<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
X ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934
FOR THE FISCAL YEAR ENDED: JUNE 30, 1996
OR
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
- ----- EXCHANGE ACT OF 1934
Commission File No.: 0-27940
HARRINGTON FINANCIAL GROUP, INC.
- --------------------------------------------------------------------------------
(Exact name of registrant as specified in its charter)
Indiana 48-1050267
- ---------------------------------------- ---------------------------------
(State or other jurisdiction (I.R.S. Employer
of incorporation or organization) Identification Number)
722 Promenade, P.O. Box 968
Richmond, Indiana 47375
- ---------------------------------------- ---------------------------------
(Address of Principal (Zip Code)
Executive Offices)
Registrant's telephone number, including area code: (317) 966-9518
Securities registered pursuant to Section 12(b) of the Act:
NOT APPLICABLE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK (PAR VALUE $0.125 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 filing
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 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
-----
As of September 24, 1996, the aggregate value of the 1,031,923 shares of Common
Stock of the Registrant issued and outstanding on such date, which excludes
2,224,815 shares held by all directors and executive officers of the Registrant
as a group, was approximately $11.1 million. This figure is based on the last
known trade price of $10.75 per share of the Registrant's Common Stock on
September 24, 1996.
Number of shares of Common Stock outstanding as of September 24, 1996:
3,256,738
DOCUMENTS INCORPORATED BY REFERENCE
List hereunder the following documents incorporated by reference and the Part of
the Form 10-K into which the document is incorporated:
(1) Portions of the Annual Report to Stockholders for the fiscal year ended
June 30, 1996 are incorporated into Parts II and IV.
(2) Portions of the definitive proxy statement for the Annual Meeting of
Stockholders are incorporated into Part III.
<PAGE>
PART I.
ITEM 1. BUSINESS
GENERAL
Harrington Financial Group, Inc. (the "Company") is an Indiana-chartered,
registered thrift holding company for Harrington Bank, FSB (the "Bank"). The
Bank is a federally chartered savings bank which conducts business through three
full-service offices located in Carmel and Fishers, Indiana, both suburbs of
Indianapolis, and Richmond, Indiana. The Company was organized in March 1988 in
connection with its acquisition of the Bank. The Bank was originally organized
in 1889 as an Indiana-chartered savings association under the name "The Peoples
Home and Savings Association of Richmond, Indiana." In 1936, the Bank obtained
federal insurance and in 1984 adopted a federal charter and changed its name to
"Peoples Federal Savings Association." In 1985, the Bank converted from mutual
to stock form and, in March 1994, changed its name to "Harrington Bank, FSB."
On May 6, 1996, the Company sold 1,265,000 shares of common stock at $10.00 per
share to investors in an initial public offering resulting in gross proceeds of
$12,650,000 to the Company. Net proceeds to the Company after offering expenses
were $11,437,000. At June 30, 1996, the Company had total consolidated assets
of $418.2 million, total consolidated borrowings of $254.1 million, total
consolidated deposits of $135.1 million, and total consolidated stockholders'
equity of $23.1 million.
The Company was organized in March 1988 by certain principals of Smith
Breeden Associates, Inc. ("Smith Breeden") for the sole purpose of acquiring the
Bank. This investor group purchased the Bank with the intention of expanding
the Bank's mortgage and investment operations and improving the Bank's return on
equity through the use of Smith Breeden's "option-adjusted pricing analysis."
Smith Breeden presently advises the Company and the Bank with respect to, among
other things, the management of its investments and borrowings, the pricing of
loans and deposits, as well as the use of various financial instruments to
reduce interest rate risk. Certain directors and officers of the Company and
the Bank are principals or affiliates of Smith Breeden.
The Company attempts to enhance profitability and reduce credit, interest
rate and liquidity risk by: (i) investing in mortgage-backed and related
securities and originating (both directly and through correspondents) loans
secured primarily by single-family residences; (ii) actively managing its
investment portfolio and funding sources in order to secure favorable spreads in
a variety of interest rate environments; (iii) controlling interest rate risk
and net portfolio volatility through the use of interest rate contracts and
mortgage-backed derivative securities; (iv) seeking to access cost-efficient
funding sources given prevailing market conditions, consisting primarily of
deposits, reverse repurchase agreements and FHLB advances; (iv) managing its
costs in order to maintain high operating efficiency; and (v) attempting to grow
its retail banking operations through increased loan originations and retail
deposit growth.
<PAGE>
Highlights of the principal elements of the Company's business strategy are
as follows:
* ACTIVE PORTFOLIO MANAGEMENT. The Company actively manages its interest-
earning assets and, with the assistance of Smith Breeden, utilizes "option-
adjusted pricing analysis" to quantify the costs embedded in the yield of an
investment, including the funding cost, the cost of the options embedded in the
investment's cash flows, if any (such as a borrower's ability to prepay a
mortgage), and any servicing costs. The objective of the Company's investment
management process is to select assets (including loans and securities) with
attractive risk-adjusted net spreads (over the Company's funding costs) and
actively manage the underlying risks of these investments. The Company uses
interest rate contracts and mortgage-backed derivative securities to secure
favorable interest rate spreads and to maintain the overall market value of its
assets and liabilities in changing interest rate environments. The Company
believes that this strategy will enhance the long-term market value of the
Company. Nevertheless, because the Company actively manages its portfolio,
nearly all of its mortgage-backed and related securities and interest rate
contracts are classified for accounting purposes as held for trading (with
unrealized gains and losses included in earnings) and, as a result, the
Company's earnings have and may in the future fluctuate significantly on a
period-to-period basis as has been illustrated by the Company's results of
operations over the past five years. The Company attempts to reduce, to the
extent possible, such fluctuations through its asset and liability management
strategies.
* CONTROL INTEREST RATE RISK. The Company attempts to manage its assets and
liabilities in order to maintain a portfolio which produces positive
returns in either an increasing or decreasing interest rate environment.
The Company has sought to control interest rate risk both internally
through the management of the composition of its assets and liabilities and
externally through the utilization of interest rate contracts. Interest
rate contracts are purchased with the intention of protecting both the net
interest income of the Bank and, along with mortgage-backed derivative
securities, the market value of the Bank's portfolio on a mark-to-market
basis.
* CONTROL CREDIT RISK. In order to limit the Company's credit exposure and
as part of its strategy to earn a positive interest rate spread, the
Company maintains a substantial portion of its assets in mortgage-backed
and related securities, which are primarily issued or guaranteed by U.S.
Government agencies or government sponsored enterprises, and single-family
residential loans. At June 30, 1996, the Company's investment in
mortgage-backed and related securities amounted to $318.8 million or 97.7%
of the Company's securities portfolio (both held for trading and available
for sale) and 76.2% of the Company's total assets. In addition, as of such
date, the Company's investment in single-family residential loans amounted
to $64.9 million or 15.5% of total assets. See "- Lending" and "-
Investment Activities."
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<PAGE>
* REDUCE FUNDING COSTS. The Company attempts to reduce its overall funding
costs by evaluating all potential sources of funds (including retail and
non-retail deposits and short and long-term borrowings) and identifying
which particular source will result in an all-in cost to the Company that
meets its funding benchmark. At the same time, the Company has attempted
to price the deposits offered through its branch system in order to promote
retail deposit growth and offer a wide array of deposit products to satisfy
its customers. See "- Sources of Funds."
* INCREASE EMPHASIS ON RETAIL BANKING. An integral part of the Company's
strategy is to increase the Bank's emphasis on retail products and
services. The Company's primary lending emphasis is on the origination
(both directly and through correspondents) of loans secured by first liens
on single-family (one-to-four units) residences. Originations of such
loans have increased from $10.3 million during fiscal 1994 to $18.9 million
during fiscal 1995 and further increased to $41.6 million during fiscal
1996. See "- Lending Activities." In addition, the Company's retail
deposits (including transaction accounts and retail certificates of
deposit) have increased from $52.0 million or 48.1% of total deposits at
June 30, 1994 to $106.7 million or 78.9% of total deposits at June 30,
1996. See "- Sources of Funds - Deposits." The Company believes that
single-family residential loan originations generally offer attractive
yields, provide a source of fee income and, with respect to direct
originations, allow the Company to establish a relationship with the
underlying borrower which the Company can utilize to cross-sell additional
products and services. In addition, the Company believes that retail
deposits are a cost-effective source of funds, provide an additional source
of fee income and also permit the further cross-selling of additional
products and services. Consequently, the Company expects to continue to
focus on increasing its retail deposit base and its portfolio of
single-family residential loans.
* CONTROL OPERATING EXPENSES. As a result of the Company maintaining a
substantial portion of its assets in mortgage-backed and related
securities, the Company has been able to maintain a low level of operating
expenses. Accordingly, the Company's total other expenses to average total
assets for the years ended June 30, 1996 and 1995 amounted to 1.13% and
1.30%, respectively. Although the Company strives to maintain a low level
of operating expenses, management recognizes that as the Bank increases its
emphasis on retail banking, its operating expenses will correspondingly
increase.
* ASSET GROWTH AND ACQUISITIONS. The Company has and will continue to pursue
a policy of utilizing its existing capital and infrastructure to grow
through the purchase of mortgage-backed and related securities and the
continued growth of the Bank's retail operations. The Company will also
consider acquisition opportunities when it perceives that they are
advantageous to the Company and its stockholders. There are currently no
plans, arrangements, understandings or
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agreements regarding any such acquisition opportunities. The Company
is deploying the net proceeds of its recent initial public offering of
common stock by purchasing mortgage-backed and related securities
funded primarily through reverse repurchase agreements and plans to
redeploy a portion of such capital into single-family residential
loans or other retail expansion opportunities as market conditions
permit.
The Company, as a registered savings and loan holding company, is subject
to examination and regulation by the Office of Thrift Supervision ("OTS") and is
subject to various reporting and other requirements of the Securities and
Exchange Commission ("SEC"). The Bank, as a federally chartered savings bank,
is subject to comprehensive regulation and examination by the OTS, as its
chartering authority and primary regulator, and by the FDIC, which administers
the SAIF, which insures the Bank's deposits to the maximum extent permitted by
law. The Bank is a member of the FHLB of Indianapolis, which is one of the 12
regional banks which comprise the FHLB System. The Bank is further subject to
regulations of the Board of Governors of the Federal Reserve System ("Federal
Reserve Board") governing reserves required to be maintained against deposits
and certain other matters. See "- Supervision and Regulation."
INVESTMENT ADVISOR
Smith Breeden is a money management and consulting firm involved in (i)
money management for separate accounts such as corporate, state and municipal
pensions, endowments and mutual funds, (ii) financial institution consulting and
investment advice, and (iii) equity investments. Smith Breeden specializes in
mortgage-backed and related securities, interest rate risk management, and the
application of option pricing to loans and investments. Smith Breeden currently
advises, or manages on a discretionary basis, assets totaling in excess of $20
billion. The firm has acted as a consultant to banks, thrifts and governmental
agencies charged with the regulation of financial institutions and the
resolution of troubled thrifts.
Smith Breeden was co-founded in 1982 by Douglas T. Breeden. Dr. Breeden is
a former professor at Stanford University, where he obtained his Ph.D. in
Finance. Dr. Breeden currently serves on the faculty at Duke University's Fuqua
School of Business and previously served on the faculty at the Massachusetts
Institute of Technology and the University of Chicago.
Since 1988, Smith Breeden and certain of its principals have been involved
in making equity investments in financial institutions in tandem with the
application of modern investment and interest rate risk management techniques.
Certain of the principals of Smith Breeden, including Dr. Breeden, the current
Chairman of the Board of the Company, and Craig J. Cerny, the current President
of the Company, are investors in Harrington West Financial Group, Inc. ("HWFG"),
a newly formed savings and loan holding company which recently acquired Los
Padres Savings Bank, F.S.B., a federally chartered savings bank headquartered in
Solvang, California. Certain principals of Smith Breeden have also made
minority investments in other banks and thrift institutions.
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<PAGE>
Smith Breeden is based in Overland Park, Kansas, and employs over 60 people
in its main office and its offices in Chapel Hill, North Carolina, Dallas, Texas
and Boulder, Colorado.
LENDING ACTIVITIES
GENERAL. At June 30, 1996, the Bank's net loan portfolio totaled $65.9
million, representing approximately 15.8% of the Company's $418.2 million of
total assets at that date. In addition to utilizing "option-adjusted pricing
analysis" in order to manage the Company's investment portfolio, the Company
also uses such analysis to price its loan originations and ascertain the net
spread expected to be earned with respect to the Bank's loan portfolio. The
Bank's primary focus with respect to its lending operations has historically
been the direct origination and servicing of single-family residential mortgage
loans. The Bank has built an efficient mortgage operation which has produced
record loan volumes each year since fiscal 1993. Since fiscal 1995, the Bank
has also been active in originating whole residential mortgage loans through
correspondents which meet its pricing and credit quality objectives. To a much
lesser extent, the Bank originates commercial real estate loans and consumer
loans. Substantially all of the Bank's loan portfolio consists of conventional
loans, which are loans that are neither insured by the Federal Housing
Administration nor partially guaranteed by the Department of Veterans Affairs.
The risks associated with mortgage lending are well-defined and
controllable. Credit risk is controlled through the adherence, with few
exceptions, to secondary market underwriting guidelines. A strong internal loan
review program monitors compliance with the Bank's underwriting standards, which
is reflected by the low level of non-performing assets. See - "Asset Quality -
Non-Performing Assets." Market risk is controlled by a disciplined approach to
pricing and by regular monitoring and hedging of the institution's overall
sensitivity to interest rate changes.
As a federally chartered savings institution, the Bank has general
authority to originate and purchase loans secured by real estate located
throughout the United States. Notwithstanding this nationwide lending
authority, the Company estimates that at June 30, 1996, approximately 94% of the
loans in the Bank's portfolio are secured by properties located or made to
customers residing in its primary market area, which consists of Wayne and
Hamilton counties in eastern and central Indiana and contiguous counties.
Although the Bank has historically originated loans with lesser dollar
balances than are permitted by federal regulations, current loans-to-one
borrower limitations may restrict its ability to do business with certain
customers. A savings institution generally may not make loans to any one
borrower and related entities in an amount which exceeds 15% of its unimpaired
capital and surplus, although loans in an amount equal to an additional 10% of
unimpaired capital and surplus may be made to a borrower if the loans are fully
secured by readily marketable securities. At June 30, 1996, the Bank's
regulatory limit on loans-to-one borrower was $4.0 million and its five largest
loans or groups of loans-to-one borrower, including related entities, aggregated
$324,000, $346,000, $348,000, $399,000 and $585,000. All five of the Bank's
largest loans or groups of loans are secured primarily by single-family
residential real estate located in its primary market area were performing in
accordance with their terms at June 30, 1996.
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<PAGE>
LOAN PORTFOLIO COMPOSITION. The following table sets forth the composition
of the Bank's loan portfolio by type of loan at the dates indicated.
<TABLE>
<CAPTION>
JUNE 30,
-----------------------------------------------------------------------------------
1996 1995 1994
----------------------- ----------------------- -----------------------
Amount Percent Amount Percent Amount Percent
-------- -------- -------- -------- -------- --------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C>
Single-family residential(1) $64,899 97.80% $35,998 96.10% $20,525 96.60%
Commercial real estate(2) 441 0.7 711 1.9 349 1.6
------- ------ ------- ------ ------- ------
Total real estate loans 65,340 98.5 36,709 98 20,874 98.2
Consumer loans:
Deposit secured 267 0.4 255 0.7 150 0.7
Home improvement/equity 732 1.1 498 1.3 210 1.0
Other -- -- -- -- 17 0.1
------- ------ ------- ------ ------- ------
Total consumer loans 999 1.5 753 2.0 377 1.8
------- ------ ------- ------ ------- ------
Total loans 66,339 100.00% 37,462 100.00% 21,251 100.00%
------- ------ ------
------- ------ ------
Less:
Unamortized push-down
accounting adjustment(3) (182) (350) (419)
Unamortized discount on loans (7) (13) (19)
Undisbursed funds(4) (420) (43) (8)
Deferred loan origination
(fees) costs (315) (75) (17)
Allowance for loan losses (120) (121) (106)
------- ------- -------
Net loans (65,925) (37,010) (20,682)
------- ------- -------
------- ------- -------
<CAPTION>
JUNE 30,
-----------------------------------------------------
1993 1992
---------------------- -----------------------
Amount Percent Amount Percent
------- ------- ------- -------
<S> <C> <C> <C> <C>
(Dollars in Thousands)
Single-family residential(1) $16,696 96.00% $21,701 96.80%
Commercial real estate(2) 456 2.6 484 2.2
------- ------ ------- ------
Total real estate loans 17,152 98.6 22,185 99
Consumer loans:
Deposit secured 88 0.5 120 0.5
Home improvement/equity 160 0.9 91 0.4
Other 3 -- 20 0.1
------- ------ ------- ------
Total consumer loans 251 1.4 231 1.0
------- ------ ------- ------
Total loans 17,403 100.00% 22,416 100.00%
------- ------ ------- ------
------- ------ ------- ------
Less:
Unamortized push-down
accounting adjustment(3) (592) (865)
Unamortized discount on loans (21) (33)
Undisbursed funds(4) (7) (1)
Deferred loan origination
(fees) costs (7) (11)
------ -------
Allowance for loan losses (156) (99)
------ -------
Net loans (16,620) (21,409)
------ -------
------ -------
</TABLE>
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(1) Includes single-family residential construction loans. At June 30, 1996,
the Bank's single-family residential loan portfolio included $586,000 of
single-family residential construction loans.
(2) Includes $291,000, $321,000, $349,000, $456,000, $484,000 and $511,000 of
mortgage revenue bonds secured by commercial real estate at each of the
respective dates.
(3) Reflects the balance of the fair value adjustments made on the loan
portfolio as a result of the completion in September 1988 of the Company's
acquisition of the Bank, which acquisition was accounted for under the
purchase method of accounting.
(4) Includes undisbursed funds relating to single-family residential
construction loans.
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<PAGE>
CONTRACTUAL PRINCIPAL REPAYMENTS AND INTEREST RATES. The following table
sets forth certain information at June 30, 1996 regarding the dollar amount of
loans maturing in the Bank's total loan portfolio, based on the contractual
terms to maturity, before giving effect to net items.
Due After Due After
Due in One One to Five Five or More
Year or Less Years Years Total
------------ ----------- ------------ -----
(In Thousands)
Single-family residential $ 611 $ 469 $ 63,819 $ 64,899
Commercial real estate 125 26 290 441
Consumer 348 214 437 999
------- ------- -------- --------
Total $ 1,084 $ 709 $ 64,546 $ 66,339
------- ------- -------- --------
------- ------- -------- --------
The following table sets forth the dollar amount of all loans, before net
items, due after one year from June 30, 1996, which have fixed interest rates or
which have floating or adjustable interest rates.
Floating or
Fixed Rates Adjustable-Rates Total
----------- ---------------- -----
(In Thousands)
Single-family residential $47,961 $16,327 $64,288
Commercial real estate 290 26 316
Consumer 613 38 651
------- ------- -------
Total $48,864 $16,391 $65,255
------- ------- -------
------- ------- -------
ORIGINATION, PURCHASE AND SALE OF LOANS. The lending activities of the
Bank are subject to the written, non-discriminatory underwriting standards and
loan origination procedures established by the Bank's Board of Directors and
management. Loan originations are obtained by a variety of sources, including
referrals from real estate brokers, builders, existing customers, walk-in
customers, loan officers and advertising. In its marketing, the Bank emphasizes
its community ties, customized personal service, competitive rates, and an
efficient underwriting and approval process. Loan applications are taken by
lending personnel, and the loan department supervises the obtainment of credit
reports, appraisals and other documentation involved with a loan. Property
valuations are performed by independent outside appraisers approved by the
Bank's Board of Directors. The Bank requires title, hazard and, to the extent
applicable, flood insurance on all security property.
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Mortgage loan applications are initially processed by loan officers who
have approval authority up to designated limits. All loans in excess of an
individual's designated limits are referred to the Bank's Loan Committee, which
has approval authority for all loans up to $1.0 million. Any loans exceeding
$1.0 million (of which, at June 30, 1996, there were none) must be approved by
the Board of Directors of the Bank. In addition, the Board of Directors of the
Bank ratifies all loans originated and purchased by the Bank.
The single-family residential loans originated by the Bank are generally
made on terms, conditions and documentation which permit the sale to the Federal
Home Loan Mortgage Corporation ("FHLMC"), the Federal National Mortgage
Association ("FNMA") and other institutional investors in the secondary market.
From fiscal 1991 to fiscal 1993, the Bank sold substantially all of its
fixed-rate single-family residential loans to FNMA in the secondary market as a
means of generating fee income as well as providing additional funds for
lending, investing and other purposes. Sales of loans were generally under
terms which did not provide any recourse to the Company by the purchaser in
the event of default on the loan by the borrower. With respect to such loan
sales, the Company generally retained responsibility for collecting and
remitting loan payments, inspecting the properties, making certain insurance
and tax payments on behalf of borrowers and otherwise servicing the loans it
sold, and received a fee for performing these services. At June 30, 1996,
the Company was servicing $5.6 million of loans for others.
During fiscal 1994, the Bank determined to increase its portfolio of
single-family residential loans and terminated its loan sale program while at
the same time emphasizing increased originations of such loans. In addition,
during fiscal 1995, the Bank began originating single-family residential loans
through a correspondent mortgage banking company headquartered in Indianapolis,
Indiana. The Bank plans to expand further its single-family residential loan
portfolio through the use of additional correspondent mortgage banking companies
in the future.
The Bank requires that all loans originated through correspondents be
underwritten in accordance with its underwriting guidelines and standards. The
Bank reviews the loans, particularly scrutinizing the borrower's ability to
repay the obligation, the appraisal and the loan-to-value ratio. Such loans are
generally obtained with servicing released.
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<PAGE>
The following table sets forth the loan origination and sale activity of
the Company during the periods indicated.
Year Ended June 30,
-----------------------------------------
1996 1995 1994
-------- ---------- --------
(Dollars in Thousands)
Direct loan originations:
Single-family residential $18,895 $ 9,082 $10,295
Commercial real estate -- 1,387 --
Consumer 1,246 1,255 580
------- ------- -------
Total loans originated
directly 20,141 11,724 10,875
Originations by
correspondents(1) 22,721 9,830 --
------- ------- -------
Total loans originated 42,862 21,554 10,875
Sales and loan principal
reductions:
Loans sold(1) -- -- (91)
Loan principal reductions (13,985) (5,343) (6,936)
------- ------- -------
Total loans sold and
principal reductions (13,985) (5,343) (7,027)
------- ------- -------
Net increase (decrease) in
loan portfolio $28,877 $16,211 $ 3,848
------- ------- -------
------- ------- -------
- -------------------
(1) Consisted solely of single-family residential loans.
SINGLE-FAMILY RESIDENTIAL REAL ESTATE LOANS. Historically, savings
institutions such as the Bank have concentrated their lending activities on the
origination of loans secured primarily by first mortgage liens on existing
single-family residences. At June 30, 1996, $64.9 million or 97.8% of the
Bank's total loan portfolio consisted of single-family residential real estate
loans, substantially all of which are conventional loans.
The Bank offers fixed-rate single family residential loans with terms of 10
to 30 years. Such loans are amortized on a monthly basis with principal and
interest due each month. Generally, the value of fixed-rate loans fluctuates
inversely with changes in interest rates. Consequently, if left unhedged,
long-term fixed-rate single-family residential loans would increase the Bank's
interest rate risk. However, the Bank believes that its sophisticated asset and
liability management techniques provide the Bank with a competitive advantage
and allow for the Bank to continue to offer fixed-rate residential mortgage
loans over a variety of interest rate scenarios.
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<PAGE>
Since the early 1980s, the Bank has also been offering adjustable-rate
single-family residential mortgage loans. Such loans generally have up to
30-year terms and an interest rate which adjusts after one, three or five years
in accordance with a designated index (the weekly average yield on U.S. Treasury
securities adjusted to a constant comparable maturity of one year, as made
available by the Federal Reserve Board). Such loans currently have a 2% cap on
the amount of any increase or decrease in the interest rate per year, and a 6%
limit on the amount by which the interest rate can increase or decrease over the
life of the loan. In addition, the Bank's adjustable-rate loans are currently
not convertible into fixed-rate loans and do not contain prepayment penalties.
Approximately 24.6% of the single-family residential loans in the Bank's loan
portfolio at June 30, 1996 had adjustable interest rates.
Adjustable-rate mortgage loans decrease but do not eliminate the risks
associated with changes in interest rates. Because periodic and lifetime caps
limit the interest rate adjustments, the value of adjustable-rate mortgage loans
also fluctuates inversely with changes in interest rates. In addition as
interest rates increase, the required payments by the borrower increase, thus
increasing the potential for default.
The demand for adjustable-rate loans in the Bank's primary market area has
been a function of several factors, including the level of interest rates, the
expectations of changes in the level of interest rates and the difference
between the interest rates and loan fees offered for fixed-rate loans and
adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate
residential loans that can be originated at any time is largely determined by
the demand for each in a competitive environment.
The Bank is permitted to lend up to 100% of the appraised value of the real
property securing a residential loan (referred to as the loan-to-value ratio);
however, if the amount of a residential loan originated or refinanced exceeds
90% of the appraised value, the Bank is required by federal regulations to
obtain private mortgage insurance on the portion of the principal amount that
exceeds 80% of the appraised value of the security property. Pursuant to
underwriting guidelines adopted by the Board of Directors, the Bank will
generally lend up to 95% of the appraised value of the property securing a
single-family residential loan. However, the Bank generally obtains private
mortgage insurance on the principal amount that exceeds 80% of appraised value
of the security property.
Although the Bank does not emphasize the origination of residential
construction loans, in recent years the Bank has occasionally originated loans
in its primary market area to construct single-family residences. At June 30,
1996, the Bank had five construction loans amounting to $586,000 in the
aggregate or 0.9% of the Bank's total loan portfolio.
COMMERCIAL REAL ESTATE LOANS. At June 30, 1996, $441,000 or 0.7% of the
Bank's total loan portfolio consisted of loans secured by commercial real
estate. At June 30, 1996, the Bank's commercial real estate loan portfolio
included four loans (which include mortgage revenue bonds) secured by commercial
buildings and vacant land, all of which are
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<PAGE>
located within the Company's primary market area. The Company's largest
commercial real estate loan at June 30, 1996 was a $196,000 loan secured by a
commercial building located in Richmond, Indiana.
Commercial real estate lending entails different and significant risks when
compared to single-family residential lending because such loans typically
involve large loan balances to single borrowers and because the payment
experience on such loans is typically dependent on the successful operation of
the project or the borrower's business. The Bank attempts to minimize its risk
exposure by limiting the extent of its commercial lending generally. In
addition, the Bank imposes stringent loan-to-value ratios, requires conservative
debt coverage ratios, and continually monitors the operation and physical
condition of the collateral. The Bank intends to continue to originate small
commercial real estate loans on a case-by-case basis that comply with its strict
underwriting standards.
CONSUMER LOANS. The Bank is authorized to make loans for a wide variety of
personal or consumer purposes. The Bank has been originating consumer loans in
recent years in order to provide a wider range of financial services to its
customers and because such loans generally have higher interest spreads than
mortgage loans. The consumer loans offered by the Bank include home equity
loans and lines of credit, home improvement loans and deposit account secured
loans. At June 30, 1996, $999,000 or 1.5% of the Bank's total loan portfolio
consisted of consumer loans.
Home equity loans and lines of credit are originated by the Bank for up to
80% of the appraised value, less the amount of any existing prior liens on the
property. The Bank also offers home improvement loans in amounts up to 95% of
the appraised value (provided the borrower has or maintains private mortgage
insurance on the principal balance that exceeds 80% of the appraised value),
less the amount of any existing prior liens on the property. Home equity loans
and home improvement loans have a maximum term of twenty years and carry fixed
interest rates. Home equity lines of credit have a maximum repayment term of 10
years, a five-year term with respect to draws, and carry interest rates which
adjust monthly in accordance with a designated prime rate. The Bank will secure
each of these types of loans with a mortgage on the property (generally a second
mortgage) and will originate the loan even if another institution holds the
first mortgage. At June 30, 1996, home equity loans and lines of credit and
home improvement loans totalled $732,000 or 1.1% of the Bank's total consumer
loan portfolio.
The Bank currently offers loans secured by deposit accounts, which amounted
to $267,000 or 0.4% of the Bank's total consumer loan portfolio at June 30,
1996. Such loans are originated for up to 95% of the deposit account balance,
with a hold placed on the account restricting the withdrawal of the account
balance.
Consumer loans generally have shorter terms and higher interest rates than
mortgage loans but generally involve more credit risk than mortgage loans
because of the type and nature of the collateral. In addition, consumer lending
collections are dependent on the
-11-
<PAGE>
borrower's continuing financial stability, and thus are more likely to be
adversely affected by job loss, divorce, illness and personal bankruptcy. The
Bank believes that the generally higher yields earned on consumer loans
compensate for the increased credit risk associated with such loans, and the
Company intends to continue to offer consumer loans in order to provide a full
range of services to its customers.
ASSET QUALITY
LOAN DELINQUENCIES. When a borrower fails to make a required payment on a
loan, the Bank attempts to cure the deficiency by contacting the borrower and
seeking payment. Contacts are generally made following the fifteenth day after
a payment is due, at which time a late payment is assessed. In most cases,
deficiencies are cured promptly. If a delinquency extends beyond 15 days, the
loan and payment history is reviewed and efforts are made to collect the loan.
While the Bank generally prefers to work with borrowers to resolve such
problems, when the account becomes 90 days delinquent, the Bank does institute
foreclosure or other proceedings, as necessary, to minimize any potential loss.
NON-PERFORMING ASSETS. All loans are reviewed on a regular basis and are
placed on non-accrual status when, in the opinion of management, the collection
of additional interest is deemed insufficient to warrant further accrual. As a
matter of policy, the Bank does not accrue interest on loans past due 90 days or
more except when the estimated value of the collateral and collection efforts
are deemed sufficient to ensure full recovery. The Bank provides an allowance
for the loss of uncollected interest on all non-accrual loans. Impaired loans
covered under SFAS No. 114 and No. 118 are defined by the Company to consist of
non-accrual commercial loans which have not been collectively evaluated for
impairment. The allowance is established by a charge to interest income equal
to all interest previously accrued, and income is subsequently recognized only
to the extent that cash payments are received until, in management's judgment,
the borrower's ability to make periodic interest and principal payments returns
to normal, in which case the loan is returned to accrual status.
Real estate acquired through foreclosure is carried at the lower of the
loan's unpaid principal balance (cost) or fair value less estimated selling
expenses at the date of transfer. A loan charge-off is recorded for any
writedown in the loan's carrying value to fair value at the date of transfer.
Real estate loss provisions are recorded if the properties' fair value
subsequently declines below the value determined at the recording date. In
determining the lower of cost or fair value at acquisition, costs relating to
development and improvement of property are considered. Costs relating to
holding real estate acquired through foreclosure, net of rental income, are
charged against earnings as incurred.
-12-
<PAGE>
The following table sets forth the amounts and categories of the Bank's
non-performing assets at the dates indicated. The Bank did not have any
troubled debt restructuring at any of the periods presented.
<TABLE>
<CAPTION>
June 30,
----------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
-------- -------- -------- -------- --------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
Non-accruing loans:
Single-family residential $ 261 $ 350 $ 559 $449 $488
Commercial real estate -- -- -- 50 50
Consumer -- -- -- -- 10
------- ------ ------ ------ ------
Total non-accruing loans 261 350 559 499 548
Accruing loans greater than
90 days delinquent -- -- -- -- --
------- ------ ------ ------ ------
Total non-performing loans 261 350 559 499 548
Real estate owned -- -- -- 26 --
Other non-performing assets(1) 1,088 1,415 2,282 -- --
------- ------ ------ ------ ------
Total non-performing assets $ 1,349 $1,765 $2,841 $525 $548
------- ------ ------ ------ ------
------- ------ ------ ------ ------
Total non-performing loans
as a percentage of total
loans 0.40% 0.95% 2.70% 3.00% 2.56%
------- ------ ------ ------ ------
------- ------ ------ ------ ------
Total non-performing assets
as a percentage of total
assets 0.32% 0.59% 1.34% 0.24% 0.24%
------- ------ ------ ------ ------
------- ------ ------ ------ ------
</TABLE>
- -------------------------
(1) Consists of a non-agency participation certificate. See "- Classified
Assets."
