its stock if the effect thereof would cause the Bank's
regulatory capital to be reduced below (1) the amount required for the
liquidation account established in connection with the Bank's conversion from
mutual to stock form, or (2) the regulatory capital requirements imposed by the
OTS.
1
<PAGE>
FSF FINANCIAL CORP.
<TABLE>
<CAPTION>
- ----------------------------------------------------------------------------------------------------------------------------------
SELECTED FINANCIAL AND OTHER DATA
Financial Condition (Dollars in Thousands)
- ----------------------------------------------------------------------------------------------------------------------------------
September 30, 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Total assets $416,232 $388,135 $354,636 $304,605 $281,467
Loans held for sale 2,672 204 443 230 729
Loans receivable, net 280,603 260,390 216,727 170,921 116,591
Mortgage-backed securities 36,418 38,539 38,557 37,110 33,267
Mortgage-backed securities available for sale 16,574 16,699 16,336 16,141 16,338
Debt securities 24,412 37,876 44,349 41,914 22,897
Debt securities available for sale 3,010 1,000 - - -
Equity securities available for sale 19,459 19,311 18,231 16,165 14,172
Cash and cash equivalents (1) 22,597 6,135 11,756 14,855 69,991
Savings deposits 226,542 208,246 189,074 171,516 156,479
Other borrowings 144,177 133,817 114,693 73,807 37,688
Stockholders' equity 42,518 43,362 47,649 57,351 20,508
Summary of Operations (Dollars in Thousands) (2)
- ----------------------------------------------------------------------------------------------------------------------------------
Year Ended September 30, 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------------------------
Interest income $ 29,981 $ 27,315 $ 23,244 $ 19,079 $ 15,320
Interest expense 18,499 16,346 13,609 9,472 7,544
Net interest income 11,482 10,969 9,635 9,607 7,776
Provision for loan losses 302 120 42 24 33
Non-interest income 2,269 1,510 1,354 1,127 184
Non-interest expense (3) 8,395 7,130 8,178 6,966 5,964
Income before cummulative effect
of change in accounting principle 3,030 3,124 1,668 2,243 1,135
Net income (3) 3,030 3,124 1,668 2,625 1,135
Other Selected Data
- ----------------------------------------------------------------------------------------------------------------------------------
Year Ended September 30, 1998 1997 1996 1995 1994
- ----------------------------------------------------------------------------------------------------------------------------------
Return on average assets before cum. eff. 0.74% 0.84% 0.69% 0.82% 0.50%
Return on average assets after cum. eff. 0.74% 0.84% 0.69% 0.95% 0.50%
Return on average equity before cum. eff. 6.94% 6.87% 4.25% 3.83% 5.58%
Return on average equity after cum. eff. 6.94% 6.87% 4.25% 4.48% 0.56%
Average equity to average assets 10.70% 12.25% 15.93% 21.31% 8.96%
Net interest rate spread (4) 2.44% 2.54% 2.36% 2.78% 3.41%
Non-performing assets to total assets 0.19% 0.15% 0.06% 0.12% 0.20%
Allowance for loan losses to total loans 0.34% 0.30% 0.33% 0.41% 0.61%
Basic earnings per share before cum. eff. (3) $ 1.14 $ 1.13 $ 0.49 $ 0.57 N/A
Diluted earnings per share before cum. eff. (3) $ 1.05 $ 1.04 $ 0.47 $ 0.55 N/A
Basic earnings per share after cum. eff. (3) $ 1.14 $ 1.13 $ 0.49 $ 0.67 N/A
Diluted earnings per share after cum. eff. (3) $ 1.05 $ 1.04 $ 0.47 $ 0.65 N/A
Cash dividends declared per share $ 0.50 $ 0.50 $ 0.50 $ 0.375 N/A
</TABLE>
- --------------------------------------------------------------------------------
(1) Consists of cash due from banks, interest-bearing deposits, and other
investments with original maturities of less than three months.
(2) The cumulative effect of the change in accounting for debt securities as a
pro-forma adjustment to prior years operations would result in an increase
in non-interest income for fiscal 1994 by $681 and net income would
increase by $382.
(3) Includes a one-time special assessment of $1,030,000 to recapitalize the
SAIF for the year ended September 30, 1996.
(4) Interest rate spread represents the difference between the average yield on
interest-earning assets and the average cost of interest-bearing
liabilities
2
<PAGE>
To Our Stockholders:
FSF Financial Corp. has continued its growth since becoming a publicly traded
company in 1994, and we are confident that profitable growth will continue.
During the first four years, total assets have increased by $135 million or 48%.
We announced the acquisitions of Insurance Planners in May, 1998 and announced
the acquisition of Homeowners Mortgage in October, 1998. Diversification is a
key to becoming a one-stop financial services provider. Insurance Planners
provides commercial and personal property and casualty insurance. Homeowners
Mortgage will become our residential mortgage origination and sales subsidiary.
Firstate Services, a subsidiary of First Federal fsb, seeks to meet the
investment needs of our customers. Acquisition of banking institutions, while
still an option, has not been utilized aggressively due to unrealistic
expectations on the part of sellers. Those expectations made potential
acquisitions dilutive to our shareholders and therefore an unacceptable
alternative.
Additional value to our shareholders has been created as a result of the
investment made in the repurchase of stock by the Company. During fiscal 1998 we
invested $5.5 million in our own stock. Our company has invested a total of
$25.9 million in the repurchase of shares since initiating our first repurchase
program in 1995. Furthermore, officers and directors of the company increased
their ownership during fiscal 1998 by exercising 135,957 options.
Asset diversification was a major focus during 1998 and should continue to
enhance performance in the future. Agricultural Lending was introduced in
December 1997 and represents 7.6% of total loans. We strongly believe in being a
proactive partner with our agricultural customers. Community and private banking
have helped in increasing commercial business loans from 2.9% of total loans
last year to 7.0% of total loans at September 30, 1998. As assets are
diversified, the risk inherent in the loans also increases. Therefore the
provision for loan losses was increased from $120,000 in 1997 to $302,000 in
1998 and the loss reserve increased from $852,000 to $1,035,000.
Even though we are decreasing our dependence on residential lending within our
loan portfolio, we are not abandoning our efforts to promote homeownership. The
acquisition of Homeowners Mortgage provides us with enhanced products, economies
of scale, and a more diversified market while allowing us to concentrate our
efforts at the Bank level, in construction lending and other non-residential
lending areas.
We will continue to assess potential acquisitions, utilize technology when
economically feasible, diversify our balance sheet and income stream, and train
our employees to provide superior customer service. We are confident that our
commitment to continued, profitable growth will provide additional return to our
shareholders.
Thank you for your confidence and investment in FSF Financial Corp. We hope that
you are using some of our many products and services. If not, please consider
doing so. Our best sales people are our customers.
Sincerely,
Donald A. Glas George B. Loban
Co-Chair/Chief Executive Officer Co-Chair/President
3
<PAGE>
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS.
The Private Securities Litigation Reform Act of 1995 contains safe harbor
provisions regarding forward-looking statements. When used in this discussion,
the words "believes", "anticipates", "contemplates", "expects", and similar
expressions are intended to identify forward-looking statements. Such statements
are subject to certain risks and uncertainties which could cause actual results
to differ materially from those projected. Those risks and uncertainties include
changes in interest rates, risks associated with the effect of integrating newly
acquired businesses, the ability to control costs and expenses, and general
economic conditions. FSF Financial Corp. undertakes no obligation to publicly
release the results of any revisions to those forward looking statements which
may be made to reflect events or circumstances after the date hereof or to
reflect the occurrence of unanticipated events.
General
The Corporation does not engage in any active business. In connection with the
conversion from the mutual to stock form of ownership, the Corporation made a
loan to the Bank's employee stock ownership plan. The Corporation also receives
interest income on its investments.
The earnings of the Corporation depend primarily on the Bank's net interest
income and to a lesser extent, income from its recently acquired wholly owned
subsidiaries: Insurance Planners (June 1998) and Homeowners Mortgage (November
1998). Net interest income is affected by the interest rates that the Bank
receives from its loans and investments and by the interest rates that the Bank
must pay for its sources of funds. The difference between average rates of
interest earned on earning assets and the average rates paid on interest bearing
liabilities is the "interest rate spread". When interest earning assets equal or
exceed interest bearing liabilities, any positive interest rate spread will
produce net interest income.
In addition, the Bank receives income from service charges on deposit accounts,
other service charges and fees, commission income and income from the sale of
loans to the secondary market. The Bank incurs expenses in addition to interest
expense in the form of salaries and benefits, deposit insurance, property
operations and maintenance, advertising and other related business expenses.
Earnings of the Bank are significantly affected by economic and competitive
conditions, particularly changes in interest rates, government policies and
regulations of various regulatory authorities.
Asset/Liability Management
The Bank, like other financial institutions, is vulnerable to changes in
interest rates to the extent that interest-bearing liabilities mature
differently than interest-earning assets. The lending activities of the Bank
have emphasized the origination of loans, the majority of which have a repricing
term which is substantially shorter than their amortization term, and the source
of funds has been deposits and borrowings. Having interest-earning assets that
reprice more frequently than interest-bearing liabilities is generally
beneficial to net interest income during periods of increasing interest rates,
such an asset/liability mismatch is generally detrimental during periods of
declining interest rates.
In an attempt to manage its exposure to changes in interest rates, management
closely monitors interest rate risk. Management meets at least quarterly to
review the interest rate risk position and projected profitability of the Bank.
In addition, management reviews the Bank's portfolio, formulates investment
strategies and oversees the timing and implementation of transactions to assure
attainment of the Bank's objectives in the most effective manner. The Board of
Directors reviews on a quarterly basis the Bank's asset/liability position,
including simulations of the effect of various interest rate scenarios on the
Bank's capital.
Depending on the relationship between long-term and short-term interest rates,
market conditions and consumer preferences, the Bank, at times, may place more
emphasis on managing net interest margin rather than matching the interest rate
sensitivity of its assets and liabilities in an effort to enhance net interest
income. Management believes that the increased net interest income resulting
from a mismatch in the maturity of its assets and liability portfolios can
provide high enough returns to justify the increased exposure to sudden and
unexpected changes in interest rates.
Management attempts to reduce the Bank's interest rate risk by the way it
structures its assets and liabilities. The Bank sells all fixed rate residential
mortgages and has primarily focused its residential lending programs on loans
with either adjustable interest rates or balloon provisions. These loans provide
the Bank with a repricing time frame which is substantially shorter than the
contractual term. During the 1998 fiscal year, the Bank originated $9.5 million
of single family mortgage loans which have initial fixed rates for terms of one
to ten years and then adjust annually off a treasury index thereafter. The Bank
also originated $11.5 million of single family mortgage loans that have a
balloon payment due in three to seven years. Originations of
4
<PAGE>
construction and land development loans, which generally have a contractual
maturity of two years or less, totaled $24.5 million. At September 30, 1998,
$127.9 million of real estate mortgages were adjustable rate mortgages, balloon
mortgages, or construction and land development loans, representing 42.4% of
total loans and 31% of total assets.
Interest rate sensitivity is the result of differences in the amounts and
repricing dates of rate-sensitive assets and rate-sensitive liabilities. These
differences, or interest rate repricing "GAP," provide an indication of the
extent to which the Bank's net interest income is affected by future changes in
interest rates. A GAP is considered positive when the amount of interest rate
sensitive assets exceeds the amount of interest rate sensitive liabilities. A
GAP is considered negative when the amount of interest rate sensitive
liabilities exceeds interest rate sensitive assets. During a period of falling
interest rates, a negative GAP would tend to result in an increase in net
interest income, while a positive GAP would tend to affect net interest income
adversely. Conversely, during a period of rising interest rates, a negative GAP
would tend to result in a decrease in net interest income, while a positive GAP
would tend to result in an increase in net interest income.
The table that follows sets forth the amounts of interest-earning assets and
interest-bearing liabilities at September 30, 1998, which are expected to
reprice or mature in each of the future time periods shown.
Analysis of Repricing Mechanisms
<TABLE>
<CAPTION>
Over One Over Five
Within to Five to Ten Over Ten
One Year Years Years Years Total
--------- --------- ---------- --------- ----------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
Interest-earning assets:
Mortgage loans $ 57,326 $ 60,622 $ 41,995 $ 56,731 $ 216,674
Other loans 47,803 31,060 5,071 1,001 84,935
Investment securities 93,274 10,641 7,088 6,240 117,243
--------- --------- --------- --------- ---------
Total interest-earning assets 198,403 102,323 54,154 63,972 418,852
--------- --------- --------- --------- ---------
Interest-bearing liabilities:
Noninterest bearing deposits -- -- -- -- --
NOW and Super now accounts 20,557 -- -- -- 20,557
Savings accounts 53,984 -- -- -- 53,984
Money market deposit accounts 2,264 -- -- -- 2,264
Certificates 81,745 58,526 1,988 -- 142,259
Other borrowed money 3,000 78,677 62,500 -- 144,177
--------- --------- --------- --------- ---------
Total interest-bearing liabilities 161,550 137,203 64,488 -- 363,241
--------- --------- --------- --------- ---------
Interest sensitivity gap $ 36,853 $ (34,880) $ (10,334) $ 63,972 $ 55,611
========= ========= ========= ========= =========
Cumulative interest sensitivity gap $ 36,853 $ 1,973 $ (8,361) $ 55,611
========= ========= ========= =========
Cumulative ratio of interest-earning assets
to interest-bearing liabilities 1.23% 1.01% 0.98% 1.15%
========= ========= ========= =========
Cumulative ratio of cumulative interest
sensitivity gap to total assets 8.85% 0.47% -2.01% 13.36%
========= ========= ========= =========
</TABLE>
The table above indicates the time periods in which interest-earning assets and
interest-bearing liabilities will mature or reprice in accordance with their
contractual terms. The following assumptions have been used in calculating the
values in the table: Adjustable-rate and balloon loans have a constant
prepayment rate of 6%; mortgages held for sale are all set to reprice in three
years or less; remaining mortgages have prepayment rates ranging from 4% to 10%;
consumer loans have a prepayment rate that is constant over time at 19%; NOW
checking, core savings deposits, and money market deposits have an increasing
decay ranging from 6.0% to 30.0%. Management utilizes its own assumptions, and
feels that these assumptions provide a reasonable estimate of actual experience.
Certain shortcomings are inherent in the method of analysis presented in the
previous table. For example, although certain assets and liabilities may have
similar maturities or periods of repricing, they may react in different degrees
to changes in
5
<PAGE>
market interest rates. Also, the interest rates on certain types of assets and
liabilities may fluctuate in advance of changes in market interest rates, while
interest rates on other types may lag behind changes in market rates.
Additionally, certain assets, such as adjustable-rate mortgage loans, have
features which restrict changes in interest rates on a short-term basis over the
life of the assets. Further, in the event of a change in interest rate,
prepayment levels and decay rates on core deposits may deviate significantly
from those assumed in calculating the table.
Market Risk Management
Market risk is the risk of loss arising from adverse changes in market prices
and rates. The Bank's market risk is comprised primarily of interest rate risk
resulting from its core banking activities of lending and deposit taking.
Interest rate risk is the risk that changes in market interest rates might
adversely affect the Bank's net interest income or the economic value of its
portfolio of assets, liabilities and off-balance sheet contracts. Management
continually develops and applies strategies to mitigate this risk. Management
does not believe that the Bank's primary market risk exposures and how those
exposures are managed in Fiscal 1998 have changed when compared to Fiscal 1997.