The interest income that would have been recorded during the years ended
June 30, 1996, 1995, 1994 and 1993 if the Bank's non-accrual loans at the end of
such periods had been current in accordance with their terms during such periods
was $6,000, $13,000, $26,000 and $46,000, respectively.
CLASSIFIED ASSETS. Federal regulations require that each insured savings
institution classify its assets on a regular basis. In addition, in connection
with examinations of insured institutions, federal examiners have authority to
identify problem assets and, if appropriate, classify them. There are three
classifications for problem assets: "substandard," "doubtful" and "loss."
Substandard assets have one or more defined weaknesses and are characterized by
the distinct possibility that the insured institution will sustain some loss if
the deficiencies are not corrected. Doubtful assets have the weaknesses of
substandard assets with the additional characteristic that the weaknesses make
collection or liquidation in full on the basis of currently existing facts,
conditions and values questionable, and there is a high possibility of loss. An
asset classified loss is considered uncollectible and of such little value that
continuance as an asset of the institution is not warranted. Another category
designated "special mention" also must be established and maintained for assets
which do not currently
-13-
<PAGE>
expose an insured institution to a sufficient degree of risk to warrant
classification as substandard, doubtful or loss. Assets classified as
substandard or doubtful require the institution to establish general allowances
for loan losses. If an asset or portion thereof is classified loss, the insured
institution must either establish specific allowances for loan losses in the
amount of 100% of the portion of the asset classified loss, or charge-off such
amount. General loss allowances established to cover possible losses related to
assets classified substandard or doubtful may be included in determining an
institution's regulatory capital, while specific valuation allowances for loan
losses do not qualify as regulatory capital.
The Bank's classified assets at June 30, 1996 consisted of $1.4 million of
assets classified as substandard (including $286,000 of loans and $1.1 million
of securities) and no loans classified as doubtful. In addition, at June 30,
1996, $971,000 of the Bank's loans were designated special mention.
The $1.1 million of securities classified as substandard at June 30, 1996
relates to a single non-agency participation certificate which was purchased by
the Bank during fiscal 1991. The security was issued by a savings institution
located in Huntington Beach, California and the underlying mortgages consist of
six-month adjustable-rate notes (priced off of LIBOR) which are secured by
single-family properties located in southern California. As of June 30, 1996,
approximately 36.9% of the underlying mortgages were at least 30 days past due
and/or in foreclosure or already foreclosed upon by the servicer. The security
was structured into both senior and subordinate classes and the Bank owns only
senior classes. As of June 30, 1996, the pool had cumulative realized losses of
$17.9 million which were initially absorbed by certain credit supports and
subsequently absorbed by subordinate certificate holders. Currently, senior
certificate holders (such as the Bank) are having to absorb some of the losses.
The credit supports, which totalled $11.0 million at the date of issuance, had
been depleted as of June 30, 1996. The security is currently held in the Bank's
available for sale portfolio and its $1.1 million carrying value at June 30,
1996 reflects $53,000 of net unrealized losses as of such date as well as
$414,000 and $253,000 of write-downs with respect to such security which were
recognized by the Bank during fiscal 1995 and 1994, respectively.
ALLOWANCE FOR LOAN LOSSES. It is management's policy to maintain an
allowance for estimated losses on loans based upon the estimated net realizable
value of the underlying collateral, general economic conditions, particularly as
they relate to the Bank's market area, historical loss experience, and other
factors related to the collectibility of the loan portfolio. Although
management believes that it uses the best information available to make such
determinations, future adjustments to the allowance may be necessary, and net
income could be significantly affected, if circumstances differ substantially
from the assumptions used in making the initial determinations.
Effective December 21, 1993, the OTS, in conjunction with the Office of the
Comptroller of the Currency, the FDIC and the Federal Reserve Board, issued an
Interagency Policy Statement on the Allowance for Loan and Lease Losses ("Policy
-14-
<PAGE>
Statement"). The Policy Statement, which effectively supersedes the proposed
guidance issued in September 1992, includes guidance (i) on the responsibilities
of management for the assessment and establishment of an adequate allowance and
(ii) for the agencies' examiners to use in evaluating the adequacy of such
allowance and the policies utilized to determine such allowance. The Policy
Statement also sets forth quantitative measures for the allowance with respect
to assets classified substandard and doubtful and with respect to the remaining
portion of an institution's loan portfolio. Specifically, the Policy Statement
sets forth the following quantitative measures which examiners may use to
determine the reasonableness of an allowance: (i) 50% of the portfolio that is
classified doubtful; (ii) 15% of the portfolio that is classified substandard
and (iii) for the portions of the portfolio that have not been classified
(including loans designated special mention), estimated credit losses over the
upcoming twelve months based on facts and circumstances available on the
evaluation date. While the Policy Statement sets forth this quantitative
measure, such guidance is not intended as a "floor" or "ceiling."
The following table sets forth an analysis of the Bank's allowance for loan
losses during the periods indicated.
<TABLE>
<CAPTION>
June 30,
--------------------------------------------------------------------------------------
1996 1995 1994 1993 1992
-------- -------- -------- -------- --------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
Total loans outstanding, net $65,925 $37,010 $20,682 $16,620 $21,409
------ ------ ------- ------ ------
------ ------ ------- ------ ------
Average loans outstanding, net $52,399 $25,467 $19,369 $19,437 $24,267
------ ------ ------- ------ ------
------ ------ ------- ------ ------
Balance at beginning of period $ 121 $ 106 $ 156 $ 99 $ 90
Charge-offs:
Single-family residential -- -- 2 -- --
Commercial real estate(1) -- -- 45 -- --
Consumer -- -- -- 10 --
------ ------ ------- ------ ------
Total charge-offs -- -- 47 10 --
Recoveries:
Consumer -- -- -- 1 --
------ ------ ------- ------ ------
Total recoveries -- -- -- 1 --
Net charge-offs -- -- 47 9 --
Provision (recovery) for loan losses (1) 15 (3) 66 9
------ ------ ------- ------ ------
Balance at end of period $ 120 $ 121 $ 106 $ 156 $ 99
------ ------ ------- ------ ------
------ ------ ------- ------ ------
Allowance for loan losses as a
percent of total loans
outstanding 0.2% 0.3% 0.5% 0.9% 0.5%
--- --- --- --- ---
--- --- --- --- ---
Ratio of net charge-offs to
average loans outstanding --% ---% 0.2% ---% ---%
--- --- --- --- ---
--- --- --- --- ---
- -----------------------------
</TABLE>
(1) The $45,000 charge-off during fiscal 1994 related to a mortgage revenue
bond secured by commercial real estate.
-15-
<PAGE>
The following table sets forth information concerning the allocation of the
Bank's allowance for loan losses by loan categories at the dates indicated.
<TABLE>
<CAPTION>
June 30,
----------------------------------------------------------------------------------------------
1996 1995 1994
--------------------------- -------------------------------- -------------------------------
Percent of Percent of Percent of
Loans in Each Loans in Each Loans in Each
Category to Category to Category to
Amount Total Loans Amount Total Loans Amount Total Loans
------- -------------- -------------- -------------- --------------- --------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C>
Single-family residential loans $ 95 97.80% $ 96 96.10% $ 91 96.60%
Commercial real estate loans(1) 10 0.7 10 1.9 -- 1.6
Consumer loans 15 1.5 15 2 15 1.8
--- ----- --- ----- --- -----
Total $120 100.0% $121 100.0% $106 100.0%
--- ----- --- ----- --- -----
--- ----- --- ----- --- -----
<CAPTION>
June 30,
-----------------------------------------------------------
1993 1992
--------------------------- ----------------------------
Percent of Percent of
Loans in Each Loans in Each
Category to Category to
Amount Total Loans Amount Total Loans
---------- -------------- ---------- ---------------
(Dollars in Thousands)
<S> <C> <C> <C> <C>
Single-family residential loans $ 96 96.0% $32 96.8%
Commercial real estate loans(1) 45 2.6 40 2.2
Consumer loans 15 1.4 27 1.0
---- ------ --- ------
Total $156 100.0% $99 100.0%
---- ------ --- ------
---- ------ --- ------
</TABLE>
- ------------------
(1) Includes mortgage revenue bonds.
-16-
<PAGE>
INVESTMENT ACTIVITIES
GENERAL. The Company's securities portfolio is managed by investment
officers in accordance with a comprehensive written investment policy which
addresses strategies, types and levels of allowable investments and which is
reviewed and approved by the Bank's Board of Directors on an annual basis. The
management of the securities portfolio is set in accordance with strategies
developed by the Bank's Investment Committee. In addition, the Bank has entered
into an agreement with Smith Breeden whereby Smith Breeden has been appointed as
investment advisor with respect to the management of the Bank's securities
portfolio. With the assistance of Smith Breeden, the Bank's Chief Executive
Officer (who is also a principal of Smith Breeden), Chief Investment Officer,
and Investment Officer (who is also a principal of Smith Breeden) execute
various transactions with respect to the portfolio and are responsible for
informing the Investment Committee of the types of investments available, the
status and performance of the portfolio and current market conditions. The
investment officers are authorized to: purchase or sell any securities as well
as commitments to hedge eligible investments; purchase or sell eligible
investments under repurchase or reverse repurchase agreements; execute hedging
strategies approved by the Investment Committee; pledge securities owned as
collateral for public agency deposits or repurchase accounts or agreements; and
lend securities to approved dealers in government securities or approved
commercial banks. Any one investment officer has the authority to purchase or
sell securities up to $5.0 million in any one transaction and acting together,
two members of the Investment Committee have authority to purchase or sell
securities up to $10.0 million in any one transaction. For purchases or sales
greater than $10.0 million, the prior approval of a majority of the Investment
Committee is required. Investment officers are also authorized to invest excess
liquidity in approved liquid investment vehicles. In addition, both the
Investment Committee and the Board of Directors of the Bank ratify all
securities purchased and sold by the Bank.
The Company invests in a portfolio of mortgage-backed securities, mortgage-
backed derivative securities, interest rate contracts, equity securities and
municipal bonds. In selecting securities for its portfolio, the Company employs
option-adjusted pricing analysis with the assistance of Smith Breeden in order
to ascertain the net risk-adjusted spread expected to be earned with respect to
the various investment alternatives. The nature of this analysis is to quantify
the costs embedded in the yield of an investment, such as the funding cost, the
costs of the options embedded in the investment's cash flows (such as a
borrower's ability to prepay a mortgage), credit costs, if any, and servicing
costs. The objective of the Company's investment management process is to
select investments with the greatest net spreads and actively manage the
underlying risks of these investments.
The Company actively manages its securities portfolio in order to enhance
net interest and other income on a risk-adjusted basis. As a result, the
Company continuously monitors the net risk-adjusted spreads of its investments
and compares them with the spreads available with respect to other securities in
the market. Accordingly, as market conditions fluctuate (E.G., as risk-adjusted
spreads narrow), the Company will sell individual securities prior to their
maturity and reinvest the proceeds into new investments which generally carry
wider risk-adjusted spreads.
-17-
<PAGE>
The Company's securities portfolio also contains various interest rate contracts
(such as interest rate swaps, collars, caps, floors, options and futures) which
are primarily utilized to hedge the Company's interest rate exposure in the
trading portfolio and which require active management in order to respond to
changing market conditions.
In recognition of the Company's business strategy of actively managing its
securities portfolio, during fiscal 1994, the Company reclassified substantially
all of its securities as held for trading. Pursuant to SFAS No. 115, securities
classified as trading securities are reported at fair value with unrealized
gains and losses included in earnings, and securities classified as available
for sale are similarly reported at fair value, but with unrealized gains and
losses excluded from earnings and instead reported as a separate component of
stockholders' equity.
MORTGAGE-BACKED AND RELATED SECURITIES. At June 30, 1996, the Company's
mortgage-backed and related securities portfolio (including $11.0 million of
mortgage-backed derivative securities) amounted to $318.8 million or 97.7% of
the Company's securities portfolio (both held for trading and available for
sale) and 76.2% of the Company's total assets. By investing in mortgage-backed
and related securities, management seeks to achieve a targeted option-adjusted
spread over applicable funding costs.
The Company invests in mortgage-backed and related securities, including
mortgage participation certificates, which are insured or guaranteed by U.S.
Government agencies and government sponsored enterprises, and CMOs and real
estate mortgage investment conduits ("REMICs"). Mortgage-backed securities
(which also are known as mortgage participation certificates or pass-through
certificates) represent a participation interest in a pool of single-family or
multi-family mortgages, the principal and interest payments on which are passed
from the mortgage originators, through intermediaries (generally U.S. Government
agencies and government sponsored enterprises) that pool and repackage the
participation interests in the form of securities, to investors such as the
Company. Such U.S. Government agencies and government sponsored enterprises,
which guarantee the payment of principal and interest to investors, primarily
include the FHLMC, the FNMA and the Government National Mortgage Association
("GNMA").
Mortgage-backed securities typically are issued with stated principal
amounts, and the securities are backed by pools of mortgages that have loans
with interest rates that are within a range and have varying maturities. The
characteristics of the underlying pool of mortgages, i.e., fixed-rate or
adjustable-rate, as well as prepayment risk, are passed on to the certificate
holder. The term of a mortgage-backed pass-through security thus approximates
the term of the underlying mortgages.
The Company's mortgage-backed derivative securities include CMOs, which
include securities issued by entities which have qualified under the Internal
Revenue Code as REMICs. CMOs and REMICs (collectively CMOs) have been developed
in response to investor concerns regarding the uncertainty of cash flows
associated with the prepayment option of the underlying mortgagor and are
typically issued by governmental agencies, government sponsored enterprises
-18-
<PAGE>
and special purpose entities, such as trusts, corporations or partnerships,
established by financial institutions or other similar institutions. A CMO can
be collateralized by loans or securities which are insured or guaranteed by
FNMA, FHLMC or GNMA. In contrast to pass-through mortgage-backed securities, in
which cash flow is received pro rata by all security holders, the cash flow from
the mortgages underlying a CMO is segmented and paid in accordance with a
predetermined priority to investors holding various CMO classes. By allocating
the principal and interest cash flows from the underlying collateral among the
separate CMO classes, different classes of bonds are created, each with its own
stated maturity, estimated average life, coupon rate and prepayment
characteristics.
The Company's mortgage-backed derivative securities also include
mortgage-backed residuals and interest-only and principal-only strips.
Mortgage-backed residuals consist of certificates of particular tranches of a
CMO whereby the principal repayments and prepayments with respect to the
underlying pool of loans are generally not allocated to the residual until all
other certificates or tranches have been fully paid and retired. Interest-only
strips are a particular class of mortgage-backed derivative security which
receives and pays only interest with respect to the underlying pool of loans,
while principal-only strips receive and pay only principal repayments and
prepayments. As a result of the foregoing, mortgage-backed derivative
securities often exhibit elasticity and convexity characteristics (i.e., respond
differently to changes in interest rates) which the Company can utilize to
internally hedge other components of the Company's portfolio of assets against
interest rate risk.
The OTS has issued a statement of policy which states, among other things,
that mortgage derivative products (including CMOs and CMO residuals and stripped
mortgage-backed securities such as interest-only and principal-only strips)
which possess average life or price volatility in excess of a benchmark
fixed-rate 30-year mortgage-backed security are "high risk mortgage
securities," and must be carried in the institution's trading account or
as assets held for sale, and therefore marked to market on a regular basis.
At June 30, 1996, $5.9 million or 1.8% of the securities held in the Company's
portfolio consisted of such "high risk mortgage securities," as defined in such
policy statement. However, the Bank is in compliance with this OTS policy
statement since all of such securities are held in the Company's trading account
and marked to market on a regular basis in accordance with generally accepted
accounting principles.
Like most fixed-income securities, mortgage-backed and related securities
are subject to interest rate risk. However, unlike most fixed-income
securities, the mortgage loans underlying a mortgage-backed or related security
generally may be prepaid at any time without penalty. The ability to prepay a
mortgage loan generally results in significantly increased price and yield
volatility (with respect to mortgage-backed and related securities) than is the
case with non-callable fixed-income securities. Furthermore, mortgage-backed
derivative securities often are more sensitive to changes in interest rates and
prepayments than traditional mortgage-backed securities and are, therefore, even
more volatile. Nevertheless, the Company utilizes sophisticated asset and
liability management techniques to hedge against both interest rate and
prepayment risk.
-19-
<PAGE>
Although mortgage-backed and related securities often carry lower yields
than traditional mortgage loans, such securities generally increase the quality
of the Company's assets by virtue of the securities' underlying insurance or
guarantees, are more liquid than individual mortgage loans (which enhances the
Company's ability to actively manage its portfolio) and may be used to
collateralize borrowings or other obligations of the Company. At June 30, 1996,
$229.7 million or 72.0% of the Company's mortgage-backed and related securities
were pledged to secure various obligations of the Company (such as reverse
repurchase agreements and interest rate swaps). In addition, as a result of the
Company maintaining a substantial portion of its assets in mortgage-backed and
related securities, the Company has been able to maintain a relatively low level
of operating expenses. Furthermore, mortgage-backed derivative securities are
often utilized by the Company to internally hedge its interest rate exposure and
can be attractive alternatives to other hedge vehicles when their
option-adjusted spreads are abnormally wide.
The following table sets forth information relating to the amortized cost
and market value of the Company's securities held for trading and securities
available for sale portfolios.
<TABLE>
<CAPTION>
June 30,
-----------------------------------------------------------------------------------------
1996 1995 1994
------------------------------ ------------------------------- ------------------------
Amortized Market Amortized Market Amortized Market
Cost Value Cost Value Cost Value
----------- --------------- ----------------- ------------ ------------ ---------
(In Thousands)
<S> <C> <C> <C> <C> <C> <C>
Securities held for trading:
FHLMC participation certificates $ 83,329 $ 83,384 $ 54,685 $ 55,247 $ 11,313 $ 11,239
FNMA participation certificates 66,182 65,997 68,286 69,201 65,900 63,347
GNMA participation certificates 153,048 154,240 90,408 91,751 46,121 45,071
Non-agency participation
certificates 3,209 3,154 3,893 3,918 4,650 4,654
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 305,768 306,775 217,272 220,117 127,984 124,311
Collateralized mortgage obligations 6,131 6,379 12,910 13,022 23,447 23,469
Residuals 707 778 4,470 4,364 3,848 4,806
Interest-only strips 3,442 2,792 4,570 2,998 10,062 9,712
Principal only strips 1,028 1,010 781 803 -- --
-------- -------- -------- -------- -------- --------
Total mortgage-backed
derivative securities 11,308 10,959 22,731 21,187 37,357 37,987
Interest rate swaps -- 620 -- (219) -- 3,358
Interest rate collar 83 (8) 155 (71) 270 58
Interest rate caps 3,692 3074 2,297 1,995 2,573 4,054
Interest rate floors 2,535 2970 1,544 3,409 1,625 751
Options 54 65 266 200 -- --
Futures -- (784) -- (134) -- --
-------- -------- -------- -------- -------- --------
Total interest rate contracts 6,364 5,937 4,262 5,180 4,468 8,221
Equity securities 496 550 223 249 401 401
-------- -------- -------- -------- -------- --------
Total securities held for trading $323,936 $324,221 $244,488 $246,733 $170,210 $170,920
-------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- --------
Securities available for sale:
Non-agency participation
certificates $ 1,141 $ 1,088 $ 1,426 $ 1,415 $ 2,363 $ 2,282
-------- -------- -------- -------- -------- --------
Total mortgage-backed securities 1,141 1,088 1,426 1,415 2,363 2,282
Municipal bonds 921 962 1,017 1,126 1,064 1,145
-------- -------- -------- -------- -------- --------
Total securities available for sale $ 2,062 $ 2,050 $ 2,443 $ 2,541 $ 3,427 $ 3,427
-------- -------- -------- -------- -------- --------
-------- -------- -------- -------- -------- --------
</TABLE>
-20-
<PAGE>
The following table sets forth the market value of the Company's securities
activities (both held for trading and available for sale) for the periods
indicated:
<TABLE>
<CAPTION>
At or For the Years
Ended June 30,
-----------------------------------
1996 1995 1994
----------- ---------- ------------
(In Thousands)
<S> <C> <C> <C>
Beginning balance $249,273 $174,347 $186,582
Mortgage-backed securities purchased -
held for trading 385,542 497,661 54,637
Mortgage-backed securities purchased -
available for sale -- -- 107,793
Collateralized mortgage obligations
purchased - held for trading -- 7,093 --
Collateralized mortgage obligations
purchased - available for sale -- -- 11,001
Mortgage-backed derivative securities
purchased - held for trading 495 2,741 975
Mortgage-backed derivative securities
purchased - available for sale -- -- 3,440
Interest rate contracts purchased - held
for trading 4,161 1,935 1,082
Interest rate contracts purchased -
available for sale -- -- 348
Equity securities purchased -
held for trading 545 880 --
Equity securities purchased -
available for sale -- -- 401
-------- -------- --------
Total securities purchased 390,743 510,310 179,677
Less:
Sale of mortgage-backed securities -
held for trading 272,108 394,967 56,602
Sale of mortgage-backed securities -
available for sale -- -- 81,675
Sale of collateralized mortgage
obligations - held for trading 7,798 17,321 --
Sale of collateralized mortgage
obligations - available for sale -- -- 17,022
Sale of mortgage-backed derivative
securities - held for trading 3,642 6,933 284
Sale of mortgage-backed derivative
securities - available for sale -- -- 619
Sale of interest rate contracts -
held for trading 1,973 (1,450) --
Sale of interest rate contracts -
available for sale -- -- (887)
Sale of equity securities -
held for trading 314 1,081 --
Sale of equity securities -
available for sale -- -- 219
-------- -------- --------
Total securities sold 285,835 418,852 155,534
Less proceeds from maturities of
securities 25,966 16,371 31,945
Realized gain (loss) on sale of
securities held for trading 1,834 66 (2,169)
Realized gain on sale of
securities available for sale -- -- 392
Unrealized gain (loss) on securities
held for trading (1,960) 1,535 710
Change in net unrealized gain (loss) on
securities available for sale 69 97 (470)
Amortization of premium (1,887) (1,445) (2,286)
Permanent impairment of securities
available for sale -- (414) (610)
-------- -------- --------
Ending balance $326,271 $249,273 $174,347
-------- -------- --------
-------- -------- --------
</TABLE>
-21-
<PAGE>
At June 30, 1996, the contractual maturity of substantially all of the
Company's mortgage-backed or related securities was in excess of ten years. The
actual maturity of a mortgage-backed or related security is less than its stated
maturity due to prepayments of the underlying mortgages. Prepayments that are
faster than anticipated may shorten the life of the security and affect its
yield to maturity. The yield to maturity is based upon the interest income and
the amortization of any premium or discount related to the security. In
accordance with generally accepted accounting principles, premiums and discounts
are amortized over the estimated lives of the loans, which decrease and increase
interest income, respectively. The prepayment assumptions used to determine the
amortization period for premiums and discounts can significantly affect the
yield of the mortgage-backed or related security, and these assumptions are
reviewed periodically to reflect actual prepayments. Although prepayments of
underlying mortgages depend on many factors, including the type of mortgages,
the coupon rate, the age of mortgages, the geographical location of the
underlying real estate collateralizing the mortgages and general levels of
market interest rates, the difference between the interest rates on the
underlying mortgages and the prevailing mortgage interest rates generally is the
most significant determinant of the rate of prepayments. During periods of
falling mortgage interest rates, if the coupon rate of the underlying mortgages
exceeds the prevailing market interest rates offered for mortgage loans,
refinancing generally increases and accelerates the prepayment of the underlying
mortgages and the related security. At June 30, 1996, of the $318.8 million of
mortgage-backed and related securities held by the Company, an aggregate of
$154.9 million were secured by fixed-rate mortgage loans and an aggregate of
$163.9 million were secured by adjustable-rate mortgage loans.
OTHER SECURITIES. Other securities owned by the Company at June 30, 1996
include various interest rate contracts, including interest rate swaps, collars,
caps, floors, options and futures, equity securities and municipal bonds. At
June 30, 1996, the carrying value of the Company's interest rate contracts,
equity securities and municipal bonds amounted to $5.9 million, $550,000 and
$962,000 million, respectively. The municipal bonds held by the Company at June
30, 1996 were scheduled to mature between one and five years. See Note 2 to the
Notes to Consolidated Financial Statements.
SOURCES OF FUNDS
GENERAL. The Company will consider various sources of funds to fund its
investing and lending activities and evaluates the available sources of funds in
order to reduce the Company's overall funding costs. Deposits, reverse
repurchase agreements, advances from the FHLB of Indianapolis, notes payable,
and sales, maturities and principal repayments on loans and securities have been
the major sources of funds for use in the Company's lending and investing
activities, and for other general business purposes. Management of the Company
closely monitors rates and terms of competing sources of funds on a daily basis
and utilizes the source which it believes to be cost effective.
-22-
<PAGE>
DEPOSITS. The Bank attempts to price its deposits in order to promote
deposit growth and offers a wide array of deposit products in order to satisfy
its customers' needs. The Bank's current deposit products include statement
savings accounts, negotiable order of withdrawal ("NOW") and checking accounts,
money market deposit accounts, fixed-rate, fixed-maturity retail certificates of
deposit ranging in terms from seven days to 10 years, individual retirement
accounts, and non-retail certificates of deposit consisting of jumbo (generally
greater than $95,000) certificates, inverse variable-rate certificates and
brokered certificates of deposit.
The Bank's retail deposits are generally obtained from residents in its
primary market area. The principal methods currently used by the Bank to
attract deposit accounts include offering a wide variety of value-added products
and services and competitive interest rates. The Bank utilizes traditional
marketing methods to attract new customers and savings deposits, including
various forms of advertising. The Bank also utilizes the services of deposit
brokers to attract non-retail certificates of deposit. Management estimates
that as of June 30, 1996, non-retail deposit accounts totalled $28.5 million or
21.1% of the Bank's total deposits. These non-retail deposits consist largely
of jumbo certificates of deposit, inverse variable-rate certificates (which are
obtained through brokers) and brokered deposits. The Bank's jumbo certificates
of deposit and other deposits are also obtained through the posting of deposit
rates on national computerized bulletin boards at no cost to the Bank. The
Bank's inverse variable-rate certificates carry rates which fluctuate inversely
with respect to market rates of interest. For example, if market rates of
interest increase, the rates on the inverse variable-rate certificates would
decrease, while if market rates of interest decrease, the rates on the inverse
variable-rate certificates would increase. As a result, the Bank would
generally be paying a higher rate on such certificates during a declining
interest rate environment. The Bank offers inverse variable-rate certificates
when they represent a lower cost source of funds.
-23-
<PAGE>
<TABLE>
<CAPTION>
The following table shows the distribution of and certain other information
relating to the Bank's deposits by type as of the dates indicated.
June 30,
-----------------------------------------------------------------------------------------
1996 1995 1994
-------------------------- ----------------------------- ------------------------
Percent of Percent of Percent of
Amount Deposits Amount Deposits Amount Deposits
-------- ------------ ---------- ------------- ---------- ------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C>
Transaction accounts:
NOW and checking $ 4,529 3.4% $ 3,266 2.8% $ 3,178 2.9%
Savings accounts 17,342 12.8 15,183 13.2 16,502 15.3
Money market deposit
accounts 1,576 1.2 1,976 1.7 7,563 7.0
-------- ------ --------- ------ --------- ------
Total transaction
accounts 23,447 17.4 20,425 17.7 27,243 25.2
-------- ------ --------- ------ --------- ------
Certificates of deposit:
Within 1 year 75,343 55.7 57,304 49.8 41,911 38.7
1-2 years 19,890 14.7 17,890 15.5 15,909 14.7
2-3 years 8,093 6.0 6,844 5.9 9,292 8.6
3-4 years 2,636 2.0 5,352 4.6 3,620 3.3
Over 4 years 5,734 4.2 7,497 6.5 10,325 9.5
-------- ------ --------- ------ --------- ------
Total certificate accounts 111,696 82.6 94,887 82.3 81,057 74.8
-------- ------ --------- ------ --------- ------
Total deposits $135,143 100.0% $115,312 100.0% $108,300 100.0%
-------- ------ --------- ------ --------- ------
-------- ------ --------- ------ --------- ------
</TABLE>
-24-
<PAGE>
The following table shows the distribution of and certain other information
relating to the Bank's certificates of deposit as of the dates indicated.
<TABLE>
<CAPTION>
June 30,
-----------------------------------------------------------------------------------------
1996 1995 1994
-------------------------- ----------------------------- ------------------------
Percent of Percent of Percent of
Amount Deposits Amount Deposits Amount Deposits
-------- ------------ ---------- ------------- ---------- ------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C>
Total retail certificates $ 89,462 66.2% $ 62,465 54.1% $ 31,845 29.4%
-------- ---- -------- ---- -------- ----
Non-retail certificates:
Jumbo certificates 6,041 4.5 9,963 8.6 21,445 19.8
Inverse variable-rate
certificates 8,423 6.2 9,993 8.7 12,065 11.1
Non-brokered out-of-
state deposits 7,276 5.4 11,476 10.0 13,029 12.0
Brokered deposits 494 0.4 990 0.9 2,673 2.5
-------- ---- -------- ---- -------- ----
Total non-retail
certificates(1) 22,234 16.5 32,422 28.2 49,212 45.4
-------- ---- -------- ---- -------- ----
Total certificates of deposit $111,696 82.7% $ 94,887 82.3% $ 81,057 74.8%
-------- ---- -------- ---- -------- ----
-------- ---- -------- ---- -------- ----
</TABLE>
- ------------------
(1) Of the Company's $22.2 million of non-retail certificates as of June 30,
1996, $6.7 million was scheduled to mature in six months or less, $5.4
million was scheduled to mature in 7-12 months, $5.3 million was scheduled
to mature in 13-36 months and $4.8 million was scheduled to mature in over
36 months.
-25-
<PAGE>
The following table presents the average balance of each deposit type and
the average rate paid on each deposit type for the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
------------------------------------------------------------------------------------------
1996 1995 1994
----------------------------- ------------------------------- --------------------------
Average Average Average Average Average Average
Balance Rate Paid Balance Rate Paid Balance Rate Paid
----------- --------------- ------------ --------------- ------------ ------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C>
NOW and checking
accounts $ 3,813 2.9% $ 3,352 2.8% $ 2,872 2.9%
Savings accounts 15,922 3.9 16,068 3.5 18,271 3.3
Money market deposit
accounts 1,777 4.3 2,147 4.1 5,396 3.4
Certificates of deposit 103,981 6.1 99,443 5.9 69,336 5.3
------- --- -------- --- ------- ----
Total deposits $125,493 5.7% $121,010 5.5% $95,875 4.7%
-------- --- -------- --- ------- ----
-------- --- -------- --- ------- ----
</TABLE>
The following table sets forth the deposit account activities of the Bank
during the periods indicated.
Year Ended June 30,
--------------------------------------
1996 1995 1994
----------- ------------- ----------
(In Thousands)
Deposits $213,601 $184,399 $173,083
Withdrawals 197,550 182,443 157,579
Net increase before
interest credited 16,051 1,956 15,504
Interest credited 3,780 5,056 3,008
--------- --------- --------
Net increase in deposits $ 19,831 $ 7,012 $ 18,512
--------- --------- --------
--------- --------- --------
The following table shows the interest rate and maturity information for the
Bank's certificates of deposit at June 30, 1996.