Market risk limits have been established by the Board of Directors based on the
Bank's tolerance for risk.
The Bank primarily relies on its Net Portfolio Value Model (the Model) to
measure its susceptibility to interest rate changes. Net portfolio value (NPV)
is defined as the present value of expected cash flows from existing assets
minus the present value of expected net cash flows from existing liabilities
plus or minus the present value of net expected cash flows from existing
off-balance sheet contracts. The Bank does not currently own any derivative
financial instruments whose values are determined from underlying instruments or
market indices, and whose notional or contractual amounts would not be
recognized in the financial statements. The Model estimates the current economic
value of each type of asset, liability, and off-balance sheet contract after
various assumed instantaneous, parallel shifts in the Treasury yield curve both
upward and downward.
The NPV Model uses an option-based pricing approach to value one to four family
mortgages, mortgages serviced by others, and firm commitments to buy, sell, or
originate mortgages. This approach makes use of an interest rate simulation
program to generate numerous random interest rate paths that, in conjunction
with a prepayment model, are used to estimate mortgage cash flows. Prepayment
options and interest rate caps and floors contained in mortgages and
mortgage-related securities introduce significant uncertainty in estimating the
timing of cash flows for these instruments that warrants the use of this
sophisticated methodology. All other financial instruments are valued using a
static discounted cash flow method. Under this approach, the present value is
determined by discounting the cash flows the instrument is expected to generate
by the yields currently available to investors from an instrument of comparable
risk and duration.
The following table sets forth the present value estimates of the Bank at
September 30, 1998, as calculated by its NPV Model. The table shows the NPV of
the Bank under rate shock scenarios of -400 basis points to +400 basis points in
increments of 100 basis points. As market rates increase, the market value of
the Bank's large portfolio of mortgage loans and securities declines
significantly and prepayments are slow. As rates decrease, the market value of
mortgage loans and securities increase only modestly due to prepayment risk,
periodic rate caps, and other embedded options. Actual changes in market value
will differ from estimated changes set forth in this table due to various risks
and uncertainties.
<TABLE>
<CAPTION>
Changes in Interest
Rates in Basis Net Portfolio Change NPV as % of Assets
----------------------------------------------- -----------------------
Points (Rate Shock) $ Amount $ Change Change % NPV Ratio Change
-------- -------- -------- --------- ------
(Dollars in thousands)
<S> <C> <C> <C> <C> <C> <C>
+400 bp $ 38,329 (13,268) (25.71) % 9.61 (243) bp
+300 bp 40,987 (10,610) (20.56) 10.11 (193) bp
+200 bp 44,044 (7,553) (14.64) 10.68 (136) bp
+100 bp 47,558 (4,039) (7.83) 11.32 (72) bp
0 bp 51,597 - - 12.04 -
-100 bp 56,243 4,646 9.00 12.85 81 bp
-200 bp 61,591 9,994 19.37 13.76 172 bp
-300 bp 67,751 16,154 31.31 14.78 274 bp
-400 bp 74,857 23,260 45.08 15.92 388 bp
</TABLE>
This table shows that the Bank's economic value of equity would decrease with
rising interest rates while increasing with falling interest rates. However,
computations of prospective effects of hypothetical interest rate changes are
based on numerous
6
<PAGE>
assumptions, including relative levels of market interest rates, loan repayments
and deposit runoffs, and may not be indicative of actual results. The
computations do not reflect any actions the Bank may undertake in response to
changes in interest rates although management cannot always predict future
interest rates or their effect on the Bank. Certain shortcomings are inherent in
the method of analysis presented in the computation of NPV. For example,
although certain assets and liabilities may have similar maturities or periods
to repricing, they may react in differing degrees to changes in market area
interest rates. Additionally, certain assets, such as adjustable rate loans,
have features that restrict changes in interest rates during the initial term
and over the remaining life of the asset. Further, in the event of a change in
interest rates, prepayment and early withdrawal levels could deviate
significantly from those assumed in the table. Finally, the ability of many
borrowers to service their adjustable rate debt may decrease in the event of an
interest rate increase.
7
<PAGE>
Average Balances
The following table sets forth information relating to the Corporation's average
yield on assets and average cost of liabilities for the periods indicated. The
yields and costs are computed by dividing income or expense by the average
balance of interest-earning assets and interest-bearing liabilities,
respectively, for the periods indicated. Average balances are derived from
month-end balances. Management does not believe that the use of month-end
balances has caused any material difference in the information presented.
<TABLE>
<CAPTION>
Years Ended September 30,
------------------------------------------------------------------------------------------
1998 1997 1996
------------------------------------------------------------------------------------------
Average Average Average
Average Income/ Yield/ Average Income/ Yield/ Average Income/ Yield/
Balance Expense Cost Balance Expense Cost Balance Expense Cost
------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Interest-Earning Assets (in thousands) (in thousands) (In thousands)
Loans receivable (1) $ 276,730 $23,512 8.50% $ 237,475 $ 20,066 8.45% $ 193,202 $16,077 8.32%
Mortgage-backed securities 54,657 3,006 5.50% 55,062 3,384 6.15% 54,208 3,270 6.03%
Investment securities (2) 65,238 3,463 5.31% 66,734 3,865 5.79% 69,676 3,897 5.59%
-------------------- -------------------- --------------------
Total interest-earning assets 396,625 29,981 7.56% 359,271 27,315 7.60% 317,086 23,244 7.33%
-------------------- -------------------- --------------------
Interest-Bearing Liabilities
NOW and money market accounts $ 28,626 407 1.42% $ 27,463 389 1.42% $ 25,697 443 2.41%
Passbook savings 50,699 1,690 3.33% 48,381 1,524 3.15% 49,120 1,576 3.52%
Certificates of deposit 136,407 7,985 5.85% 127,211 7,426 5.84% 108,665 6,243 5.75%
-------------------- -------------------- --------------------
Total deposits 215,732 10,082 4.67% 203,055 9,339 4.60% 183,482 8,262 4.50%
FHLB advances 145,459 8,417 5.79% 120,093 7,007 5.83% 90,408 5,347 5.91%
-------------------- -------------------- --------------------
Total interest-bearing liabilities 361,191 18,499 5.12% 323,148 16,346 5.06% 273,890 13,609 4.97%
-------------------- -------------------- --------------------
Net Interest Income $11,482 $ 10,969 $ 9,635
======== ========== =========
Net Interest Rate Spread (3) 2.44% 2.54% 2.36%
Net Interest Rate Margin (4) 2.89% 3.05% 3.04%
Ratio of average interest-earning assets
to average interest-bearing liabilities 1.10x 1.11x 1.16x
========= ========= ========
</TABLE>
(1) Average balances include non-accrual loans and loans held for sale.
(2) Includes interest-bearing deposits in other financial institutions.
(3) Net interest rate spread represents the difference between the average
yield on interest-earning assets and the average cost of
interest-bearing liabilities.
(4) Net interest rate margin represents net interest income as a
percentage of average interest-earning assets
8
<PAGE>
Rate/Volume Analysis
The table below sets forth certain information regarding changes in interest
income and interest expense of the Bank for the periods indicated. For each
category of interest-earning assets and interest-bearing liabilities,
information is provided on changes attributable to (1) changes in volume
(changes in average volume multiplied by old rate); (2) changes in rates
(changes in rate multiplied by old average volume); (3) total changes in
rate-volume. The combined effects of changes in both volume and rate which
cannot be separately identified, have been allocated proportionately to the
change due to volume and the change due to rate.
<TABLE>
<CAPTION>
Increase (Decrease) Due To
-----------------------------------------------------------
Rate Volume Rate/Volume Total
--------- ----------- ------------ ---------
Year Ended September 30, 1998 vs 1997: (In Thousands)
<S> <C> <C> <C> <C>
Interest income:
Loans Receivable $ 109 $ 3,317 $ 20 $3,446
Mortgage-backed securities (350) (25) (3) (378)
Investment securities (308) (87) (7) (402)
------ -------- -------- -----
Total change in interest income (549) 3,205 10 2,666
Interest expense:
Savings accounts 151 583 9 743
FHLB Borrowings (59) 1,479 (10) 1,410
------ -------- -------- ------
Total change in interest expense 92 2,062 (1) 2,153
------ -------- -------- ------
Net change in net interest income $ (641) $ 1,143 $ 11 $ 513
====== ======== ======== ======
Year Ended September 30, 1997 vs 1996:
Interest income:
Loans Receivable $ 247 $ 3,684 $ 58 $3,989
Mortgage-backed securities 55 51 8 114
Investment securities 117 (164) 15 (32)
------- -------- -------- ------
Total change in interest income 419 3,571 81 4,071
Interest expense:
Savings accounts (813) 1,849 41 1,077
FHLB Borrowings (70) 1,754 (24) 1,660
------- -------- -------- ------
Total change in interest expense (883) 3,603 17 2,737
------- -------- -------- ------
Net change in net interest income $1,302 $ (32) $ 64 $1,334
======= ======== ======== ======
</TABLE>
9
<PAGE>
Changes in Financial Condition
General. Total assets increased from $388.1 million at
September 30, 1997, to $416.2 million at September 30, 1998, an increase of
$28.1 million or 7.2%. The Bank continues to experience good demand for loans
and supplemented the internal loan originations ($147.6 million) with purchases
of other loans ($10.8 million) that meet the interest rate risk and credit risk
criteria established by management.
Securities Available for Sale. Equity securities available
for sale increased by $148,000 during the 1998 fiscal year as a result of the
purchase of additional stock in the Federal Home Loan Bank of Des Moines
("FHLB"). The additional stock purchase was required as FHLB borrowings
increased. The net unrealized losses on securities available for sale increased
from $606,000 at September 30, 1997 to $832,000 at September 30, 1998. This
increase was primarily due to the market rate of interest decreasing compared to
the contractual rate. Debt securities available for sale increased $2.0 million
due to the purchase of such securities for liquidity purposes. Mortgage-backed
and related securities remained about the same.
Securities Held to Maturity. Debt securities held to
maturity decreased from $37.9 million to $24.4 million due to maturities and the
exercise of call options by issuers. Mortgage-backed securities held to maturity
decreased from $38.5 million to $36.4 million during fiscal 1998, due to
principal repayments. The net unrealized losses on securities held to maturity
decreased from $1.8 million at September 30, 1997 to $1.5 million at September
30, 1998. These increases were primarily due to the market rate of interest
decreasing compared to the contractual rate.
Loans Held for Sale. Loans held for sale increased from $204,000 at
September 30, 1997, to $2,672,000 at September 30, 1998. The Bank had firm
commitments to sell all of the loans held for sale that were closed by
September, 1998.
Loans Receivable. Loans receivable increased from $260.4 million at
September 30, 1997, to $280.6 million at September 30, 1998, an increase of
$20.2 million or 7.8%. The increase was
primarily comprised of increases in agricultural and commercial business loans.
Deposits. Total deposits increased by $18.3 million, or 8.8% during the
1998 fiscal year. The increase in deposits can be primarily attributed to an
increase in savings and certificates of deposit. The increase in total deposits
was accompanied by an increase in the weighted average cost of funds from 4.60%
to 4.67% for the years ended September 30, 1997 and 1998, respectively. The
increase in cost is primarily attributable to the change in the composition of
deposits.
Borrowings. In addition to the growth in deposits, additional borrowings of
$10.4 million were needed utilized to fund the growth in assets. Management
utilizes a least cost, at the margin, approach to fund assets. As a result,
borrowings are utilized as a funding source when it provides the least cost, at
the margin. FHLB advances are used to fund lending and investment activities,
withdrawals from deposit accounts and other ordinary business activity.
Stockholders' Equity. Stockholders' equity decreased from $43.4 million at
September 30, 1997, to $42.5 million at September 30, 1998, a decrease of $0.9
million. The Corporation repurchased 288,218 shares of its common stock during
the year at an average price of $19.05, thereby reducing stockholders' equity.
The repurchase of shares also reduced the total number of shareholders. Book
value per share decreased from $16.24 at September 30, 1997, to $16.22 at
September 30, 1998.
Comparison of Years Ended September 30, 1998 and 1997
Net Income. Net income decreased to $3.0 million for the year ended
September 30, 1998, from $3.1 million for the year ended September 30, 1997. The
decrease was primarily due to an increase in non-interest expense.
Interest Income. Total interest income increased $2.7 million to $30.0
million for the year ended September 30, 1998, from $27.3 million for the year
ended September 30, 1997. Interest income on loans increased by $3.4 million
from $20.1 million for the year ended September 30, 1997, to $23.5 million for
the year ended September 30, 1998, as a result of a $39.3 million increase in
the average balance of loans receivable from $237.5 million at September 30,
1997, to $276.7 million at September 30, 1998. Furthermore, the average yield
increased from 8.45% at September 30, 1997, to 8.50% at September 30, 1998.
Interest income on mortgage-backed securities decreased from $3.4 million for
the year ended September 30, 1997, to $3.0 million for the year ended September
30, 1998. The decrease was primarily the result of a decrease in average rate
from 6.15% for the 1997 fiscal year to 5.50% for the 1998 fiscal year. The
average balance of investment securities decreased by $1.5 million during the
fiscal year and the yield decreased from 5.79% to 5.31%. The decrease in yield
for investment securities was primarily impacted by maturities and the exercise
of call options by issuers. The yield on interest-earning assets decreased from
7.60% for the year ended September 30, 1997, to 7.56% for the year ended
September 30, 1998. Interest income increased by $3.3 million as a result of
increased volume during the year while the changes in rates caused interest
income to decrease by $549,000 and the rate/volume change increased interest
income by $10,000.
10
<PAGE>
Interest Expense. Total interest expense increased to $18.5 million for
1998 from $16.3 million for 1997 as both the average balance of total interest
bearing liabilities and the average cost of funds increased. The increased cost
of deposits attendant to the growth of balances was approximately $583,000 while
the increase associated with a change in interest rates was approximately
$151,000. The cost associated with interest bearing deposits increased from
4.60% for the year ended September 30, 1997, to 4.67% for the same period ended
September 30, 1997. The cost associated with borrowed funds decreased to 5.79%
for fiscal 1998 compared to 5.83% for fiscal 1997. $59,000 of the decrease in
the cost of borrowed funds was a result of increases in rates, $1.5 million of
the increase was attributable to the increased volumes and $10,000 of the
decrease was rate/volume related.
Net Interest Income. Net interest income increased $513,000. Changes in
interest rates caused a decrease in net interest income of $641,000, volumes
accounted for an increase in net interest income of $1.1 million and rate/volume
differences increased $11,000.
Provision For Loan Losses. The allowance for losses on loans is maintained
at a level which is considered by management to be adequate to absorb probable
losses on existing loans that may become uncollectible based on an evaluation of
the collectibility, prior loss experience and market conditions. The evaluation
takes into consideration such factors as changes in the nature and volume of the
loan portfolio, overall portfolio quality, review of specific problem loans, and
current economic conditions that may affect the borrower's ability to pay. The
allowance for loan losses is established through a provision for loan losses
charged to expense.
The Bank's loan loss provision increased from $120,000 for the year ended
September 30, 1997, to $302,000 for the year ended September 30, 1998, due to
the change in composition of the loan portfolio. The Bank's allowance for loan
losses was $1,035,000 at September 30, 1998. The allowance for loan losses
represents .34% of total loans outstanding and 127.6% of total non-performing
assets. While the Bank maintains its allowance for loan losses at a level which
it considers to be adequate, there can be no assurance that further additions
will not be made to the loss allowances or that such losses will not exceed the
estimated amounts.