<TABLE>
<CAPTION>
Maturity Date
-------------------------------------------------------------------------------------------------
Interest Rate One Year or Less Over 1-2 Years Over 2-3 Years Over 3 Years Total
- -------------------------- ------------------- ----------------- ------------------ ------------------ --------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
3.00% or less $ 2 $ -- $ 1 $ 13 $ 16
3.01 - 5.00% 4,683 1,050 470 71 6,274
5.01 - 7.00% 65,284 17,535 4,836 4,114 91,769
7.01 - 9.00% 5,374 1,210 2,491 3,492 12,567
9.01% or greater -- 95 295 680 1,070
-------- -------- -------- ------- --------
Total $ 75,343 $ 19,890 $ 8,093 $ 8,370 $111,696
-------- -------- -------- ------- --------
-------- -------- -------- ------- --------
</TABLE>
-26-
<PAGE>
The following table sets forth the maturities of the Bank's certificates of
deposit having principal amounts of $100,000 or more at June 30, 1996.
Certificates of deposit maturing
in quarter ending: Amount
- ------------------------------------------------------------- --------------
(In Thousands)
September 30, 1996 $10,430
December 31, 1996 2,363
March 31, 1997 1,325
After March 31, 1997 6,037
-------
Total certificates of deposit with
balances of $100,000 or more $20,155
-------
-------
BORROWINGS. The following table sets forth certain information regarding the
borrowings of the Company at or for the dates indicated.
At or For the Year Ended June 30,
---------------------------------
1996 1995 1994
---------- ----------- --------
(Dollars in Thousands)
FHLB advances:
Average balance outstanding $ 27,586 $ 31,051 $31,000
Maximum amount outstanding at
any month-end during the period 31,000 31,000 31,000
Balance outstanding at end of period 26,000 31,000 31,000
Average interest rate during the
period 5.8% 5.6% 3.4%
Average interest rate at end of period 5.4% 6.1% 4.3%
Securities sold under agreements to
repurchase:
Average balance outstanding $148,523 $ 68,277 $66,813
Maximum amount outstanding at
any month-end during the period 219,067 130,217 78,545
Balance outstanding at end of period 219,067 130,217 54,651
Average interest rate during the
period 5.6% 5.4% 3.2%
Average interest rate at end of period 5.2% 6.0% 4.1%
-27-
<PAGE>
The Company obtains both fixed-rate and variable-rate long-term and
short-term advances from the FHLB of Indianapolis upon the security of certain
of its residential first mortgage loans and other assets, provided certain
standards related to creditworthiness of the Bank have been met. FHLB of
Indianapolis advances are available for general business purposes to expand
lending and investing activities. Borrowings have generally been used to fund
the purchase of mortgage-backed and related securities or lending activities and
have been collateralized with a pledge of loans, securities in the Company's
portfolio or any mortgage-backed or related securities purchased.
Advances from the FHLB of Indianapolis are made pursuant to several different
credit programs, each of which has its own interest rate and range of
maturities. The Company currently has two variable-rate advances from the FHLB
of Indianapolis which mature in 1997. At June 30, 1996, the Company had total
FHLB of Indianapolis advances of $26.0 million at a weighted average interest
rate of 5.4%.
The Company also obtains funds from the sales of securities to investment
dealers under agreements to repurchase ("reverse repurchase agreements"). In a
reverse repurchase agreement transaction, the Company will generally sell a
mortgage-backed security agreeing to repurchase either the same or a
substantially identical security (i.e., "dollar rolls") on a specified later
date (generally not more than 90 days) at a price less than the original sales
price. The difference in the sale price and purchase price is the cost of the
use of the proceeds. The mortgage-backed securities underlying the agreements
are delivered to the dealers who arrange the transactions. For agreements in
which the Company has agreed to repurchase substantially identical securities,
the dealers may sell, loan or otherwise dispose of the Company's securities in
the normal course of their operations; however, such dealers or third party
custodians safe-keep the securities which are to be specifically repurchased by
the Company. Reverse repurchase agreements represent a competitive cost funding
source for the Company. Nevertheless, the Company is subject to the risk that
the lender may default at maturity and not return the collateral. The amount at
risk is the value of the collateral which exceeds the balance of the borrowing.
In order to minimize this potential risk, the Company only deals with large,
established investment brokerage firms when entering into these transactions.
Reverse repurchase transactions are accounted for as financing arrangements
rather than as sales of such securities, and the obligation to repurchase such
securities is reflected as a liability in the Consolidated Financial Statements.
In April 1993, the Company entered into a $10.0 million loan facility with an
unrelated financial institution. This facility, as amended in 1995, includes a
$9.2 million term loan (the "Refinancing Loan") and a non-revolving line of
credit of $800,000. Proceeds from the Refinancing Loan were utilized to repay
the unpaid balance of a $10.0 million loan that the Company obtained in 1988 in
connection with its acquisition of the Bank (which loan had a principal balance
of $6.6 million as of the date of repayment), reduce the average interest rate
paid on such indebtedness and increase the capitalization of the Bank. The loan
facility matures in March 2000 (which can, under certain circumstances, be
extended for an additional five years) and carries an interest rate of 1/2%
over the prime rate published in the WALL STREET JOURNAL if the ratio of the
loan balance to the Bank's capital is equal to or less than 50%; otherwise, the
interest
-28-
<PAGE>
rate is 1% over the prime rate. The loan facility requires quarterly principal
and interest repayments. The loan facility is secured by (i) a general pledge
agreement between the parties pursuant to which the Company has pledged 100% of
the outstanding stock of the Bank; (ii) a security agreement between the parties
pursuant to which the Company has provided a blanket security interest in all of
its assets; and (iii) the assignment of life insurance policies on Messrs.
Breeden and Cerny by the Company in the aggregate amount of $1.25 million. At
June 30, 1996, the total balance of the loan facility was $9.0 million. A July
1996 amendment to the loan facility recharacterized the aggregate $9.3 principal
balance outstanding as a term loan and provided an additional $3.0 million
non-revolving line of credit, which is intended to further increase the capital
of the Bank. In addition, the amended loan agreement also removed the corporate
guarantee of Smith Breeden Associates, Inc. and the personal guarantee from a
stockholder of the Company.
TRUST AND FIDUCIARY SERVICES
The Company also provides a full range of trust and investment services, and
acts as executor or administrator of estates and as trustee for various types of
trusts. Trust and investment services are offered through Harrington Investment
Management and Trust Services ("Trust Department"), which was created in
December 1994 as a separate division of the Bank. Services offered include
financial services related to trusts and estates, money management, custodial
services and pension and employee benefits consulting and plan administration.
As of June 30, 1996, the Trust Department administered approximately 60
trust/fiduciary accounts, with aggregate assets of $13.4 million at such date.
Gross fee income from the Trust Department amounted to $31,000 and $4,000 during
fiscal 1996 and 1995, respectively, while the Trust Department recognized net
losses with respect to its operations of $59,000 and $91,000 during the
respective periods.
SUBSIDIARIES
The Bank is permitted to invest up to 2% of its assets in the capital stock
of, or secured or unsecured loans to, subsidiary corporations, with an
additional investment of 1% of assets when such additional investments is
utilized primarily for community development purposes. The Bank's only
subsidiary, Pine Tree Mortgage Corp., is an inactive corporation formed in 1987
to originate mortgage loans in North Carolina, and has conducted no business
since 1988. The Bank's investment in the subsidiary is not material to its
operations or financial condition.
SUPERVISION AND REGULATION
SET FORTH BELOW IS A BRIEF DESCRIPTION OF THOSE LAWS AND REGULATIONS WHICH,
TOGETHER WITH THE DESCRIPTIONS OF LAWS AND REGULATIONS CONTAINED ELSEWHERE
HEREIN, ARE DEEMED MATERIAL TO AN INVESTOR'S UNDERSTANDING OF THE EXTENT TO
WHICH THE COMPANY AND THE BANK ARE REGULATED. THE DESCRIPTION OF THE LAWS AND
REGULATIONS HEREUNDER, AS WELL AS DESCRIPTIONS OF LAWS AND REGULATIONS CONTAINED
ELSEWHERE HEREIN, DOES NOT PURPORT TO BE COMPLETE AND IS QUALIFIED IN ITS
ENTIRETY BY REFERENCE TO APPLICABLE LAWS AND REGULATIONS.
-29-
<PAGE>
THE COMPANY
GENERAL. The Company is a registered savings and loan holding company
within the meaning of the Home Owners' Loan Act ("HOLA"), and is subject to OTS
regulations, examinations, supervision and reporting requirements. As a
subsidiary of a savings and loan holding company, the Bank is subject to certain
restrictions in its dealings with the Company and affiliates thereof.
ACTIVITIES RESTRICTIONS. Although there are generally no restrictions on
the activities of a savings and loan holding company which holds only one
subsidiary savings institution under applicable OTS regulations, the Company may
be considered to be a multiple savings and loan holding company because
principals and affiliates of Smith Breeden are deemed for regulatory purposes to
control both the Company and HWFG, a recently formed savings and loan holding
company which owns all of the outstanding common stock of Los Padres Savings
Bank, F.S.B., Los Padres, California.
Multiple savings and loan holding companies are subject to restrictions
which do not apply to unitary savings and loan holding companies. Among other
things, no multiple savings and loan holding company or subsidiary thereof which
is not a savings institution shall commence or continue for a limited period of
time after becoming a multiple savings and loan holding company or subsidiary
thereof any business activity, upon prior notice to, and no objection by the
OTS, other than: (i) furnishing or performing management services for a
subsidiary savings institution; (ii) conducting an insurance agency or escrow
business; (iii) holding, managing, or liquidating assets owned by or acquired
from a subsidiary savings institution; (iv) holding or managing properties used
or occupied by a subsidiary savings institution; (v) acting as trustee under
deeds of trust; (vi) those activities authorized by regulation as of March 5,
1987 to be engaged in by multiple savings and loan holding companies; or (vii)
unless the Director of the OTS by regulation prohibits or limits such activities
for savings and loan holding companies, those activities authorized by the
Federal Reserve Board as permissible for bank holding companies. Those
activities described in (vii) above also must be approved by the Director of the
OTS prior to being engaged in by a multiple savings and loan holding company.
The Company does not believe that if the OTS designates it as a multiple thrift
holding company, such a designation will limit its ability to conduct its normal
business operations.
In addition, if the Director of the OTS determines that there is reasonable
cause to believe that the continuation by a savings and loan holding company of
an activity constitutes a serious risk to the financial safety, soundness or
stability of its subsidiary savings institution, the Director may impose such
restrictions as deemed necessary to address such risk, including limiting (i)
payment of dividends by the savings institution; (ii) transactions between the
savings institution and its affiliates; and (ii) any activities of the savings
institution that might create a serious risk that the liabilities of the
holding company and its affiliates may be imposed on the savings institution.
-30-
<PAGE>
LIMITATIONS ON TRANSACTIONS WITH AFFILIATES. Transactions between savings
institutions and any affiliate are governed by Sections 23A and 23B of the
Federal Reserve Act. An affiliate of a savings institution is any company or
entity which controls, is controlled by or is under common control with the
savings institution. In a holding company context, the parent holding company
of a savings institution (such as the Company) and any companies which are
controlled by such parent holding company are affiliates of the savings
institution. Generally, Sections 23A and 23B (i) limit the extent to which the
savings institution or its subsidiaries may engage in "covered transactions"
with any one affiliate to an amount equal to 10% of such institution's capital
stock and surplus, and contain an aggregate limit on all such transactions with
all affiliates to an amount equal to 20% of such capital stock and surplus and
(ii) require that all such transactions be on terms substantially the same, or
at least as favorable, to the institution or subsidiary as those provided to a
non-affiliate. The term "covered transaction" includes the making of loans,
purchase of assets, issuance of a guarantee and other similar transactions. In
addition to the restrictions imposed by Sections 23A and 23B, no savings
institution may (i) loan or otherwise extend credit to an affiliate, except for
any affiliate which engages only in activities which are permissible for bank
holding companies, or (ii) purchase or invest in any stocks, bonds, debentures,
notes or similar obligations of any affiliate, except for affiliates which are
subsidiaries of the savings institution.
In addition, Sections 22(h) and (g) of the Federal Reserve Act places
restrictions on loans to executive officers, directors and principal
stockholders. Under Section 22(h), loans to a director, an executive officer
and to a greater than 10% stockholder of a savings institution, and certain
affiliated interests of either, may not exceed, together with all other
outstanding loans to such person and affiliated interests, the savings
institution's loans to one borrower limit (generally equal to 15% of the
institution's unimpaired capital and surplus). Section 22(h) also requires that
loans to directors, executive officers and principal stockholders be made on
terms substantially the same as offered in comparable transactions to other
persons and also requires prior board approval for certain loans. In addition,
the aggregate amount of extensions of credit by a savings institution to all
insiders cannot exceed the institution's unimpaired capital and surplus.
Furthermore, Section 22(g) places additional restrictions on loans to executive
officers. At June 30, 1996, the Bank was in compliance with the above
restrictions.
RESTRICTIONS ON ACQUISITIONS. Except under limited circumstances, savings
and loan holding companies are prohibited from acquiring, without prior approval
of the Director of the OTS, (i) control of any other savings institution or
savings and loan holding company or substantially all the assets thereof or (ii)
more than 5% of the voting shares of a savings institution or holding company
thereof which is not a subsidiary. Except with the prior approval of the
Director of the OTS, no director or officer of a savings and loan holding
company or person owning or controlling by proxy or otherwise more than 25% of
such company's stock, may acquire control of any savings institution, other than
a subsidiary savings institution, or of any other savings and loan holding
company.
The Director of the OTS may only approve acquisitions resulting in the
formation of a multiple savings and loan holding company which controls savings
institutions in more than one
-31-
<PAGE>
state if (i) the multiple savings and loan holding company involved controls a
savings institution which operated a home or branch office located in the state
of the institution to be acquired as of March 5, 1987; (ii) the acquiror is
authorized to acquire control of the savings institution pursuant to the
emergency acquisition provisions of the Federal Deposit Insurance Act ("FDIA");
or (iii) the statutes of the state in which the institution to be acquired is
located specifically permit institutions to be acquired by the state-chartered
institutions or savings and loan holding companies located in the state where
the acquiring entity is located (or by a holding company that controls such
state-chartered savings institutions).
Under the Bank Holding Company Act of 1956, the Federal Reserve Board is
authorized to approve an application by a bank holding company to acquire
control of a savings institution. In addition, a bank holding company that
controls a savings institution may merge or consolidate the assets and
liabilities of the savings institution with, or transfer assets and liabilities
to, any subsidiary bank which is a member of the BIF with the approval of the
appropriate federal banking agency and the Federal Reserve Board. As a result
of these provisions, there have been a number of acquisitions of savings
institutions by bank holding companies in recent years.
THE BANK
GENERAL. The OTS has extensive authority over the operations of federally
chartered savings institutions. As part of this authority, savings institutions
are required to file periodic reports with the OTS and are subject to periodic
examinations by the OTS. The last regulatory examination of the Bank by the OTS
was conducted in March 1996. The Bank was not required to make any material
changes to its operations as a result of such examination. The investment and
lending authority of savings institutions are prescribed by federal laws and
regulations, and such institutions are prohibited from engaging in any
activities not permitted by such laws and regulations. Those laws and
regulations generally are applicable to all federally chartered savings
institutions and may also apply to state-chartered savings institutions. Such
regulation and supervision is primarily intended for the protection of
depositors.
The OTS' enforcement authority over all savings institutions and their
holding companies includes, among other things, the ability to assess civil
money penalties, to issue cease and desist or removal orders and to initiate
injunctive actions. In general, these enforcement actions may be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with the OTS.
INSURANCE OF ACCOUNTS. The deposits of the Bank are insured to the maximum
extent permitted by the SAIF, which is administered by the FDIC, and are backed
by the full faith and credit of the U.S. Government. As insurer, the FDIC is
authorized to conduct examinations of, and to require reporting by, FDIC-insured
institutions. It also may prohibit any FDIC-insured institution from engaging
in any activity the FDIC determines by regulation or order to pose a serious
threat to the FDIC. The FDIC also has the authority to initiate enforcement
actions against savings institutions, after giving the OTS an opportunity to
take such action.
-32-
<PAGE>
Both the SAIF and BIF are statutorily required to be capitalized to a ratio
of 1.25% of insured reserve deposits. While the BIF has reached the required
reserve ratio, the SAIF is not expected to be recapitalized until 2002 at the
earliest. Legislation has authorized $8 billion for the SAIF; however, such
funds only become available to the SAIF if the FDIC determines that the funds
are needed to cover losses of the SAIF and several other stringent criteria are
met.
Effective January 1, 1996, deposit insurance premiums for BIF member
institutions were reduced to zero basis points (subject to a $2,000 minimum) for
institutions in the lowest risk category, while deposit insurance premiums for
SAIF members were maintained at their current levels (23 basis points for
institutions in the lowest risk category, as discussed below.)
Under current FDIC regulations, SAIF member institutions are assigned to
one of three capital groups which are based solely on the level of an
institution's capital--"well capitalized," "adequately capitalized," and
"undercapitalized." These three groups are then divided into three subgroups
which reflect varying levels of supervisory concern, from those which are
considered to be healthy to those which are considered to be of substantial
supervisory concern. The matrix so created results in nine assessment risk
classifications, with rates ranging from .23% for well capitalized, healthy
institutions to .31% for undercapitalized institutions with substantial
supervisory concerns. The insurance premium for the Bank for 1996 was .23% (per
annum) of insured deposits.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices or is in
an unsafe or unsound condition to continue operations, or if the insured
depository institution or any of its directors or trustees have violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is aware of no existing circumstances which would result
in termination of the Bank's deposit insurance.
REGULATORY CAPITAL REQUIREMENTS. Federally insured savings institutions
are required to maintain minimum levels of regulatory capital. The OTS has
established capital standards applicable to all savings institutions. These
standards generally must be as stringent as the comparable capital requirements
imposed on national banks. The OTS also is authorized to impose capital
requirements in excess of these standards on individual institutions on a case-
by-case basis.
Current OTS capital standards require savings institutions to satisfy three
different capital requirements. Under these standards, savings institutions
must maintain "tangible" capital equal to at least 1.5% of adjusted total
assets, "core" capital equal to at least 3.0% of adjusted total assets and
"total" capital (a combination of core and "supplementary" capital) equal to at
least
-33-
<PAGE>
8.0% of "risk-weighted" assets. For purposes of the regulation, core capital
generally consists of common stockholders' equity (including retained earnings),
noncumulative perpetual preferred stock and related surplus, minority interests
in the equity accounts of fully consolidated subsidiaries, certain
nonwithdrawable accounts and pledged deposits and "qualifying supervisory
goodwill." Tangible capital is given the same definition as core capital but
does not include qualifying supervisory goodwill and is reduced by the amount of
all the savings institution's intangible assets, with only a limited exception
for purchased mortgage servicing rights. The Bank had no goodwill or other
intangible assets at June 30, 1996. Both core and tangible capital are further
reduced by an amount equal to a savings institution's debt and equity
investments in subsidiaries engaged in activities not permissible to national
banks (other than subsidiaries engaged in activities undertaken as agent for
customers or in mortgage banking activities and subsidiary depository
institutions or their holding companies). At June 30, 1996, there were no such
adjustments to the Bank's regulatory capital.
In determining compliance with the risk-based capital requirement, a
savings institution is allowed to include both core capital and supplementary
capital in its total capital, provided that the amount of supplementary capital
included does not exceed the savings institution's core capital. Supplementary
capital generally consists of hybrid capital instruments; perpetual preferred
stock which is not eligible to be included as core capital; subordinated debt
and intermediate-term preferred stock; and general allowances for loan losses up
to a maximum of 1.25% of risk-weighted assets. In determining the required
amount of risk-based capital, total assets, including certain off-balance sheet
items, are multiplied by a risk weight based on the risks inherent in the type
of assets. The risk weights assigned by the OTS for principal categories of
assets are (i) 0% for cash and securities issued by the U.S. Government or
unconditionally backed by the full faith and credit of the U.S. Government; (ii)
20% for securities (other than equity securities) issued by U.S.
Government-sponsored agencies and mortgage-backed securities issued by, or
fully guaranteed as to principal and interest by, FNMA or FHLMC, except for
those classes with residual characteristics or stripped mortgage-related
securities; (iii) 50% for prudently underwritten permanent one- to four-family
first lien mortgage loans not more than 90 days delinquent and having a
loan-to-value ratio of not more than 80% at origination unless insured to such
ratio by an insurer approved by FNMA or FHLMC, qualifying residential bridge
loans made directly for the construction of one- to four-family residences and
qualifying multi-family residential loans; and (iv) 100% for all other loans and
investments, including consumer loans, commercial loans, and one- to four-family
residential real estate loans more than 90 days delinquent, and for repossessed
assets.
Any savings institution that fails any of the capital requirements is
subject to possible enforcement actions by the OTS or the FDIC. Such actions
could include a capital directive, a cease and desist order, civil money
penalties, the establishment of restrictions on the institution's operations
(including growth), termination of federal deposit insurance and the appointment
of a conservator or receiver. The OTS' capital regulation provides that such
actions, through enforcement proceedings or otherwise, could require one or more
of a variety of corrective actions.
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LIQUIDITY REQUIREMENTS. All savings institutions are required to maintain
an average daily balance of liquid assets equal to a certain percentage of the
sum of its average daily balance of net withdrawable deposit accounts and
borrowings payable in one year or less. The liquidity requirement may vary from
time to time (between 4.0% and 10.0%) depending upon economic conditions and
savings flows of all savings institutions. At the present time, the required
minimum liquid asset ratio is 5.0%. At June 30, 1996, the Bank's liquidity
ratio was 5.5%.
CAPITAL DISTRIBUTIONS. OTS regulations govern capital distributions by
savings institutions, which include cash dividends, stock redemptions or
repurchases, cash-out mergers, interest payments on certain convertible debt and
other transactions charged to the capital account of a savings institution to
make capital distributions. Generally, the regulation creates a safe harbor for
specified levels of capital distributions from institutions meeting at least
their minimum capital requirements, so long as such institutions notify the OTS
and receive no objection to the distribution from the OTS. Savings institutions
and distributions that do not qualify for the safe harbor are required to obtain
prior OTS approval before making any capital distributions.
Generally, a savings institution that before and after the proposed
distribution meets or exceeds its fully phased-in capital requirements (Tier 1
institutions) may make capital distributions during any calendar year equal to
the higher of (i) 100% of net income for the calendar year-to-date plus 50% of
its "surplus capital ratio" at the beginning of the calendar year or (ii) 75% of
net income over the most recent four-quarter period. The "surplus capital
ratio" is defined to mean the percentage by which the institution's ratio of
total capital to assets exceeds the ratio of its fully phased-in capital
requirement to assets. "Fully phased-in capital requirement" is defined to mean
an institution's capital requirement under the statutory and regulatory
standards applicable on December 31, 1994, as modified to reflect any applicable
individual minimum capital requirement imposed upon the institution. Failure to
meet fully phased-in or minimum capital requirements will result in further
restrictions on capital distributions, including possible prohibition without
explicit OTS approval. In order to make distributions under these safe harbors,
Tier 1 institutions such as the Bank must submit 30 days written notice to the
OTS prior to making the distribution. The OTS may object to the distribution
during that 30-day period based on safety and soundness concerns.
In December 1994, the OTS published a notice of proposed rulemaking to
amend its capital distribution regulation. Under the proposal, institutions
would be permitted to only make capital distributions that would not result in
their capital being reduced below the level required to remain "adequately
capitalized." Because the Bank will be a subsidiary of a holding company, the
proposal would require the Bank to provide notice to the OTS of its intent to
make a capital distribution. The Bank does not believe that the proposal will
adversely affect its ability to make capital distributions if it is adopted
substantially as proposed.
LOANS TO ONE BORROWER. The permissible amount of loans-to-one borrower now
generally follows the national bank standard for all loans made by savings
institutions, as compared to the pre-FIRREA rule that applied that standard only
to commercial loans made by federally chartered savings institutions. The
national bank standard generally does not permit loans-to-one borrower to exceed
the greater of $500,000 or 15% of unimpaired capital and
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<PAGE>
surplus. Loans in an amount equal to an additional 10% of unimpaired capital
and surplus also may be made to a borrower if the loans are fully secured by
readily marketable securities. For information about the largest borrowers from
the Bank, see "- Lending Activities."
BRANCHING BY FEDERAL SAVINGS INSTITUTIONS. OTS policy permits interstate
branching to the full extent permitted by statute (which is essentially
unlimited). Generally, federal law prohibits federal savings institutions from
establishing, retaining or operating a branch outside the state in which the
federal institution has its home office unless the institution meets the IRS'
domestic building and loan test (generally, 60% of a thrift's assets must be
housing-related) ("IRS Test"). The IRS Test requirement does not apply if,
among other things, the law of the state where the branch would be located would
permit the branch to be established if the federal savings institution were
chartered by the state in which its home office is located. Furthermore, the
OTS will evaluate a branching applicant's record of compliance with the
Community Reinvestment Act of 1977 ("CRA"). An unsatisfactory CRA record may be
the basis for denial of a branching application.
QUALIFIED THRIFT LENDER TEST. All savings institutions are required to
meet a QTL test to avoid certain restrictions on their operations. A savings
institution that does not meet the QTL test must either convert to a bank
charter or comply with the following restrictions on its operations: (i) the
institution may not engage in any new activity or make any new investment,
directly or indirectly, unless such activity or investment is permissible for a
national bank; (ii) the branching powers of the institution shall be restricted
to those of a national bank; (iii) the institution shall not be eligible to
obtain any advances from its FHLB; and (iv) payment of dividends by the
institution shall be subject to the rules regarding payment of dividends by a
national bank. Upon the expiration of three years from the date the savings
institution ceases to be a QTL, it must cease any activity and not retain any
investment not permissible for a national bank and immediately repay any
outstanding FHLB advances (subject to safety and soundness considerations).
Currently, the QTL test requires that 65% of an institution's "portfolio
assets" (as defined) consist of certain housing and consumer-related assets on a
monthly average basis in nine out of every 12 months. Assets that qualify
without limit for inclusion as part of the 65% requirement are loans made to
purchase, refinance, construct, improve or repair domestic residential housing
and manufactured housing; home equity loans; mortgage-backed securities (where
the mortgages are secured by domestic residential housing or manufactured
housing); stock issued by the FHLB of Indianapolis; and direct or indirect
obligations of the FDIC. In addition, the following assets, among others, may
be included in meeting the test subject to an overall limit of 20% of the
savings institution's portfolio assets: 50% of residential mortgage loans
originated and sold within 90 days of origination; 100% of consumer and
educational loans (limited to 10% of total portfolio assets); and stock issued
by FHLMC or FNMA. Portfolio assets consist of total assets minus the sum of (i)
goodwill and other intangible assets, (ii) property used by the savings
institution to conduct its business, and (iii) liquid assets up to 20% of the
institution's total assets. At June 30, 1996, the qualified thrift investments
of the Bank were approximately 97.8% of its portfolio assets.
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<PAGE>
ACCOUNTING REQUIREMENTS. Applicable OTS accounting regulations and
reporting requirements apply the following standards: (i) regulatory reports
will incorporate generally accepted accounting principles ("GAAP") when GAAP is
used by federal banking agencies; (ii) savings institution transactions,
financial condition and regulatory capital must be reported and disclosed in
accordance with OTS regulatory reporting requirements that will be at least as
stringent as for national banks; and (iii) the Director of the OTS may prescribe
regulatory reporting requirements more stringent than GAAP whenever the Director
determines that such requirements are necessary to ensure the safe and sound
reporting and operation of savings institutions.
FEDERAL HOME LOAN BANK SYSTEM. The Bank is a member of the FHLB of
Indianapolis, which is one of 12 regional FHLBs that administers the home
financing credit function of savings institutions. Each FHLB serves as a
reserve or central bank for its members within its assigned region. It is
funded primarily from proceeds derived from the sale of consolidated obligations
of the FHLB System. It makes loans to members (i.e., advances) in accordance
with policies and procedures established by the Board of Directors of the FHLB.
At June 30, 1996, the Company had $26.0 million of FHLB advances. See "-
Sources of Funds - Borrowings."
As a member, the Bank is required to purchase and maintain stock in the
FHLB of Indianapolis in an amount equal to at least 1% of its aggregate unpaid
residential mortgage loans, home purchase contracts or similar obligations at
the beginning of each year. At June 30, 1996, the Bank had $2.6 million in FHLB
stock, which was in compliance with this requirement.
The FHLBs are required to provide funds for the resolution of troubled
savings institutions and to contribute to affordable housing programs through
direct loans or interest subsidies on advances targeted for community investment
and low- and moderate-income housing projects. These contributions have
adversely affected the level of FHLB dividends paid in the past and could
continue to do so in the future. These contributions also could have an adverse
effect on the value of FHLB stock in the future.
FEDERAL RESERVE SYSTEM. The Federal Reserve Board requires all depository
institutions to maintain reserves against their transaction accounts (primarily
NOW and Super NOW checking accounts) and non-personal time deposits. As of June
30, 1996, the Bank was in compliance with this requirement. Because required
reserves must be maintained in the form of vault cash or a noninterest-bearing
account at a Federal Reserve Bank, the effect of this reserve requirement is to
reduce an institution's earning assets.
FEDERAL TAXATION
GENERAL. The Company and Bank are subject to the generally applicable
corporate tax provisions of the Code, and Bank is subject to certain additional
provisions of the Code which apply to thrifts and other types of financial
institutions. The following discussion of federal taxation is intended only to
summarize certain pertinent federal income tax matters material to the taxation
of the Company and the Bank and is not a comprehensive discussion of the tax
rules applicable to the Company and Bank.
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<PAGE>
YEAR. The Company files a consolidated federal income tax return on the
basis of a fiscal year ending on June 30. The Company's federal income tax
returns for the tax years ended June 30, 1993 forward are open under the statute
of limitations and are subject to review by the IRS.
BAD DEBT RESERVES. Savings institutions, such as the Bank, which meet
certain definitional tests primarily relating to their assets and the nature of
their businesses, are permitted to establish a reserve for bad debts and to make
annual additions to the reserve. These additions may, within specified formula
limits, be deducted in arriving at the institution's taxable income. For
purposes of computing the deductible addition to its bad debt reserve, the
institution's loans are separated into "qualifying real property loans" (i.e.,
generally those loans secured by certain interests in real property) and all
other loans ("non-qualifying loans"). The deduction with respect to
non-qualifying loans must be computed under the experience method as
described below. The following formulas may be used to compute the bad debt
deduction with respect to qualifying real property loans: (i) actual loss
experience, or (ii) a percentage of taxable income. Reasonable additions to the
reserve for losses on non-qualifying loans must be based upon actual loss
experience and would reduce the current year's addition to the reserve for
losses on qualifying real property loans, unless that addition is also
determined under the experience method. The sum of the additions to each
reserve for each year is the institution's annual bad debt deduction.
Under the experience method, the deductible annual addition to the
institution's bad debt reserves is the amount necessary to increase the balance
of the reserve at the close of the taxable year to the greater of (a) the amount
which bears the same ratio to loans outstanding at the close of the taxable year
as the total net bad debts sustained during the current and five preceding
taxable years bear to the sum of the loans outstanding at the close of the six
years, or (b) the lower of (i) the balance of the reserve account at the close
of the Bank's "base year," which was its tax year ended December 31, 1987, or
(ii) if the amount of loans outstanding at the close of the taxable year is less
than the amount of loans outstanding at the close of the base year, the amount
which bears the same ratio to loans outstanding at the close of the taxable year
as the balance of the reserve at the close of the base year bears to the amount
of loans outstanding at the close of the base year.
Under the percentage of taxable income method, the bad debt deduction
equals 8% of taxable income determined without regard to that deduction and with
certain adjustments. The availability of the percentage of taxable income
method permits a qualifying savings institution to be taxed at a lower effective
federal income tax rate than that applicable to corporations in general. This
resulted generally in an effective federal income tax rate payable by a
qualifying savings institution fully able to use the maximum deduction permitted
under the percentage of taxable income method, in the absence of other factors
affecting taxable income, of 31.3% exclusive of any minimum tax or environmental
tax (as compared to 34.0% for corporations generally). For tax years beginning
on or after January 1, 1993, the maximum corporate tax rate was increased to
35.0%, which increased the maximum effective federal income tax rate payable by
a qualifying savings institution fully able to use the maximum deduction to
32.2%. Any savings institution at least 60.0% of whose assets are qualifying
assets, as described in the Code,
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<PAGE>
will generally be eligible for the full deduction of 8.0% of taxable income. As
of June 30, 1996, approximately 88.4% of the assets of the Bank were "qualifying
assets" as defined in the Code, and the Bank anticipates that at least 60.0% of
its assets will continue to be qualifying assets in the immediate future. If
this ceases to be the case, the institution may be required to restore some
portion of its bad debt reserve to taxable income in the future.
Under the percentage of taxable income method, the bad debt deduction for
an addition to the reserve for qualifying real property loans cannot exceed the
amount necessary to increase the balance in this reserve to an amount equal to
6.0% of such loans outstanding at the end of the taxable year. The bad debt
deduction is also limited to the amount which, when added to the addition to the
reserve for losses on non-qualifying loans, equals the amount by which 12.0% of
deposits at the close of the year exceeds the sum of surplus, undivided profits
and reserves at the beginning of the year. Based on experience, it is not
expected that these restrictions will be a limiting factor for the Bank in the
foreseeable future. In addition, the deduction for qualifying real property
loans is reduced by an amount equal to all or part of the deduction for
non-qualifying loans.
At June 30, 1996, the federal income tax reserves of the Company included
$3.0 million for which no federal income tax has been provided. Deferred income
taxes have not been provided on such bad debt deductions since the Company does
not intend to use the accumulated bad debt deductions for purposes other than to
absorb loan losses. If, in the future, this portion of retained earnings is
used for any purpose other than to absorb bad debt losses, federal income taxes
may be imposed on such amounts at the then current corporation income tax rate.
In August 1996, the "Small Business Job Protection Act of 1996" was passed
into law. One provision of the act repeals the special bad debt reserve method
for thrift institutions currently provided for in Section 593 of the Code. The
provision requires thrifts to recapture any reserve accumulated after 1987 but
forgives taxes owed on reserves accumulated prior to 1988. Thrift institutions
will be given six years to account for the recaptured excess reserves, beginning
with the first taxable year after 1995, and will be permitted to delay the
timing of this recapture for one or two years, subject to whether they meet
certain residential loan test requirements. Management does not believe that
this legislation will have a material adverse effect on the Company's
consolidated financial position.
STATE TAXATION
The State of Indiana imposes a franchise tax on the "adjusted gross income"
of financial institutions at a fixed rate of 8.5% per annum. This franchise tax
is imposed in lieu of the gross income tax, adjusted gross income tax, and
supplemental net income tax otherwise imposed on certain corporate entities.
"Adjusted gross income" is computed by making certain modifications to an
institution's federal taxable income. Tax-exempt interest, for example, is
included in the savings association's adjusted gross income and the bad debt
deduction is limited to actual charge-offs for purposes of the financial
institutions tax.
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<PAGE>
ITEM 2. PROPERTIES
The Company's principal executive office is located at 722 Promenade,
Richmond, Indiana, 47375. The following table sets forth certain information
with respect to the offices and other properties of the Bank at June 30, 1996.
Net Book Value
Description/Address Leased/Owned of Property(1) Deposits
------------------------- ------------- --------------- ----------
(In Thousands)
Main Office Owned $1,680 $80,810
722 Promenade
Richmond, Indiana
Carmel Branch(2) Leased(3) 112 41,900
11592 Westfield Boulevard
Carmel, Indiana
Fishers Branch(4) Owned 950 12,433
7150 East 116th Street
Fishers, Indiana
- ------------------------
(1) Includes leasehold improvements.
(2) Branch opened in May 1994.
(3) The lease expires in June 2008 and may be extended for an additional ten
years provided that proper notice is timely given.
(4) Branch opened in December 1995.
-40-
<PAGE>
ITEM 3. LEGAL PROCEEDINGS.
There are no material legal proceedings to which the Company is a party or
to which any of their property is subject.
ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
Not applicable.
PART II
ITEM 5. MARKET FOR REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS.
Shares of the Company's common stock are traded nationally under the symbol
"HFGI" on the NASDAQ National Market System. The following table shows market
price information for the Company's common stock. The prices set forth below
represent the high and low prices during the period indicated:
Price Per Share
------------------------------------
High Low
---------------- -----------------
June 30, 1996(1) $11.00 $10.125
(1) The Company's common stock commenced trading on May 10, 1996.
The Company has declared no cash dividends on its common stock. There have
been no stock dividends, stock splits or reverse stock splits.
At September 24, 1996 the Company had approximately 54 stockholders of
record.
ITEM 6. SELECTED FINANCIAL DATA.
The information required herein is incorporated by reference from page 14
of the Registrant's 1996 Annual Report.
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<PAGE>
ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
The information required herein is incorporated by reference from pages 15
to 29 of the Registrant's 1996 Annual Report.
ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA.
The information required herein is incorporated by reference from pages 30
to 61 of the Registrant's 1996 Annual Report.
ITEM 9. CHANGES IN AND DISAGREEMENTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.
Not applicable.
PART III
ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT.
The information required herein is incorporated by reference from pages two
to 9 of the Registrant's Proxy Statement dated September 25, 1996 ("Proxy
Statement").
ITEM 11. EXECUTIVE COMPENSATION.
The information required herein is incorporated by reference from pages 11
to 19 of the Registrant's Proxy Statement.
ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT.
The information required herein is incorporated by reference from pages 9
and 10 of the Registrant's Proxy Statement.
ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS.
The information required herein is incorporated by reference from pages 15
and 16 of the Registrant's Proxy Statement.
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<PAGE>
PART IV
ITEM 14. EXHIBITS, FINANCIAL STATEMENT SCHEDULES AND REPORTS ON FORM 8-K.
(a) Document filed as part of this Report.
(1) The following documents are filed as part of this report and are
incorporated herein by reference from the Registrant's 1996 Annual Report.
Independent Auditors' Report.
Consolidated Balance Sheets as of June 30, 1996 and 1995.
Consolidated Statements of Income for the Years Ended June 30, 1996, 1995
and 1994.
Consolidated Statements of Changes in Stockholders' Equity for the Years
Ended June 30, 1996, 1995 and 1994.
Consolidated Statements of Cash Flows for the Years Ended June 30, 1996,
1995 and 1994.
Notes to Consolidated Financial Statements.
(2) All schedules for which provision is made in the applicable
accounting regulation of the Securities and Exchange Commission are omitted
because they are not applicable or the required information is included in the
Consolidated Financial Statements or notes thereto.
(3) Report of predecessor accountant is attached as Exhibit 99.1.
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<PAGE>
(3)(a) The following exhibits are filed as part of this Form 10-K,
and this list includes the Exhibit Index.
No. Description
- ------ ---------------------------------------------------------------------
3.1 Amended and Restated Articles of Incorporation of Harrington Financial
Group, Inc.(1)
3.2 Amended and Restated Bylaws of Harrington Financial Group, Inc.(1)
10.1 Stock Option Plan of Harrington Financial Group, Inc.(1)(*)
10.2 Loan Agreement between Financial Research Corporation (now Harrington
Financial Group, Inc.) and Mark Twain Kansas Bank, dated April 14,
1994, First Amendment and Loan Agreement between such parties and
Smith Breeden Associates, Inc. and Douglas T. Breeden, dated July 21,
1995.(1)
10.2.1 Second Amendment and Loan Modification Agreement between Harrington
Financial Group, Inc. and Mark Twain Kansas City Bank, dated July 26,
1996 (modifies version set forth in Exhibit 10.2)
10.3 Investment Advisory Agreement between Peoples Federal Savings
Association (now Harrington Bank, FSB) and Smith Breeden Associates,
Inc. dated April 1, 1992, as amended on March 1, 1995.(1)
10.4 Lease Agreement on Carmel Branch Office Facility, set forth in
Assignment of Lease, between NBD Bank, N.A. and Peoples Federal
Savings Association, dated November 8, 1993.(1)
10.5 Trust Services Agreement dated September 30, 1994 by and between
Harrington Bank, FSB and The Midwest Trust Company.(1)
11.1 Statement of Computation of Per Share Earnings
13 1996 Annual Report to Stockholders specified portion (p. 1 and pp.
13-61) of the Registrant's Annual Report to Stockholders for the year
ended June 30, 1996.
21 Subsidiaries of the Registrant - Reference is made to Item 1.
"Business" for the Required information
23.1 Consent of Deloitte & Touche LLP
23.2 Consent of Geo. S. Olive & Co. LLC
27 Financial Data Schedule
99.1 Report of Geo. S. Olive & Co. LLC
- ----------------------
(1) Incorporated by reference from the Registration Statement on Form S-1
(Registration No. 333-1556) filed by the Registrant with the Securities and
Exchange Commission ("SEC") on February 20, 1996, as amended.
(*) Management contract or compensatory plan or arrangement.
(3)(b) Reports filed on Form 8-K.
None.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.
HARRINGTON FINANCIAL GROUP, INC.
By: /s/ Craig J. Cerny
------------------------------
Craig J. Cerny
President
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
/s/ Craig J. Cerny
- ---------------------------------------- September 30, 1996
Craig J. Cerny
President (Principal Executive Officer)
/s/ Catherine A. Habschmidt
- ---------------------------------------- September 30, 1996
Catherine A. Habschmidt
Chief Financial Officer and Treasurer
(Principal Accounting Officer)
/s/ William F. Quinn, Jr.
- ---------------------------------------- September 30, 1996
William F. Quinn, Jr.
Executive Vice President and Director
/s/ Douglas T. Breeden
- ---------------------------------------- September 30, 1996
Douglas T. Breeden
Chairman of the Board
<PAGE>
/s/ Gerald J. Madigan
- ---------------------------------------- September 30, 1996
Gerald J. Madigan
Director
/s/ Michael J. Giarla
- ---------------------------------------- September 30, 1996
Michael J. Giarla
Director
/s/ Stephen A. Eason
- ---------------------------------------- September 30, 1996
Stephen A. Eason
Director
/s/ Lawrence E. Golaszewski
- ---------------------------------------- September 30, 1996
Lawrence E. Golaszewski
Director
/s/ David F. Harper
- ---------------------------------------- September 30, 1996
David F. Harper
Director
/s/ Stanley J. Kon
- ---------------------------------------- September 30, 1996
Stanley J. Kon
Director
/s/ John J. McConnell
- ---------------------------------------- September 30, 1996
John J. McConnell
Director
<PAGE>
SECOND AMENDMENT AND LOAN MODIFICATION AGREEMENT
This Agreement ("Second Amendment") is entered into on July 26, 1996, by
and among MARK TWAIN KANSAS CITY BANK, a Missouri banking association and
successor-in-interest to Mark Twain Kansas Bank ("Lender") and HARRINGTON
FINANCIAL GROUP, INC., formerly known as Financial Research Corporation, an
Indiana corporation ("Borrower").
RECITALS
A. Borrower is presently indebted to Lender as evidenced by that certain
Amended and Restated Promissory Note, dated July 21, 1995, in the original
maximum principal amount of $10,000,000, executed by Borrower in favor of Lender
(the "Amended Note").
B. The Amended Note was issued pursuant to that certain First Amendment
and Loan Modification Agreement, dated July 21, 1995 (the "First Amendment"),
among Borrower, Lender, Smith Breeden Associates, Inc., a Kansas corporation
("Smith Breeden") and Douglas T. Breeden ("Breeden") which amended that certain
Loan Agreement, dated April 14, 1994, between Borrower and Lender (collectively,
the "Loan Agreement"). The Amended Note and the Loan Agreement are sometimes
collectively referred to herein as the "Loan Documents."
C. The Loan Documents are secured by (i) a General Pledge Agreement from
Borrower, pledging 100% of the outstanding stock of Harrington Bank, FSB
("Harrington") to Lender ("Pledge Agreement"); (ii) a Security Agreement from
Borrower in favor of Lender providing a blanket security interest in all of
Borrower's assets ("Security Agreement"); (iii) a Guaranty, dated April 14,
1994, from Breeden in favor of Lender (the "Breeden Guaranty"); (iv) a Guaranty,
dated April 14, 1994 from Smith Breeden in favor of Lender ("Smith Breeden
Guaranty"); (v) an Assignment of Life Insurance Policy, dated July 21,1995, on
the life of Breeden in the amount of $1,000,000 from Borrower ("Breeden Life
Insurance Assignment"); and (vi) an Assignment of Life Insurance Policy, dated
June 13, 1994, on the life of Craig Cerny in the amount of $250,000 from
Borrower ("Cerny Life Insurance Assignment"). The Pledge Agreement, the
Security Agreement, the Breeden Guaranty, the Smith Breeden Guaranty, the
Breeden Life Insurance Assignment and the Cerny Life Insurance Assignment are
collectively referred to as the "Security Documents."
D. Borrower has offered its stock to the public pursuant to the
Registration Statement on Form S-1, dated February 20, 1996 (Reg. No. 333-1556),
as amended (the "Offering").
<PAGE>
E. Borrower has requested that Lender release the Smith Breeden Guaranty
and the Breeden Guaranty (collectively, the "Guaranties") and amend certain
other provisions of the Loan Documents, including providing Borrower the right
to borrow an additional $3,000,000 from Lender.
F. The outstanding principal balance of the Amended Note as of the date
hereof is $9,263,102.21
NOW, THEREFORE, the parties hereby agree as follows:
1. CONDITIONS PRECEDENT. The modifications described in this Second
Amendment and the obligations of Lender set forth in this Second Amendment will
not be effective unless and until each of the following conditions precedent
have been satisfied, in form, manner and substance satisfactory to Lender:
a. SUCCESSFUL COMPLETION OF OFFERING. Borrower shall have received
at least Nine Million Nine Hundred Thousand Dollars ($9,900,000) in gross
proceeds pursuant to the Offering and at the time of requesting a draw on
the Capital Loan (as defined in Section 2.01(b) of the Loan Agreement),
shall have contributed all of the proceeds of the Offering to the capital
of Harrington; provided, however, that Borrower may retain up to One
Million Dollars ($1,000,000) for general working capital purposes.
b. DOCUMENTS TO BE DELIVERED. Borrower shall have delivered or
caused to be delivered to Lender the following documents, all of which
shall be properly completed, fully executed, and otherwise satisfactory to
Lender:
i. this Amendment;
ii. the Second Amended and Restated Promissory Note in the
form attached hereto as Exhibit "A" (the "Second Amended Note");
iii. a copy of resolutions of the Board of Directors of
Borrower, duly adopted, which authorize the execution, delivery and
performance of this Amendment and the Second Amended Note, certified
by the Secretary of Borrower;
iv. a copy of the Certificate or Articles of Incorporation of
Borrower, including any amendments thereto, certified by the Secretary
of State of the State of Indiana;
v. a copy of the Bylaws of Borrower, including any
amendments thereto, certified by the Secretary of Borrower;
2
<PAGE>
vi. an incumbency certificate, executed by the Secretary of
Borrower, which shall identify by name and title and bear the
signatures of all of the officers of Borrower executing this Amendment
and/or the Second Amended Note;
vii. certificates of corporate good standing of Borrower
issued by the Secretaries of State for the States of Indiana and
Kansas;
viii. an opinion of Borrower's securities counsel, in a form
satisfactory to Lender, stating that the Offering was conducted in
accordance with all applicable federal requirements; and
ix. an opinion of Borrower's corporate counsel, in a form
satisfactory to Lender, stating the opinions set forth on Exhibit "B"
hereto;
x. a certificate of the chief financial officer of Borrower
stating that Borrower has received at least $9,900,000 pursuant to the
Offering and that at the time of requesting a draw on the Capital
Loan, all of the proceeds of the Offering (except as provided under
Section 1 a. hereof) have been contributed to the capital of
Harrington; and
xi. a Federal Reserve Form U-1 purpose statement for
Borrower.
c. CLOSING FEE. In consideration for Lender's agreement to make an
additional $3,000,000 available to Borrower, Borrower shall pay to Lender a
closing fee of $15,000, which shall be deemed fully earned as of the date
hereof.
d. TRANSACTIONAL FEES. Borrower hereby agrees to pay upon demand
any and all reasonable costs and expenses, including, but not limited to,
attorneys fees and disbursements, incurred by Lender in connection with the
negotiation and preparation of this Amendment and all other documents and
instruments executed pursuant hereto;
If all of the above-described conditions precedent are not satisfied by July 31,
1996, this Second Amendment shall be null and void, and the Loan Documents and
Security Documents, including the Guaranties, shall remain in full force and
effect as if this Second Amendment shall have never been executed by the
parties.
2. RELEASE OF GUARANTIES. Lender hereby releases the Smith Breeden
Guaranty and the Breeden Guaranty.
3
<PAGE>
3. ACCRUED INTEREST PAYMENT. On the date the Second Amended Note is
executed and delivered to Lender, Borrower shall pay to Lender all accrued but
unpaid interest to such date under the Amended Note.
4. AMENDMENTS TO LOAN AGREEMENT. The Loan Agreement is hereby amended as
follows:
a. MAXIMUM FACILITY. Section 2.01 of the Loan Agreement is hereby
amended and restated in its entirety as follow:
2.01 MAXIMUM FACILITY. The total principal amount to be advanced by Lender
to Borrower under this Agreement shall be Twelve Million Two Hundred Sixty-
Three Thousand One Hundred Two and 21/100 Dollars ($12,263,102.21) (the
"Loan Facility"). The Loan Facility shall be divided into two loans as
follows:
a. TERM LOAN. A $9,263,102.21 loan which has been fully funded prior
to the date of this Second Amendment (the "Term Loan"); and
b. CAPITAL LOAN. A $3,000,000, nonrevolving, line of credit which
shall be available to Borrower in no more than four draws (the
"Capital Loan"). Lender, in its sole discretion, may terminate Borr-
ower's ability to draw on the Capital Loan after December 31, 1996, or
upon the earlier occurrence of any Event of Default. All advances
under the Capital Loan must be contributed to the capital of Harring-
ton.
b. PRINCIPAL AND INTEREST PAYMENTS. Section 2.06 (a) of the Loan
Agreement is hereby amended and restated in its entirety as follows:
(a) Beginning October 1, 1996, Borrower shall make four (4) level
quarterly principal and interest payments of Five Hundred Thousand and
no/100 Dollars ($500,000) and thereafter, until the Note is paid in full,
level quarterly principal and interest payments of Five Hundred Eighty Five
Thousand and no/100 Dollars ($585,000), in each case, to Lender at the
place designated in Section 2.09 hereof.
c. LIMITATION ON MARGIN BORROWINGS. Section 6.01 of the Loan
Agreement is hereby amended and restated in its entirety as follows:
4
<PAGE>
6.01 ADDITIONAL DEBT. Issue any additional debt instrument, borrow any
monies or incur any Indebtedness outside the ordinary course of business
other than margin borrowings of 50% or less, not to exceed $1,000,000, to
purchase investment securities.
d. RESTRICTION ON DIVIDENDS. Section 6.03 of the Loan Agreement is
hereby amended and restated in its entirety as follows:
6.03 RESTRICTION ON DIVIDENDS. (i) Pay any dividends or any distributions
on stock in excess of 35% of Borrower's average consolidated earnings for
the prior four fiscal quarterly periods previous to the date on which the
dividend payment is to be made or (ii) without the prior written consent of
Lender, redeem any of Borrower's issued and outstanding stock.
e. RESTRICTION ON BUSINESS ACTIVITIES. Section 6.05 of the Loan
Agreement is hereby amended and restated in its entirety as follows:
6.05 CHANGE IN BUSINESS ACTIVITY. Borrower shall not and shall not permit
Harrington to change (i) the business activities which it is presently
conducting or (ii) its loan portfolio mix to include commercial real estate
or commercial and industrial loans which in the aggregate exceed 10% of
Harrington's assets without Lender's prior written consent. Borrower shall
give Lender 30 days prior written notice of such change, which shall
include a detailed analysis of the effect of any new activity or portfolio
mix change on Borrower and Harrington. If Borrower desires to establish a
service corporation to engage in a new business activity, such notice shall
also include the resumes of the proposed management in addition to the
above-stated analysis.
f. RESTRICTION ON MANAGEMENT AGREEMENTS AND EMPLOYMENT
CONTRACTS. Section 6.11 of the Loan Agreement is hereby deleted in its
entirety.
g. EVENTS OF DEFAULT. Section 8.01 of the Loan Agreement is hereby
amended as follows:
i. Subsections (g), (j), (k) and (l) are hereby deleted in
their entirety;
ii. Subsection (m) is hereby amended and restated as follows:
5
<PAGE>
(m) Harrington incurs a loss, other than a loss due solely to a change
in accounting principles promulgated under the Federal Accounting
Standards Board in two quarterly fiscal periods during any twelve-
month rolling period which causes the ratio of the total outstanding
Loans to Harrington's net worth to exceed .50; provided, however, that
Borrower shall have a 30-day grace period to cure any default under
this Section 8.01(m).
iii. Subsection (w) is hereby amended and restated as follows:
(w) The occurrence of any material change in Borrower or Harrington
which Lender in good faith determines will have a material adverse
effect on the business prospects of Borrower or Harrington or
Borrower's ability to perform its obligations under any of the Loan
Documents.
5. NO DEFAULT. Borrower hereby represents and warrants that it is not in
default under any of the terms or provisions of the Loan Documents or Security
Documents, and no "Event of Default" (as such term is defined in any of the Loan
Documents), nor any condition, event, act or omission which would constitute,
with notice, or the passage of time, or both, an "Event of Default," exits as
of the date of this Second Amendment.
6. DUE AUTHORIZATION, VALID AND BINDING ON BORROWER. Borrower represents
and warrants to Lender that the execution and delivery by Borrower of this
Second Amendment and the Second Amended Note has been duly and properly made and
authorized, and the Loan Documents and Security Documents, as modified by this
Second Amendment, and the Second Amended Note constitute the valid and binding
obligations of Borrower, enforceable in accordance with their respective terms.
7. RATIFICATION OF LOAN DOCUMENTS. Except as specifically modified
hereby, the Loan Documents, the Security Documents and all of the terms,
conditions, and covenants contained therein shall remain in full force and
effect, and Borrower hereby fully ratify and confirm such Loan Documents and
Security Documents. Without limiting the generality of the forgoing, Borrower
(i) hereby confirm that the Security Documents continue to secure the Second
Amended Note, the Loan Agreement (as modified by this Second Amendment and the
other Security Documents, and (ii) hereby ratifies and reaffirms, as if made on
the date of this Second Amendment, each of the representations and warranties
contained in the Loan Documents and the Security Documents.
6
<PAGE>
8. RELEASE OF LENDER. Borrower for itself and for its heirs, executors,
successors and assigns, hereby releases, acquit and forever discharges Lender
and all of Lender's stockholders, directors, officers, employees, agents and
representatives (collectively, the "Released Parties") from any and all actions,
causes of action, claims, counterclaims, debts, demands, liabilities,
obligations, and setoffs of any kind and character, whether known or unknown,
which arise out of acts or omissions of the Released Parties prior to or on the
date hereof, and relating in any manner whatsoever to Borrower's dealings and
communications with Lender, the Loan Documents, the Security Documents and/or
the negotiation and execution of this Second Amendment.
9. GOVERNING LAW. This Second Amendment shall be construed and enforced
in accordance with the laws of the State of Kansas.
10. DEFINED TERMS. Except as otherwise specifically defined herein, all
capitalized terms shall have the same meaning given to such term in the Loan
Agreement.
11. ENTIRE AGREEMENT. THE PARTIES AGREE THAT THIS ENTIRE AGREEMENT IS
NONSTANDARD AND CONTAINS SUFFICIENT SPACE FOR THE PLACEMENT OF NONSTANDARD
TERMS. THIS AGREEMENT (AND THE EXHIBITS AND SCHEDULES ATTACHED HERETO) CONTAIN
ALL OF THE AGREEMENTS AND IS INTENDED TO BE THE FINAL EXPRESSION OF THE CREDIT
AGREEMENT OF BORROWER AND LENDER, AND SUPERSEDES ANY AND ALL PRIOR DISCUSSIONS
AND/OR AGREEMENTS RELATIVE THERETO. THIS AGREEMENT MAY NOT BE CONTRADICTED BY
EVIDENCE OF ANY PRIOR ORAL CREDIT AGREEMENT OR OF A CONTEMPORANEOUS ORAL CREDIT
AGREEMENT BETWEEN BORROWER AND LENDER. BORROWER AND LENDER HEREBY INITIAL THIS
PROVISION AS AN AFFIRMATION THAT NO UNWRITTEN, ORAL CREDIT AGREEMENTS BETWEEN
THE PARTIES EXIST.
Borrower's Initials /s/ CJC
----------
Lender's Initials /s/ MJ
------------
7
<PAGE>
IN WITNESS WHEREOF, the parties have executed this Amendment on the day and year
first above written.
HARRINGTON FINANCIAL GROUP, INC., formerly known as
Financial Research Corporation, an Indiana
corporation
By:/s/ Craig J. Cerny
-----------------------------------------------
Title: President
--------------------------------------------
MARK TWAIN KANSAS CITY BANK, a Missouri banking
association and successor in interest to Mark Twain
Kansas Bank
By:/s/ Mark Jorgenson
-----------------------------------------------
Title:/s/
--------------------------------------------
8
<PAGE>
HARRINGTON FINANCIAL GROUP, INC.
EXHIBIT 11.1 - COMPUTATION OF PER SHARE EARNINGS
FOR THE YEAR ENDED JUNE 30, 1996
YEAR ENDED JUNE 30, 1996:
<TABLE>
<CAPTION>
Fully
Primary Diluted
--------------- ----------------
<S> <C> <C>
Weighted Average Number of Shares:
Average Common Shares Outstanding at June 30, 1996 2,160,233 2,160,233
Dilutive Effect for Stock Options at June 30, 1996 40,914 40,914
--------- ---------
Weighted Average Shares at June 30, 1996 2,201,147 2,201,147
--------- ---------
--------- ---------
Net Income To Be Used To Compute Primary And
Fully Diluted Earnings Per Average Common Share:
Net Income $ 1,223 $ 1,223
--------- ---------
--------- ---------
Earnings Per Common Share $ 0.56(a) $ 0.56(a)
--------- ---------
--------- ---------
</TABLE>
Note:
(a) This calculation is submitted in accordance with Regulation S-K item
601(b)(11) although not required by footnote 2 to paragraph 14 of APB
Opinion No. 15 because it results in dilution of less than 3%.
<PAGE>
EXHIBIT 13
<TABLE>
<CAPTION>
FINANCIAL HIGHLIGHTS
(DOLLARS IN THOUSANDS EXCEPT PER SHARE AMOUNTS)
FOR THE YEAR ENDED JUNE 30, 1996 1995
--------------------------
<S> <C> <C>
Net interest income $ 5,480 $ 4,781
Income before tax provision and gain (loss) on securities 1,997 1,837
Net realized and unrealized gain (loss) on securities (126) 1,187
Net income 1,223 1,853
Return on average assets 0.37% 0.76%
Return on average equity 9.49% 22.24%
AT JUNE 30
Total assets $ 418,196 $ 300,174
Total loans 65,925 37,010
Total securities 326,271 249,274
Total deposits 135,143 115,312
Stockholders' equity 23,117 10,361
Common shares outstanding 3,256,738 1,961,626
AVERAGE BALANCES
Assets $ 329,938 $ 242,910
Loans 52,399 25,467
Core retail deposits 91,902 72,175
Other deposits 33,591 48,835
Total deposits 125,493 121,010
PER SHARE
Net income $ 0.57 $ 1.20
Book value, fiscal year end 7.10 5.28
Market price, fiscal year end 10.50 N/A
ASSET QUALITY AT JUNE 30
Non-performing assets to total assets 0.32% 0.59%
Loan loss reserves to non-performing loans 45.98% 34.57%
CAPITAL RATIOS AT JUNE 30(HARRINGTON BANK)
Tangible capital 6.27% 6.12%
Core capital 6.27% 6.12%
Risk-based capital 30.10% 24.62%
</TABLE>
<PAGE>
CONTENTS
FINANCIAL REVIEW
Selected Consolidated Financial Data 14
Management's Discussion and Analysis
of Financial Condition and
Results of Operations 15
Consolidated Balance Sheets 30
Consolidated Statements of Income 31
Consolidated Statements of Changes
in Stockholders' Equity 32
Consolidated Statements
of Cash Flows 33
Notes to Consolidated
Financial Statements 35
Independent Auditors' Report 61
13
<PAGE>
SELECTED CONSOLIDATED
FINANCIAL DATA
The following table represents selected consolidated financial and other data of
the Company for the five years in the period ended June 30, 1996. The selected
consolidated financial data should be read in conjunction with the Consolidated
Financial Statements of the Company, including the accompanying Notes, presented
elsewhere herein.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS, EXCEPT PER SHARE DATA)
AT OR FOR THE YEAR ENDED JUNE 30, 1996 1995 1994 1993 1992
-----------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
BALANCE SHEET DATA
Securities held for trading and available for sale $326,271 $249,274 $174,347 $186,582 $185,805
Loans receivable-net 65,925 37,010 20,682 16,620 21,409
Total assets 418,196 300,174 211,688 220,095 226,622
Deposits 135,143 115,312 108,300 89,788 93,476
Securities sold under agreements to repurchase 219,067 130,217 54,651 83,709 116,993
Federal Home Loan Bank advances 26,000 31,000 31,000 31,000
Note payable 8,998 9,200 7,880 7,431 8,435
Stockholders' equity 23,117(1) 10,361 5,926 5,294 5,128
Stockholders' equity per share 7.10 5.28 4.20 3.75 3.63
INCOME STATEMENT DATA
Interest income $ 23,484 $ 17,560 $ 13,607 $ 12,746 $ 15,407
Interest expense 18,004 12,779 8,284 8,975 12,714
-----------------------------------------------------------------
Net interest income 5,480 4,781 5,323 3,771 2,693
Provision for loan losses (1) 15 (3) 66 8
-----------------------------------------------------------------
Net interest income after provision for loan losses 5,481 4,766 5,326 3,705 2,685
Retail banking fees and other income 256 238 267 249 106
-----------------------------------------------------------------
Total net revenue 5,737 5,004 5,593 3,954 2,791
Operating expenses 3,740 3,167 2,519 2,749(2) 1,835
-----------------------------------------------------------------
Income before tax provision and gain (loss) on securities 1,997 1,837 3,074 1,205 956
-----------------------------------------------------------------
Gain (loss) on sale of securities held for trading 1,834 66 (2,169)
Gain on sale of securities available for sale 392 1,384 1,108
Unrealized gain (loss) on securities held for trading (1,960) 1,535 710
Permanent impairment of securities available for sale (414) (610) (2,531) (1,057)
-----------------------------------------------------------------
Net gain (loss) on securities (126) 1,187 (1,677) (1,147) 51
-----------------------------------------------------------------
Income before income tax provision and cumulative effect
of change in accounting for deferred income taxes 1,871 3,024 1,397 58 1,007
Income tax provision 648 1,171 391 188 190
-----------------------------------------------------------------
Income (loss) before cumulative effect of change in
accounting for deferred income taxes 1,223 1,853 1,006 (130) 817
Cumulative effect of change in accounting for deferred
income taxes (3) (79)
-----------------------------------------------------------------
Net income (loss) $ 1,223 $ 1,853 $ 927 $ (130) $ 817
-----------------------------------------------------------------
-----------------------------------------------------------------
Net income (loss) per share $ 0.57 $ 1.20 $ 0.66 $ (0.09) $ 0.58
-----------------------------------------------------------------
-----------------------------------------------------------------
PERFORMANCE RATIOS
Return on average assets .37% .76% 0.44% -0.06% 0.36%
Return on average equity 9.49 22.24 14.98 -2.67 17.06
Interest rate spread 1.64 2.13 2.63 1.79 1.65
Net interest margin 1.73 2.10 2.64 1.81 1.25
Average interest-earning assets to average interest
bearing liabilities 101.55 99.57 100.25 100.39 100.61
Net interest income after provision for loan losses to total
other expenses 146.55 150.49 211.43 134.78 146.32
Total other expenses to average total assets 1.13 1.30 1.19 1.27 0.82
Full service offices 3 2 2 1 1
ASSET QUALITY RATIOS (AT END OF PERIOD)
Non-performing loans to total loans (4) .40 0.95 2.70 3.00 2.56
Non-performing assets to total assets (4) .32 0.59 1.34 0.24 0.24
Allowance for loan losses to total loans .18 0.33 .51 0.94 0.46
Allowance for loan losses to total non-performing loans 45.98 34.57 18.96 29.71 18.07
CAPITAL RATIOS (5)
Tangible capital ratio 6.27 6.12 6.07 5.58 5.31
Core capital ratio 6.27 6.12 6.07 5.58 5.35
Risk-based capital ratio 30.10 24.62 21.40 18.56 16.59
Equity to assets at end of period 5.53 3.45 2.80 2.41 2.26
</TABLE>
(1)On May 6, 1996, the Company sold 1,265,000 shares of common stock at $10.00
per share to investors in an initial public offering resulting in gross
proceeds of $12,650,000 to the Company. Net proceeds after offering expenses
were $11,437,000.