Non-interest Income. Total non-interest income increased by $759,000 to
$2.3 million for the year ended September 30, 1998, from $1.5 million for the
year ended September 30, 1997. Gains on loans sold increased from $48,000 in the
1997 fiscal year to $360,000 in the 1998 fiscal year. The gains are a result of
fixed-rate mortgages that were sold in the secondary market because they do not
fit the interest rate risk profile of the Bank. Other service charges and fees
increased from $422,000 for the year ended September 30, 1997 to $457,000 for
the year ended September 30, 1998. Service charges on deposit accounts increased
$105,000 during the periods compared as a result of an increase in the number of
accounts affected and to a lesser degree by an increase in the fees associated
with deposit accounts.
Commission income increased from $227,000 for the year ended September 30, 1997
to $543,000 for the year ended September 30, 1998. $214,000 of the increase was
a result of the acquisition of Insurance Planners, $50,000 was a result of
increased investment sales and $45,000 was due to the sale of federal crop
insurance (an ancillary activity to our agricultural lending).
Non-interest Expense. Total non-interest expense increased to $8.4 million
for the year ended September 30, 1998, from $7.1 million for the year ended
September 30, 1997, or 18.3%. Compensation and benefits increased from $4.5
million to $5.4 million or 20.2%, due to the acquisition of Insurance Planners
($122,000), the hiring of critical management and related support positions,
including Agricultural Lending, Marketing, Community Banking, internal audit
($400,000) and merit increases, which averaged 4.5%. Occupancy and equipment
expense increased $46,000. The Company expects increased compensation and
property costs in fiscal 1999, due to the acquisition of Homeowners Mortgage in
November, 1998. Deposit insurance premiums decreased $36,000. Professional fees
increased from $235,000 for fiscal year 1997 to $258,000 for fiscal year 1998.
Data processing increased $99,000 to $492,000 for the period ended September 30,
1998, due to processing expense associated with increased delivery of electronic
services to customers, the introduction of agricultural lending and the
expansion of commercial lending and to a lesser extent, as a result of the costs
associated with the Corporation's Year 2000 compliance program.
Furthermore, due to the acquisitions of Insurance Planners and Homeowners
Mortgage, the Company will experience approximately $115,000 in annual expense
due to the amortization, over a 25 year period, of goodwill associated with such
acquisitions.
Income Tax Expense. Income tax expense decreased to $2.0 million for the
year ended September 30, 1998, from $2.1 million for the year ended September
30, 1997. The decrease was primarily due to a decrease in pre-tax income of
$175,000.
11
<PAGE>
Comparison of Years Ended September 30, 1997 and 1996
Net Income. Net income increased by $1.4 million to $3.1 million for the
year ended September 30, 1997, from $1.7 million for the year ended September
30, 1996. The increase was primarily due to an increase in net interest income
and non-interest income and the decrease of non-interest expense.
Interest Income. Total interest income increased $4.1 million to $27.3
million for the year ended September 30, 1997, from $23.2 million for the year
ended September 30, 1996. Interest income on loans increased by $4.0 million
from $16.1 million for the year ended September 30, 1996, to $20.1 million for
the year ended September 30, 1997, as a result of a $44.3 million increase in
the average balance of loans receivable from $193.2 million at September 30,
1996, to $237.5 million at September 30, 1997. Furthermore, the average yield
increased from 8.32% at September 30, 1996, to 8.45% at September 30, 1997.
Interest income on mortgage-backed securities increased from $3.3 million for
the year ended September 30, 1996, to $3.4 million for the year ended September
30, 1997. The increase was primarily the result of an increase in average rate
from 6.03% for the 1996 fiscal year to 6.15% for the 1997 fiscal year. The
average balance of investment securities decreased by $3.0 million during the
fiscal year and the yield increased from 5.59% to 5.79%. The increase in yield
for investment securities was primarily impacted by maturities and the exercise
of call options by issuers. The yield on interest-earning assets increased from
7.33% for the year ended September 30, 1996, to 7.60% for the year ended
September 30, 1997. Interest income increased by $3.6 million as a result of
increased volume during the year while the changes in rates caused interest
income to increase by $419,000 and the rate/volume change increased interest
income by $81,000.
Interest Expense. Total interest expense increased to $16.3 million for
1997 from $13.6 million for 1996 as both the average balance of total interest
bearing liabilities and the average cost of funds increased. The increased cost
of deposits attendant to the growth of balances was approximately $1.8 million
while the decrease associated with a change in interest rates was approximately
$813,000. The cost associated with interest bearing deposits increased from
4.50% for the year ended September 30, 1996, to 4.60% for the same period ended
September 30, 1997. The cost associated with borrowed funds decreased to 5.83%
for fiscal 1997 compared to 5.91% for fiscal 1996. $70,000 of the decrease in
the cost of borrowed funds was a result of increases in rates, $1.8 million of
the increase was attributable to the increased volumes and $24,000 of the
decrease was rate/volume related.
Net Interest Income. Net interest income increased $1.3 million. Changes in
interest rates caused an increase in net interest income of $1.3 million,
volumes accounted for a decrease in net interest income of $32,000 and
rate/volume differences increased net interest income by $64,000.
Provision For Loan Losses. The allowance for losses on loans is maintained
at a level which is considered by management to be adequate to absorb probable
losses on existing loans that may become uncollectible based on an evaluation of
the collectibility, prior loss experience and market conditions. The evaluation
takes into consideration such factors as changes in the nature and volume of the
loan portfolio, overall portfolio quality, review of specific problem loans, and
current economic conditions that may affect the borrower's ability to pay. The
allowance for loan losses is established through a provision for loan losses
charged to expense.
The Bank's loan loss provision increased from $42,000 for the year ended
September 30, 1996, to $120,000 for the year ended September 30, 1997, due to
the change in composition of the loan portfolio. The Bank's allowance for loan
losses was $852,000 at September 30, 1997. The allowance for loan losses
represents .30% of total loans outstanding and 149% of total non-performing
assets. While the Bank maintains its allowance for loan losses at a level which
it considers to be adequate, there can be no assurance that further additions
will not be made to the loss allowances or that such losses will not exceed the
estimated amounts.
Non-interest Income. Total non-interest income increased by $156,000 to
$1.5 million for the year ended September 30, 1997, from $1.4 million for the
year ended September 30, 1996. Gains on loans sold increased from $38,000 in the
1996 fiscal year to $48,000 in the 1997 fiscal year. The gains are a result of
long-term fixed-rate mortgages (with an amortization of greater than 20 years)
that were sold in the secondary market because they do not fit the interest rate
risk profile of the Bank. Other service charges and fees decreased from $430,000
for the year ended September 30, 1996 to $422,000 for the year ended September
30, 1997. Service charges on deposit accounts increased $177,000 during the
periods compared as a result of an increase in the number of accounts affected
and to a lesser degree by an increase in the fees associated with deposit
accounts.
Non-interest Expense. Total non-interest expense decreased to $7.1 million
for the year ended September 30, 1997, from $8.2 million for the year ended
September 30, 1996, or 13.4%. Compensation and benefits increased from $4.4
million to $4.5 million or 1.9%, primarily due to merit increases. Occupancy and
equipment expense remained unchanged. Deposit insurance premiums decreased
58.9%, as a result of the reduction in the SAIF premium and the absence of a
one-time
12
<PAGE>
$1.0 million charge to recapitalize the SAIF in fiscal 1996. Professional fees
decreased from $249,000 for fiscal year 1996 to $235,000 for fiscal year 1997.
Income Tax Expense. Income tax expense increased to $2.1 million for the
year ended September 30, 1997, from $1.1 million for the year ended September
30, 1996, or 91.2%. The increase was primarily due to an increase in pre-tax
income of $2.5 million.
Liquidity and Capital Resources
The liquidity of a banking institution reflects its ability to provide funds to
meet loan requests, accommodate possible outflows in deposits, and take
advantage of interest rate market opportunities. Funding of loan requests,
providing for liability outflows, and management of interest rate fluctuations
require a continuous analysis in order to match the maturities of specific
categories of short-term loans and investments with specific types of deposits
and borrowings. The Bank's liquidity, represented by cash and cash equivalents,
is a product of its operating, investing and financing activities. The primary
sources of cash were net income and cash derived from investing activities.
Operating activities provided cash of $1.3 million, $3.8 million and $3.0
million during the years ended September 30, 1998, 1997, and 1996, respectively.
In fiscal 1997 and 1996, the cash flow in operating activities was primarily
influenced by the changes in accrued liabilities associated with the accrual of
the SAIF special assessment in fiscal 1996, which was paid out in fiscal 1997.
In fiscal 1998, the cash flow in operating activities was influenced primarily
by the change in loans held for sale.
Investing activities used $8.0 million, $39.5 million, and $52.2 million during
the years ended September 30, 1998, 1997, and 1996, respectively. During fiscal
1997 and fiscal 1996, the cash used in investing activities was primarily due to
the origination and purchase of loans, and to a lesser extent, the result of the
purchase of securities. The use of cash in those periods was offset by
maturities or the exercise of call options by the issuer of investments. Net
cash used in investing activities in fiscal 1998 was substantially reduced from
fiscal 1997 and fiscal 1996. The net of loan originations and principal payments
on loans used $10 million of cash flow in 1998 versus $41.2 million in 1997. The
reduction is a result of an increase in loans originated for sale ($27.4 million
in 1998 and $2.3 million in 1997), and an increase in prepayments of loans as
mortgage refinancing continued at high levels. The purchase of loans used $10.8
million in fiscal 1998 and was largely comprised of commercial business loans
that represented participation interests with other financial institutions.
Investment activities provided $13.4 million net, as a result of principal
payments, maturity of securities, and the exercise of call provisions by
issuers.
The primary activity of the Bank is originating and purchasing loans, and
purchasing investment and mortgage-backed securities. During the years ended
September 30, 1998, 1997, and 1996, the Bank originated loans in the amounts of
$147.6 million, $119.2 million and $97.6 million, respectively. The Bank also
purchases loans, investment and mortgage-backed securities to manage liquidity
and interest rate risk, to supplement local loan demand and to diversify its
loan portfolio. Funding of loans purchased was $10.8 million, $2.4 million and
$17.4 million for the 1998, 1997 and 1996 fiscal years, respectively. Purchases
of investment and mortgage-backed securities held to maturity totaled $0, $3.0
million, and $21.0 million, and securities available for sale totaled $3.7
million, $2.0 million and $2.0 million during the years ended September 30,
1998, 1997, and 1996, respectively. Other investment activities included
investments in U. S. Government and federal agency obligations, and FHLB of Des
Moines stock.
For the year ended September 30, 1998, $18.3 million in cash was provided as a
result of an increase in deposits and $10.4 million in cash was provided as a
result of an increase in borrowings. The purchase of treasury stock, and
dividends on common stock used $5.5 million, and $1.4 million, respectively.
During the fiscal year ended September 30, 1997, $19.2 million in cash was
provided as a result of an increase in deposits and $19.1 million was provided
as a result of an increase in borrowings. The purchase of treasury stock used
$7.2 million and dividends on common stock used $1.4 million during the 1997
fiscal year. Basic and diluted earnings per share for the year ended September
30, 1998, were $1.14 and $1.05, respectively. A portion of the earnings per
share was a result of the purchase of treasury stock during the fiscal year.
Financing activities provided $23.2 million, $30.0 million, and $46.2 million in
cash during the years ended September 30, 1998, 1997 and 1996, respectively.
Financing activities in the foreseeable future are expected to primarily include
changes in deposits and advances from FHLB of Des Moines. See Consolidated
Statements of Cash Flow for FSF Financial Corp. and Subsidiary.
The Bank's liquidity is a measure of its ability to fund loans, pay withdrawals
of deposits, and other cash outflows in an efficient, cost effective manner. The
Bank's primary source of funds are deposits and scheduled amortization and
prepayments of loan and mortgage-backed security principal. During the past
several years, the Bank has used such funds primarily to fund maturing time
deposits, pay savings withdrawals, fund lending commitments, purchase new
investments, and increase liquidity. The Bank funds its operations internally
and as needed with borrowed funds from the FHLB. As of September 30, 1998, such
borrowed funds totaled $144.2 million. While loan repayments and maturing
investments and mortgage-backed securities are relatively predictable sources of
funds, deposit flows and loan and mortgage-backed security prepayments are
greatly influenced by general interest rates, economic conditions and
competition.
13
<PAGE>
The Bank is required under federal regulations to maintain certain specified
levels of "liquid investments," which include certain United States government
obligations and other approved investments. In December of 1997, the OTS reduced
the requirement for banks to maintain liquid assets from 5% to not less than 4%
of its net withdrawable accounts plus short term borrowings. The Bank's
regulatory liquidity was 6.05%, 5.12%, and 6.08% at September 30, 1998, 1997,
and 1996, respectively. The options from the previous method were used in the
current period, which are more restrictive.
The amount of certificate accounts which are scheduled to mature during the
twelve months ending September 30, 1999, was approximately $81.7 million. To the
extent that these deposits do not remain at the Bank upon maturity, the Bank
believes that it can replace these funds with deposits, current excess
liquidity, FHLB advances or outside borrowings. It has been the Bank's
experience that a substantial portion of such maturing deposits remain at the
Bank.
At September 30, 1998, the Bank had commitments to extend credit of $31.7
million. Funds required to fill these commitments are derived primarily from
FHLB borrowings, current excess liquidity, deposit inflows, or loan and security
repayments.
OTS regulations require the Bank to maintain core capital of 4% of assets, of
which 2.0% must be tangible equity capital, excluding goodwill. The Bank is also
required to maintain risk-based capital equal to 8% of total risk-based assets.
The Bank's regulatory capital exceeded its tangible equity, tier 1 (risk based),
tier 1 (core) and risk-based capital requirements by 7.6%, 5.1%, 11.5% and 8.0%,
respectively.
Management believes that under current regulations, the Bank will continue to
meet its minimum capital requirements in the foreseeable future. Events beyond
the control of the Bank, such as increased interest rates or a downturn in the
economy in areas in which the Bank operates, could adversely affect future
earnings and as a result, the ability of the Bank to meet its future minimum
capital requirements.
Year 2000
The Year 2000 problem exists because many computer programs use only the last
two digits to refer to a year. This convention could affect date-sensitive
calculations that treat "00" as the year 1900, rather than 2000. An additional
issue is that 1900 was not a leap year, whereas the year 2000 is. Therefore,
some programs may not properly provide for February 29, 2000. This anomaly could
result in miscalculations when processing critical date-sensitive information
after December 31, 1999.
The following discussion of the implications of the Year 2000 problem for the
Bank, contains numerous forward looking statements based on inherently uncertain
information. The cost of the project and the date on which the Bank plans to
complete the internal Year 2000 modifications are based on management's best
estimates, which are derived utilizing a number of assumptions of future events
including the continued availability of internal and external resources, third
party modifications and other factors. However, there can be no guarantee that
these statements will be achieved and actual results could differ. Moreover,
although management believes it will be able to make the necessary modifications
in advance, there can be no guarantee that failure to modify the systems would
not have a material adverse effect on the Bank.
The Bank places a high degree of reliance on computer systems of third parties,
such as customers, suppliers, and other financial and governmental institutions.
Although the Bank is assessing the readiness of these third parties and
preparing contingency plans, there can be no guarantee that the failure of these
third parties to modify their systems in advance of December 31, 1999 would not
have a material adverse affect on the Bank.