(2)Includes a write-off of goodwill and core deposit of $663,000.
(3)Reflects the Company's adoption of Statement of Financial Accounting
Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective July 1,
1993.
(4)Non-performing loans consist of non-accrual loans and accruing loans that are
contractually past due 90 days or more, and non-performing assets consist of
non-performing loans, real estate acquired by foreclosure or deed-in-lieu
thereof and a single non-agency participation certificate classified as
substandard.
(5)Regulatory capital ratios apply to the Bank (Harrington Bank, FSB) as a
federally chartered savings bank.
14
<PAGE>
MANAGEMENT'S DISCUSSION
AND ANALYSIS OF FINANCIAL
CONDITION AND RESULTS OF OPERATIONS
Harrington Financial Group, Inc. ("Harrington" or the "Company") is an Indiana-
chartered, registered thrift holding company for Harrington Bank, FSB (the
"Bank"). The following financial review presents an analysis of the Company's
operations and financial position for the periods presented in this annual
report.
GENERAL
Harrington's business strategy focuses on achieving attractive returns
consistent with prudent risk management. Harrington has sought to implement this
strategy by (i) controlling interest rate risk by using interest rate risk
management contracts to match the interest rate sensitivity of its assets to
that of its liabilities; (ii) controlling credit risk by maintaining a
substantial portion of the Company's assets in mortgage-backed and related
securities and single-family residential loans; (iii) reducing funding costs
through the utilization of retail and non-retail deposits and other borrowings;
(iv) increasing its emphasis on retail banking through the origination of
single-family residential loans and the expansion of its core deposit base; (v)
maintaining a relatively low level of operating expenses; and (vi) continued
internal growth and the pursuit of acquisition opportunities when appropriate.
Harrington invests primarily in mortgage-backed and related securities and
originates (both directly and through correspondents) loans secured by single-
family residences located primarily in eastern and central Indiana. While
Harrington's focus is to expand its portfolio of originated mortgage loans, over
75% of its assets currently consist of purchased mortgage-backed and related
securities. Although mortgage-backed securities often carry lower yields than
traditional mortgage loans, such securities generally increase the quality of
the Company's assets by virtue of the securities' underlying insurance or
guarantees, are more liquid than individual mortgage loans and may be used to
collateralize borrowings or other obligations of the Company. Management
believes that the lower operating expenses and reduced credit and interest rate
risk associated with the investment in securities have enhanced Harrington's
overall profitability as well as its ability to remain profitable over a variety
of interest rate scenarios.
Harrington's funding strategy focuses on accessing cost-efficient funding
sources, including securities sold under agreements to repurchase, retail and
non-retail deposits and FHLB advances. The Company continues to build a
community-oriented retail banking operation in order to sustain loan
originations and deposit growth and generate additional fee income. Management's
primary goal is to increase stockholders' value, as measured on a risk-adjusted
total return basis.
To reduce the institution's exposure to interest rate risk, the Company utilizes
interest rate risk management contracts and mortgage-backed derivative
securities in conjunction with regular adjustments to the composition of the
Company's investment portfolio. Harrington marks a substantial portion of its
assets and interest rate contracts to market in order to fully account for the
market value changes in the Company's investment portfolio. This method of
accounting is consistent with Harrington's strategy of active portfolio
management and provides the Company with the flexibility to quickly adjust the
mix of its interest-earning assets in response to changing market conditions or
to take advantage of retail growth opportunities.
The Company recognizes that marking substantially all of its assets to market
subjects Harrington to potential earnings volatility. Market value volatility is
not unique to Harrington, though, as most unhedged financial institutions have
even greater volatility in market values. The difference is that Harrington
reflects the changes in market values directly in earnings, while most other
institutions do not.
15
<PAGE>
ASSET AND LIABILITY MANAGEMENT
In general, financial institutions are negatively affected by an increase in
interest rates to the extent that interest-bearing liabilities mature or reprice
more rapidly than interest-earning assets. The lending activities of savings
institutions have historically emphasized the origination of long-term, fixed-
rate loans secured by single-family residences, and the primary source of funds
of such institutions has been deposits, which largely mature or are subject to
repricing within a shorter period of time.
This factor has historically caused the income and market value of portfolio
equity ("MVPE") of savings institutions to be more volatile than other financial
institutions. MVPE is defined as the net present value of an institution's
existing assets, liabilities and off-balance sheet instruments. While having
liabilities that reprice more frequently than assets is generally beneficial to
net interest income and market value of portfolio equity in times of declining
interest rates, such an asset/liability mismatch is generally detrimental during
periods of rising interest rates.
The Company believes that its asset and liability management strategy, as
discussed below, provides Harrington with a competitive advantage over other
financial institutions. Harrington's ability to effectively hedge its interest
rate exposure through the use of various financial instruments allows the
Company to acquire loans and investments which offer attractive net risk-
adjusted spreads whether the individual loans or investments are fixed-rate or
adjustable-rate or short-term or long-term. Similarly, the Company can choose a
cost-effective source of funds and subsequently engage in an interest rate swap
or other hedging transaction so that the interest rate sensitivities of its
interest-earning assets and interest-bearing liabilities are generally matched.
Harrington's asset and liability management strategy is formulated and monitored
by the Boards of Directors of both the Company and Bank, the Company's wholly-
owned subsidiary. The Boards' written policies and procedures are implemented by
the Investment Committee of the Bank, which is comprised of the Chief Executive
Officer, Chief Financial Officer, Chief Investment Officer, Investment Officer,
and three outside directors. The Investment Committee meets at least monthly to
review, among other things, the sensitivity of the Bank's assets and liabilities
to interest rate changes, the book and market values of assets and liabilities
with the resulting unrealized gains and losses, the past month's purchase and
sale activity and maturities of investments and borrowings.
The Investment Committee also consults with the Chief Operating Officer of the
Bank regarding retail pricing and funding decisions with respect to the Bank's
overall asset and liability composition. In accordance therewith, the Investment
Committee reviews the Bank's liquidity, cash flow needs, interest rate
sensitivity of investments, deposits and borrowings, core deposit activity,
current market conditions and interest rates on both a local and national level.
Harrington has contracted with Smith Breeden Associates, Inc. ("Smith Breeden")
for the provision of consulting services regarding, among other things, the
management of its investments and borrowings, the pricing of loans and deposits,
and the use of various financial instruments to reduce interest rate risk. Smith
Breeden is a consulting firm which renders investment advice and asset and
liability management services to financial institutions, corporate and
government pension plans, foundations and government agencies nationally.
Certain directors and officers of the Company and the Bank are principals or
affiliates of Smith Breeden.
The Investment Committee regularly reviews interest rate risk by utilizing
analyses prepared by Smith Breeden with respect to the impact of alternative
interest rate scenarios on net interest income and on the Bank's market value of
portfolio equity. The Investment Committee also reviews analyses prepared by
Smith Breeden concerning the impact of changing market volatility, prepayment
forecast error, changes in option-adjusted spreads and non-parallel yield curve
shifts.
16
<PAGE>
MVPE analysis is used by regulatory authorities for assessing an institution's
interest rate risk. The extent to which assets will gain or lose value net of
the gains or losses of liabilities and/or interest rate contracts determines the
appreciation or depreciation in equity on a market-value basis. Such market
value analysis is intended to evaluate the impact of immediate and sustained
parallel interest-rate shifts upon the market value of the current balance
sheet.
In the absence of the Company's hedging activities, the MVPE of the Company
would decline as a result of a general increase in market rates of interest.
This decline would be due to the market values of Harrington's assets being
generally more sensitive to interest rate fluctuations than are the market
values of the Company's liabilities due to Harrington's investment in generally
longer-term assets which are funded with shorter-term liabilities. Consequently,
the elasticity (i.e., the change in the market value of an asset or liability as
a result of a change in interest rates) of Harrington's assets is greater than
the elasticity of its liabilities.
Accordingly, the primary goal of Harrington's asset and liability management
policy is to effectively increase the elasticity of the Company's liabilities
and/or effectively contract the elasticity of the Company's assets so that the
respective elasticities are matched as closely as possible. This elasticity
adjustment can be accomplished internally by restructuring Harrington's balance
sheet, or externally by adjusting the elasticities of Harrington's assets and/or
liabilities through the use of interest rate contracts, such as interest rate
swaps, collars, caps, floors, options and futures. Harrington's strategy is to
hedge either internally through the use of longer-term certificates of deposits,
FHLB advances and mortgage-backed derivative securities or externally through
the use of various interest rate contracts.
External hedging involves the use of interest rate swaps, collars, caps, floors,
options and futures. The notional amount of interest rate contracts represents
the underlying amount on which periodic cash flows are calculated and exchanged
between counterparties. However, this notional amount does not represent the
principal amount of securities which would effectively be hedged by that
interest rate contract.
In selecting the type and amount of interest rate contract to utilize, the
Company compares the elasticity of a particular contract to that of the
securities to be hedged. An interest rate contract with the appropriate
offsetting elasticity may have a notional amount much greater than the face
amount of the securities being hedged.
An interest rate swap is an agreement where one party (generally the Company)
agrees to pay a fixed rate of interest on a notional principal amount to a
second party (generally a broker) in exchange for receiving from the second
party a variable rate of interest on the same notional amount for a
predetermined period of time. No actual assets are exchanged in a swap of this
type and interest payments are generally netted. These swaps are generally
utilized by Harrington to synthetically convert fixed-rate assets into
adjustable-rate assets without having to sell or transfer the underlying assets.
At June 30, 1996, Harrington was a party to eight interest rate swap agreements.
The agreements had an aggregate notional amount of approximately $63.5 million
and maturities from August 1996 to April 2001. With respect to the agreements
whereby the Company pays a fixed-rate and receives a floating-rate (which
constitute the majority of the agreements), Harrington makes fixed interest
payments ranging from 4.55% to 6.58% and receives payments based upon the three-
month London Interbank Offer Rate ("LIBOR").
The net expense (income) relating to Harrington's fixed-pay interest rate swaps
(which are held in the Company's trading portfolio) was $(168,000), $(113,000)
and $1.3 million during the years ended June 30, 1996, 1995 and 1994,
respectively. The approximate market value of these fixed-pay interest rate
swaps was $620,000 and $(219,000) as of June 30, 1996 and 1995, respectively.
17
<PAGE>
The Company also has two swaps whereby it pays a floating rate (based on three-
month LIBOR) and receives fixed rates of 6.12% and 6.96%, respectively.
Harrington's two floating-pay swaps, which have an aggregate notional amount of
$17.5 million, are not included in the Company's trading portfolio. These swaps
are used to modify the interest rate sensitivity of certain certificates of
deposit issued by the Bank. These certificates of deposit, called inverse
variable-rate certificates, adjust according to a formula in such a way as to
pay a higher rate of interest when rates fall, and a lower rate of interest when
rates rise. The swaps protect the Company against the exposure to falling rates
inherent in these certificates of deposit.
The net (income) relating to Harrington's floating-pay swaps was $(129,000),
$(158,000) and $(596,000) during the years ended June 30, 1996, 1995 and 1994,
respectively. This income is netted against interest expense in the Company's
Consolidated Statements of Income. The approximate market value of the Company's
floating-pay interest rate swaps (which are not reflected in the Company's
financial statements) was $110,000 and $403,000 as of June 30, 1996 and 1995,
respectively.
An interest rate cap or an interest rate floor consists of a guarantee given by
the issuer (i.e., a broker), to the purchaser (i.e., the Company), in exchange
for the payment of a premium. This guarantee states that if interest rates rise
above (in the case of a cap) or fall below (in the case of a floor) a specified
rate on a specified interest rate index, the issuer will pay to the purchaser
the difference between the then current market rate and the specified rate on a
notional principal amount. No funds are actually borrowed or repaid.
Similarly, an interest rate collar is a combination of a purchased cap and a
written floor at different strike rates. Accordingly, an interest rate collar
requires no payments if interest rates remain within a specified range, but will
require the Company to be paid if interest rates rise above the cap rate or
require the Company to pay if interest rates fall below the floor rate.
Consequently, interest rate caps are a means of reducing interest expense by
placing a ceiling on the cost of floating-rate liabilities, or offsetting the
caps on the coupons inherent in the Company's adjustable rate mortgage loans and
securities. Interest rate floors permit Harrington to maintain its desired
interest rate spread in the event that falling interest rates lead to increased
prepayments with respect to the Company's mortgage-backed and related securities
portfolio requiring reinvestment at lower rates.
At June 30, 1996, Harrington held eight interest rate cap agreements, seven
interest rate floor agreements and one interest rate collar in its trading
portfolio. These contracts, which expire from October 1996 to June 2004, have an
aggregate notional amount of approximately $329.5 million. The interest rate cap
agreements are triggered, depending on the particular contract, whenever the
defined floating-rate exceeds 5.0% to 9.0%. The interest rate floor agreements
are triggered, depending on the particular contract, whenever the defined
floating-rate is less than 5.0% to 7.5%. The interest rate collar is triggered
whenever the defined floating-rate is greater than 10.25% or less than 5.25%.
The aggregate net expense (income) relating to the Company's interest rate caps,
collars and floors held in the trading portfolio was $(245,000), $58,000 and
$542,000 during the years ended June 30, 1996, 1995 and 1994, respectively. The
approximate market value of Harrington's interest rate caps, collars and floors
which are maintained in the trading portfolio was $6.0 million and $5.3 million
as of June 30, 1996 and 1995, respectively.
During fiscal 1996 Harrington also purchased one interest rate cap with a
notional amount of $30.0 million which is not held in the Company's trading
portfolio. This cap, which matures in May 2001, is triggered whenever the
defined floating rate exceeds 7.0%. The instrument is used to effectively cap at
7.0% the interest rate on the Company's floating-rate borrowings from the FHLB.
Net expense on this cap was $25,000 for the year ended June 30, 1996. The
approximate market value of the cap, which is not reflected in the Company's
financial statements, was $747,000 at June 30, 1996.
18
<PAGE>
Interest rate futures are commitments to either purchase or sell designated
instruments at a future date for a specified price. Futures contracts are
generally traded on an exchange, are marked to market daily and subject to
initial and maintenance margin requirements. Harrington generally uses 91-day
Eurodollar certificates of deposit contracts ("Eurodollar futures contracts")
which are priced off LIBOR as well as Treasury Note futures contracts. The
Company will from time to time agree to sell a specified number of contracts at
a specified date. To close out a contract, Harrington will enter into an
offsetting position to the original transaction.
If interest rates rise, the value of the Company's short futures positions
increases. Consequently, sales of futures contracts serve as a hedge against
rising interest rates. At June 30, 1996, Harrington has sold Eurodollar and
Treasury Note futures contracts with an aggregate notional amount of
approximately $1.4 billion. The Company had total gains (losses) on its futures
contracts of $1.9 million and $(2.0) million for the fiscal years ended June 30,
1996 and 1995, respectively.
Options are contracts which grant the purchaser the right to buy or sell the
underlying asset by a certain date for a specified price. Generally Harrington
will purchase options on financial futures to hedge the changing elasticity
exhibited by mortgage loans and mortgage-backed securities. The changing
elasticity results from the ability of a borrower to prepay a mortgage. As
market interest rates decline, borrowers are more likely to prepay their
mortgages, shortening the elasticity of the mortgages. Consequently, where
interest rates are declining, the value of mortgage loans or mortgage-backed
securities will increase at a slower rate than would be expected if borrowers
did not have the ability to prepay their mortgages.
Harrington, therefore, generally purchases out-of-the-money calls and puts so
that the increase in value of the options resulting from interest rate movements
offsets the reductions in MVPE resulting from the changing elasticity inherent
in the Company's balance sheet. At June 30, 1996, Harrington had 130 purchased
options contracts covering an aggregate notional amount of approximately $13.0
million. The net expense relating to the Company's options contracts was
$640,000, $148,000 and $0 during the years ended June 30, 1996, 1995 and 1994,
respectively. The approximate market value of the Company's options contracts
which are maintained in the trading portfolio was $65,000 and $200,000 as of
June 30, 1996 and 1995, respectively.
The following table summarizes the periodic exchanges of interest payments with
counterparties including the amortization of premiums paid for interest rate
contracts as discussed above. Such payments and amortization amounts are
accounted for as adjustments to the yields of securities held for trading, and
are reported as a separate component of interest income.
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
-------------------------------------
Interest rate contract
(income) expense:
Swaps $(168) $(113) $1,334
Caps, floors, and collars (220) 58 542
Futures 4
Options 640 148
-------------------------------------
Net interest expense on
interest rate contracts $ 252 $ 93 $1,880
-------------------------------------
-------------------------------------
The above table does not include realized and unrealized gains and losses with
respect to the market value of interest rate contracts held in the trading
portfolio. Such gains and losses are generally offset by fluctuations in the
market value of the Company's assets held for trading. All realized and
unrealized gains and losses pertaining to interest rate contracts in the trading
portfolio are reported as other income in the Company's Consolidated Statements
of Income.
Harrington is subject to the risk that its counterparties with respect to
various interest rate contracts (such as swaps, collars, caps, floors, options
and futures) may default at or prior to maturity of a particular instrument. In
such a case, the Company might be unable to recover any unrealized gains with
respect to a particular contract.
19
<PAGE>
To reduce this potential risk, the Company generally deals with large,
established investment brokerage firms when entering into these transactions. In
addition, if the Company enters into an interest rate contract with a non-AA-
rated (or above) entity and the Company has an unrealized gain with respect to
such contract, the Company generally requires the entity to post some form of
collateral to secure its obligations. Furthermore, the Company has a policy
whereby it limits its unsecured exposure to any one counterparty to 25% of the
Bank's equity during any two-month period and 35% of the Bank's equity during
any one-month period.
The Office of Thrift Supervision ("OTS") requires each thrift institution to
calculate the estimated change in the institution's MVPE assuming an
instantaneous, parallel shift in the Treasury yield curve of 100 to 400 basis
points either up or down in 100 basis point increments. The OTS permits
institutions to perform this MVPE analysis using their own internal model (based
upon reasonable assumptions) or they may utilize the OTS' model, which is based
upon data submitted in the institution's quarterly thrift financial reports. The
Company retains Smith Breeden to perform the required calculation of the
sensitivity of its market value to changes in interest rates.
Both Smith Breeden and the OTS use option-adjusted pricing analysis and present
value calculations of estimated cash flows in their simulation models.
Nevertheless, the results of the OTS model may vary from Smith Breeden's results
primarily due to differences between assumptions utilized in the respective
models, including estimated interest rates and volatilities, prepayment rates,
reinvestment rates and decay rates. In addition, Smith Breeden utilizes detailed
data on individual loans and securities while the OTS model uses aggregated data
for similar instruments. The OTS reviews the Smith Breeden analysis in
conjunction with its regular examinations of the Bank.
The following table sets forth at June 30, 1996 the estimated sensitivity of the
Bank's MVPE to parallel yield curve shifts using Harrington's internal market
value. The table demonstrates the sensitivity of the Bank's assets and
liabilities both before and after the inclusion of its interest rate contracts.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
CHANGE IN
INTEREST RATES -400 -300 -200 -100 -- +100 +200 +300 +400
----------------------------------------------------------------------------------------------------
(IN BASIS POINTS)(1)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Market value gain (loss)
of assets $ 25,277 $ 20,270 $ 15,499 $9,580 -- $(12,973) $(28,169) $(44,451) $(60,996)
Market value gain (loss)
of liabilities (7,556) (5,695) (3,815) (1,864) -- 1,750 3,411 5,016 6,554
----------------------------------------------------------------------------------------------------
Market value gain (loss)
of net assets before
interest rate contracts 17,721 14,575 11,684 7,716 -- (11,223) (24,758) (39,435) (54,442)
Market value gain (loss)
of interest rate
contracts (21,335) (17,555) (13,057) (7,395) -- 9,834 21,455 34,097 47,045
----------------------------------------------------------------------------------------------------
Total change in MVPE(2) $ (3,614) $ (2,980) $ (1,373) $ 321 -- $ (1,389) $(3,303) $ (5,338) $ (7,397)
----------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
Change in MVPE as a
percent of:
MVPE(2) (13.1)% (11.5)% (5.3)% 1.2% -- (5.3)% (12.7)% (20.5)% (28.5)%
Total assets of
the Bank (0.9)% (0.7)% (0.3)% 0.1% -- (0.3)% (0.8)% (1.3)% (1.8)%
</TABLE>
(1) Assumes an instantaneous parallel change in interest rates at all
maturities.
(2) Based on the Bank's pre-tax MVPE of $26.0 million at June 30, 1996.
The table set forth above does not purport to show the impact of interest rate
changes on Harrington's equity under generally accepted accounting principles.
Market value changes only impact the Company's income statement or the balance
sheet (i) to the extent the affected instruments are marked to market, and (ii)
over the life of the instruments as an impact on recorded yields. Since a large
portion of Harrington's assets is recorded at market value, the following table
is included to show the estimated impact on the Company's equity of instan-
20
<PAGE>
taneous, parallel shifts in the yield curve. The assets and interest rate
contracts included in the table below are only those which are either classified
by the Company as held for trading or available for sale and, therefore,
reflected at market value. Consequently, Harrington's liabilities, which are
reflected at cost, are not included in the table below. All amounts are shown
net of taxes, with an estimated effective tax rate of 36.0%.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
CHANGE IN
INTEREST RATES -400 -300 -200 -100 -- +100 +200 +300 +400
----------------------------------------------------------------------------------------------------
(IN BASIS POINTS)
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Market value gain (loss)
of assets $12,649 $10,028 $ 7,596 $ 4,703 -- $(6,564) $(14,463) $(23,064) $(31,896)
Market value gain (loss)
of interest rate
contracts (13,920) (11,325) (8,322) (4,659) -- 6,088 13,183 20,854 28,700
----------------------------------------------------------------------------------------------------
After tax gain (loss)
in equity $(1,271) $ (1,297) $ (726) $ 44 -- $ (476) $ (1,280) $ (2,210) $ (3,196)
----------------------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------------------
After tax gain (loss)
in equity as a percent
of the Company's equity
at June 30, 1996 (5.5)% (5.6)% (3.1)% 0.2% -- (2.1)% (5.5)% (9.6)% (13.8)%
</TABLE>
CHANGES IN FINANCIAL CONDITION
GENERAL - At June 30, 1996, Harrington's total assets amounted to $418.2
million, as compared to $300.2 million at June 30, 1995. The increase in total
assets was primarily due to the completion in fiscal 1996 of the Company's
initial offering of common stock, which raised $11.4 million in net proceeds.
The Company utilized the proceeds from the offering to purchase additional
mortgage-backed securities funded primarily by securities sold under agreements
to repurchase.
CASH AND INTEREST-BEARING DEPOSITS - Cash and interest-bearing deposits amounted
to $17.1 million and $5.7 million at June 30, 1996 and 1995, respectively.
Harrington actively manages its cash and cash equivalents based upon the
Company's operating, investing and financing activities. Based upon the
Company's current size, cash and cash equivalents generally fluctuate within a
range of $5.0 million to $20.0 million. Harrington generally attempts to invest
its excess liquidity into higher yielding assets such as loans or securities.
SECURITIES HELD FOR TRADING AND AVAILABLE FOR SALE - In order to reduce the
Company's credit risk exposure and to earn a positive interest rate spread,
Harrington maintains a substantial portion of its assets in mortgage-backed and
related securities, which are primarily issued or guaranteed by U.S. Government
agencies or government sponsored enterprises. Almost all of these securities and
their related interest rate risk management contracts are classified as held for
trading and, pursuant to SFAS 115, are reported at fair value with unrealized
gains and losses included in earnings. The remainder of the securities are
classified as available for sale and thus also reported at fair value, but with
unrealized gains and losses excluded from earnings and reported instead as a
separate component of stockholders' equity.
Securities held for trading (consisting of mortgage-backed securities, mortgage-
backed derivative securities, interest rate contracts and equity securities)
amounted to $324.2 million and $246.7 million at June 30, 1996 and 1995,
respectively. During the year ended June 30, 1996, securities held for trading
increased by $77.5 million or 31.4%, due primarily to an increase in mortgage-
backed securities resulting from the utilization of the capital raised during
the May 1996 initial public offering of the Company's common stock.
Securities classified as available for sale (consisting of a non-agency
mortgage-backed security and municipal bonds) remained relatively stable at $2.1
million and $2.5 million at June 30, 1996 and 1995, respectively.
LOANS RECEIVABLE - At June 30, 1996, loans receivable (net of the Company's
allowance for loan losses) amounted to $65.9 million, an increase of 78.1% over
the June 30,
21
<PAGE>
1995 total of $37.0 million. Harrington has actively attempted to increase its
retail banking operations, particularly the origination (both directly and
through correspondent mortgage banking companies) of single-family residential
loans to individuals residing in eastern and central Indiana.
Currently, Harrington is originating single-family residential loans through a
correspondent mortgage banking company headquartered in Indianapolis, Indiana.
The Company desires to expand further its originations of single-family
residential loans through the use of additional correspondent mortgage banking
companies located within central Indiana. Loans originated through
correspondents must meet the same pricing and underwriting standards as loans
originated internally.
ALLOWANCE FOR LOAN LOSSES - At June 30, 1996, Harrington's allowance for loan
losses totaled $120,000, compared to $121,000 at June 30, 1995. At June 30,
1996, the Company's allowance represented approximately 0.2% of the total loan
portfolio and 46.0% of total non-performing loans, as compared to 0.3% and 34.6%
at June 30, 1995. The ratio of total non-performing loans to total loans
amounted to 0.4% at June 30, 1996, compared to 1.0% at June 30, 1995, which
reflects Harrington's emphasis on reducing credit risk with respect to its
operations.
Although Harrington management believes that its allowance for loan losses at
June 30, 1996 was adequate based on facts and circumstances available to it
(including the historically low level of loan charge-offs), there can be no
assurances that additions to the allowance will not be necessary in future
periods, which could adversely affect the Company's results of operations.
DEPOSITS - At June 30, 1996, deposits totaled $135.1 million, as compared to
$115.3 million as of June 30, 1995. Retail deposits increased $29.5 million,
from $82.3 million at June 30, 1995 to $111.8 million at June 30, 1996,
primarily due to Harrington's expansion in Hamilton County. Non-retail deposits
declined by $9.7 million during the same period, for a total increase in
deposits of $19.8 million.
Harrington attempts to reduce its overall funding costs by evaluating all
potential sources of funds (including retail and non-retail deposits and short
and long-term borrowings) and identifying which particular source will result in
an all-in cost to the Company that meets its funding benchmark. At the same
time, the Bank has attempted to price the deposits offered through its branch
system in order to promote retail deposit growth and offer a wide array of
deposit products to satisfy its customers. In addition to providing a cost-
efficient funding source, these retail deposits provide a source of fee income
and the ability to cross-sell other products or services.
BORROWINGS - At June 30, 1996, reverse repurchase agreements and dollar rolls
(both of which are securities sold under agreements to repurchase and are
accounted for as a financing) totaled $219.1 million, as compared to $130.2
million as of June 30, 1995. The substantial increase during the year ended June
30, 1996 was principally due to reverse repurchase agreements which were used to
fund the purchase of mortgage-backed securities. Although a substantial portion
of Harrington's growth in recent periods has been funded by reverse repurchase
agreements, part of management's strategy is to gradually replace such
borrowings with retail deposits.
Advances from the FHLB of Indianapolis amounted to $26.0 million and $31.0
million as of June 30, 1996 and 1995, respectively. At June 30, 1996, all $26.0
million of FHLB advances were scheduled to mature in fiscal 1998, with an
average interest rate thereon of 5.4%, as compared to 6.1% at June 30, 1995.
The Company's note payable amounted to $9.0 million and $9.2 million at June 30,
1996 and 1995, respectively. The note payable relates to a loan facility which
was used to refinance, to a significant extent, the unpaid balance of a $10.0
million acquisition loan which financed the Company's acquisition of the Bank. A
July 1996 amendment to the loan facility provided an additional $3.0 million
non-revolving line of credit which is intended to further increase the capital
of the Bank to support additional asset growth.
22
<PAGE>
STOCKHOLDERS' EQUITY - Stockholders' equity increased from $10.4 million at June
30, 1995 to $23.1 million at June 30, 1996. This increase was due to (i) $1.2
million of net income recognized during fiscal 1996; (ii) $11.4 million in net
proceeds from the fiscal 1996 initial public offering of the Company's common
stock; and (iii) $165,000 raised in connection with the exercise of existing
stock options during fiscal 1996. In addition, at June 30, 1995 and 1996, the
Company's stockholders' equity included $61,000 and $(8,000), respectively, of
unrealized gains (losses) on securities classified as available for sale, net of
deferred taxes.
RESULTS OF OPERATIONS
SUMMARY OF EARNINGS - Harrington reported net income of $1.2 million or $0.57
per share for the year ended June 30, 1996, compared to $1.9 million or $1.20
per share for the year ended June 30, 1995. This $630,000 or 34.0% decrease in
net income was due primarily to a decrease in the net gain on the trading
portfolio.
Gains and losses in the trading portfolio are included as a component of
reported earnings whether or not the assets are sold. Gains or losses on assets
sold are referred to as realized gains or losses. Market value gains or losses
on assets held in the trading portfolio are unrealized gains or losses. The net
realized or unrealized gain or loss refers to the combination of both these
components of income. Harrington reported a net realized and unrealized loss of
$126,000 on the securities portfolio in fiscal 1996, compared to a net realized
and unrealized gain on this portfolio of $1.2 million in fiscal 1995. The
decrease in the securities gain, as well as a $573,000 increase in other
expense, were partially offset by a $699,000 increase in net interest income and
a $523,000 decrease in the income tax provision.
Net income for the year ended June 30, 1995 was $1.9 million or $1.20 per share,
compared to $927,000 or $0.66 per share during the year ended June 30, 1994. The
$926,000 or 99.8% increase in net income was due to a $2.8 million increase in
total other income which was partially offset by a $780,000 increase in the
income tax provision, a $647,000 increase in total other expense, and a $542,000
decrease in net interest income.