During fiscal 1998, the Bank adopted a Year 2000 Compliance Plan (the "Plan")
and established a Year 2000 Compliance Committee (the "Committee"). The
objectives of the Plan and the Committee are to prepare the Bank for the new
millennium. As recommended by the Office of Thrift Supervision, the Plan
encompasses the following phases: Awareness, Assessment, Renovation, Validation
and Implementation. These phases will enable the Bank to identify risks, develop
an action plan, perform adequate testing and complete affirmation that its
processing systems will be Year 2000 ready. Execution of the Plan is currently
on target. The Bank is currently in Phase 4, Validation, which involves testing
of changes to hardware and software, accompanied by monitoring and testing with
vendors. Concurrently, the Bank is also addressing some issues related to
subsequent phases. Prioritization of the most critical applications has been
addressed, along with contract and service agreements. The material data
processing functions for the Bank are performed and maintained by a third party
vendor. The Bank has maintained ongoing contact with this vendor so that
modification of the software for Year 2000 readiness is a top priority and is
expected to be accomplished, though there is no assurance, by June 30, 1999. The
Bank has contacted all other material vendors and suppliers regarding their Year
2000 state of readiness. Each of these third parties has delivered written
assurance to the Bank that they expect to be Year 2000 compliant prior to the
Year 2000. The Bank has completed contacting all material customers and
non-information technology suppliers (i.e., utility systems, telephone systems
and security systems) regarding their Year 2000 state of readiness. The
Validation phase is targeted for completion by June 30, 1999. The
14
<PAGE>
Implementation phase is to certify that systems are Year 2000 ready, along with
assurances that any new systems are compliant on a going-forward basis. The
Implementation phase is targeted for completion by September 30, 1999.
Monitoring and managing the Year 2000 project will result in additional direct
and indirect costs to the Bank. Direct costs include potential charges by third
party software vendors for product enhancements, costs involved in testing
software products for Year 2000 compliance, and any resulting costs for
developing and implementing contingency plans for critical software products
which are not enhanced. Indirect costs will principally consist of the time
devoted by existing employees in managing software vendor progress, testing
enhanced software products and implementing any necessary contingency plans.
Total direct costs are estimated not to exceed $50,000. Actual costs will be
charged to earnings over the next five quarters, as incurred.
The Bank is developing remediation contingency plans and business resumption
contingency plans specific to the Year 2000. Remediation contingency plans
address the actions to be taken if the current approach to remediating a system
is falling behind schedule or otherwise appears to be in jeopardy of failing to
deliver a Year 2000 ready system when needed. Business resumption contingency
plans address the actions that would be taken if critical business functions can
not be carried out in the normal manner upon entering the next century due to
system or supplier failure.
Despite the best efforts of management to address this issue, the vast number of
external entities that have direct and indirect business relationships with the
Bank, such as customers, vendors, payment system providers and other financial
institutions, makes it impossible to assure that a failure to achieve compliance
by one or more of these entities would not have material adverse impact on the
operations of the Bank.
Impact of Inflation and Changing Prices
The financial statements and related data have been prepared in accordance with
generally accepted accounting principles which require the measurement of
financial position and operating results in terms of historical dollars, without
consideration for changes in the relative purchasing power of money over time
caused by inflation.
Unlike industrial companies, nearly all of the assets and liabilities of a
financial institution are monetary in nature. As a result, interest rates have a
more significant impact of a financial institution's performance than general
levels of inflation. Interest rates do not necessarily move in the same
direction or in the same magnitude as the price of goods and services, since
goods and services are affected by inflation. In the current interest rate
environment, liquidity and the maturity structure of the Bank's assets and
liabilities are critical to the maintenance of acceptable performance levels.
15
<PAGE>
INDEPENDENT AUDITOR'S REPORT
To the Board of Directors and Stockholders
FSF Financial Corp. and Subsidiaries
Hutchinson, MN 55350
We have audited the accompanying consolidated statements of financial condition
of FSF Financial Corp. and Subsidiaries (the Corporation) as of September 30,
1998, and 1997, and the related consolidated statements of income, changes in
stockholders' equity, and cash flows for each of the three fiscal years in the
period ended September 30, 1998. These financial statements are the
responsibility of the Corporation's management. Our responsibility is to express
an opinion on these financial statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.
In our opinion the financial statements referred to above present fairly, in
all material respects, the consolidated financial position of FSF Financial
Corp. and Subsidiaries as of September 30, 1998, and 1997, and the consolidated
results of their operations and their cash flows for each of the fiscal years in
the three-year period ended September 30, 1998, in conformity with generally
accepted accounting principles.
Bertram Cooper & Co., LLP
Waseca, Minnesota
October 23, 1998
16
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
<TABLE>
<CAPTION>
September 30,
--------------------------------------
1998 1997
--------------------------------------
(In thousands)
ASSETS
<S> <C> <C>
Cash and cash equivalents $ 22,597 $ 6,135
Securities available for sale, at fair value:
Equity securities 19,459 19,311
Mortgage-backed and related securities 16,574 16,699
Debt securities 3,010 1,000
Securities held to maturity, at amortized cost:
Debt securities (Fair value of $23,953 and $37,065) 24,412 37,876
Mortgage-backed and related securities (Fair value of $35,369 and $37,535) 36,418 38,539
Loans held for sale 2,672 204
Loan receivable, net 280,603 260,390
Foreclosed real estate 502 72
Accrued interest receivable 3,089 2,436
Premises and equipment 4,111 3,772
Other assets 2,785 1,701
---------------------------------
Total Assets $ 416,232 $ 388,135
=================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Liabilities:
Demand deposits $ 30,299 $ 28,059
Savings accounts 53,984 47,847
Certificates of deposit 142,259 132,340
---------------------------------
Total deposits 226,542 208,246
Federal Home Loan Bank borrowings 144,177 133,817
Advances from borrowers for taxes and insurance 819 773
Other liabilities 2,176 1,937
---------------------------------
Total liabilities 373,714 344,773
Stockholders' equity:
Serial preferred stock, no par value 5,000,000 shares
authorized, no shares issued
- -
Common stock, $.10 par value 10,000,000 shares authorized,
4,501,277 and 4,501,277 shares issued 450 450
Additional paid in capital 43,382 43,334
Retained earnings, substantially restricted 25,451 23,779
Treasury stock at cost (1,603,663 and 1,491,562 shares) (23,298) (20,267)
Unearned ESOP shares at cost (198,773 and 234,745 shares) (1,988) (2,347)
Unearned MSP stock grants at cost (77,214 and 104,604 shares) (818) (1,108)
Unrealized (loss) on securities available for sale (661) (479)
---------------------------------
Total stockholders' equity 42,518 43,362
---------------------------------
Total Liabilities and Stockholders' Equity $ 416,232 $ 388,135
=================================
</TABLE>
The accompanying notes are an integral part of these statements
17
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
Years Ended September 30,
----------------------------------------
1998 1997 1996
----------------------------------------
(In thousands)
<S> <C> <C> <C>
Interest income:
Loans receivable $ 23,512 $ 20,066 $ 16,077
Mortgage-backed and related securities 3,006 3,384 3,270
Investment Securities 3,463 3,865 3,897
----------------------------------------
Total interest income 29,981 27,315 23,244
----------------------------------------
Interest expense:
Deposits 10,082 9,339 8,262
Borrowed funds 8,417 7,007 5,347
----------------------------------------
Total interest expense 18,499 16,346 13,609
----------------------------------------
Net interest income 11,482 10,969 9,635
Provision for loan losses 302 120 42
----------------------------------------
Net interest income after provision for loan losses 11,180 10,849 9,593
----------------------------------------
Non-interest income:
Gain (loss) on loans - net 360 48 38
Other service charges and fees 457 422 430
Service charges on deposit accounts 822 717 540
Commission income 543 227 231
Other 87 96 115
----------------------------------------
Total non-interest income 2,269 1,510 1,354
----------------------------------------
Non-interest expense:
Compensation and benefits 5,393 4,487 4,404
Occupancy and equipment 846 800 797
Deposit insurance premiums 131 167 406
SAIF special assessment - - 1,030
Data processing 492 393 379
Professional fees 258 235 249
Other 1,275 1,048 913
----------------------------------------
Total non-interest expense 8,395 7,130 8,178
----------------------------------------
Income before provision for income taxes 5,054 5,229 2,769
Income tax expense 2,024 2,105 1,101
----------------------------------------
Net income 3,030 3,124 1,668
========================================
Basic earnings per share $ 1.14 $ 1.13 $ 0.49
Diluted earnings per share $ 1.05 $ 1.04 $ 0.47
</TABLE>
The accompanying notes are an integral part of these statements
18
<PAGE>
<TABLE>
<CAPTION>
FSF FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(In thousands)
Unallocated Unrealized
Retained Common Unearned (Loss) on
Additional Earnings Stock Stock Securities
Common Paid-in Substantially Held by Acquired by Treasury Available
Stock Capital Restricted ESOP MSP Stock For Sale Total
---------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance, September 30, 1995 $ 450 $ 43,069 $ 22,158 $ (3,103) $(1,688) $ (2,589) $ (946) $ 57,351
Net earnings - - 1,668 - - - - 1,668
Treasury stock acquired - - - - - (10,560) - (10,560)
Stock issued for stock options - 6 - - - 54 - 60
Amortization of MSP shares - - - - 290 - - 290
Common stock dividends
($0.50 per share) - - (1,758) - - - - (1,758)
Allocated ESOP shares - 75 - 384 - - - 459
Adjust valuation allowance for
securities available for sale - - - - - - 139 139
---------------------------------------------------------------------------------------------
Balance September 30, 1996 450 43,150 22,068 (2,719) (1,398) (13,095) (807) 47,649
Net earnings - - 3,124 - - - - 3,124
Treasury stock acquired - - - - - (7,245) - (7,245)
Stock issued for stock options - (12) - - - 73 - 61
Amortization of and tax on MSP shares - 40 - - 290 - - 330
Common stock dividends
($0.50 per share) - - (1,413) - - - - (1,413)
Allocated ESOP shares - 156 - 372 - - - 528
Adjust valuation allowance for
securities available for sale - - - - - - 328 328
---------------------------------------------------------------------------------------------
Balance September 30, 1997 450 43,334 23,779 (2,347) (1,108) (20,267) (479) 43,362
Net earnings - - 3,030 - - - - 3,030
Treasury stock acquired - - - - - (5,492) - (5,492)
Stock issued for stock options - (341) - - - 1,911 - 1,570
Amortization of and tax on MSP shares - 100 - - 290 - - 390
Common stock dividends
($0.50 per share) - - (1,358) - - - - (1,358)
Purchase of subsidiary - 106 550 656
Allocated ESOP shares - 183 - 359 - - - 542
Adjust valuation allowance for
securities available for sale - - - - - - (182) (182)
---------------------------------------------------------------------------------------------
Balance September 30, 1998 $ 450 $ 43,382 $ 25,451 $ (1,988) $ (818) $(23,298) $ (661) $ 42,518
=============================================================================================
</TABLE>
The accompanying notes are an integral part of these statements
19
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
Years Ended September 30,
-----------------------------------------------
1998 1997 1996
-----------------------------------------------
(In thousands)
<S> <C> <C> <C>
Cash flows from operating activities:
Net income $ 3,030 $ 3,124 $ 1,668
Adjustments to reconcile net income to net cash
provided by operating activities:
Depreciation 359 329 340
Net amortization of discounts and premiums on
securities held to maturity (42) (31) (36)
Provision for loan losses 302 120 42
Net market value adjustment on ESOP shares 185 141 89
Tax benefit on stock options 254 10 -
Amortization of ESOP and MRP stock compensation 650 669 674
Amortization of intangibles 10 - -
Net gain on sale of assets (18) - (5)
Federal Home Loan Bank stock dividends - - (81)
Net loan fees deferred and amortized (194) 214 283
(Increase) decrease in:
Loans held for sale (2,469) (160) (213)
Accrued interest receivable (653) (111) (228)
Other assets (142) 132 (72)
Increase (decrease) other liabilities 67 (589) 499
------------------------------------------------
Net cash provided by operating activities 1,339 3,848 2,960
Cash flows from investing activities:
Loan originations and principal payments on loans, net (9,928) (41,245) (28,770)
Purchase of loans (10,832) (2,445) (17,447)
Principal payments on securities held to maturity 2,125 19 49
Purchase of mortgage-related securities held to maturity - - (1,494)
Purchase of securities available for sale (3,671) (1,956) (1,963)
Purchase of securities held to maturity - (3,000) (19,552)
Proceeds from securities available for sale 411 - -
Proceeds from maturities of securities available for sale 1,000 - -
Proceeds from maturities of securities held to maturity 13,500 9,500 17,150
Investment in foreclosed real estate (12) (2) (21)
Proceeds from sale of REO 24 22 112
Proceeds from sale of fixed assets 5 - 2
Purchase of equipment and property improvements (666) (373) (311)
------------------------------------------------
Net cash (used in) investing activities $ (8,044) $ (39,480) $ (52,245)
</TABLE>
The accompanying notes are an integral part of these statements
20
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
CONSOLIDATED STATEMENTS OF CASH FLOWS (Continued)
<TABLE>
<CAPTION>
Years Ended September 30,
--------------------------------------------
1998 1997 1996
--------------------------------------------
Cash flows from financing activities: (In thousands)
<S> <C> <C> <C>
Net increase in deposits, $ 18,297 $ 19,171 $ 17,558
Net increase in short-term borrowings 10,359 19,124 40,886
Net increase in mortgage escrow funds 46 305 6
Treasury stock purchased (5,492) (7,245) (10,559)
Dividends on common stock (1,358) (1,413) (1,758)
Proceeds from exercise of stock options 1,315 69 53
--------------------------------------------
Net cash provided by financing activities 23,167 30,011 46,186
--------------------------------------------
Net increase in cash and cash equivalents 16,462 (5,621) (3,099)
Cash and cash equivalents:
Beginning of year 6,135 11,756 14,855
--------------------------------------------
End of period $ 22,597 $ 6,135 $ 11,756
============================================
Supplemental disclosures of cash flow information:
Cash payments for:
Interest on advances and other borrowed money $ 8,464 $ 6,976 $ 5,368
Interest on deposits 10,220 9,188 8,258
Income taxes 1,850 1,999 1,656
Loans originated for sale 27,421 2,342 2,138
Cash received:
Loans sold 25,156 2,103 1,852
Supplemental schedule of noncash investing and
financing activities:
Federal Home Loan Bank stock dividends $ - $ - $ 81
Reinvested amounts of capital gains and dividends
from mutual fund investments 121 22 163
Foreclosed real estate 449 20 74
Stock acquisition of Insurance Planners 656 - -
</TABLE>
The accompanying notes are an integral part of these statements
21
<PAGE>
(1) Summary of Significant Accounting Policies
The unaudited consolidated financial statements as of and for the period ended
September 30, 1998, include the accounts of FSF Financial Corp. ("the
Corporation") and its wholly owned subsidiaries, Insurance Planners of
Hutchinson, Inc. ("Insurance Planners"), First Federal fsb ("the Bank") and
Firstate Services, a wholly owned subsidiary of the Bank. The Corporation's
business is conducted principally through the Bank. All significant intercompany
accounts and transactions have been eliminated in consolidation.