23
<PAGE>
AVERAGE BALANCES, NET INTEREST INCOME AND YIELDS EARNED AND RATES PAID. The
following table presents for the periods indicated the total dollar amount of
interest from average interest-earning assets and the resultant yields, as well
as the interest expense on average interest-bearing liabilities, expressed both
in dollars and rates, and the net interest margin. The table does not reflect
any effect of income taxes. All average balances are based on average month end
balances for the Company and average daily balances for the Bank during the
periods presented.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
------------------------------------------------------------------------------------------
AVERAGE YIELD/ Average Yield/ Average Yield/
BALANCE INTEREST RATE (1) Balance Interest Rate Balance Interest Rate
------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
INTEREST-EARNING ASSETS:
Interest-bearing deposits $ 14,520 $ 780 5.37% $ 11,493 $ 603 5.25% $ 12,454 $ 415 3.33%
Securities held for trading (2)(3) 243,862 18,038 7.40 185,014 14,332 7.75 163,825 10,996 6.71
Securities available for sale 2,672 190 7.11 3,110 250 8.04 3,928 311 7.92
Loans receivable, net (4) 52,399 4,276 8.16 25,467 2,223 8.73 19,369 1,778 9.18
Federal Home Loan Bank stock 2,533 200 7.90 2,172 152 7.00 1,843 107 5.81
------------------------------------------------------------------------------------------
Total interest-earning assets 315,986 23,484 7.43% 227,256 17,560 7.73% 201,419 13,607 6.76%
Non-interest-earning assets 13,952 15,654 10,904
------------------------------------------------------------------------------------------
Total assets $329,938 $242,910 $212,323
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
INTEREST-BEARING LIABILITIES:
Deposits:
NOW and checking accounts $ 3,813 $ 110 2.88% $ 3,352 $ 94 2.80% $ 2,872 $ 83 2.89%
Savings accounts 15,922 613 3.85 16,068 568 3.53 18,271 598 3.27
Money market deposit accounts 1,777 77 4.33 2,147 88 4.10 5,396 184 3.41
Certificates of deposit 103,981 6,351 6.11 99,443 5,904 5.94 69,336 3,651 5.27
------------------------------------------------------------------------------------------
Total deposits 125,493 7,151 5.70 121,010 6,654 5.50 95,875 4,516 4.71
Securities sold under agreements
to repurchase 148,523 8,352 5.62 68,277 3,654 5.35 66,813 2,134 3.19
Federal Home Loan Bank advances 27,586 1,596 5.79 31,051 1,722 5.55 31,000 1,057 3.41
Note payable 9,553 905 9.47 7,890 749 9.49 7,227 577 7.98
------------------------------------------------------------------------------------------
Total interest-bearing liabilities 311,155 18,004 5.79% 228,228 $12,779 5.60% 200,915 8,284 4.12%
Non-interest bearing liabilities 5,894 6,349 5,221
------------------------------------------------------------------------------------------
Total liabilities 317,049 234,577 206,136
Stockholders' equity 12,889 8,333 6,187
------------------------------------------------------------------------------------------
Total liabilities and stockholders'
equity $329,938 $242,910 $212,323
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
Net interest income; interest
rate spread (3)(5) $ 5,480 1.64% $ 4,781 2.13% $ 5,323 2.64%
------------------------------------------------------------------------------------------
Net interest margin (3)(5)(6) 1.73% 2.10% 2.64%
------------------------------------------------------------------------------------------
Average interest-earning assets
to average interest-bearing
liabilities 101.55% 99.57% 100.25%
------------------------------------------------------------------------------------------
</TABLE>
(1) At June 30, 1996, the yields earned and rates paid were as follows:
interest-bearing deposits, 5.44%; securities held for trading, 7.42%;
securities avaliable for sale, 7.21%; loans receivable, net 8.11%; FHLB
stock, 6.79%; total interest-earning assets, 7.45%; deposits, 5.51%;
securities sold under agreements to repurchase, 5.21%; FHLB advances, 5.41%;
note payable, 9.27%; total interest-bearing liabilities, 5.42%; interest
rate spread, 2.03%.
(2) Both the interest and yields earned on the Company's securities portfolio
reflect the net interest expense incurred with respect to various interest
rate contracts (such as interest rate swaps, collars, caps, floors, options
and futures) which were utilized to hedge the Company's interest rate
exposure. During the years ended June 30, 1996, 1995 and 1994, the net
costs of hedging the Company's interest rate exposure with respect to its
securities held for trading amounted to $252,000 or 0.21%, $93,000 or 0.05%
and $1.9 million or 1.15%, respectively.
(3) During fiscal 1994, interest earned on securities held for trading reflected
$1.5 million of non-recurring interest earned from the call of two mortgage-
backed securities. Excluding this non-recurring income, the Company's
interest rate spread and net interest margin would have amounted to 1.87%
and 1.88%, respectively.
(4) Net of deferred loan fees, loan discounts and undisbursed loan funds.
Includes nonaccrual loans. Interest on nonaccrual loans is recorded when
received.
(5) Excluding the costs of hedging the Company's interest rate exposure (which
has effectively reduced the yields earned on the Company's securities
portfolio), the Company's interest rate spread amounted to 1.72%, 2.17% and
3.57%, and the Company's net interest margin amounted to 1.81%, 2.14% and
3.58% for the years ended June 30, 1996, 1995 and 1994, respectively.
(6) Net interest margin is net interest income divided by average interest-
earning assets.
24
<PAGE>
RATE/VOLUME ANALYSIS - The following table describes the extent to which changes
in interest rates and changes in volume of interest-related assets and
liabilities have affected the Company's interest income and interest expense
during the periods indicated. For each category of interest-earning assets and
interest-bearing liabilities, information is provided on changes attributable to
(i) changes in volume (change in volume multiplied by prior year rate), (ii)
changes in rate (change in rate multiplied by prior year volume), and (iii)
total change in rate and volume. The combined effect of changes in both rate and
volume has been allocated in proportion to the absolute dollar amounts of the
changes due to rate and volume.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1996 VS. 1995 1995 vs. 1994
---------------------------------------------------------------------------------
INCREASE INCREASE
(DECREASE) TOTAL (DECREASE) TOTAL
DUE TO INCREASE DUE TO INCREASE
RATE VOLUME (DECREASE) RATE VOLUME (DECREASE)
---------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Interest-bearing deposits $ 15 $ 162 $ 177 $ 222 $ (34) $ 188
Securities held for trading and
securities available for sale (700) 4,346 3,646 1,810 1,465 3,275
Loans receivable, net (154) 2,207 2,053 (91) 536 445
Federal Home Loan Bank stock 21 27 48 24 21 45
---------------------------------------------------------------------------------
Total interest-earning assets $(818) $6,742 5,924 $1,965 $1,988 3,953
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
Interest-bearing liabilities:
NOW and checking accounts $ 3 $ 13 16 $ (3) $ 14 11
Savings accounts 50 (5) 45 46 (76) (30)
Money market deposit accounts 5 (16) (11) 32 (128) (96)
Certificates of deposit 173 274 447 511 1,742 2,253
---------------------------------------------------------------------------------
Total deposits 231 266 497 586 1,552 2,138
Securities sold under agreements
to repurchase 194 4,504 4,698 1,472 48 1,520
Federal Home Loan Bank advances 72 (198) (126) 663 2 665
Note payable (2) 158 156 116 56 172
---------------------------------------------------------------------------------
Total interest-bearing liabilities $ 495 $4,730 $5,225 $2,837 $1,658 4,495
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
Increase (decrease) in net
interest income $ 699 $ (542)
---------------------------------------------------------------------------------
---------------------------------------------------------------------------------
</TABLE>
NET INTEREST INCOME - Net interest income is determined by the Company's
interest rate spread (i.e., the difference between the yields earned on its
interest-earning assets and the rates paid on its interest-bearing liabilities)
and the relative amounts of interest-earning assets and interest-bearing
liabilities. For the year ended June 30, 1996, Harrington's net interest income
increased by $699,000 or 14.4% to $5.5 million, compared to the year ended June
30, 1995. The increase was primarily due to a $88.7 million increase in the
amount of average interest-earning assets.
25
<PAGE>
The growth in asset size is a major component of Harrington's strategic plan. As
capital is raised, either internally through the retention of profits or
externally through the issuance of stock, the proceeds are invested initially in
the Company's securities portfolio. As retail expansion opportunities become
available and as mortgage loans are originated, these funds will be redeployed
in those sectors.
The increase in net interest income caused by asset growth was partially offset
by a 49 basis point decline in the Company's interest rate spread during the
year, from 2.13% to 1.64%. Interest rate spread is the difference between
interest income as a percentage of interest-earning assets and interest expense
as a percentage of interest-bearing liabilities. This decline was primarily due
to the Bank investing the capital raised in Harrington's initial public stock
offering in mortgage-backed and related securities, which earn somewhat lower
option-adjusted spreads than the mortgage loans in the Company's portfolio.
These purchases were funded primarily through reverse repurchase agreements.
For the year ended June 30, 1995, Harrington's net interest income amounted to
$4.8 million, compared to $5.3 million for the year ended June 30, 1994. The
$542,000 decrease was primarily due to a 51 basis point decline in the Company's
interest rate spread, from 2.64% to 2.13%. A principal reason for the decrease
in the interest rate spread was $1.5 million of non-recurring interest earned
during fiscal 1994 due to the call of two mortgage-backed residuals during the
year. Excluding this non-recurring income, Harrington's interest rate spread
would have increased by 26 basis points during the year.
PROVISION FOR LOAN LOSSES - The provision for loan losses is charged to earnings
to bring the total allowance to a level considered appropriate by management
based on the estimated net realizable value of the underlying collateral,
general economic conditions, particularly as they relate to the Company's market
area, historical loan loss experience and other factors related to the
collectability of the Company's loan portfolio. While management endeavors to
use the best information available in making its evaluations, future allowance
adjustments may be necessary if economic conditions change substantially from
the assumptions used in making the evaluations.
Harrington established provisions (recoveries) for loan losses of $(1,000),
$15,000, and $(3,000) during the years ended June 30, 1996, 1995 and 1994,
respectively. During such respective periods, loan charge-offs (net of
recoveries) amounted to $0, $0 and $47,000, respectively. The allowance for loan
losses as a percentage of total non-performing loans was 46.0%, 34.6% and 19.0%
at June 30, 1996, 1995 and 1994, respectively. The allowance for loan losses as
a percentage of total loans was 0.2%, 0.3% and 0.5% at June 30, 1996, 1995 and
1994, respectively.
OTHER INCOME - Other income is comprised of two distinct components: gains and
losses on the Company's investment portfolios, and fee and other income from
retail bank operations. Total other income has fluctuated considerably over the
years presented, due primarily to the component related to securities gains and
losses.
Since Harrington has classified most of its investment securities and related
hedge instruments as held for trading, all market value changes in this
portfolio are reported in earnings whether or not the assets are sold. Gains or
losses on assets which have been sold are reported as realized gains or losses,
and market value gains or losses on assets and hedges which remain in the
Company's portfolio are reported as unrealized gains or losses.
Management's goal is to attempt to offset any change in the market value of its
securities portfolio with the change in the market value of the interest rate
risk management contracts and mortgage-backed derivative securities utilized by
the Company to hedge its interest rate exposure. In addition, management
attempts to produce an overall gain with respect to its securities portfolio
through the use of option-adjusted pricing analysis. The Company utilizes such
analysis to select securities with wider spreads for purchase and to select
securities to sell for a gain as spreads tighten (net of the gain or loss
recognized with respect to related interest rate contracts).
26
<PAGE>
However, the use of mark-to-market accounting for the trading portfolio can
cause volatility in reported earnings due to short-term fluctuations in the
market value of the securities relative to that of the hedge instruments.
Harrington accepts this volatility and realizes that a major benefit of marking
assets to market is that it provides shareholders with more timely information
on the economic value of the Company's portfolio.
The following table sets forth information regarding other income for the
periods shown.
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
------------ ------------ ------------
Gain (loss) on sale of
securities held
for trading $ 1,834 $ 66 $(2,169)
Gain on sale of securities
available for sale 392
Unrealized gain (loss) on
securities held
for trading (1,960) 1,535 710
Permanent impairment
of securities available
for sale (414) (610)
Other(1) 256 238 267
------------ ------------ ------------
Total other income $ 130 $ 1,425 $(1,410)
------------ ------------ ------------
------------ ------------ ------------
(1) Consists primarily of loan servicing fees and late charges, checking account
fees, trust and investment management service fees, rental income and other
miscellaneous fees.
Total other income amounted to $130,000 for the year ended June 30, 1996. This
total was comprised of fee and other retail bank income of $256,000 which was
reduced by a net realized and unrealized loss of $126,000 on securities held for
trading. The securities loss resulted from changes in the market values of
mortgage-backed securities which were not entirely offset by changes in the
market values of the interest rate contracts in the trading portfolio.
Total other income amounted to $1.4 million during the year ended June 30, 1995,
primarily due to $1.6 million of net realized and unrealized gains on securities
held for trading. This gain was partially offset by a $414,000 charge relating
to the permanent impairment of securities classified as available for sale.
Pursuant to SFAS No. 115, if a security classified as available for sale
experiences an other than temporary decline in value below the amortized cost of
the security, the cost basis of the security is required to be written down to
fair value and the amount of the write-down deducted from earnings. As a result,
during fiscal 1995 the Company recorded $414,000 of such impairment adjustments
which related to a non-agency participation certificate secured by a significant
amount of delinquent single-family residential loans.
Total other income amounted to a loss of $1.4 million for the year ended June
30, 1994, due primarily to a $1.5 million net realized and unrealized loss on
securities held for trading. This loss was caused by less proceeds than
anticipated being realized at the early call of two mortgage-backed residuals,
as well as by a general widening of net risk-adjusted spreads with respect to
mortgage-backed securities. A $610,000 impairment adjustment on securities
available for sale was partially offset by a $392,000 gain on sale of such
securities.
OTHER EXPENSE. In order to enhance the Company's profitability, management
strives to maintain a low level of operating expenses relative to its peer
group. During the years ended June 30, 1996, 1995 and 1994, total other expense
as a percentage of average total assets amounted to 1.1%, 1.3% and 1.2%,
respectively. The following table sets forth certain information regarding other
expense for the periods shown.
27
<PAGE>
(DOLLARS IN THOUSANDS)
YEAR ENDED
JUNE 30, 1996 1995 1994
--------------------------------------
Salaries and employee
benefits $1,552 $1,295 $ 925
Premises and equipment 466 414 331
FDIC insurance premiums 276 260 238
Marketing 200 122 136
Computer services 143 112 83
Consulting fees 232 195 183
Other(1) 871 769 623
--------------------------------------
Total other expense $3,740 $3,167 $2,519
--------------------------------------
--------------------------------------
(1) Consists primarily of costs relating to postage, forms and supplies,
professional fees, supervisory assessments and other miscellaneous expenses.
The principal category of Harrington's other expense is salaries and employee
benefits, which increased by $257,000 or 19.8% and $370,000 or 40.0% during
fiscal 1996 and 1995, respectively. A major cause of these increases was the
opening of two new branch offices in Hamilton County, Indiana. One branch was
opened in Carmel, Indiana in May 1994, and a second one was opened in Fishers,
Indiana in December 1995. Additional factors impacting salaries and employee
benefits expense were the additional employees hired in connection with the
growth in the Bank's mortgage lending operations and the opening of Harrington's
Investment Management and Trust Services.
Premises and equipment expense increased by $52,000 or 12.6% and $83,000 or
25.0% during fiscal 1996 and 1995, respectively. The increase in premises and
equipment expense during the periods was primarily due to the opening of new
branches during fiscal years 1994 and 1996.
FDIC insurance premiums increased by $16,000 or 6.2% and $22,000 or 9.2% during
fiscal 1996 and 1995, respectively. FDIC insurance premiums are a function of
the size of the Bank's deposit base. Harrington currently pays 23 basis points
on its deposits for FDIC insurance. Since the Company has experienced
significant growth in its deposit base, its insurance expense has increased as
well.
Harrington incurred marketing expense of $200,000, $122,000 and $136,000 during
the years ended June 30, 1996, 1995 and 1994, respectively. The fluctuations in
marketing expense during the periods reflected the advertising costs associated
with the opening of the Bank's new branch offices during fiscal 1994 and 1996.
Computer services expense increased by $31,000 or 27.7% and $29,000 or 34.9%
during fiscal 1996 and 1995, respectively. Computer services expense relates to
the fees paid by Harrington to a third party who performs the Company's data
processing functions as well as to the third party servicer who performs the
back-office functions with respect to the Company's trust and investment
management services which were implemented in December 1994. The increase in
expense for the years presented relates primarily to the increase in the number
of deposit and loan accounts held by Harrington.
Harrington has contracted with Smith Breeden to provide investment advisory
services and interest rate risk analysis. Certain stockholders of the Company
are also principals of Smith Breeden. The consulting fees paid by Harrington to
Smith Breeden during the years ended June 30, 1996, 1995 and 1994, which are
based on the Company's asset size, amounted to $232,000, $195,000 and $183,000,
respectively.
INCOME TAX PROVISION. The Company incurred income tax expense of $648,000, $1.2
million and $391,000 during the years ended June 30, 1996, 1995 and 1994,
respectively. The Company's effective tax rate amounted to 34.6%, 38.7% and
28.0% during the years ended June 30, 1996, 1995 and 1994, respectively.
Effective July 1, 1993, the Company changed its method of accounting for income
taxes pursuant to SFAS No. 109. SFAS No. 109 establishes an asset and liability
approach for financial accounting and reporting for income taxes. The cumulative
effect of the change in adopting SFAS No. 109 amounted to a $79,000 charge to
earnings for the year ended June 30, 1994.
28
<PAGE>
LIQUIDITY
The Bank is required under applicable federal regulations to maintain specified
levels of "liquid" investments in qualifying types of U.S. Government and
government agency obligations and other similar investments having maturities of
five years or less. Such investments are intended to provide a source of
relatively liquid funds upon which the Bank may rely if necessary to fund
deposit withdrawals and for other short-term funding needs. The required level
of such liquid investments is currently 5% of certain liabilities as defined by
the OTS.
The regulatory liquidity of the Bank was 5.53% at June 30, 1996, as compared to
5.36% at June 30, 1995. At June 30, 1996, the Bank's liquid assets as defined by
the OTS totaled approximately $17.0 million, which was $1.6 million in excess of
the current OTS minimum requirement.
The Company manages its liquidity so as to maintain a minimum regulatory ratio
of 5%. However, as a result of the Company's active portfolio management, the
Bank's regulatory liquidity can be expected to fluctuate from a minimum of 5% to
approximately 6%, based upon investment alternatives available and market
conditions. In addition, the Company also calculates the amount of cash which
could be raised in one, seven or thirty days, either by selling unpledged assets
or by borrowing against them. The ratio of this amount of liquidity to total
deposits generally ranges from over 50% to 90% or more for one- and thirty-day
time frames, respectively. Harrington believes that it has adequate resources to
fund ongoing commitments such as deposit account withdrawals and loan
commitments.
INFLATION AND CHANGING PRICES
The Consolidated Financial Statements and related data presented herein have
been prepared in accordance with generally accepted accounting principles, which
require the measurement of financial position and operating results in terms of
historical dollars (except with respect to securities which are carried at
market value), without considering changes in the relative purchasing power of
money over time due to inflation. Unlike most industrial companies,
substantially all of the assets and liabilities of the Company are monetary in
nature. As a result, interest rates have a more significant impact on the
Company's performance than the effects of general levels of inflation. Interest
rates do not necessarily move in the same direction or in the same magnitude as
the prices of goods and services.
RECENT ACCOUNTING PRONOUNCEMENTS
The Financial Accounting Standards Board has issued Statement Nos. 121, 122, 123
and 125 that the Company will be required to adopt in future periods. See Note 1
to the consolidated financial statements for further discussion of these
pronouncements.
29
<PAGE>
CONSOLIDATED BALANCE SHEETS
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
JUNE 30, 1996 1995
---------------------
<S> <C> <C>
ASSETS
Cash $ 1,036 $ 773
Interest-bearing deposits (Note 13) 16,107 4,932
---------------------
Total cash and cash equivalents 17,143 5,705
Securities held for trading - at fair value (amortized cost of
$323,936 and $244,488) (Notes 2, 8, 13) 324,221 246,733
Securities available for sale - at fair value (amortized cost of
$2,062 and $2,444) (Note 2) 2,050 2,541
Loans receivable (net of allowance for loan losses of
$120 and $121) (Note 3) 65,925 37,010
Interest receivable, net (Note 4) 1,807 1,353
Premises and equipment, net (Note 5) 3,105 2,392
Federal Home Loan Bank of Indianapolis stock - at cost 2,645 2,500
Other 1,300 1,940
---------------------
TOTAL ASSETS $418,196 $300,174
---------------------
---------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits (Note 6) $135,143 $115,312
Securities sold under agreements to repurchase (Note 7) 219,067 130,217
Federal Home Loan Bank advances (Note 8) 26,000 31,000
Interest payable 1,970 1,692
Note payable (Note 9) 8,998 9,200
Advance payments by borrowers for taxes and insurance 392 264
Deferred income taxes, net (Note 10) 663 1,576
Accrued income taxes payable (Note 10) 115 195
Deferred compensation payable (Note 12) 119 152
Accrued expenses payable and other liabilities 2,612 205
---------------------
Total liabilities 395,079 289,813
---------------------
COMMITMENTS AND CONTINGENCIES (NOTES 13, 14, 16)
STOCKHOLDERS' EQUITY (NOTES 1, 10, 11, 12, 16):
Preferred Stock ($1 par value) Authorized and unissued -
5,000,000 shares
Common Stock:
Voting ($.125 par value) Authorized - 10,000,000 shares
issued and outstanding 3,256,738 and 1,961,626 407 245
Additional paid-in capital 15,623 4,183
Unrealized gain (loss) on securities available for sale, net of deferred
taxes of $(4) and $36 (8) 61
Retained earnings 7,095 5,872
---------------------
Total stockholders' equity 23,117 10,361
---------------------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $418,196 $300,174
---------------------
---------------------
</TABLE>
See notes to consolidated financial statements.
30
<PAGE>
CONSOLIDATED STATEMENTS OF INCOME
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
YEARS ENDED JUNE 30, 1996 1995 1994
--------------------------------------
<S> <C> <C> <C>
INTEREST INCOME:
Securities held for trading $18,290 $14,425 $12,876
Net interest expense on interest rate contracts maintained in
the trading portfolio (Note 13) (252) (93) (1,880)
Securities available for sale 190 250 311
Loans receivable (Note 3) 4,276 2,223 1,778
Dividends on Federal Home Loan Bank of Indianapolis stock 200 152 107
Deposits 780 603 415
--------------------------------------
23,484 17,560 13,607
--------------------------------------
INTEREST EXPENSE:
Deposits (Notes 6, 13) 7,151 6,654 4,516
Federal Home Loan Bank advances (Note 8) 1,596 1,722 1,057
Short-term borrowings (Note 7) 8,352 3,654 2,134
Long-term borrowings (Note 9) 905 749 577
--------------------------------------
18,004 12,779 8,284
--------------------------------------
NET INTEREST INCOME 5,480 4,781 5,323
PROVISION (CREDIT) FOR LOAN LOSSES (NOTE 3) (1) 15 (3)
--------------------------------------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES 5,481 4,766 5,326
--------------------------------------
OTHER INCOME (LOSS):
Gain (loss) on sale of securities held for trading (Note 13) 1,834 66 (2,169)
Gain on sale of securities available for sale 392
Unrealized gain (loss) on securities held for trading (Notes 2, 13) (1,960) 1,535 710
Permanent impairment of securities available for sale (Note 2) (414) (610)
Other 256 238 267
--------------------------------------
130 1,425 (1,410)
--------------------------------------
OTHER EXPENSE:
Salaries and employee benefits (Note 12) 1,552 1,295 925
Premises and equipment expense (Note 5) 466 414 331
FDIC insurance premiums 276 260 238
Marketing 200 122 136
Computer services 143 112 83
Consulting fees (Note 15) 232 195 183
Other 871 769 623
--------------------------------------
3,740 3,167 2,519
--------------------------------------
INCOME BEFORE INCOME TAX PROVISION AND CUMULATIVE EFFECT
OF CHANGE IN ACCOUNTING FOR DEFERRED INCOME TAXES 1,871 3,024 1,397
INCOME TAX PROVISION (NOTE 10) 648 1,171 391
--------------------------------------
INCOME BEFORE CUMULATIVE EFFECT OF CHANGE IN
ACCOUNTING FOR DEFERRED INCOME TAXES 1,223 1,853 1,006
CUMULATIVE EFFECT OF CHANGE IN ACCOUNTING FOR
DEFERRED INCOME TAXES (NOTE 10) (79)
--------------------------------------
NET INCOME $ 1,223 $ 1,853 $ 927
--------------------------------------
--------------------------------------
EARNINGS PER SHARE (NOTE 1):
INCOME PER SHARE BEFORE CUMULATIVE EFFECT OF
ACCOUNTING CHANGE $ 0.57 $ 1.20 $ 0.72
CUMULATIVE EFFECT OF ACCOUNTING CHANGE (0.06)
--------------------------------------
NET INCOME PER SHARE $ 0.57 $ 1.20 $ 0.66
--------------------------------------
--------------------------------------
</TABLE>
See notes to consolidated financial statements.
31
<PAGE>
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
<TABLE>
<CAPTION>
Additional Unrealized Total
Shares Common Paid-In Gain Retained Stockholders'
Outstanding Stock Capital (Loss) Earnings Equity
--------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
(DOLLARS IN THOUSANDS EXCEPT SHARE DATA)
BALANCES, JULY 1, 1993 176,548 $176 $ 1,730 $ 296 $3,092 $ 5,294
Reclassification of securities available
for sale to securities held for trading (252) (252)
Net income 927 927
Net change in unrealized gain (loss) on
securities available for sale (44) (44)
--------------------------------------------------------------------------------------
BALANCES, JUNE 30, 1994 176,548 176 1,730 4,019 5,925
Stock split 4 for 1 529,644
Issuance of common stock under equity
offering (Note 16) 263,821 66 2,355 2,421
Stock options exercised (Note 12) 10,800 3 98 101
Net income 1,853 1,853
Net change in unrealized gain (loss) on
securities available for sale, net of
deferred tax of $36 61 61
--------------------------------------------------------------------------------------
BALANCES, JUNE 30, 1995 980,813 245 4,183 61 5,872 10,361
Stock split 2 for 1 980,813
Stock options exercised (Note 12) 30,112 4 161 165
Issuance of common stock under initial
public offering (Note 1) 1,265,000 158 11,279 11,437
Net income 1,223 1,223
Net change in unrealized gain (loss)
on securities available
for sale, net of deferred tax of $(4) (69) (69)
--------------------------------------------------------------------------------------
BALANCES, JUNE 30, 1996 3,256,738 $407 $15,623 $ (8) $7,095 $23,117
--------------------------------------------------------------------------------------
--------------------------------------------------------------------------------------
</TABLE>
See notes to consolidated financial statements.
32
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
-----------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income $ 1,223 $ 1,853 $ 927
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Provision (credit) for loan losses (1) 15 (3)
Depreciation 210 176 141
Premium and discount amortization on securities, net 1,887 1,485 2,286
Amortization of premiums and discounts on loans receivable (37) (132) (210)
(Gain) loss on sale of securities held for trading (1,834) (66) 2,169
Gain on sale of securities available for sale (392)
Unrealized (gain) loss on securities held for trading 1,960 (1,535) (710)
Permanent impairment of securities available for sale 414 610
Deferred income tax provision (913) 673 165
(Increase) decrease in interest receivable (454) (41) 271
Increase in interest payable 278 219 175
Increase (decrease) in accrued income taxes (80) (254) 449
Purchases of securities held for trading (390,743) (510,309) (69,425)
Proceeds from maturities of securities held for trading 25,407 15,798 7,809
Proceeds from sales of securities held for trading 285,835 419,340 66,433
(Increase) decrease in other assets 640 (1,511) (192)
Increase (decrease) in accrued expenses 2,374 (642) 412
Increase in other liabilities 128 124 33
-----------------------------------------
Net cash provided by (used in) operating activities (74,120) (74,393) 10,948
-----------------------------------------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Federal Home Loan Bank of Indianapolis stock (145) (657)
Purchases of securities available for sale (110,251)
Proceeds from maturities of securities available for sale 422 574 24,134
Proceeds from sales of securities available for sale 89,101
Loan originations, net of principal repayments (28,877) (16,211) (3,822)
Purchases of premises and equipment (923) (411) (471)
-----------------------------------------
Net cash used in investing activities (29,523) (16,705) (1,309)
-----------------------------------------
</TABLE>
(continued)
33
<PAGE>
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
-----------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM FINANCING ACTIVITIES:
Net increase in deposits 19,831 7,011 18,511
Increase (decrease) in securities sold under
agreements to repurchase 88,850 75,565 (29,058)
Proceeds from issuance of common stock under equity offering 2,421
Proceeds from issuance of common stock under initial public offering 11,437
Proceeds from stock options exercised 165 101
Proceeds from Federal Home Loan Bank advances 10,000
Proceeds from note payable 800 1,900 8,000
Principal repayments on Federal Home Loan Bank advances (15,000)
Principal repayments on note payable (1,002) (600) (7,631)
-----------------------------------------
Net cash provided by (used in) financing activities 115,081 86,398 (10,178)
-----------------------------------------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS 11,438 (4,700) (539)
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR 5,705 10,405 10,944
-----------------------------------------
CASH AND CASH EQUIVALENTS AT END OF YEAR $ 17,143 $ 5,705 $ 10,405
-----------------------------------------
-----------------------------------------
SUPPLEMENTAL DISCLOSURES OF CASH FLOW
INFORMATION:
Cash paid for interest $ 18,354 $ 12,562 $ 8,109
Cash paid (refunded) for income taxes 1,600 753 (427)
Non-cash reclassification of securities from available
for sale to held for trading 166,092
</TABLE>
See notes to consolidated financial statements.
34
<PAGE>
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
I. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
BUSINESS OF THE COMPANY - Harrington Financial Group, Inc. ("HFG" or the
"Company") is a savings and loan holding company incorporated on March 3, 1988
to acquire and hold all of the outstanding common stock of Harrington Bank, FSB
(the "Bank"), a federally chartered savings bank with principal offices in
Richmond, Indiana and branch locations in Hamilton County, Indiana. On May 6,
1996, the Company sold 1,265,000 shares of common stock at $10.00 per share to
investors in an initial public offering resulting in gross proceeds of
$12,650,000 to the Company. Net proceeds to the Company after offering expenses
were $11,437,000.
BASIS OF PRESENTATION - The consolidated financial statements include the
accounts of HFG and the Bank. All significant intercompany accounts and
transactions have been eliminated. The preparation of financial statements in
conformity with generally accepted accounting principles requires management to
make estimates and assumptions that affect the amounts reported in the financial
statements and accompanying notes. Actual results could differ from those
estimates.
CASH AND CASH EQUIVALENTS - All highly liquid investments with an original
maturity of three months or less are considered to be cash equivalents.
SECURITIES HELD FOR TRADING AND AVAILABLE FOR SALE - Statement of Financial
Accounting Standards (SFAS) No. 115, ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT
AND EQUITY SECURITIES, addresses the accounting and reporting for investments in
equity securities that have readily determinable fair values and all investments
in debt securities. SFAS No. 115 requires these securities to be classified in
one of three categories and accounted for as follows:
- - Debt securities that the Company has the positive intent and ability to hold
to maturity are classified as "securities held to maturity" and reported at
amortized cost.
- - Debt and equity securities that are acquired and held principally for the
purpose of selling them in the near term with the objective of generating
economic profits on short-term differences in market characteristics are
classified as "securities held for trading" and reported at fair value, with
unrealized gains and losses included in earnings.
- - Debt and equity securities not classified as either held to maturity or
trading securities are classified as "securities available for sale" and
reported at fair value, with unrealized gains and losses, after applicable
taxes, excluded from earnings and reported in a separate component of
stockholders' equity. Declines in the value of debt securities and marketable
equity securities that are considered to be other than temporary are recorded as
a permanent impairment of securities available for sale in the statement of
income.
Premiums and discounts are amortized over the contractual lives of the related
securities using the level yield method. Gains or losses on sales of these
securities are based on the specific identification method. The Company records
the balance sheet effects of security transactions on a settlement date basis,
however, unrealized and realized gains and losses from security transactions are
recorded as of the trade date in the statement of income for the year in which
the securities are purchased or sold. Net unsettled mortgage-backed security
purchases were approximately $38,390,000 as of June 30, 1996, which consisted of
$93,526,000 of purchases and $55,136,000 of sales. Net unsettled mortgage-backed
security purchases as of June 30, 1995, were approximately $18,100,000 which
consisted of $49,762,000 of purchases and $31,662,000 of sales.
35
<PAGE>
In implementing SFAS No. 115 on June 30, 1993, the Company designated all of its
securities as available for sale. During fiscal year 1994, the Company
reclassified substantially all of its securities into the trading portfolio. At
the time of reclassification to the trading category from the available for sale
category, gross gains of $7,210,000 and gross losses of $6,958,000 were included
in earnings. The Company's trading portfolio consists of mortgage-backed
securities, mortgage-backed security derivatives, equity securities and interest
rate contracts, which accordingly are carried at fair value. Realized and
unrealized changes in fair values are recognized in other income in the period
in which the changes occur. Interest income from trading activities is included
in the statement of income as a component of net interest income.
The Company's available for sale portfolio consists of municipal bonds and a
non-agency participation certificate.
Management's estimates of fair value of securities are based upon a number of
assumptions such as prepayments which may shorten the life of such securities.
Although prepayments of underlying mortgages depend on many factors, including
the type of mortgages, the coupon rate, the age of mortgages, the geographical
location of the underlying real estate collateralizing the mortgages and general
levels of market interest rates, the difference between the interest rates on
the underlying mortgages and the prevailing mortgage interest rates generally is
the most significant determinant of the rate of prepayments. While management
endeavors to use the best information available in determining prepayment
assumptions, actual results could differ from those assumptions.
FINANCIAL INSTRUMENTS HELD FOR ASSET AND LIABILITY MANAGEMENT PURPOSES -
Effective June 30, 1995, the Bank adopted the provisions of SFAS No. 119,
DISCLOSURE ABOUT DERIVATIVE INSTRUMENTS AND FAIR VALUE OF FINANCIAL INSTRUMENTS.
The statement addresses disclosures of derivative financial instruments such as
futures, forward rate agreements, interest rate swap agreements, option
contracts and other financial instruments with similar characteristics. SFAS No.
119 requires disclosures about amounts and the nature and terms of derivative
financial instruments regardless of whether they result in off-balance-sheet
risk or risk of accounting loss. The Bank has incorporated the requirements of
this statement in Note 13.
The Bank is party to a variety of interest rate contracts consisting of interest
rate futures, options, caps, swaps, floors and collars in the management of its
interest rate exposure of the trading portfolio. These financial instruments are
included in the trading portfolio and are reported at fair value with realized
and unrealized gains and losses on these instruments recognized in other income
(see Note 2).
The Bank enters into certain other interest rate swap agreements as a means of
managing the interest rate exposure of certain inverse variable rate deposits.
The Bank also entered into an interest rate cap agreement to effectively fix the
interest rate on floating-rate Federal Home Loan Bank advances. These interest
rate agreements are accounted for under the accrual method. Under this method,
the differential to be paid or received on these interest rate agreements is
recognized over the lives of the agreements in interest expense. Changes in fair
value of interest rate swaps and of the interest rate cap accounted for under
the accrual method are not reflected in the accompanying financial statements.
Realized gains and losses on terminated interest rate swaps accounted for under
the accrual method are deferred as an adjustment to the carrying amount of the
designated instruments and amortized over the remaining original life of the
agreements. If the designated instruments are disposed of, the fair value of the
interest rate swap, interest rate cap or unamortized deferred gains or losses
are included in the determination of the gain or loss on the disposition of such
instruments. To qualify for such accounting, the interest rate swaps are
designated to the inverse variable rate deposits and the interest rate cap is
designated to the Federal Home Loan Bank advances which alter the designated
instruments' interest rate characteristics.
36
<PAGE>
LOANS RECEIVABLE are carried at the principal amount outstanding, adjusted for
premiums or discounts which are amortized or accreted using a level-yield
method. The Company adopted SFAS No. 114 and No. 118, ACCOUNTING BY CREDITORS
FOR IMPAIRMENT OF A LOAN AND INCOME RECOGNITION AND DISCLOSURES, as amended,
effective July 1, 1995. These statements require that impaired loans be measured
based on the present value of future cash flows discounted at the loan's
effective interest rate or the fair value of the underlying collateral, and
specifies alternative methods for recognizing interest income on loans that are
impaired or for which there are credit concerns. For purposes of applying these
standards, impaired loans have been defined as all nonaccrual commercial loans
which have not been collectively evaluated for impairment. The Company's policy
for income recognition was not affected by adoption of these standards. The
adoption of SFAS No. 114 and No. 118 did not have any effect on the total
reserve for credit losses or related provision. At July 1, 1995 and June 30,
1996, the Company had no impaired loans required to be disclosed under SFAS No.
114 and No. 118.
Discounts and premiums on purchased residential real estate loans are amortized
to income using the interest method over the remaining period to contractual
maturity, adjusted for anticipated prepayments.
Nonrefundable origination fees net of certain direct origination costs are
deferred and recognized, as a yield adjustment, over the life of the underlying
loan.
ALLOWANCE FOR LOAN LOSSES - A provision for estimated losses on loans is charged
to operations based upon management's evaluation of the potential losses. Such
an evaluation, which includes a review of all loans for which full
collectibility may not be reasonably assured, considers, among other matters,
the estimated net realizable value of the underlying collateral, as applicable,
economic conditions, historical loan loss experience and other factors that are
particularly susceptible to changes that could result in a material adjustment
in the near term. While management endeavors to use the best information
available in making its evaluations, future allowance adjustments may be
necessary if economic conditions change substantially from the assumptions used
in making the evaluations.
INTEREST RECEIVABLE - Interest income on securities and loans is accrued
according to the contractual terms of the underlying asset including interest
rate, basis and date of last payment. Income on derivatives of mortgage-backed
securities is recorded based on the median of major brokers' prepayment
assumptions for the underlying securities. The Bank provides an allowance for
the loss of uncollected interest on loans which are more than 90 days past due.
The allowance is established by a charge to interest income equal to all
interest previously accrued, and income is subsequently recognized only to the
extent that cash payments are received until, in management's judgment, the
borrower's ability to make periodic interest and principal payments returns to
normal, in which case the loan is returned to accrual status.
PREMISES AND EQUIPMENT are carried at cost less accumulated depreciation.
Depreciation is computed on the straight-line method over estimated useful lives
ranging from 3 to 40 years. Maintenance and repairs are expensed as incurred
while major additions and improvements are capitalized. Gains and losses on
dispositions are included in current operations.
FEDERAL INCOME TAXES - The Company and its wholly-owned subsidiary file a
consolidated tax return. The Company adopted SFAS No. 109 effective July 1,
1993. The statement requires, among other things, a change from the deferred
method to the liability method of accounting for deferred income taxes. Deferred
income tax assets and liabilities reflect the impact of temporary differences
between amounts of assets and liabilities for financial reporting purposes and
basis of such assets and liabilities as measured by tax laws and regulations.
37
<PAGE>
EARNINGS PER SHARE - Earnings per share of common stock is based on the weighted
average number of common shares outstanding during the year. The weighted
average number of common shares outstanding was 2,160,233, 1,544,080 and
1,412,384 for fiscal 1996, 1995 and 1994, respectively. All per share
information has been restated to reflect the Company's four-for-one stock split
in October 1994 and the Company's two-for-one stock split in October 1995. The
assumed exercise of stock options does not have a materially dilutive effect.
NEW ACCOUNTING PRONOUNCEMENTS - SFAS No. 121, ACCOUNTING FOR THE IMPAIRMENT OF
LONG-LIVED ASSETS AND FOR LONG-LIVED ASSETS TO BE DISPOSED OF, is effective for
fiscal years beginning after December 15, 1995. This statement establishes
accounting standards for the impairment of long-lived assets, certain
liabilities, certain intangibles and goodwill. Management does not believe the
adoption of this statement will have a material effect on the financial position
or results of operations of the Company.
SFAS No. 122, ACCOUNTING FOR MORTGAGE SERVICING RIGHTS AN AMENDMENT OF FASB
STATEMENT NO. 65, is effective for fiscal years beginning after December 15,
1995. This Statement specifies conditions under which mortgage servicing rights
should be accounted for separately from the underlying mortgage loans.
Management does not believe the adoption of this statement will have a material
effect on the financial position or results of operations of the Company.
SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION, was issued in October
1995 and requires adoption no later than fiscal years beginning after December
15, 1995. The new standard defines a fair value method of accounting for stock
options and similar equity instruments. Under the fair value method,
compensation cost is measured at the grant date based on the fair value of the
award and is recognized over the service period, which is usually the vesting
period.
Pursuant to the new standard, companies are encouraged, but not required, to
adopt the fair value method of accounting for employee stock-based transactions.
Companies are also permitted to continue to account for such transactions under
Accounting Principles Board Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES, but would be required to disclose in a note to the financial
statements pro forma net income and, if presented, earnings per share as if the
company had applied the new method of accounting.
The accounting requirements of the new method are effective for all employee
awards granted after the beginning of the fiscal year of adoption. The Company
has not yet determined if it will elect to change to the fair value method, nor
has it determined the effect the new standard will have on net income and
earnings per share should it elect to make such a change. Adoption of the new
standard will have no effect on the Company's cash flows.
SFAS No. 125, ACCOUNTING FOR TRANSFERS AND SERVICING OF FINANCIAL ASSETS AND
EXTINGUISHMENTS OF LIABILITIES, was issued in June 1996 and provides accounting
and reporting standards for transfers and servicing of financial assets and
extinguishments of liabilities. SFAS 125 applies to transactions occurring after
December 31, 1996. Management has not yet quantified the effect, if any, of this
new standard on the consolidated financial statements.
The Financial Accounting Standards Board issued EXPOSURE DRAFT, ACCOUNTING FOR
DERIVATIVE AND SIMILAR FINANCIAL INSTRUMENTS AND FOR HEDGING ACTIVITIES, in June
1996. Management has not yet quantified the effect, if any, of this Exposure
Draft on the consolidated financial statements.
RECLASSIFICATIONS of certain amounts in the 1995 and 1994 consolidated financial
statements have been made to conform to the 1996 presentation.
38
<PAGE>
2. SECURITIES
The amortized cost and estimated fair values of securities held for trading and
securities available for sale are summarized as follows:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
GROSS GROSS APPROXIMATE
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------------------------------------------------------
<S> <C> <C> <C> <C>
SECURITIES HELD FOR TRADING:
GNMA certificates $153,048 $1,515 $ 323 $154,240
FHLMC certificates 83,329 211 156 83,384
FNMA certificates 66,182 304 489 65,997
Non-Agency participation certificates 3,209 55 110 3,154
Collateralized mortgage obligations 6,131 248 6,379
Residuals 707 115 44 778
Interest-only strips 3,442 105 755 2,792
Principal-only strip 1,028 16 34 1,010
Interest rate swaps 620 620
Interest rate collar 83 91 (8)
Interest rate caps 3,692 214 832 3,074
Interest rate floors 2,535 1,049 614 2,970
Options 54 12 1 65
Futures 784 (784)
Equity securities 496 58 4 550
---------------------------------------------------------
TOTALS $323,936 $4,522 $4,237 $324,221
---------------------------------------------------------
---------------------------------------------------------
SECURITIES AVAILABLE FOR SALE:
Municipal bonds $ 921 $ 41 $ 962
Non-Agency participation certificate 1,141 $ 53 1,088
---------------------------------------------------------
TOTALS $ 2,062 $ 41 $ 53 $ 2,050
---------------------------------------------------------
---------------------------------------------------------
</TABLE>
The Bank's CMO portfolio at June 30, 1996 consisted of
two agency investments with an estimated remaining
weighted average life of 13.6 years.
39
<PAGE>
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
GROSS GROSS APPROXIMATE
AMORTIZED UNREALIZED UNREALIZED FAIR
COST GAINS LOSSES VALUE
---------------------------------------------------------
<S> <C> <C> <C> <C>
SECURITIES HELD FOR TRADING:
GNMA certificates $ 90,408 $ 1,400 $ 58 $ 91,750
FHLMC certificates 54,685 750 189 55,246
FNMA certificates 68,286 1,008 92 69,202
Non-Agency participation certificates 3,893 43 18 3,918
Collateralized mortgage obligations 12,910 116 4 13,022
Residuals 4,470 385 492 4,363
Interest-only strips 4,570 36 1,607 2,999
Principal-only strip 781 22 803
Interest rate swaps 1,320 1,539 (219)
Interest rate collar 155 226 (71)
Interest rate caps 2,297 317 619 1,995
Interest rate floors 1,544 1,914 49 3,409
Options 266 9 74 201
Futures 3 137 (134)
Equity securities 223 26 249
---------------------------------------------------------
TOTALS $244,488 $ 7,349 $ 5,104 $246,733
---------------------------------------------------------
---------------------------------------------------------
SECURITIES AVAILABLE FOR SALE:
Municipal bonds $ 1,018 $ 109 $ 1,127
Non-Agency participation certificate 1,426 $ 12 1,414
---------------------------------------------------------
TOTALS $ 2,444 $ 109 $ 12 $ 2,541
---------------------------------------------------------
---------------------------------------------------------
</TABLE>
The Bank's CMO portfolio at June 30, 1995 consisted of
four agency investments with an estimated remaining
weighted average life of 9.2 years.
For a complete discussion of the Bank's Risk
Management Activities, see Note 13.
40
<PAGE>
The amortized cost and estimated fair values of securities
by contractual maturity are as follows:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
Held for Trading Available for Sale
------------------------- --------------------------
Amortized Fair Amortized Fair
Cost Value Cost Value
------------------------------------------------------
<S> <C> <C> <C> <C>
Debt securities:
Due after 1 year through 5 years $ 921 $ 962
Mortgage-backed securities $302,559 $303,621
Non-agency participation certificates 3,209 3,154 1,141 1,088
Collateralized mortgage obligations 6,131 6,379
Mortgage-backed derivatives 5,177 4,580
Interest rate contracts 6,364 5,937
Equity securities 496 550
------------------------------------------------------
$323,936 $324,221 $2,062 $2,050
------------------------------------------------------
------------------------------------------------------
</TABLE>
Securities with a total amortized cost of $230,558,000 and $134,988,000 and a
total fair value of $229,680,000 and $138,026,000 were pledged at June 30, 1996
and 1995, respectively to secure interest rate swaps and securities sold under
agreements to repurchase. As of June 30, 1996, the Bank had a blanket collateral
agreement for the advances instead of utilizing specific securities as
collateral and as of June 30, 1995, securities with a total amortized cost of
$37,124,000 and a total fair value of $37,605,000 were pledged for advances.
Activities related to the sale of securities are summarized as follows:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
------------------------------------
<S> <C> <C> <C>
Proceeds from sales of securities held for trading $285,835 $419,340 $66,433
Proceeds from sales of securities available for sale 89,101
Gross gains on sales of securities held for trading 30,492 12,761 34
Gross losses on sales of securities held for trading 28,658 12,695 2,203
Gross gains on sales of securities available for sale 2,593
Gross losses on sales of securities available for sale 2,201
</TABLE>
Declines in the value of a non-agency participation certificate which is
included in the available for sale portfolio which are considered to be other
than temporary totaling $414,000 and $253,000 were recorded in the statements of
income for the years ended June 30, 1995 and 1994, respectively. In addition, an
other than temporary decline totaling $357,000 from certain mortgage derivatives
which were included in the available for sale portfolio was recorded in the
statement of income for the year ended June 30, 1994.
41
<PAGE>
3. LOANS RECEIVABLE
Approximately 94% of the Bank's loans are to customers in Wayne and Hamilton
counties in Indiana or surrounding counties. The portfolio consists primarily of
owner-occupied single-family residential mortgages.
Loans receivable are summarized as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
----------------------
Loans secured by one to
four family residences:
Real estate mortgage $64,537 $34,740
Participation loans purchased 305 1,198
Commercial 441 711
Property improvement 315 166
Loans on savings accounts 267 255
Consumer 417 332
Real estate sold on contract 57 60
----------------------
Subtotal 66,339 37,462
Unamortized push-down
accounting adjustment (182) (350)
Undisbursed loan proceeds (420) (43)
Net deferred loan fees,
premiums and discounts 308 62
Allowance for loan losses (120) (121)
----------------------
LOANS RECEIVABLE, NET $65,925 $37,010
----------------------
----------------------
The principal balance of loans on nonaccrual status totaled approximately
$261,000 and $350,000 at June 30, 1996 and 1995, respectively. For the years
ended June 30, 1996, 1995 and 1994, gross interest income which would have been
recorded had the Bank's non-accruing loans been current with their original
terms amounted to $6,000, $13,000 and $26,000, respectively.
The Bank had commitments to originate or purchase loans consisting primarily of
real estate mortgages secured by one to four family residences approximating
$1,041,000 and $5,071,000 excluding undisbursed portions of loans in-process at
June 30, 1996 and 1995, respectively.
The Bank has transactions in the ordinary course of business with directors,
officers and employees. Loans to such individuals totaled $293,000 and $45,000
at June 30, 1996 and 1995, respectively.
The amount of loans serviced for others totaled $5,587,000, $6,820,000 and
$7,540,000 at June 30, 1996, 1995 and 1994, respectively. Servicing loans for
others generally consists of collecting mortgage payments, maintaining escrow
amounts, disbursing payments to investors and foreclosure processing. In
connection with loans serviced for others, the Bank held borrower's escrow
balances of $44,000 and $59,000 at June 30, 1996 and 1995, respectively.
Loan servicing fee income included in other income for the years ended June 30,
1996, 1995 and 1994 was $23,000, $27,000 and $32,000, respectively.
An analysis of the allowance for loan losses is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED
JUNE 30, 1996 1995 1994
----------------------------------
Beginning balance $121 $106 $156
Provision for
loan losses (1) 15 (3)
Recoveries 1
Charge-offs (48)
----------------------------------
ENDING BALANCE $120 $121 $106
----------------------------------
----------------------------------
As a federally-chartered savings bank, aggregate commercial real estate loans
may not exceed 400% of capital as determined under the capital standards
provisions of FIRREA. This limitation was approximately $104 million and $74
million at June 30, 1996 and 1995, respectively. Also under FIRREA, the loans-
to-one borrower limitation is generally 15% of unimpaired capital and surplus
which, for the Bank, was approximately $4 million and $3 million at June 30,
1996 and 1995, respectively. Management believes the Bank was in compliance with
all of these requirements at June 30, 1996 and 1995.
42
<PAGE>
4. INTEREST RECEIVABLE
Interest receivable is summarized as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
---------------------
Loans (less allowance for
uncollectibles - $6 and $13) $328 $180
Interest-bearing deposits 26 23
Securities held for trading 1,403 1,090
Securities available for sale 50 60
---------------------
INTEREST RECEIVABLE, NET $1,807 $1,353
---------------------
---------------------
5. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
----------------------
Land $ 395 $ 395
Buildings and leasehold
improvements 2,631 1,985
Parking lot improvements 148 148
Furniture, fixtures and equipment 844 578
----------------------
Total 4,018 3,106
Less accumulated depreciation (913) (714)
----------------------
PREMISES AND EQUIPMENT, NET $3,105 $2,392
----------------------
----------------------
Depreciation expense included in operations during the years ended June 30,
1996, 1995 and 1994 totaled $210,000, $176,000 and $141,000, respectively.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30,
1996 1995
-------------------------------------------------------
Weighted Weighted
Average Average
Amount Rate Amount Rate
-------------------------------------------------------
<S> <C> <C> <C> <C>
NOW and Super NOW accounts $ 4,529 3.04% $ 3,266 2.77%
Savings accounts 17,342 3.96 15,183 3.71
Money market deposit accounts 1,576 4.05 1,976 4.36
-------------------------------------------------------
23,447 20,425
-------------------------------------------------------
Certificates of deposit:
1 year and less 75,343 57,304
1 to 2 years 19,890 17,890
2 to 3 years 8,093 6,844
3 to 4 years 2,636 5,352
Over 4 years 5,734 7,497
-------------------------------------------------------
111,696 5.98 94,887 6.17
-------------------------------------------------------
TOTAL DEPOSITS $135,143 $115,312
-------------------------------------------------------
-------------------------------------------------------
</TABLE>
Certificates of deposit in the amount of $100,000 or more totaled approximately
$20 million and $18 million at June 30, 1996 and 1995, respectively. A summary
of certificate accounts by scheduled fiscal year maturities at June 30, 1996, is
as follows:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
1997 1998 1999 2000 2001 THEREAFTER TOTAL
-------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
3.00% or less $ 2 $ 1 $ 13 $ 16
3.01% - 5.00% 4,683 $ 1,050 470 $ 71 6,274
5.01% - 7.00% 65,284 17,535 4,836 1,571 $ 441 2,102 91,769
7.01% - 9.00% 5,374 1,210 2,491 988 113 2,391 12,567
9.01% or greater 95 295 6 674 1,070
-------------------------------------------------------------------------------------------------
TOTALS $75,343 $19,890 $8,093 $2,636 $1,228 $4,506 $111,696
-------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------
</TABLE>
43
<PAGE>
Interest expense on deposits is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
NOW and Super NOW accounts $ 110 $ 94 $ 83
Savings accounts 613 568 598
Money market deposit accounts 77 88 184
Certificates of deposit 6,351 5,904 3,651
----------------------------------------
Total $ 7,151 $ 6,654 $ 4,516
----------------------------------------
----------------------------------------
Interest expense on certificates of deposit is net of interest income on
interest rate contracts of $129,000, $158,000 and $596,000 in 1996, 1995 and
1994, respectively.
For a complete discussion of the Bank's Risk Management Activities, see Note 13.
7. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
---------------------------
Securities sold under
agreements to repurchase:
Same securities $ 98,724 $ 29,696
Substantially identical securities 120,343 100,521
---------------------------
Total $ 219,067 $ 130,217
---------------------------
---------------------------
At June 30, 1996, securities sold under agreements to repurchase mature within
one month.
An analysis of securities sold under agreements to repurchase is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED
JUNE 30, 1996 1995 1994
----------------------------------------
Maximum amount
outstanding at
any month-end $219,067 $130,217 $78,545
Daily average amount
outstanding 148,524 68,277 66,813
Weighted average
interest rate at end
of year 5.21% 6.01% 4.05%
----------------------------------------
----------------------------------------
Assets pledged to secure securities sold under agreements to repurchase are
concentrated among six dealers and the Bank exercises control over the
securities pledged when the same security is repurchased. Assets pledged are as
follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
-------------------------
Mortgage-backed securities:
At amortized cost $226,091 $127,991
At fair value $225,161 $130,964
8. FEDERAL HOME LOAN BANK ADVANCES
Advances from the Federal Home Loan Bank of Indianapolis are as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
-------------------------------------------------------
Variable Variable
Weighted Weighted
Average Average
Fiscal Year Maturity Amount Rate Amount Rate
1996 $15,000 6.02%
1998 $26,000 5.41% 16,000 6.12%
-------------------------------------------------------
Total $26,000 $31,000
-------------------------------------------------------
-------------------------------------------------------
As of June 30, 1996, the Bank had a blanket collateral agreement for the
advances instead of utilizing specific securities as collateral. Mortgage-backed
securities with a total amortized cost of $37,124,000 and a total fair value of
$37,605,000 were pledged as collateral for the advances outstanding as of
June 30, 1995.
44
<PAGE>
9. NOTE PAYABLE
At June 30, 1996 HFG has a $10,000,000 loan facility from Mark Twain Kansas Bank
consisting of a non-revolving line of credit of $800,000 and a $9,200,000 term
loan of which $1,002,000 had been repaid under the term loan at June 30, 1996.
Interest is payable quarterly at 1/2% over the prime rate published in the Wall
Street Journal (8.25% at June 30, 1996). Quarterly principal and interest
payments of $470,000 are payable during the term July 1, 1995 through March 31,
2000.
As of June 30, 1996, the loan was secured by the Harrington Bank, FSB stock held
by HFG, a personal guarantee from a stockholder of HFG, a blanket security
interest in all of HFG's assets, a corporate guarantee of Smith Breeden
Associates, Inc., a related party, and the assignment of certain life insurance
policies owned by HFG. Under the terms of the agreement, HFG is bound by certain
restrictive debt covenants. As of June 30, 1996, HFG was in compliance with all
such debt covenants. Following is a schedule of principal payments as of June
30, 1996:
(DOLLARS IN THOUSANDS)
YEARS ENDING JUNE 30,
1997 $1,129
1998 1,231
1999 1,343
2000 5,295
--------
$8,998
--------
--------
During July 1996, the Company amended its loan facility agreement with Mark
Twain Kansas Bank and increased its non-revolving line of credit to $3,000,000
with a total loan facility of approximately $12,263,000. Under the terms of the
amended loan agreement, the Company will make quarterly principal and interest
payments of $500,000 commencing October 1, 1996 which increases to $585,000 on
October 1, 1997 through June 30, 2000. The amended loan agreement also removed
the corporate guarantee of Smith Breeden Associates, Inc. and the personal
guarantee from a stockholder of HFG.
10. INCOME TAXES
An analysis of the income tax provision is as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
----------------------------------
Current:
Federal $1,203 $ 372 $245
State 358 126 60
Deferred:
Federal (776) 572 47
State (137) 101 39
----------------------------------
TOTAL INCOME TAX PROVISION $ 648 $1,171 $391
----------------------------------
----------------------------------
The difference between the financial statement provision and amount computed by
using the statutory rate of 34% is reconciled as follows:
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
--------------------------------
Federal statutory income
tax at 34% $636 $1,028 $475
Tax exempt interest and dividends (29) (32) (32)
State income taxes,
net of federal tax benefit 129 83 65
Amortization of fair value adjustments (53) (19) (54)
Other, net (35) 111 (63)
--------------------------------
Total income tax provision $648 $1,171 $391
--------------------------------
--------------------------------
The Company adopted SFAS No. 109 effective July 1, 1993. The cumulative effect
of adopting SFAS No. 109 on the Company's consolidated financial statements was
to decrease income by $79,000 for the year ended June 30, 1994.
45
<PAGE>
The Company's deferred income tax assets and liabilities are as follows:
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
------------------
Deferred tax assets:
Permanent impairment on securities
available for sale $205
Deferred compensation $ 48 61
Deferred loan fees/costs, net 6
Differences in depreciation methods 16
Unrealized loss on securities
available for sale 4
Other 31 14
------------------
105 280
------------------
Deferred tax liabilities:
Differences in depreciation methods 2
Bad debt reserves, net 79 150
Unrealized gain on securities
held for trading 114 898
Differences in income recognition
on investments 575 740
Unrealized gain on securities
available for sale 36
Deferred loan fees/costs, net 30
------------------
768 1,856
------------------
Deferred income taxes, net $663 $1,576
------------------
------------------
Retained earnings at June 30, 1996 and 1995 includes approximately $3 million of
income that has not been subject to tax because of deductions for bad debts
allowed for Federal income tax purposes. Deferred income taxes have not been
provided on such bad debt deductions since the Company does not intend to use
the accumulated bad debt deductions for purposes other than to absorb loan
losses. If, in the future, this portion of retained earnings is used for any
purpose other than to absorb bad debt losses, federal income taxes may be
imposed on such amounts at the then current corporation income tax rate.
In August 1996, the "Small Business Job Protection Act of 1996" was passed into
law. One provision of the act repeals the special bad debt reserve method for
thrift institutions currently provided for in Section 593 of the IRC. The
provision requires thrifts to recapture any reserve accumulated after 1987 but
forgives taxes owed on reserves accumulated prior to 1988. Thrift institutions
will be given six years to account for the recaptured excess reserves, beginning
with the first taxable year after 1995, and will be permitted to delay the
timing of this recapture for one or two years, subject to whether they meet
certain residential loan test requirements. Management does not believe that
this legislation will have a material adverse effect on the Company's
consolidated financial position.
46
<PAGE>
11. REGULATORY CAPITAL REQUIREMENTS
Effective December 7, 1989, the Office of Thrift Supervision ("OTS") set forth
capital standards applicable to all thrifts. These standards include a core
capital requirement, a tangible capital requirement and a risk-based capital
requirement, as defined. The tables below present the Bank's position relative
to the three capital requirements. The Bank exceeds all of the requirements at
June 30, 1996 and 1995.
The Bank's capital ratios are as follows:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
--------------------------------------------------------------------------
Actual Actual
Required Capital Capital
Capital Actual as a % of Required Actual as a % of Required
Ratio Capital Assets (1) Capital Capital Assets (1) Capital
--------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Total Bank capital $26,038 $18,375
Unrealized (gains) losses on certain
securities available for sale 8 (61)
------- -------
Total Bank tangible capital 1.50% 26,046 6.27% $ 6,228 18,314 6.12% $4,489
------- -------
Total Bank core capital
(Tier 1 capital) 3.00% 26,046 6.27% $12,456 18,314 6.12% $8,978
General allowance for loan losses 115 115
------- -------
Total Bank risk-based capital 8.00% $ 26,161 30.10% $ 6,953 $18,429 24.62% $5,989
------- -------
</TABLE>
(1) Tangible capital and core capital are computed as a percentage of Bank
adjusted total assets of $415,212,000 and $299,253,000 as of June 30, 1996
and 1995, respectively. Risk-based capital is computed as a percentage of
bank adjusted risk-weighted assets of $86,909,000 and $74,865,000 as of
June 30, 1996 and 1995, respectively.
47
<PAGE>
The various federal banking agencies recently adopted the final Prompt
Corrective Action regulations that are required by the Federal Deposit Insurance
Corporation Improvement Act of 1991 ("FDICIA"). Such regulations require
specific supervisory actions as capital levels decrease.
The specifications of the capital categories are shown below. The most recent
notification from the OTS categorized the Bank as well capitalized under the
regulatory frame work for prompt corrective action. As of the report date, there
are no conditions or events since that notification that management believes
have changed the institution category.
<TABLE>
<CAPTION>
Total Tier 1 Tier 1
Risk-based Risk-based Leverage
(DOLLARS IN THOUSANDS) Ratio Ratio (1) Ratio
------------------------------------------
<S> <C> <C> <C>
Capital Category:
Well-capitalized (greater than or equal to) 10% 6% 5%
Adequately capitalized (greater than or equal to) 8% 4% 4%
Under-capitalized (less than) 8% 4% 4%
Significantly under-capitalized (less than) 6% 3% 3%
Critically under-capitalized N/A N/A N/A
Bank actual capital at June 30, 1996 $26,161 $26,046 $26,046
Bank actual capital at June 30, 1995 $18,429 $18,314 $18,314
As a percentage of adjusted assets:
June 30, 1996 30.10% 29.97% 6.27%
June 30, 1995 24.62% 24.46% 6.12%
</TABLE>
(1) The Tier 1 Risked-based ratio is defined as total core capital
(Tier 1 capital) divided by adjusted risk-weighted assets.
12. EMPLOYEE BENEFIT PLANS
PROFIT-SHARING PLAN - The Bank has a qualified noncontributory profit-sharing
plan for all eligible employees. The plan provides for contributions by the Bank
in such amounts as its Board of Directors may annually determine. Contributions
charged to expense for the years ended June 30, 1996, 1995 and 1994 were
$39,000, $79,000 and $69,000, respectively.
DEFERRED COMPENSATION PLAN - On September 30, 1988, three senior officers of the
Bank entered into consulting agreements with the Bank to take effect at their
retirement. The agreements obligate the Bank to make monthly payments to these
individuals for the remainder of their lives. At September 30, 1988, the Bank
recorded a liability for this deferred compensation calculated as the present
value of the estimated future cash payments. The amount of benefit expense for
fiscal years 1996, 1995 and 1994 was $29,000, $26,000 and $23,000, respectively.
48
<PAGE>
STOCK OPTIONS - The Company has granted stock options to existing stockholders,
officers, directors and other affiliated individuals to purchase shares of the
Company's stock. At June 30, 1996, all outstanding stock options were
exercisable between December 1997 and January 1998. The options are
nontransferable and are forfeited upon termination of employment, as applicable.
The following is an analysis of stock option activity for each of the three
years in the period ended June 30, 1996, and the stock options outstanding at
the end of the respective years:
Weighted
Average
Options Shares Price
- --------------------------------------------------------
Outstanding July 1, 1993 161,200 $7.50
Forfeited or expired (6,000) 7.50
--------------------------
Outstanding June 30, 1994 155,200 7.50
Granted 41,000 5.04
Exercised (21,600) 4.66
Forfeited or expired (11,400) 6.66
--------------------------
Outstanding June 30, 1995 163,200 7.32
Granted 14,112 5.32
Exercised (30,112) 5.48
Forfeited or expired (4,000) 7.50
--------------------------
Outstanding June 30, 1996 143,200 $7.50
---------------------------
---------------------------
The Company also adopted a new Stock Option Plan during fiscal 1996 which
authorized 126,500 shares of common stock to be granted. At June 30, 1996, no
shares were granted under the Stock Option Plan.