Nature of Business
The Corporation is a unitary thrift holding company whose subsidiary provides
financial services. The Bank's business is that of a financial intermediary and
consists primarily of attracting deposits from the general public and using such
deposits, together with borrowings and other funds, to make mortgage loans
secured by residential real estate located primarily in Minnesota. At September
30, 1998, the Bank operated 11 retail banking offices in Minnesota. The Bank is
subject to significant competition from other financial institutions, and is
also subject to regulation by certain federal agencies and undergoes periodic
examinations by those regulatory authorities. Insurance Planners is a property
and casualty insurance agency.
Use of Estimates
In preparing the consolidated financial statements, management is required to
make estimates and assumptions that affect the reported amounts of assets and
liabilities as of the date of the consolidated statements of financial
condition, and income and expenses for the period. Actual results could differ
from those estimates. Material estimates that are particularly susceptible to
significant change relate to the determination of the allowance for losses on
loans and the valuation of real estate acquired in connection with foreclosures
or in satisfaction of loans. In connection with the determination of the
allowances for losses on loans and foreclosed real estate, management obtains
independent appraisals for significant properties. While management uses
available information to recognize losses on loans and foreclosed real estate,
future additions to the allowances may be necessary based on changes in local
economic conditions. In addition, regulatory agencies, as an integral part of
their examination process, periodically review the Bank's allowance for losses
on loans and foreclosed real estate. Such agencies may require the Bank to
recognize additions to the allowance based on their judgments about information
available to them at the time of their examination.
Cash Equivalents (In thousands)
For purposes of the consolidated statements of cash flows, the Corporation
considers all highly liquid debt instruments with original maturities of three
months or less and money market funds to be cash equivalents. Cash and cash
equivalents include interest bearing deposits of $15,299 and, $3,645 at
September 30, 1998, and 1997, respectively.
Debt and Equity Securities
The Corporation classifies its investments, including marketable equity
securities, mortgage-backed securities, and mortgage-related securities, in one
of three categories:
Trading Account Securities
Securities held principally for resale in the near term, are classified
as trading account securities and recorded at their fair values.
Unrealized gains and losses on trading account securities are included
in other income. The Corporation did not hold any trading securities at
September 30, 1998 or 1997.
Securities Held to Maturity
Debt securities which the Corporation has the positive intent and
ability to hold to maturity are reported at cost, adjusted for premiums
and discounts that are recognized in interest income using the interest
method over the period to maturity. Unrealized losses on held to
maturity securities reflecting a decline in value judged to be other
than temporary are charged to income.
Securities Available for Sale
Available for sale securities consist of equity securities and certain
debt securities not classified as trading securities nor as held to
maturity securities. Unrealized holding gains and losses, net of income
taxes, on available for sale securities are reported as a net amount in
a separate component of shareholders' equity until realized. Gains and
losses on the sale of available for sale securities are determined
using the specific identification method. Any decision to sell
available for sale securities would be based on various factors,
22
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
including movements in interest rates, changes in the maturity mix of
the Corporation's assets and liabilities, liquidity demands, regulatory
capital considerations, and other similar factors. Premiums and
discounts are recognized in interest income using the interest method
over the period to maturity. Unrealized losses on available for sale
securities reflecting a decline in value judged to be other than
temporary are charged to income.
The Bank, as a member of the Federal Home Loan Bank System, is required to
maintain an investment in capital stock of the Federal Home Loan Bank of Des
Moines ("FHLB") in varying amounts based on balances of outstanding home loans
and on amounts borrowed from the FHLB. Because no ready market exists for this
stock, and it has no quoted market value, the Bank's investment in this stock is
carried at cost.
Loans Held for Sale
Mortgage loans originated and intended for sale in the secondary market are
carried at the lower of cost or estimated market value in the aggregate. Net
unrealized losses are recognized through a valuation
allowance by charges to income.
Loans Receivable
Loans receivable that management has the intent and ability to hold for the
foreseeable future or until maturity or payoff are reported at their outstanding
principal adjusted by any charge-offs, the allowance for loan losses, and any
deferred fees or costs on originated loans and unamortized premiums or discounts
on purchased loans. Discounts and premiums on purchased real estate loans are
amortized to income using the interest method over the remaining period to
contractual maturity, adjusted for anticipated prepayments. Discounts and
premiums on purchased consumer loans are recognized over the expected lives of
the loans using the level yield method.
The allowance for loan losses is increased by charges to income and decreased by
charge-offs (net of recoveries). Management's periodic evaluation of the
adequacy of the allowance is based on the Bank's past loan loss experience,
known and inherent risks in the portfolio, adverse situations that may affect
the borrower's ability to repay, estimated value of any underlying collateral,
and current economic conditions. Loans are considered impaired if full principal
or interest payments are not anticipated in accordance with the contractual loan
terms. Impaired loans are carried at the present value of expected future cash
flows discounted at the loan's effective interest rate or at the fair value of
the collateral if the loan is collateral dependent. A portion of the allowance
for loan losses is allocated to impaired loans if the value of such loans is
deemed to be less than the unpaid balance. If these allocations cause the
allowance for loan losses to require an increase, such an increase is reported
as a component of the provision for loan losses.
Uncollectible interest on loans that are contractually past due for three months
is charged off or an allowance is established, based on management's periodic
evaluation. 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 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.
Loan origination fees and certain direct origination costs are capitalized with
the net fee or cost recognized as an adjustment to interest income using the
interest method.
Foreclosed Real Estate
Real estate properties acquired through, or in lieu of, loan foreclosure are
initially recorded at fair value at the date of foreclosure establishing a new
cost basis. After foreclosure, valuations are periodically performed by
management and the real estate is carried at the lower of carrying amount or
fair value minus estimated costs to sell. Revenue and expenses from operations
and changes to the valuation allowance are included in operations.
Income Taxes
The Corporation calculates income taxes on the liability method, under which the
net deferred tax asset or liability is determined based on the tax effects of
the differences between the book and tax bases of the various assets and
liabilities of the Corporation giving current recognition to changes in tax
rates and laws.
Premises and Equipment
Land is carried at cost. Buildings, leasehold improvements and equipment are
carried at cost, less accumulated depreciation and amortization. Buildings and
equipment are depreciated using the straight-line method over the estimated
useful lives of the assets. The cost of leasehold improvements is being
amortized using the straight-line
23
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
method over the terms of the related leases. Net gains and losses on disposal or
retirement of premises and equipment are included in other income.
Mortgage Loan-Servicing Rights
The Bank has established accounting and reporting standards for transfers and
servicing of financial assets and extinguishments of liabilities based on the
consistent application of the financial-components approach. This approach
requires the recognition of financial assets and servicing assets that are
controlled by the Bank, and the derecognition of financial assets and
liabilities when control is extinguished. Liabilities and derivatives incurred
or obtained in conjunction with the transfer of financial assets are measured at
fair value, if practicable. Servicing assets and other retained interest in
transferred assets are measured by allocating the carrying amount between the
assets sold and the interest retained, based on their relative fair value.
Mortgage servicing rights are amortized in proportion to, and over the period
of, estimated net servicing revenues. Impairment of mortgage servicing rights is
assessed based on the fair value of those rights. Fair values are estimated
using discounted cash flows based on a current market interest rate. The Bank
evaluates the mortgage servicing rights strata for impairment by estimating the
fair value based on anticipated future net cash flows, taking into consideration
prepayment predictions. The predominant characteristics used as the basis for
stratifying are loan types, period of origination, and interest rates. The
amount of impairment recognized is the amount by which the capitalized mortgage
servicing rights for a stratum exceed their fair value.
Earnings Per Share
The Corporation adopted Statement of Financial Accounting Standard ("SFAS") No.
128, "Earnings Per Share," during the year ended September 30, 1998.
Accordingly, all prior period earnings per share amounts have been restated in
accordance with this standard.
Basic income per share amounts are computed by dividing the net income by the
weighted average number of common shares outstanding. Diluted income per share
amounts were computed by dividing net income, adjusted for the effect of assumed
conversions, by the weighted average number of common shares outstanding plus
dilutive potential common shares calculated for stock options outstanding using
the treasury stock method.
Treasury Stock
Treasury stock is recorded at cost. In the event of subsequent reissue, the
treasury stock account will be reduced by the cost of such stock on the average
cost basis with any excess proceeds credited to additional paid-in capital.
Treasury stock is available for general corporate purposes.
Stock-Based Compensation
Effective for the year ended September 30, 1998, the Corporation has adopted
SFAS No. 123, "Accounting for Stock-Based Compensation." As allowed by SFAS No.
123, the Corporation has elected to continue using the accounting methods
prescribed by Accounting Principles Board (APB) Opinion No. 25 and related
interpretations, which measure compensation cost using the intrinsic value
method. See Note 10 for the impact of the fair value of employee stock-based
compensation plans on net income and earnings per share on a pro forma basis for
awards granted after October 1, 1995.
Fair Values of Financial Instruments
The following methods and assumptions were used by the Corporation in estimating
fair values of financial instruments as disclosed herein:
Cash and cash equivalents - The carrying value of cash and cash equivalents
approximate fair value.
Debt and equity securities - Fair values of debt and equity securities have
been estimated using quoted market prices.
Loans receivable - For variable-rate loans, loans with balloon maturities,
loans with relatively near-term maturities (such as consumer installment
loans) carrying values approximate fair values. The fair value of long-term
fixed rate loans has been estimated using present value cash flows,
discounted at a rate approximating current market rates and giving
consideration to estimated prepayment risk and credit loss factors. The
estimated fair value of loans held for sale is based on quoted market
prices of similar instruments trading in the secondary market.
Originated mortgage servicing rights - The carrying amounts of originated
mortgage servicing rights approximate fair values.
24
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Accrued interest - The carrying
amounts of accrued interest receivable approximate their fair values
Deposit liabilities - The fair values of demand deposits are, by
definition, equal to the amount payable on demand at the reporting date
(that is, their carrying amounts). The carrying amounts of variable-rate,
fixed-term money market accounts and certificates of deposits approximate
their fair values at the reporting date. Fair values for fixed-rate
certificates of deposit are estimated using a discounted cash flow
calculation that applies interest rates currently being offered on
certificates to a schedule of aggregated expected monthly maturities on
time deposits. Short-term borrowings - The carrying amounts of advances
from the Federal Home Loan Bank (FHLB) of Des Moines maturing within 90
days approximate their fair values. Long-term borrowings - The carrying
amounts of amounts of long-term borrowings are estimated using discounted
cash flow analyses based on the Bank's current incremental borrowing rates
for similar types of borrowing arrangements. Off-balance-sheet items - Fair
value for off-balance-sheet lending commitments are based on fees currently
charged to enter into similar agreements, taking into account the remaining
terms of the agreements and the counterparties' credit standings. The
carrying value and fair value of commitments to extend credit are not
considered material for disclosure.
(2) Business Combination
On June 1, 1998, the Corporation acquired 100% of the outstanding common stock
of Insurance Planners. The business combination was accounted for by the
purchase method and the financial statements reflect the operating results of
Insurance Planners for the four month period ended September 30, 1998. The
Corporation issued 38,691 shares of common stock held as treasury shares to
complete the acquisition. The acquisition price of $750,000, resulted in an
acquired identifiable customer based intangible asset of $674,628, which will be
amortized using the straight line method over twenty five years. The acquisition
did not have a material pro-forma effect on the results of operations for the
twelve month periods ending September 30, 1998, 1997 and 1996.
(3) Debt and Equity Securities (in thousands)
Debt and equity securities have been classified in the consolidated balance
sheets according to management's intent. The carrying amount of securities and
their approximate fair values at September 30 are presented as follows:
<TABLE>
<CAPTION>
September 30, 1998
--------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
--------------- ------------- -------------- ---------------
<S> <C> <C> <C> <C>
Available for sale securities:
Equity securities
Fund Investments $ 12,522 $ - $ 426 $ 12,096
Stock in FHLB 7,363 - - 7,363
--------------- ------------- -------------- ---------------
Total $ 19,885 $ - $ 426 $ 19,459
=============== ============= ============== ===============
Mortgage backed securities:
REMICs $ 16,980 $ - $ 406 $ 16,574
=============== ============= ============== ===============
Debt Securities: $ 3,000 $ 10 $ - $ 3,010
=============== ============= ============== ===============
Held to maturity securities:
Debt securities:
U.S. Government and Agenc $ 24,412 $ 646 $ 1,105 $ 23,953
=============== ============= ============== ===============
Mortgage backed securities:
REMICs $ 36,363 $ 65 $ 1,120 $ 35,308
GNMA certificates 49 6 - $ 55
FHLMC certifiactes 6 - - $ 6
--------------- ------------- -------------- ---------------
Total $ 36,418 $ 71 $ 1,120 $ 35,369
=============== ============= ============== ===============
</TABLE>
25
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The amortized cost of debt and mortgage-backed securities at September 30, 1998
included unamortized premiums of $232 and unaccreted discounts of $392,
respectively.
<TABLE>
<CAPTION>
September 30, 1997
---------------------------------------------------------------------
Gross Gross
Amortized Unrealized Unrealized Fair
Cost Gains Losses Value
-------------- ---------------- ---------------- ---------------
<S> <C> <C> <C> <C>
Available for sale securities:
Equity securities
Fund Investments $ 12,522 $ - $ 325 $ 12,197
Stock in FHLB 6,692 - - 6,692
Preferred Stock 399 23 - 422
--------------- -------------- -------------- --------------
Total $ 19,613 $ 23 $ 325 $ 19,311
=============== ============== ============== ==============
Mortgage backed securities:
REMICs $ 16,980 $ - $ 281 $ 16,699
=============== ============== ============== ==============
Debt Securities: $ 1,000 $ - $ - $ 1,000
=============== ============== ============== ==============
Held to maturity securities:
Debt securities:
U.S. Government and Agency $ 37,876 $ 372 $ 1,183 $ 37,065
=============== ============== ============== ==============
Mortgage backed securities:
REMICs $ 38,469 $ 90 $ 1,103 $ 37,456
GNMA certificates 63 8 - 71
FHLMC certifiactes 7 1 - 8
--------------- -------------- -------------- --------------
Total $ 38,539 $ 99 $ 1,103 $ 37,535
=============== ============== ============== ==============
</TABLE>
The amortized cost of debt and mortgage backed securities at September 30, 1997,
includes unamortized premiums of $241 and unaccreted discounts of $444,
respectively.
Gross realized gains on sales of available for sale securities was $11 for the
year ended September 30, 1998. There were no sales of securities during the two
years ended September 30, 1997 and 1996.
The scheduled maturities of securities held-to-maturity and securities (other
than equity securities) available-for-sale at September 30, 1998, were as
follows:
<TABLE>
<CAPTION>
Held-to-Maturity Available-for-Sale
Securities Securities
---------------------------------- -------------- --------------
Amortized Fair Amortized Fair
Cost Value Cost Value
--------------- --------------- -------------- --------------
<S> <C> <C> <C> <C>
Due in one year or less $ 3,502 $ 3,502 $ - $ -
Due from one to five years 7,628 7,313 3,000 3,010
Due from five to ten years 7,065 6,382 - -
Due after ten years 42,635 42,125 16,980 16,574
--------------- --------------- -------------- --------------
Total $ 60,830 $ 59,322 $ 19,980 $ 19,584
=============== =============== ============== ==============
</TABLE>
For purposes of the maturity table, mortgage-backed securities, which are not
due at a single maturity date, have been allocated over maturity groupings based
on the weighted-average contractual maturities of underlying collateral. The
mortgage-backed securities may mature earlier than their weighted-average
contractual maturities because of principal prepayments.
26
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Debt and mortgage-backed securities carried at approximately $26.7 million at
September 30, 1998 and $27.5 million at September 30, 1997, were pledged to
secure public deposits and for other purposes required or permitted by law.
(4) Loans Receivable (in thousands)
Loans receivable are summarized as follows:
<TABLE>
<CAPTION>
September 30,
--------------------------------------
1998 1997
----------------- ----------------
<S> <C> <C>
First mortgage loans:
Secured by one-to-four family residences $ 154,668 $ 170,366
Secured by other properties 25,235 28,364
Construction and Land Development loans 34,098 34,384
----------------- ----------------
214,001 233,114
Less:
Undisbursed portion of construction and land development loans (16,658) (20,364)
Unearned discounts - (22)
Net deferred loan origination fees (850) (1,014)
----------------- ----------------
Sub-total first mortgage loans 196,493 211,714
Consumer and other loans:
Consumer loans 17,275 20,417
Home equity and second mortgages 23,606 20,812
Commercial 21,095 8,114
Agricultural loans 22,960 -
----------------- ----------------
84,936 49,343
Add: net deferred loan origination costs 209 185
----------------- ----------------
Sub-total consumer and other loans 85,145 49,528
----------------- ----------------
Sub-total all loans 281,638 261,242
Less: allowance for loan losses (1,035) (852)
----------------- ----------------
Total $ 280,603 $ 260,390
================= ================
</TABLE>
A summary of the activity in the allowance for loan losses is as follows:
<TABLE>
<CAPTION>
Years Ended Spetember 30,
-----------------------------------------------------
1998 1997 1996
----------------- ---------------- ----------------
<S> <C> <C> <C>
Balance, beginning of period $ 852 $ 776 $ 764
Provision for losses 302 120 42
Charge-offs (132) (50) (34)
Recoveries 13 6 4
----------------- ---------------- ----------------
Balance, end of period $ 1,035 $ 852 $ 776
================= ================ ================
</TABLE>
Recorded investments in impaired loans were $0 at September 30, 1998, and $82,
at September 30, 1997. The average recorded investment in impaired loans during
1998 and 1997 was $178 and $137, respectively. The total allowance for loan
losses related to these loans was $3, on September 30, 1997. No interest income
on these loans was recognized or received in 1998 and 1997.
Loans having carrying values of $449 and $20 were transferred to foreclosed real
estate in 1998 and 1997, respectively.
The Bank is not committed to lend additional funds to debtors whose loans have
been modified.
27
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The aggregate amount of loans to executive officers and directors of the
Corporation were $489, and $639 at September 30, 1998, and 1997, respectively.
During 1998 repayments on loans to executive officers and directors aggregated
$55 and $94 was advanced.
(5) Loan Servicing (in thousands)
Mortgage loans serviced for others are not included in the accompanying
consolidated statements of financial condition. The unpaid principal balances of
these loans serviced for others was $46,456 and $42,734 at September 30, 1998
and 1997, respectively.
Custodial escrow balances maintained in connection with the foregoing loan
servicing, and included in demand deposits, were $274 and $237 at September 30,
1998 and 1997, respectively.
Capitalized mortgage servicing rights and excess servicing receivables are
summarized as follows:
<TABLE>
<CAPTION>
Years Ended Spetember 30,
----------------------------------------------------
1998 1997 1996
----------------- ---------------- ----------------
<S> <C> <C> <C>
Beginning balance,net of accumulated amortization $ 148 $ 157 $ 155
Amounts capitalized 98 20 23
Amortization (42) (30) (18)
Valuation adjustments (3) 1 (3)
----------------- ---------------- ----------------
Balance, end of period $ 201 $ 148 $ 157
================= ================ ================
</TABLE>
(6) Foreclosed Real Estate (In thousands)
Gain on foreclosed real estate, including net revenues from operations, was not
material for the three years ended September 30, 1998. The Bank held foreclosed
real estate at September 30, 1998 and 1997 amounting to $502 and $72,
respectively.
(7) Premises and Equipment (in thousands)
Premises and equipment are summarized as follows:
<TABLE>
<CAPTION>
September 30,
---------------------------------
1998 1997
---------------- ----------------
<S> <C> <C>
Land $ 685 $ 490
Buildings and improvements 3,787 3,693
Furniture, equipment and automobiles 2,818 2,685
Leasehold improvements 40 40
---------------- ----------------
Total costs 7,330 6,908
Less accumulated depreciation 3,219 3,136
---------------- ----------------
Total $ 4,111 $ 3,772
================ ================
</TABLE>
At September 30, 1998, the Bank was obligated under noncancelable operating
leases for office space. Net rental expense under operating leases, included in
occupancy and equipment, was $51, $58, and $59 for the years ended September 30,
1998, 1997, and 1996, respectively.
28
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The projected minimum rental commitments under the terms of the leases at
September 30, 1998, are as follows:
Rental Income Rental Expense
Fiscal as Lessor as Lessee
- ------ ----------------------- -------------------
1999 $ 18 $ 45
2000 5 36
2001 - 36
2002 - 28
2003 - 28
----------- ----------
$ 23 $ 173
=========== ==========
(8) Deposits (in thousands)
The aggregate amount of short-term jumbo CDs, each with a minimum denomination
of $100,000, was $24,311 and $30,938 in 1998 and 1997 respectively.
Interest expense on deposits is summarized as follows:
September 30,
-----------------------------------------------------
1998 1997 1996
---------------- ----------------- ----------------
Savings accounts $ 1,690 $ 1,548 $ 1,576
Demand deposits 407 389 443
Certificates of deposit 7,985 7,402 6,243
---------------- ----------------- ----------------
$ 10,082 $ 9,339 $ 8,262
================ ================= ================
At September 30, 1998, the scheduled maturities of certificates of deposit are
as follows:
Years Ending September 30,
--------------------------
1999 $ 81,745
2000 43,626
2001 12,204
2002 2,278
2003 and thereafter 2,406
-------------
$ 142,259
=============
(9) Federal Home Loan Bank Borrowings (in thousands)
Borrowings by the Bank from the Federal Home Loan Bank of Des Moines (FHLB) are
summarized as follows:
<TABLE>
<CAPTION>
September 30,
--------------------------------------------------------
1998 1997
---------------------------- ---------------------------
Fiscal Year of Maturity - Advances Weighted Weighted
- ----------------------------------
Amount Rate Amount Rate
------------- -------------- ------------- ------------
<S> <C> <C> <C> <C>
1998 $ - - % $ 90,400 5.75 %
1999 3,000 6.55 13,000 6.03
2000 24,677 5.89 7,417 5.89
2001 24,000 5.80 15,000 6.00
2002 30,000 5.46 - -
2003 and thereafter 62,500 5.01 - -
------------- ----------
Total 144,177 125,817
Line of Credit from FHLB - variable 8,000 variable
------------- -------------- ---------- -------------
$144,177 5.42 $ 133,817 5.83
============= ============== ============= =============
</TABLE>
29
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
At September 30, 1998, borrowed funds are collateralized by stock in the FHLB,
first mortgage loans with carrying value of $155,197 and debt and
mortgage-backed securities with carrying values of $44,149 under a collateral
agreement. The line of credit has a variable rate of interest that is adjusted
daily based on the FHLB's short-term investment return. The interest rate on the
line of credit was 5.37% and 5.75% at September 30, 1998, and 1997,
respectively. The total amount available to the Bank on its line of credit was
$12,500 and $17,000 at September 30, 1998 and 1997, respectively.
(10) Employee and Stock Benefit Plans (in thousands except shares)
Salary Continuation Plans
The Bank has adopted insured salary continuation plans for the benefit of
selected members of management by providing them with retirement and death
benefits. The estimated liability under the agreements is charged to income over
the expected remaining years of employment. The Bank's policy is to fund the
costs accrued with insurance contracts. Salary continuation expense amounted to
$151, $142, and $134 for the three years ended September 30, 1998, respectively.
Employee Stock Ownership Plan
At the time of the stock conversion, the Bank established an Employee Stock
Ownership Plan (ESOP) covering all employees, over the age of 21, with at least
one year of service and who work at least 1,000 hours during a plan year. The
ESOP borrowed funds from the Corporation to purchase a total of 359,720 shares
of the Corporation's Common Stock, the loan being collateralized by the Common
Stock. Contributions by the Bank, along with dividends received on unallocated
shares, are being used to repay the loan with shares being released from the
Corporation's lien proportional to the loan repayments. Annually, on September
30, the released shares are allocated to the participants in the same proportion
that their wages bear to the total compensation of all of the participants.
Unreleased ESOP shares are not considered outstanding in calculating earnings
per share.
The Corporation presents these financial statements in accordance with the AICPA
Statement of Position (SOP) No. 93-6, "Employers' Accounting for Employee Stock
Ownership Plans." The price of the shares issued and unreleased are charged to
unearned compensation, a contra-equity account, and shares released are reported
as compensation expense equal to the current market value price of the released
shares. Dividends paid on allocated shares are charged to retained earnings and
those on unallocated shares are charged to expense. The total amount charged to
expense in the fiscal year ended September 30, 1998, 1997 and 1996 was $668,
$549 and $449, respectively.
A summary of the ESOP share allocation is as follows:
<TABLE>
<CAPTION>
September 30,
------------------------------------------------------
1998 1997 1996
---------------- ---------------- ----------------
<S> <C> <C> <C>
Shares allocated beginning of year 124,975 87,870 49,461
Shares allocated during year 35,972 37,105 38,409
Unreleased shares 198,773 234,745 271,850
---------------- ---------------- ----------------
Total ESOP 359,720 359,720 359,720
================ ================ ================
Fair value of unreleased shares $ 3,131 $ 4,607 $ 3,466
================ ================ ================
</TABLE>
Management Stock Plan
The Bank established the Management Stock Plan (MSP) for key officers during the
year ended September 30, 1998. Following shareholder approval of the MSP in
January 1995, the Bank purchased 179,860 shares of the Corporation's common
stock in the open market at $10.59 per share to be awarded to officers in
accordance with the provisions of the MSP. The cost of the shares awarded under
these plans is recorded as unearned compensation, a contra equity account, and
is recognized as an expense in accordance with the vesting requirements defined
by the MSP. For each of the three fiscal years ended September 30, 1998, the
amount included in compensation expense related to the MSP was $290. The
following summarizes the activity in the MSP for the three years ended September
30, 1998.
30
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Unawarded Awarded
Shares Shares
------------------ ----------------
At September 30, 1995 42,964 136,896
Vested - (27,379)
------------------ ----------------
At September 30, 1996 42,964 109,517
Vested - (27,379)
------------------ ----------------
At September 30, 1997 42,964 82,138
Vested - (27,379)
------------------ ----------------
At September 30, 1998 42,964 54,759
================== ================
Director's Stock Compensation Plan
In January 1998, the shareholders of the Corporation approved a stock
compensation plan for its non-employee directors. The plan granted 6,000 shares
of common stock issued from treasury that vests over a four year period, with
1,200 shares awarded in January 1998. The compensation cost associated with this
plan is the fair value of the stock ($19.42/share) on the date the plan was
approved by shareholders. Compensation cost included in the accompanying
financial statements for the year ended September 30, 1998 was $40,814. During
the year ended September 30, 1998, 1,200 shares of the total grant were vested
to the plan recipients.
Stock Option Plans
The Corporation maintains the 1995 stock option plan, approved by the
Corporation's stockholders on January 17, 1995 (the 1995 Plan); and the 1998
stock option plan, approved by the Corporation's stockholders on January 20,
1998 (the 1998 Plan). These plans permit the granting of stock options, with an
exercise price equal to the fair value of the Corporation's stock on the date of
the option grant. All options granted under these plans may be exercised over a
ten-year period beginning on the date the option is granted or vested (becomes
exercisable by the recipient). Awards made under the Plans may be incentive
stock plans (ISO's) as defined by Section 422 of the Internal Revenue Code or
options that do not qualify. Those options granted that qualify as ISO's are
generally exercisable on the date of the grant while those not qualifying
(non-incentive stock options granted to executives and directors of the
Corporation) vest over 3-5 years. The following summarizes the activity in the
two Plans for the three years ended September 30, 1998:
<TABLE>
<CAPTION>
Available Options Weighted Average
for Grant Outstanding Exercise Price
------------ -------------- -----------------
<S> <C> <C> <C>
At September 30, 1995 7,487 438,757 $ 9.50
Exercised - (5,599) 9.50
------------ -------------- -----------------
At September 30, 1996 7,487 433,158
Granted - (5,405) 9.50
Cancelled 1,500 (1,500) 9.50
------------ -------------- -----------------
At September 30, 1997 8,987 426,253 -
1998 Plan Created 300,000 - -
Granted (145,601) 145,601 19.18
Exercised - (135,957) 9.50
------------ -------------- -----------------
At September 30, 1998 163,386 435,897 $ 12.73
============ ============== =================
</TABLE>
Shares available for future grants
1995 Plan 7,987
1998 Plan 155,399
31
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The following table summarizes information about stock options outstanding at
December 31, 1998:
- --------------------------------------------------------------------------------
Options Outstanding Options Exercisable
- --------------------------------------------------------------------------------
Weighted average
Exercise Number remaining contractual
price Outstanding life in years Number Price
- --------------------------------------------------------------------------------
$ 9.500 290,296 6.3 201,864 $ 9.500
20.000 1,000 9.3 200 20.000
19.125 102,601 9.3 33,075 19.125
19.416 12,000 9.3 2,400 19.416
19.250 30,000 9.7 7,500 19.250
------------
435,897
============
The Corporation applies APB Opinion No. 25 and related Interpretations in
accounting for its stock option and incentive plans. Accordingly, no
compensation cost has been recognized for stock options granted. Had the
compensation cost of the Corporation's 1998 stock compensation plan been
determined based on the fair value at the grant date for awards under the plan
consistent with the provisions of SFAS No. 123, the Corporation's net income and
earnings per share for the year ended September 30, 1998 would have been reduced
to the pro forma amounts indicated in the following table. Since July 1, 1995,
is the initial phase-in period for the Corporation in applying the provisions of
SFAS No. 123, the results are not necessarily representative of the effects on
pro forma disclosures of net income and earnings per share since such results
exclude stock options granted prior to July 1, 1995.
1998
-------------
Net Income
As reported $ 3,030
Pro forma 2,943
Earnings per common share
As reported
Basic $ 1.14
Diluted 1.05
Pro forma
Basic $ 1.10
Diluted 1.02
The above disclosed pro forma effects of applying SFAS No. 123 to compensation
costs may not be representative of the effects on reported pro forma net income
for future years.
The fair value for each option grant is estimated on the date of the grant using
the Black Scholes Model. The Model incorporates the following assumptions for
the 1998 grants:
Risk free interest rate 5.32%
Expected life 10 years
Expected volatility 62.65%
Expected dividends -
The weighted average fair value of the options granted in fiscal 1998 was $11.33
per option.