EMPLOYEE STOCK OWNERSHIP PLAN - The Company established an Employee Stock
Ownership Plan (ESOP) on February 5, 1996 for employees of the Company and the
Bank. Full-time employees of the Company and the Bank who have been credited
with at least 1,000 hours of service during a twelve month period and who have
attained age 21 are eligible to participate in the ESOP. The ESOP purchased
7,000 shares in the initial public offering at $10.00 per share which were
allocated to eligible employees based on their eligible compensation as defined
in the ESOP Agreement. Gross compensation expense (i.e. the value of shares
contributed to the ESOP by the Company) was $70,000 for the year ended June 30,
1996.
13. RISK MANAGEMENT ACTIVITIES
The Bank closely monitors the sensitivity of its balance sheet and income
statement to potential changes in the interest rate environment. Derivative
financial instruments such as interest rate swaps, caps, floors, collars,
futures and options are used on an aggregate basis to protect the trading
portfolio and certain liabilities from adverse rate movements. The Bank's
objective, with regard to managing interest rate risk, is to maintain at an
acceptably low level the sensitivity to rising or falling rates of its market
value of portfolio equity.
Interest rate swaps are contracts in which the parties agree to exchange fixed
and floating rate payments for a specified period of time on a specified
(notional) amount. The notional amount is only used to calculate the amount of
the periodic interest payments to be exchanged, and does not represent the
amount at risk. The Bank uses swaps to modify the effective duration of various
assets and liabilities. The floating rates are generally indexed to the three-
month London Interbank Offered Rates (LIBOR).
Interest rate caps and floors are instruments in which the writer (seller)
agrees to pay the holder (purchaser) the amount that an agreed-upon index is
above or below the specified cap or floor rate, respectively, times the notional
amount. In return for this promise of future payments, the purchaser pays a
premium to the seller. The notional amount is never exchanged between the two
parties and does not represent the amount at risk. The Bank purchases interest
rate caps and floors to reduce the impact of rising or falling interest rates on
the fair value of its trading portfolio. The interest rate caps and floors
generally have indexes equal to one or
49
<PAGE>
three month LIBOR, except for one interest rate cap which is tied to the five
year Constant Maturity Treasury.
The Bank is a party to an interest rate collar which also is used to manage
interest rate risk in the trading portfolio. The interest rate collar consists
of an interest rate cap held by the Bank and an interest rate floor written by
the Bank. The notional amount of the interest rate collar is based on the
balance in the collection accounts of certain Merrill Lynch collateralized
mortgage obligation trusts.
Interest rate futures contracts are commitments to either purchase or sell
designated instruments at a future date for a specified price. Initial margin
requirements are met in cash or other instruments, and changes in the contract
values are settled in cash daily. The Bank enters into futures contracts when
these instruments are economically advantageous to interest rate swaps, caps and
floors. The Bank uses primarily Eurodollar contracts which are structured in
calendar quarter increments and therefore result in a much larger notional
amount than longer maturity swap, cap or floor contracts which represent a
series of quarterly repricing.
Financial options are contracts which grant the purchaser, for a premium
payment, the right to either purchase from or sell to the writer a specified
financial instrument under agreed-upon terms. Financial options to buy or sell
securities are typically traded in standardized contracts on organized
exchanges. The Bank purchases financial options to reduce the risk of the
written financial options embedded in mortgage related assets.
CASH RESTRICTIONS - The Bank maintained $1,548,000 and $399,000 at June 30, 1996
and 1995, respectively, in U.S. Treasury Securities, which are considered cash
equivalents, as a deposit with a broker for its futures activities.
CREDIT RISK - The Bank is dedicated to managing credit risks associated with
trading activities. The Bank maintains trading positions with a variety of
counterparts or obligors (counterparts). To limit credit exposure arising from
such transactions, the Bank evaluates the credit standing of counterparts,
establishes limits for the total exposure to any one counterparty, monitors
exposure against the established limits and monitors trading portfolio
composition to manage concentrations. In addition, the Bank maintains qualifying
netting agreements with its counterparts and records gains and losses on
derivative financial instruments net in the trading portfolio.
The Bank's exposure to credit risk from derivative financial instruments is
represented by the fair value of instruments. Credit risk amounts represent the
replacement cost the Bank could incur should counterparts with contracts in a
gain position completely fail to perform under the terms of those contracts and
any collateral underlying the contracts proves to be of no value to the Bank.
Counterparts are subject to the credit approval and credit monitoring policies
and procedures of the Bank. Certain instruments require the Bank or the
counterparty to maintain collateral for all or part of the exposure. Limits for
exposure to any particular counterparty are established and monitored. Notional
or contract amounts indicate the total volume of transactions and significantly
exceed the amount of the Bank's credit or market risk associated with these
instruments.
50
<PAGE>
The following off balance sheet positions are included in the Bank's trading
portfolio and are thus reported in the financial statements at current fair
value.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
Estimated
Contract or Fair Value Weighted Average Interest Rate
Notional ---------------------------------------------------------------------------------
Amount Asset Liability Payable Receivable Cap Floor
-------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay fixed rate $ 63,500 $ 620 5.56% 5.52% NA NA
Interest rate caps 158,000 3,074 NA NA 7.46% NA
Interest rate floors 165,000 2,970 NA NA NA 6.41%
Interest rate collar 6,484 $ 8 NA NA 10.25% 5.25%
Futures 1,361,900 784 NA NA NA NA
Options 13,000 65 NA NA NA NA
------------------------------------------------------------------------------------------------
$1,767,884 $6,729 $792
------------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------------
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1995
Estimated
Contract or Fair Value Weighted Average Interest Rate
Notional ---------------------------------------------------------------------------------
Amount Asset Liability Payable Receivable Cap Floor
-------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay fixed rate $124,500 $ 827 $1,539 5.87% 6.10% NA NA
Pay floating rate 10,000 493 6.06% 7.23% NA NA
Interest rate caps 123,000 1,995 NA NA 7.00% NA
Interest rate floors 95,000 3,409 NA NA NA 6.55%
Interest rate collar 117,972 71 NA NA 10.25% 5.25%
Futures 455,800 3 137 NA NA NA NA
Options 51,500 200 NA NA NA NA
-------------------------------------------------------------------------------------------------
$977,772 $6,927 $1,747
-------------------------------------------------------------------------------------------------
-------------------------------------------------------------------------------------------------
<CAPTION>
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1996 1995
----------------------------------------------------------
Monthly Monthly
Average Average
Fair Value Fair Value
------------------------------------------------------------
Asset Liability Asset Liability
------------------------------------------------------------
<S> <C> <C> <C> <C>
Interest rate swaps:
Pay fixed rate $ 534 $1,469 $3,280 $180
Pay floating rate 59
Interest rate caps 3,228 3,779
Interest rate floors 4,370 2,467
Interest rate collar 48 49
Futures 134 8
Options 136 73
------------------------------------------------------------
$8,268 $1,651 $9,648 $247
------------------------------------------------------------
------------------------------------------------------------
</TABLE>
51
<PAGE>
The following table shows the various components of the Company's recorded net
gain (loss) on its trading portfolio. All realized and unrealized gains and
losses are reported as other income in the statement of income. The periodic
exchanges of interest payments and the amortization of premiums paid for
contracts are accounted for as adjustments to the yields, and are reported on
the statement of income as interest income.
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1996
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
(Losses) (Losses) (Losses)
-----------------------------------------
Interest rate contracts:
Swaps $(1,116) $839 $(277)
Caps (316) (316)
Floors (1,430) (1,430)
Collar 135 135
Futures 2,522 (650) 1,872
Options 256 76 332
------------------------------------------
Total 1,662 (1,346) 316
MBS and other trading assets 172 (614) (442)
-----------------------------------------
Total trading portfolio $1,834 $(1,960) $(126)
-----------------------------------------
-----------------------------------------
(DOLLARS IN THOUSANDS)
YEAR ENDED JUNE 30, 1995
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
(Losses) (Losses) (Losses)
------------------------------------------
Interest rate contracts:
Swaps $ (651) $ (3,577) $ (4,228)
Caps (110) (1,783) (1,893)
Floors 42 2,737 2,779
Collar (14) (14)
Futures (1,854) (134) (1,988)
Options 135 (65) 70
-----------------------------------------
Total (2,438) (2,836) (5,274)
MBS and other trading assets 2,504 4,371 6,875
-----------------------------------------
Total trading portfolio $ 66 $ 1,535 $ 1,601
-----------------------------------------
-----------------------------------------
52
<PAGE>
The following table sets forth the maturity distribution and weighted average
interest rates of financial instruments used on an aggregate basis to protect
the trading portfolio from adverse rate movements at June 30, 1996.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
MATURITIES DURING FISCAL
YEARS ENDING JUNE 30, 1997 1998 1999 2000 2001 Thereafter
------- ------- ------ ------- ------- ----------
<S> <C> <C> <C> <C> <C> <C>
Interest rate swaps-Pay fixed rate
Notional amount $16,000 $26,500 $16,000 $5,000
Weighted average payable rate 5.15% 5.20% 6.27% 6.58%
Weighted average receivable rate 5.50% 5.51% 5.54% 5.54%
Interest rate caps
Notional amount 25,000 37,000 10,000 $86,000
Weighted average cap rate 5.00% 8.09% 6.50% 8.01%
Interest rate floors
Notional amount 35,000 $60,000 40,000 30,000
Weighted average floor rate 7.50% 6.42% 6.50% 5.00%
Interest rate collar
Notional amount 6,484
Weighted average cap rate 10.25%
Weighted average floor rate 5.25%
Futures
Notional amount 196,900 226,000 217,000 162,000 238,000 322,000
Options
Notional amount 13,000
</TABLE>
The following interest rate hedges are not included in the Bank's trading
portfolio. Interest rate swaps are used to modify the interest rate sensitivity
of certain certificates of deposit issued by the Bank. These certificates of
deposit, called inverse variable rate CDs, adjust according to a formula in such
a way as to pay a higher rate of interest when the index falls, and a lower rate
of interest when the index rises. As of June 30, 1996 and 1995, the Bank held
approximately $8.4 million and $10 million of inverse variable rate CDs, with
original terms to maturity ranging from three to ten years. The Bank utilizes
interest rate swaps with the same notional amount as the inverse variable rate
CDs to convert such certificates of deposit effectively to fixed rate deposits.
A similar notional amount of interest rate swaps are then utilized to convert
such certificates from fixed rate to variable rate deposits. Consequently, the
notional amount of interest rate swaps is approximately twice that of the
inverse variable rate CDs. The swaps protect the Bank against the exposure to
falling interest rates inherent in these CDs.
The Bank also has a 7% interest rate cap which is used to effectively cap the
interest rate on the Company's floating-rate Federal Home Loan Bank advances. As
of June 30, 1996, the Bank held two advances totaling $26 million that reprice
based on the three month LIBOR quarterly. The interest rate cap has a notional
amount of $30 million and reprices based on the three month LIBOR quarterly
within a few days of the advances. The cap matures May 2001 and the advances
mature October and November 1997, however, it is the Bank's intent to replace
the advances when they mature with additional floating rate liabilities, which
will be designated against the cap.
53
<PAGE>
The fair values of the following swaps and cap are not reflected in the
Company's financial statements. The periodic exchanges of interest payments and
the net expense of the cap are included in interest expense in the statements of
income.
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1996
CONTRACT OR ESTIMATED FAIR VALUE WEIGHTED AVERAGE INTEREST RATE
NOTIONAL --------------------------------------------------------------------
AMOUNT ASSET LIABILITY PAYABLE RECEIVABLE
-------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay floating rate $17,500 $110 5.57% 6.48%
Interest rate cap $30,000 $747 N/A N/A
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1995
CONTRACT OR ESTIMATED FAIR VALUE WEIGHTED AVERAGE INTEREST RATE
NOTIONAL -------------------------------------------------------------------
AMOUNT ASSET LIABILITY PAYABLE RECEIVABLE
-------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay floating rate $22,500 $403 6.46% 6.59%
</TABLE>
The following table sets forth the maturity distribution and weighted average
interest rates of the interest rate swaps used to protect the inverse variable
rate CDs from adverse rate movements and the interest rate cap used to cap the
Federal Home Loan Bank advances at 7% as of June 30, 1996:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
MATURITIES DURING FISCAL
YEARS ENDING JUNE 30, 1997 1998 1999 2000 2001 THEREAFTER
-------- ------ ------ ------- -------- ------------
<S> <C> <C> <C> <C> <C> <C>
Interest rate swaps-Pay floating rate
Notional amount $10,000 $7,500
Weighted average payable rate 5.53% 5.63%
Weighted average receivable rate 6.12% 6.96%
Interest rate cap
Notional amount $30,000
Weighted average cap rate 7.0%
</TABLE>
14. CREDIT COMMITMENTS
The Bank is a party to commitments to extend credit as part of its normal
business operations to meet the financing needs of its customers. These
commitments involve, to varying degrees, elements of credit and interest rate
risk in excess of the amount recognized in the balance sheet. Exposure to credit
loss in the event of nonperformance by the other party to the financial
instrument for commitments to extend credit is represented by the contract
amount of those instruments. The Bank uses the same credit policies in making
commitments as it does for on-balance-sheet instruments. Unless noted otherwise,
the Bank does not require collateral or other security to support financial
instruments with credit risk.
Real estate loan commitments whose contract amounts represent credit risk were
approximately $1,041,000 and $5,071,000 at June 30, 1996 and 1995, respectively.
54
<PAGE>
15. RELATED PARTY TRANSACTIONS
The Company has contracted with Smith Breeden Associates Inc. ("SBA") to provide
investment advisory services and interest rate risk analysis. Certain
stockholders of HFG are also principals of SBA. The amount of consulting expense
relating to SBA for fiscal years ending June 30, 1996, 1995 and 1994 was
$232,000, $194,000 and $183,000, respectively.
16. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS
EQUITY OFFERING - Under the terms of an offering memorandum the Company offered
up to 555,556 shares of stock to certain stockholders, directors and officers of
the Company and the Bank during fiscal 1995. The shares of common stock were
offered at $4.50 per share beginning on November 1, 1994; however, the purchase
price increased each day thereafter at a rate of prime plus 2% until the closing
of the equity offering on January 31, 1995.
LIQUIDATION ACCOUNT - On July 10, 1985, the Bank converted from a federally
chartered mutual association to a federally chartered stock association through
the issuance of 463,173 shares of common stock ($1 par value) at a price of $8
per share. From the proceeds, $463,000 was allocated to capital stock at the par
value of $1 per share and $2,919,000, which is net of conversion costs of
$324,000, was allocated to additional paid-in-capital.
The Bank established a special liquidation account (in memorandum form) in an
amount equal to its total retained earnings as of June 1, 1984 for the purpose
of granting to eligible savings account holders a priority in the event of
future liquidation. In the event of future liquidation of the converted
institution (and only in such event), an eligible account holder who continues
to maintain his savings account shall be entitled to receive a distribution from
the liquidation account. The total amount of the liquidation account will be
decreased in an amount proportionately corresponding to decreases in the savings
accounts of eligible account holders on each subsequent annual determination
date.
DIVIDEND RESTRICTIONS - Regulations provide that the Bank may not declare or pay
a cash dividend on or repurchase any of its stock if the result thereof would be
to reduce the consolidated stockholders' equity of the Bank below the amount
required for the liquidation account (as defined by regulations). Under the
capital distribution regulations of the OTS, the Bank, as a "Tier 1"
institution, is permitted to make capital distributions during a calendar year
up to one hundred percent of its net income to date during the calendar year
plus the amount that would reduce by one-half its surplus capital ratio, as
defined, at the beginning of the calendar year. Under this limitation,
$5,739,000 was available for dividends at June 30, 1996.
Recapitalization of SAIF and Related Legislative Proposals - The deposits of the
Company are currently insured by the Savings Association Insurance Fund ("SAIF")
of the FDIC. Both the SAIF and the Bank Insurance Fund ("BIF"), the federal
deposit insurance fund that covers commercial bank deposits, are required by law
to attain and thereafter maintain a reserve ratio of 1.25% of insured deposits.
The BIF has achieved a fully funded status in contrast to the SAIF and,
therefore, as discussed below, the FDIC has substantially reduced the average
deposit insurance premium paid by commercial banks to a level approximately 75%
below the average premium paid by savings institutions.
On November 14, 1995, the FDIC approved a final rule regarding deposit insurance
premiums. The final rule will reduce deposit insurance premiums for BIF member
institutions to zero basis points (subject to a $2,000 minimum) for institutions
in the lowest risk category, while holding deposit insurance premiums for SAIF
members at their current levels (23 basis points for institutions in the lowest
risk category). The reduction was effective with respect to the semiannual
premium assessment beginning January 1, 1996. Accordingly, in the absence of
further legislative action, SAIF members such as the Bank will be competitively
disadvantaged as
55
<PAGE>
compared to commercial banks by the resulting premium differential.
The U.S. House of Representatives and Senate have actively considered
legislation which would eliminate the premium differential between SAIF-member
institutions provided that all SAIF-member institutions pay a special one-time
assessment to recapitalize the SAIF, which in the aggregate would have been
sufficient to bring the reserve ratio in the SAIF to 1.25% of insured deposits.
Based on the current level of reserves maintained by the SAIF it was anticipated
that the amount of the special assessment required to recapitalize the SAIF
would have been approximately 80 to 85 basis points of the SAIF-assessable
deposits. It was anticipated that after the recapitalization of the SAIF,
premiums paid by SAIF-insured institutions would be reduced to match those
currently being assessed BIF-insured commercial banks. The legislation also
provided for the merger of the BIF and the SAIF, with such merger being
conditioned upon the prior elimination of the thrift charter.
The legislation discussed above had been, for some time, included as part of a
fiscal 1996 federal budget bill, but was eliminated prior to the bill being
enacted on April 26, 1996. If legislation were to be enacted in the future which
would assess a one-time special assessment of 85 basis points, the Bank would
(based upon the Bank's SAIF deposits as of March 31, 1995) pay approximately
$700,000, net of related tax benefits. In addition, the enactment of such
legislation may have the effect of immediately reducing the capital of SAIF-
member institutions by the amount of the special assessment. Nevertheless,
management does not believe that this one-time charge to the Bank, if incurred,
will have a material adverse effect on the Company's consolidated financial
condition.
In light of the different proposals currently under consideration and the
uncertainty of the legislative process generally, management cannot predict
whether legislation reducing SAIF premiums and/or imposing a special one-time
assessment will be adopted, or, if adopted, the amount of the assessment, if
any, that would be imposed on the Company.
56
<PAGE>
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
The following disclosure of the estimated fair value of financial instruments is
made in accordance with the requirements of SFAS No. 107, DISCLOSURES ABOUT FAIR
VALUE OF FINANCIAL INSTRUMENTS:
<TABLE>
<CAPTION>
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
--------------------------------------------------------
CARRYING FAIR CARRYING FAIR
VALUE VALUE VALUE VALUE
-------------------------------------------------------
<S> <C> <C> <C> <C>
Assets:
Cash $ 1,036 $ 1,036 $ 773 $ 773
Interest-bearing deposits 16,107 16,107 4,932 4,932
Securities held for trading 324,221 324,221 246,733 246,733
Securities available for sale 2,050 2,050 2,541 2,541
Loans receivable, net 65,925 65,900 37,010 38,443
Interest receivable 1,807 1,807 1,353 1,353
Federal Home Loan Bank stock 2,645 2,645 2,500 2,500
Liabilities:
Deposits 135,143 134,951 115,312 116,415
Securities sold under agreements
to repurchase 219,067 218,967 130,217 130,235
Federal Home Loan Bank advances 26,000 26,000 31,000 31,000
Interest payable 1,970 1,970 1,692 1,692
Note payable 8,998 8,998 9,200 9,200
Advance payments by borrowers for
taxes and insurance 392 392 264 264
Off Balance Sheet Hedging
Instruments:
Interest rate swaps 110 403
Interest rate cap 863 747
</TABLE>
The estimated fair value amounts are determined by the Company, using available
market information and appropriate valuation methodologies. However,
considerable judgment is required in interpreting market data to develop the
estimates of fair value. Accordingly, the estimates presented herein are not
necessarily indicative of the amounts the Company could realize in a current
market exchange. The use of different market assumptions and/or estimation
methodologies may have a material effect on the estimated fair value amounts.
CASH, INTEREST-BEARING DEPOSITS, INTEREST RECEIVABLE AND PAYABLE, ADVANCE
PAYMENTS BY BORROWERS FOR TAXES AND INSURANCE AND NOTE PAYABLE - The carrying
amounts of these items are a reasonable estimate of their fair value.
LOANS RECEIVABLE - The fair value of loans receivable is estimated by
discounting future cash flows at market interest rates for loans of similar
terms and maturities, taking into consideration repricing characteristics and
prepayment risk.
Securities held for trading consist of mortgage-backed securities,
collateralized mortgage obligations, residuals, interest-only strips, a
principal-only strip, interest rate swaps, an interest rate collar, interest
rate caps, interest rate floors, options, futures and equity securities.
57
<PAGE>
Fair values are based on quoted market prices or dealer quotes. Where such
quotes are not available, fair value is estimated by using quoted market prices
for similar securities or by discounting future cash flows at a risk adjusted
spread to Treasury.
Securities available for sale consist of municipal bonds and a non-agency
participation certificate. Fair values for the municipal bonds are based on
quoted market prices. The non-agency participation certificate fair value is
based on projected future cash flows using a published analysis of the
underlying credit risks.
FEDERAL HOME LOAN BANK STOCK - The fair value is estimated to be the carrying
value which is par. All transactions in the capital stock of the Federal Home
Loan Bank of Indianapolis are executed at par.
DEPOSITS - The fair value of deposits is calculated by discounting the future
cash flows at a market interest rate.
SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE - Fair values are based on the
discounted value of contractual cash flows using dealer quoted rates for
agreements of similar terms and maturities.
FEDERAL HOME LOAN BANK ADVANCES - The fair value is estimated by discounting
future cash flows using rates currently available to the bank for advances of
similar maturities.
Off balance sheet hedging instruments consist of interest rate swaps and an
interest rate cap used to modify the interest rate sensitivity of certain
certificates of deposits and Federal Home Loan Bank advances, respectively. Fair
values are based on quoted market prices or dealer quotes. Where such quotes are
not available, fair value is estimated by using quoted market prices for similar
securities or by discounting future cash flows at a risk adjusted spread to
Treasury.
COMMITMENTS - The estimated fair value of commitments to originate fixed-rate
loans is determined based on the fees currently charged to enter into similar
agreements and the difference between current levels of interest rates and the
committed rates. Based on that analysis, the estimated fair value of such
commitments is a reasonable estimate of the loan commitments at par.
The fair value estimates presented herein are based on information available to
management as of June 30, 1996 and 1995. Although management is not aware of any
factors that would significantly affect the estimated fair value amounts, such
amounts have not been comprehensively revalued for purposes of these
consolidated financial statements since that date, and therefore, current
estimates of fair value may differ significantly from the amounts presented
herein.
58
<PAGE>
18. HARRINGTON FINANCIAL GROUP, INC.
FINANCIAL INFORMATION (PARENT COMPANY ONLY)
The following condensed balance sheets as of June 30, 1996 and 1995, and
condensed statements of income and cash flows for the three years in the period
ended June 30, 1996 for Harrington Financial Group, Inc. should be read in
conjunction with the consolidated financial statements and notes thereto.
CONDENSED BALANCE SHEETS
(DOLLARS IN THOUSANDS)
JUNE 30, 1996 1995
--------------------------
Cash and cash equivalents $ 5,271 $ 434
Securities held for trading 550 249
Other assets 82 90
Intercompany receivable 70
Investment in subsidiary 26,039 18,376
-------------------------
Total assets $32,012 $19,149
-------------------------
-------------------------
Note payable $ 8,998 $ 9,200
Deferred income taxes, net 10 (5)
Accrued income taxes (210) (421)
Accrued expenses payable
and other liabilities 97 14
-------------------------
Total liabilities 8,895 8,788
-------------------------
Common stock 407 245
Additional paid-in capital 15,623 4,183
Unrealized gain (loss)
on securities available
for sale (8) 61
Retained earnings 7,095 5,872
-------------------------
Total stockholders' equity 23,117 10,361
-------------------------
Total liabilities and
stockholders' equity $32,012 $19,149
-------------------------
-------------------------
CONDENSED STATEMENTS OF INCOME
(DOLLARS IN THOUSANDS)
YEARS ENDED
JUNE 30, 1996 1995 1994
-----------------------------------
Dividends from subsidiary $ 855 $1,455
Interest income from securities
held for trading 8 $ 18 17
Interest on deposits 12 12 6
Gain on sale of securities
held for trading 42 24
Unrealized gain on securities
held for trading 28 26
-----------------------------------
Total income 945 80 1,478
-----------------------------------
Interest expense on
long-term borrowings 905 749 577
Salaries and employee benefits 98 29
Other expenses 19 48 3
------------------------------------
Total expenses 1,022 826 580
------------------------------------
Income (loss) before equity in
undistributed earnings (77) (746) 898
Income tax benefit (359) (296) (195)
Equity in undistributed earnings
of subsidiary 941 2,303 (166)
------------------------------------
Net income $1,223 $1,853 $ 927
------------------------------------
------------------------------------
59
<PAGE>
<TABLE>
<CAPTION>
CONDENSED STATEMENTS OF CASH FLOWS
(DOLLARS IN THOUSANDS)
YEARS ENDED JUNE 30, 1996 1995 1994
-------------------------------------
<S> <C> <C> <C>
Cash flows from operating activities:
Net income $1,223 $1,853 $927
Adjustments to reconcile net income to net
cash provided by (used in) operating activities:
Decrease (increase) in other assets 8 23 27
Increase in intercompany receivable (70)
Increase (decrease) in accrued expenses
and other liabilities 83 14 (42)
Gain on sale of securities held for trading (42) (24)
Unrealized gain on securities held for trading (28) (26)
Purchases of securities held for trading (545) (880)
Proceeds from sales of securities held for trading 314 1,081
Deferred income tax provision 16 (4) 29
Increase (decrease) in accrued income taxes 211 (189) (36)
Increase in undistributed earnings of subsidiary (941) (2,303) 166
--------------------------------------
Net cash provided by (used in)
operating activities 229 (455) 1,071
---------------------------------------
Cash flows from investing activities:
Capital contributions to subsidiary (6,792) (3,250) (1,000)
Purchase of securities available for sale (401)
Proceeds from sales of securities available for sale 219
---------------------------------------
Net cash used in investing activities (6,792) (3,250) (1,182)
---------------------------------------
Cash flows from financing activities:
Proceeds from issuance of common stock under
equity offering 2,421
Proceeds from issuance of common stock
under initial public offering 11,437
Proceeds from stock options exercised 165 101
Proceeds from note payable 800 1,900 8,000
Principal repayments on note payable (1,002) (600) (7,631)
---------------------------------------
Net cash provided by financing activities 11,400 3,822 369
---------------------------------------
Net increase in cash and equivalents 4,837 117 258
Cash and cash equivalents
beginning of year 434 317 59
---------------------------------------
Cash and cash equivalents
end of year $5,271 $434 $317
---------------------------------------
---------------------------------------
</TABLE>
60
<PAGE>
TO THE BOARD OF DIRECTORS AND STOCKHOLDERS OF HARRINGTON FINANCIAL GROUP, INC.:
We have audited the accompanying consolidated balance sheets of Harrington
Financial Group, Inc. and its subsidiary (the "Company") as of June 30, 1996 and
1995, and the related consolidated statements of income, changes in
stockholders' equity and cash flows for the years then ended. These financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits. The financial statements of Harrington Financial Group, Inc. and its
subsidiary for the year ended June 30, 1994 were audited by other auditors whose
report, dated August 9, 1994, on those statements included an explanatory
paragraph concerning a change in accounting for income taxes discussed in Note 1
to the financial statements.
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, such 1996 and 1995 consolidated financial statements present
fairly, in all material respects, the financial position of Harrington Financial
Group, Inc. and its subsidiary as of June 30, 1996 and 1995, and the results of
their operations and their cash flows for the years then ended, in conformity
with generally accepted accounting principles.
/s/ DELOITTE & TOUCHE LLP
DELOITTE & TOUCHE LLP
Indianapolis, Indiana
August 12, 1996
61
<PAGE>
EXHIBIT 23.1
INDEPENDENT AUDITORS CONSENT
We consent to the incorporation by reference in Registration Statement
No. 333-08481 of Harrington Financial Group, Inc. on Form S-8 of our report
dated August 12, 1996, appearing in this Annual Report on Form 10-K of
Harrington Financial Group, Inc. for the year ended June 30, 1996.
/s/ DELOITTE & TOUCHE LLP
DELOITTE & TOUCHE LLP
Indianapolis, Indiana
September 26, 1996
<PAGE>
EXHIBIT 23.2
CONSENT OF INDEPENDENT ACCOUNTANT
We consent to the incorporation by reference in Registration Statement
No. 333-08481 of Harrington Financial Group, Inc. on Form S-8 of our report
dated August 9, 1994, appearing in this Annual Report on Form 10-K of Harrington
Financial Group, Inc. for the year ended June 30, 1996.
/s/ Geo. S. Olive & Co. LLC
Geo. S. Olive & Co. LLC
Indianapolis, Indiana
September 24, 1996
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 9
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JUN-30-1996
<PERIOD-START> JUL-01-1995
<PERIOD-END> JUN-30-1996
<CASH> 1,036
<INT-BEARING-DEPOSITS> 16,107
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 324,221
<INVESTMENTS-HELD-FOR-SALE> 2,050
<INVESTMENTS-CARRYING> 0
<INVESTMENTS-MARKET> 0
<LOANS> 66,045
<ALLOWANCE> (120)
<TOTAL-ASSETS> 418,196
<DEPOSITS> 135,143
<SHORT-TERM> 219,067
<LIABILITIES-OTHER> 5,871
<LONG-TERM> 34,998
0
0
<COMMON> 407
<OTHER-SE> 22,710
<TOTAL-LIABILITIES-AND-EQUITY> 23,117
<INTEREST-LOAN> 4,276
<INTEREST-INVEST> 19,208
<INTEREST-OTHER> 0
<INTEREST-TOTAL> 23,484
<INTEREST-DEPOSIT> 7,151
<INTEREST-EXPENSE> 18,004
<INTEREST-INCOME-NET> 5,480
<LOAN-LOSSES> (1)
<SECURITIES-GAINS> (126)
<EXPENSE-OTHER> 3,740
<INCOME-PRETAX> 1,871
<INCOME-PRE-EXTRAORDINARY> 1,871
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,223
<EPS-PRIMARY> 0.57
<EPS-DILUTED> 0.57
<YIELD-ACTUAL> 7.43
<LOANS-NON> 261
<LOANS-PAST> 0
<LOANS-TROUBLED> 0
<LOANS-PROBLEM> 0
<ALLOWANCE-OPEN> 121
<CHARGE-OFFS> 0
<RECOVERIES> (1)
<ALLOWANCE-CLOSE> 120
<ALLOWANCE-DOMESTIC> 100
<ALLOWANCE-FOREIGN> 0
<ALLOWANCE-UNALLOCATED> 0
</TABLE>
<PAGE>
INDEPENDENT AUDITOR'S REPORT
Board of Directors
Harrington Financial Group, Inc.
Richmond, Indiana
We have audited the accompanying consolidated statements of income, changes in
stockholders' equity and cash flows of Harrington Financial Group, Inc.
(formerly Financial Research Corporation) and subsidiary for the year ended
June 30, 1994. These consolidated financial statements are the responsibility
of the Company's management. Our responsibility is to express an opinion on
these consolidated financial statements based on our audit.
We conducted our audit 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 audit provides a reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above present
fairly, in all material respects, the results of operations and cash flows of
Harrington Financial Group, Inc. and subsidiary for the year ended June 30,
1994, in conformity with generally accepted accounting principles.
As discussed in the notes to the consolidated financial statements, the Company
changed its method of accounting for income taxes in 1994.
/s/ Geo. S. Olive & Co. LLC
Richmond, Indiana
August 9, 1994