(11) Income Taxes (in thousands)
The Corporation files a consolidated federal income tax return. The Corporation
and its subsidiaries entered into a tax-sharing agreement that provides for the
allocation and payment of federal and state income taxes. The provision for
32
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
income taxes of each corporation is computed on a separate company basis,
subject to certain adjustments. Income tax expense (benefit) is summarized as
follows:
<TABLE>
<CAPTION>
September 30,
--------------------------------------------------------
1998 1997 1996
----------------- ---------------- -----------------
<S> <C> <C> <C>
Current
Federal $ 1,650 $ 1,494 $ 1,263
State 534 498 403
----------------- ---------------- -----------------
Subtotal 2,184 1,992 1,666
Deferred
Federal (120) 85 (423)
State (40) 28 (142)
----------------- ---------------- -----------------
Subtotal (160) 113 (565)
----------------- ---------------- -----------------
Total income tax provision $ 2,024 $ 2,105 $ 1,101
================= ================ =================
</TABLE>
The State of Minnesota follows the Internal Revenue Code for the determination
of taxable income, in connection with temporary differences. The State portion
of deferred tax assets and liabilities is approximately 25 percent.
Temporary differences between the financial statement carrying amounts and the
tax basis of assets and liabilities that can create deferred tax assets and
liabilities are as follows:
<TABLE>
<CAPTION>
September 30,
-------------------------------
1998 1997
--------------- --------------
<S> <C> <C>
Deferred tax assets:
Deferred compensation $ 866 $ 530
Deferred net loan fees 265 336
Securities unrealized loss 324 227
Allowance for loan losses 419 344
--------------- --------------
Subtotal 1,874 1,437
Less: Valuation allowance 172 131
--------------- --------------
Total 1,702 1,306
Deferred tax liabilities:
FHLB Stock 241 241
Tax bad debt reserve 256 256
Premises and equipment 337 302
Installment obligation sale of former building 29 29
Mortgage servcing rights 43 14
Discount of loans 7 11
Section 475 "For Sale Assets" 161 105
--------------- --------------
Total 1,074 958
--------------- --------------
Net deferred tax asset $ 628 $ 348
=============== ==============
</TABLE>
The valuation allowance was established to reduce the deferred tax asset related
to the unrealized loss on equity securities because management is uncertain that
more likely than not it will be realized. The Corporation has paid sufficient
taxes in prior carryback years which will enable it to recover the balance of
the net deferred tax assets, and therefore, no additional valuation allowance
was required at September 30, 1998 and 1997.
33
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
The actual income tax expense varied from the expected tax expense (computed by
applying the United States federal corporate income tax rate of 34 percent to
earnings before income taxes) as follows:
<TABLE>
<CAPTION>
Years Ended September 30,
----------------------------------------------------
1998 1997 1996
---------------- ---------------- ----------------
<S> <C> <C> <C>
Computed "expected" tax expense $ 1,718 $ 1,778 $ 941
Exempt dividends (5) (8) (20)
State income taxes, net of federal tax benefit 322 336 173
Other, net (11) (1) 7
---------------- ---------------- ----------------
Total income tax provision $ 2,024 $ 2,105 $ 1,101
================ ================ ================
</TABLE>
Retained earnings at September 30, 1998, includes $6,492 for which no deferred
federal income tax liability has been recognized. This amount represents an
allocation of income to bad-debt deductions for tax purposes only that arose in
tax years beginning before September 30, 1988, (that is, the base-year amount).
Reduction of the amount so allocated for purposes other than tax bad-debt losses
or adjustments arising from this carryback of net operating losses would create
income for tax purposes only, which would be subject to the then-current
corporate income-tax rate. The unrecorded deferred income-tax liability on the
above amount was approximately $2,600 at September 30, 1998.
(12) Earnings per Share
The following table sets forth the computation of basic and diluted earnings per
share:
<TABLE>
<CAPTION>
For the Years ended
September 30,
------------------------------------------------------
1998 1997 1996
------------------- --------------- ----------------
<S> <C> <C> <C>
Numerator:
Net income - Numerator for basic earnings
per share and diluted earnings per share--
income available to common stockholders $3,030,000 $3,124,000 $ 1,668,000
=================== =============== ================
Denominator:
Denominator for basic earnings per share--
weighted-average shares 2,669,586 2,763,481 3,384,930
Effect of dilutive securities:
Stock - based compensation plans 222,598 230,656 139,110
------------------- --------------- ----------------
Denominator for diluted earnings per share--
adjusted weighted-average shares and
assumed conversions 2,892,184 2,994,137 3,524,040
=================== =============== ================
Basic earnings per share $ 1.14 $ 1.13 $ 0.49
Diluted earnings per share $ 1.05 $ 1.04 $ 0.47
</TABLE>
(13) Contingencies (in thousands)
Loans Sold
During 1982, the Bank sold loans subject to recourse provisions. The balance of
these loans at September 30, 1998, and 1997 was $238 and $302, respectively. The
loans had interest rates ranging from 9.50% to 9.875% with an original balance
of $3,400 and were sold to FHLMC.
(14) Stockholders' Equity and Regulatory Capital (in thousands)
On October 6, 1994, the Bank converted from a federally chartered mutual savings
and loan association to a federally chartered stock savings bank pursuant to a
Plan of Conversion (the Conversion) via the issuance of common stock. Upon the
Conversion, the preexisting liquidation rights of the depositors of the Bank
were unchanged. Such rights are
34
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
accounted for by the Bank for the benefit of such depositors in proportion to
their liquidation interests as of the Eligibility Record Date or the
Supplemental Eligibility Record Date, as defined, in the Conversion.
The Bank is subject to various regulatory capital requirements administered by
the Office of Thrift Supervision (OTS). Failure to meet minimum capital
requirements can initiate certain mandatory - and possibly additional
discretionary - actions by regulators that, if undertaken, could have a direct
material effect on the Bank's financial statements. Under capital adequacy
guidelines and the regulatory framework for prompt corrective action, the Bank
must meet specific capital guidelines that involve quantitative measures of the
Bank's assets, liabilities and certain off-balance sheet items as calculated
under regulatory accounting practices. The Bank's capital amounts and
classification are also subject to qualitative judgments by the regulators about
components, risk weightings and other factors.
Quantitative measures established by regulation to ensure capital adequacy
require the Bank to maintain minimum amounts and ratios (set forth in the table
below) of total and Tier 1 capital (as defined in the regulations) to
risk-weighted assets (as defined), and of tangible and Tier 1 capital (as
defined) to adjusted total assets (as defined). Management believes, as of
September 30, 1998, that the Bank meets all capital adequacy requirements to
which it is subject.
As of September 30, 1998, and 1997, the most recent notification from the OTS
categorized the Bank as "well capitalized" under the regulatory framework for
prompt corrective action. To be categorized as well capitalized the Bank must
maintain minimum total risk-based, Tier 1 risk-based, and Tier 1 leverage ratios
as set forth in the table below. There are no conditions or events since that
notification that management believes have changed the institution's category.
The Bank's actual regulatory capital amounts, with reconciliation to the
Corporation's investment in the Bank determined in accordance with Generally
Accepted Accounting Principles (GAAP), and ratios, are also presented in the
table below.
<TABLE>
<CAPTION>
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
--------------------- ------------------------ -----------------------
<S> <C> <C> <C> <C> <C> <C>
GAAP captial, September 30, 1998 $37,220
Add: Unrealized losses on debt
securities held for sale 236
----------
Tangible equity capital and ratio to
adjusted total assets $37,456 9.1% $ 6,168 1.5% $ 8,229 2.0%
--------------------- ------------------------ -----------------------
Tier 1 (Core) capital and ratio to
adjusted total assets $37,456 9.1% $16,457 4.0% $20,560 5.0%
--------------------- ------------------------ -----------------------
Tier 1 capital and ratio to
risk-weighted assets $37,456 15.5% $ 9,645 4.0% $14,467 6.0%
----------- ------------------------ -----------------------
Tier 2 capital, allowance for loan losses 1,035
----------
Total risk-based capital and ratio to
risk-weighted assets, September 30 , 1998 $38,491 16.0% $19,290 8.0% $24,112 10.0%
===================== ======================== =======================
</TABLE>
35
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
<TABLE>
<CAPTION>
To Be Well
Capitalized Under
For Capital Prompt Corrective
Actual Adequacy Purposes Action Provisions
------------------- ---------------------- -----------------------
<S> <C> <C> <C> <C> <C> <C>
GAAP captial, September 30, 1997 $38,440
Add: Unrealized losses on debt
securities held for sale 168
---------
Tangible equity capital and ratio to
adjusted total assets $38,608 10.1% $ 5,754 1.5%
------------------- ----------------------
Tier 1 (Core) capital and ratio to
adjusted total assets $38,608 10.1% $11,509 3.0% $19,181 5.0%
------------------- ---------------------- -----------------------
Tier 1 capital and ratio to
risk-weighted assets $38,608 18.8% $ 8,221 4.0% $12,331 6.0%
---------- ---------------------- -----------------------
Tier 2 capital, allowance for loan losses 852
---------
Total risk-based capital and ratio to
risk-weighted assets, September 30 , 1997 $39,460 19.2% $16,523 8.0% $20,654 10.0%
=================== ====================== =======================
</TABLE>
The Bank may not declare or pay cash dividends to the Corporation if the effect
would be to reduce GAAP capital below applicable regulatory capital requirements
or if such declaration and payment would otherwise violate regulatory
requirements.
(15) Concentration of Credit Risk (in thousands)
The Bank is primarily engaged in originating mortgage, consumer, and business
loans in the Minnesota counties of McLeod, Dakota, Meeker, Wright, Carver,
Washington and Sibley. The Bank offers fixed and adjustable rates of interest on
these loans which have amortization terms ranging up to thirty years. Loans are
generally originated on the basis of not more than an 80% loan-to-value ratio,
which has historically provided the Bank with more than adequate collateral
coverage in the event of default. Nevertheless, the Bank, as with any lending
institution, is subject to the risk that economic conditions in its primary
lending area will deteriorate, thereby potentially impairing collateral values.
However, management believes that the economy is presently stable in its primary
lending area and that loan loss allowances have been provided for in amounts
commensurate with its current perception of the foregoing risks in the
portfolio.
The Corporation had cash on deposit in a financial institution in excess of
Federal deposit insurance limits of approximately $15,299 at September 30, 1998.
(16) Financial Instruments (in thousands)
The Corporation is party to financial instruments with off-balance-sheet risk in
the normal course of business to meet the financing needs of its customers and
to reduce its own exposure to fluctuations in interest rates. These financial
instruments include commitments to extend credit and forward commitments to
purchase securities. Those instruments involve, to varying degrees, elements of
credit and interest-rate risk in excess of the amount recognized in the
statement of financial position. The contract or notional amount of those
instruments reflect the extent of the Bank's involvement in particular classes
of financial instruments.
The Bank's exposure to credit loss in the event of nonperformance by the other
party to the financial instrument for commitments to extend credit and standby
letters of credit is represented by the contractual notional amount of those
instruments. The Bank uses the same credit policies in making commitments and
conditional obligations as it does for on-balance sheet instruments.
Commitments to extend credit are unused lines of credit and loan commitments
which are agreements to lend to a customer as long as there is no violation of
any condition established in the contract. Since some of the commitments may be
expected to expire without being drawn upon, the total commitment amounts do not
necessarily represent future cash requirements. The Bank evaluates each
customer's creditworthiness on a case-by-case basis. The amount of collateral
obtained, if it is deemed necessary by the Bank upon extension of credit, is
based on management's credit evaluation of the counterparty. Collateral held
varies but may include accounts receivable, inventory, property, plant and
equipment, and income producing commercial properties.
36
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
Standby letters of credit are conditional commitments issued by the Bank to
guarantee the performance of a customer to a third party. The credit risk
involved in issuing letters of credit is essentially the same as that involved
in extending loan facilities to customers. Typically, the Bank issues letters of
credit to municipalities and generally does not require collateral for standby
letters of credit.
Forward commitments to purchase securities and mortgages involve an agreement
whereby the seller agrees to make delivery at a specified future date of a
specified instrument, at a specified price or yield. Risks arise from the
possible inability of counterparties to meet the terms of their contracts and
from movements in securities values and interest rates.
Forward commitments to sell mortgages involve an agreement whereby the bank
agrees to make delivery at a specified future date of a specified loan, at a
specified price or yield. Risks arise from the possible inability on
counterparties to meet the terms of their contracts and from movements in loan
values and interest rates.
A summary of the notional amounts of the Bank's financial instruments at
September 30, 1998 follows:
Commitments to extend credit $ 31,684
Standby letters of credit 113
Commitments to sell loans 5,711
The carrying value and fair value of the Corporation's financial assets and
financial liabilities are as follows:
<TABLE>
<CAPTION>
September 30,
----------------------------------------------------------
1998 1997
------------------------------- ----------------------
Carrying Fair Carrying Fair
Value Value Value Value
------------------------------- ----------------------
<S> <C> <C> <C> <C>
Financial assets:
Cash & cash equivalents $ 22,597 $ 22,597 $ 6,135 $ 6,135
Investment securities 46,881 46,422 58,187 57,376
Mortgage-backed and related securities 52,992 51,943 55,238 54,234
Loans held for sale 2,672 2,672 204 220
Loans receivable, net 280,603 282,857 260,390 259,994
Accrued interest receivable 3,089 3,089 2,436 2,436
Financial liabilities:
Deposits 226,542 226,909 208,246 208,487
Borrowings 144,177 146,042 133,817 134,060
</TABLE>
(17) Effects of New Financial Accounting Standards
SFAS No. 130, "Reporting Comprehensive income" - issued June 1997, establishes
standards for reporting and displaying comprehensive income and its components
in general-purpose financial statements. Comprehensive income includes net
income and several other items that current accounting standards require to be
recognized outside of net income. This statement requires entities to display
comprehensive income and its components in the financial statements, with
presentation of the accumulated balances of other comprehensive income reported
in stockholders' equity separately from retained earnings and additional
paid-in-capital. SFAS No. 130 is effective for the quarter ending December 31,
1998. Reclassification of financial statements for earlier periods that are
presented for comparative purposes is required.
SFAS No. 131, "Disclosures about Segments of and Enterprise and Related
Information" - issued June 1997, requires public business enterprises to report
information about their operating segments in a complete set of financial
statements to shareholders. This statements also requires entities to report
enterprise-wide information about their products and services, their activities
in different geographic areas, and their reliance on major customers. Certain
segment information is also to be reported in interim financial statements. The
basis for determining an enterprise's operating segments is the manner in which
management operates the business. Specifically, financial information is
required to be reported on the basis that it is used internally by the
enterprise's chief operating decision maker in
37
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
making decisions related to resource allocation and segment performance. SFAS
No. 131 is effective beginning October 1, 1998.
SFAS No. 132, "Employers' Disclosures About Pensions and Other Post Retirement
Benefits" - issued February 1998, revises disclosures about pension and other
postretirement benefits to the extent practicable, requires additional
information on changes in the benefit obligations and fair values of plan assets
that will facilitate financial analysis, and eliminates certain disclosures that
are no longer useful. It is effective for the fiscal year beginning October 1,
1998.
SFAS No. 134, "Accounting for Mortgage-Backed Securities Retained after the
Securitization Retained after the Securitization of Mortgage Loans Held for Sale
by a Mortgage Banking Enterprise" - issued October 1998, revises the accounting
and reporting standard for certain activities of mortgage banking enterprises
and other enterprises that conduct operations that are substantially similar to
the primary operations of a mortgage banking enterprise. It requires that after
the securitization of a mortgage loan held for sale, an entity engaged in
mortgage banking activities classify the resulting mortgage-backed security as a
trading security. It also requires that after the securitization of mortgage
loans held, an entity engaged in mortgage banking activities classify the
resulting mortgage-backed securities or other retained interests based on its
ability and intent to sell or hold those investments. This statement is
effective for the fiscal quarter beginning January 1, 1999.
Management believes adoption of the above-described Statements will not have a
material effect on financial positions and the results of operations, nor will
adoption require additional capital resources.
SFAS No. 133, "Accounting For Derivative Instruments and Hedging Activities" -
issued June 1998, establishes accounting and reporting standards for derivative
instruments, including certain derivative instruments embedded in other
contracts, (collectively referred to as derivatives) and for hedging activities.
It requires that an entity recognize all derivatives as either assets or
liabilities in the statement of financial position and measure those instruments
at fair value. This statement is effective for the fiscal year beginning October
1, 1999. On the date of adoption, the Corporation may transfer any held to
maturity security into the available for sale category and then be able to
designate the transferred security as a hedge item. Any unrealized holding gain
or loss on transferred securities will be reported in net income or accumulated
other comprehensive income. Management has not determined its strategy for the
adoption of Statement No. 133 or its effect on the financial statements. If the
Corporation elects to apply hedge accounting, it is required to establish, at
the inception of the hedge, the method it will use for assessing the
effectiveness of the hedging activities and the measurement approach for
determining the ineffective aspect of the hedge.
38
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(18) Parent Only Condensed Financial Information (in thousands)
This information should be read in conjunction with the other Notes to
Consolidated Financial Statements. Stockholders' equity differs from the
consolidated statements by the amount of consolidating ESOP and MSP adjustments.
The investment in the Bank subsidiary is carried net of the Banks' unrealized
loss on securities available for sale.
STATEMENT OF FINANCIAL CONDITION
<TABLE>
<CAPTION>
September 30,
-----------------------------------
ASSETS 1998 1997
--------------- ---------------
<S> <C> <C>
Cash and cash equivalents $ 2,916 $ 1,412
Investment securites available for sale 423
-
Investment securities held to maturity 1,568 3,062
Investment in Bank subsidiary 37,220 38,440
Investment in Insurance subsidiary 660
-
Loan to Bank ESOP 1,988 2,347
Other assets 286 66
--------------- ---------------
$ 44,638 $ 45,750
=============== ===============
LIABILITIES AND STOCKHOLDERS' EQUITY
Other liabilities $ 132 $ 41
Stockholders' equity:
Common stock 450 450
Additional paid-in capital 43,382 43,334
Unrealized gain on securities available for sale 14
-
Treasury stock (23,298) (20,267)
Unearned MSP stock (818) (1,108)
Retained earnings 24,790 23,286
--------------- ---------------
Total stockholders' equity 44,506 45,709
--------------- ---------------
$ 44,638 $ 45,750
=============== ===============
</TABLE>
STATEMENT OF INCOME
<TABLE>
<CAPTION>
Years Ended September 30,
--------------------------------------
Income: 1998 1997 1996
------------ ----------- -----------
<S> <C> <C> <C>
Dividends from Bank subsidiary $ 4,500 $ 4,202 $ 3,500
Interest from
Bank's ESOP loan 193 222 254
Investments 309 343 641
Non-interest income 12
- -
------------ ----------- -----------
5,014 4,767 4,395
Expense:
Non-interest expense 615 566 474
------------ ----------- -----------
Income before income taxes and equity in undistributed
net income of subsidiaries 4,399 4,201 3,921
Income tax (benefit) expense (54) (1) 154
------------ ----------- -----------
4,453 4,202 3,767
Subsidiaries dividends received in excess of subsidiaries net income (1,423) (1,078) (2,100)
------------ ----------- -----------
Net income $ 3,030 $ 3,124 $ 1,667
============ =========== ===========
</TABLE>
39
<PAGE>
FSF FINANCIAL CORP. AND SUBSIDIARIES
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS - CONTINUED
(18) Parent Only Condensed Financial Information - Continued (in thousands)
STATEMENT OF CASH FLOWS
<TABLE>
<CAPTION>
Years Ended September 30,
------------------------------------------
1998 1997 1996
------------- -------------- -------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net Income $ 3,030 $ 3,124 $ 1,667
Adjustments:
Subsidiaries dividends received in excess
of subsidiaries net income 1,423 1,078 2,100
(Increase) decrease in other assets (123) 10 97
Increase (decrease)in other liabilities 82 27 (7)
Other 356 115 85
------------- -------------- -------------
Net cash provided by operations 4,768 4,354 3,942
Cash flows from investing activities:
Proceeds from maturities of investments 1,500 1,500 8,650
Purchase of investment securities - - (2,559)
Proceeds from securities available for sale 411
- -
------------- -------------- -------------
Net cash provided by investing activities 1,911 1,500 6,091
Cash flows from financing activities:
Payments received on ESOP bank loan 360 371 385
Purchases of treasury stock (5,492) (7,245) (10,559)
Proceeds from exercise of stock options 1,315 73 52
Payments of cash dividends (1,358) (1,413) (1,758)
------------- -------------- -------------
Net cash used in financing activities (5,175) (8,214) (11,880)
------------- -------------- -------------
Increase (decrease) in cash and cash equivalents 1,504 (2,360) (1,847)
Cash and cash equivalents:
Beginning of year 1,412 3,772 5,619
------------- -------------- -------------
End of year $ 2,916 $ 1,412 $ 3,772
============= ============== =============
</TABLE>
(19)Subsequent Event
On November 17, 1998, the Company acquired, in a transaction that was a
combination of stock and cash, all of the outstanding shares of Homeowners
Mortgage Corporation ("Homeowners"). Homeowners originates residential mortgage
loans from three locations in Minnesota. The main office is located at 1001
Labore Industrial Court, Vadnais Heights, Minnesota, and additional offices are
in Hastings and Mankato, Minnesota. Homeowners was organized in 1988.
The Company acquired 20,000 shares at a price of $125 per share, resulting in a
purchase price of $2,500,000. The acquisition will be accounted for using the
purchase method of accounting and will result in goodwill of approximately $2.3
million.
40
<PAGE>
Selected Quarterly Financial Data (Unaudited)
For Three Years Ended September 30, 1998
<TABLE>
<CAPTION>
First Second Third Fourth
Quarter Quarter Quarter Quarter Year
---------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Fiscal 1998
Interest income $ 7,364 $ 7,518 $ 7,554 $ 7,545 $29,981
Interest expense 4,548 4,591 4,657 4,703 18,499
---------------------------------------------------------------------
Net Interest Income 2,816 2,927 2,897 2,842 11,482
Provision for loan losses 45 75 107 75 302
Gain on sale of assets 15 107 130 108 360
Net income $ 746 $ 810 $ 767 $ 707 $ 3,030
Basic earnings per share 0.28 0.30 0.29 0.27 $ 1.14
Diluted earnings per share 0.26 0.28 0.27 0.25 $ 1.05
Cash dividends declared per share $ 0.125 $ 0.125 $ 0.125 $ 0.125 $ 0.50
Market range:
High bid (1) $ 20.94 $ 20.88 $ 20.75 $ 18.50 $ 20.94
Low bid (1) $ 19.00 $ 19.50 $ 18.00 $ 13.38 $ 13.38
Fiscal 1997
Interest income $ 6,564 $ 6,728 $ 6,933 $ 7,090 27,315
Interest expense 3,886 4,011 4,104 4,345 16,346
---------------------------------------------------------------------
Net Interest Income 2,678 2,717 2,829 2,745 10,969
Provision for loan losses 30 30 30 30 120
Gain on sale of assets 13 15 15 48
5
Net income $ 722 $ 725 $ 823 $ 854 $ 3,124
Basic earnings per share 0.25 0.26 0.31 0.32 $ 1.13
Diluted earnings per share 0.24 0.24 0.28 0.29 $ 1.04
Cash dividends declared per share $ 0.125 $ 0.125 $ 0.125 $ 0.125 $ 0.50
Market range:
High bid (1) $ 15.13 $ 18.25 $ 18.13 $ 21.00 $ 21.00
Low bid (1) $ 12.75 $ 14.75 $ 16.38 $ 17.25 $ 12.75
Fiscal 1996
Interest income $ 5,488 $ 5,583 $ 5,898 $ 6,275 23,244
Interest expense 3,219 3,335 3,427 3,628 13,609
---------------------------------------------------------------------
Net Interest Income 2,269 2,248 2,471 2,647 9,635
Provision for loan losses 6 15 15 42
6
Gain on sale of assets 9 21 38
5 3
Net income $ 421 $ 460 $ 684 $ 103 $ 1,668
Basic earnings per share 0.11 0.13 0.21 0.03 $ 0.49
Diluted earnings per share 0.11 0.13 0.20 0.03 $ 0.47
Cash dividends declared per share $ 0.125 $ 0.125 $ 0.125 $ 0.125 $ 0.50
Market range:
High bid (1) $ 13.50 $ 13.50 $ 13.00 $ 13.25 $ 13.50
Low bid (1) $ 12.38 $ 12.38 $ 11.50 $ 11.38 $ 11.38
</TABLE>
- --------------------------
(1) As reported by the Nasdaq Stock Market. Such over-the-counter quotations
do not reflect inter-dealer prices, without retail mark-up, mark-down or
commission and may not necessarily represent actual transactions.
41
<PAGE>
FSF Financial Corp.
-------------------
Corporate Office
201 Main Street South
Hutchinson, MN 55350-2573
(320) 234-4500
FIRST FEDERAL fsb
- --------------------------------------------------------------------------------
Office Locations
Hutchinson Main Office Hastings Office
201 Main Street South 1320 South Frontage Road
Hutchinson, MN 55350-2573 Hastings, MN 55033-2426
(320) 234-4500 (651) 437-6169
Hutchinson South Office Apple Valley Office
905 Hwy. 15 South Frontage Road 14994 Glazier Avenue
Hutchinson, MN 55350 Apple Valley, MN 55124-7498
(320) 234-4563 (651) 432-6840
Buffalo Office Glencoe Office
19 Central Avenue, PO Box 338 1002 Greeley Avenue
Buffalo, MN 55313-0338 Glencoe, MN 55336-2128
(320) 682-3035 (320) 864-5541
Inver Grove Heights Office Litchfield Office
6505 Cahill Avenue East 501 North Sibley Avenue, PO Box 577
Inver Grove Heights, MN 55076-2022 Litchfield, MN 55355-0577
(651) 455-1553 (320) 693-2861
Waconia Office Waite Park Office
200 East Frontage Road, Hwy 5, PO Box 287 113 Waite Avenue South, PO Box 641
Waconia, MN 55387-0287 Waite Park, MN
(612) 442-2141 (320) 656-1133
Winthrop Office
122 East Second Street, PO Box 424
Winthrop, MN 55396-0424
(507) 647-5356
- --------------------------------------------------------------------------------
Insurance Planners
------------------
135 3rd Avenue Southeast
Hutchinson, MN 55350
(320) 587-2299
- --------------------------------------------------------------------------------
Homeowners Mortgage
-------------------
Vadnais Heights Office
1001 Labore Industrial Court, Suite E
Vadnais Heights, MN 55110
(651) 415-1020
Mankato Office Hastings Office
423 Belgrade Avenue 830 Vermillion Street, Suite 102
North Mankato, MN 56003 Hastings, MN 55033
- --------------------------------------------------------------------------------
42
<PAGE>
43
Our Board of Directors and Management Team
Board of Directors of FSF Financial Corp.
Donald A. Glas, Co-Chair of the Board George B. Loban, Co-Chair of the Board
Richard H. Burgart James J. Caturia
Jerome R. Dempsey Sever B. Knutson
Roger R. Stearns
Board of Directors of First Federal fsb
Donald A. Glas, Co-Chair of the Board George B. Loban, Co-Chair of the Board
Richard H. Burgart James J. Caturia
Jerome R. Dempsey Sever B. Knutson
Roger R. Stearns
Executive Officers of FSF Financial Corp.
and First Federal fsb
Donald A. Glas George B. Loban
Chief Executive Officer President
Richard H. Burgart
Chief Financial Officer & Corporate Secretary
- --------------------------------------------------------------------------------
Corporate Counsel Special Counsel
Mackall Crounse & Moore Malizia, Spidi, Sloane & Fisch, P.C.
1400 AT&T Tower One Franklin Square
901 Marquette Avenue 1301 K Street NW, Ste. 700 East
Minneapolis, MN 55402 Washington, DC 20005
Independent Auditors Transfer Agent and Registrar
Bertram Cooper & Co. LLP American Securities Transfer, Inc.
110 Second Avenue SE 1825 Lawrence
Waseca, MN 56093 Denver, CO 80202
43
EXHIBIT 21
<PAGE>
EXHIBIT 21
SUBSIDIARIES OF THE REGISTRANT
Parent
- ------
FSF Financial Corp.
Percentage State of
Subsidiaries Owned Incorporation
- ------------ ---------- -------------
First Federal fsb (a) 100% United States
Insurance Planners (b) 100% Minnesota
- ---------------
(a) Because FSF Financial Corporation neither completed its initial public
offering nor conducted any operations prior to the year ended September 30,
1994, the operations of First Federal fsb are included in the consolidated
financial statements contained in the 1994 Annual Report to Stockholders
incorporated herein by reference. First Federal fsb became a wholly owned
subsidiary of FSF Financial Corp. on October 6, 1994.
(b) Insurance Planners became a wholly owned subsidiary of FSF Financial Corp.
on June 1, 1998.
24
EXHIBIT 23
<PAGE>
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statement No.
33-93114 of FSF Financial Corp. on Form S-8 (filed with the Securities and
Exchange Commission on June 5, 1995) of our report dated October 23, 1998
included in this Annual Report on Form 10-K of FSF Financial Corp. for the
fiscal year ended September 30, 1998.
/s/Bertram Cooper & Co.,LLP
Bertram Cooper & Co., LLP
Waseca, Minnesota
December 11, 1998
<TABLE> <S> <C>
<ARTICLE> 9
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION DERIVED FROM THE
ANNUAL REPORT ON FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO
SUCH FINANCIAL INFORMATION.
</LEGEND>
<MULTIPLIER> 1000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-END> SEP-30-1998
<CASH> 22,597
<INT-BEARING-DEPOSITS> 0
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 0
<INVESTMENTS-HELD-FOR-SALE> 39,043
<INVESTMENTS-CARRYING> 60,830
<INVESTMENTS-MARKET> 59,322
<LOANS> 284,310
<ALLOWANCE> (1,035)
<TOTAL-ASSETS> 416,232
<DEPOSITS> 226,542
<SHORT-TERM> 144,177
<LIABILITIES-OTHER> 2,995
<LONG-TERM> 0
0
0
<COMMON> 450
<OTHER-SE> 42,068
<TOTAL-LIABILITIES-AND-EQUITY> 416,232
<INTEREST-LOAN> 23,512
<INTEREST-INVEST> 6,469
<INTEREST-OTHER> 0
<INTEREST-TOTAL> 29,981
<INTEREST-DEPOSIT> 10,082
<INTEREST-EXPENSE> 8,417
<INTEREST-INCOME-NET> 11,482
<LOAN-LOSSES> 302
<SECURITIES-GAINS> 360
<EXPENSE-OTHER> 8,395
<INCOME-PRETAX> 5,054
<INCOME-PRE-EXTRAORDINARY> 3,030
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,030
<EPS-PRIMARY> 1.14
<EPS-DILUTED> 1.05
<YIELD-ACTUAL> 2.89
<LOANS-NON> 811
<LOANS-PAST> 0
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 852
<CHARGE-OFFS> 132
<RECOVERIES> 13
<ALLOWANCE-CLOSE> 1,035
<ALLOWANCE-DOMESTIC> 1,035
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
