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, 1998
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 East Main Street, P. O. Box 968
Richmond, Indiana 47375
- ------------------------------------------ --------------------------
(Address of Principal (Zip Code)
Executive Offices)
Registrant's telephone number, including area code: (765) 962-8531
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. [ ]
<PAGE>
As of September 18, 1998, the aggregate value of the 848,888 shares of Common
Stock of the Registrant issued and outstanding on such date, which excludes
2,364,229 shares held by all directors and executive officers of the Registrant
as a group, was approximately $7.7 million. This figure is based on the last
known trade price of $9.125 per share of the Registrant's Common Stock on
September 18, 1998.
Number of shares of Common Stock outstanding as of September 18, 1998: 3,213,117
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, 1998 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 seven full-service offices located in Carmel, Fishers,
Noblesville, Indianapolis, and Richmond, Indiana. In addition, the Bank
commenced commercial lending operations in the Kansas City area during the
fiscal year ended June 30, 1998 and opened its first full service banking
facility in Mission, Kansas in August 1998.
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, 1998, the Company had total consolidated assets of
$484.4 million, total consolidated borrowings of $279.9 million, total
consolidated deposits of $178.3 million, and total consolidated stockholders'
equity of $22.7 million.
The Company was organized in March 1988 by certain principals of Smith
Breeden Associates, Inc. ("Smith Breeden") for the sole purpose of acquiring the
Bank. This investor group purchased the Bank with the intention of expanding the
Bank's mortgage originations, investment and retail operations and improving the
Bank's return on equity. The Company has contracted with Smith Breeden for the
provision of consulting services regarding, among other things, providing advice
on management of its investments and borrowings, the pricing of loans and
deposits, and the use of various financial instruments to reduce interest rate
risk. Certain officers and directors of the Company and the Bank are principals
or affiliates of Smith Breeden.
The Company's business strategy focuses on achieving attractive returns
consistent with prudent risk management. The Company has sought to implement
this strategy by (1) expanding its banking locations and product offerings in
order to build a strong community banking franchise through de novo branching
and the pursuit of acquisition opportunities; (2) controlling interest rate risk
by matching the interest rate sensitivity of its assets to that of its
liabilities; (3) controlling credit risk by maintaining a substantial portion of
the Company's assets in mortgage-backed and related securities and single-family
residential loans and by applying conservative underwriting standards and credit
risk monitoring; and (4) utilizing excess capital balances through the
management of a hedged investment portfolio.
<PAGE>
Highlights of the principal elements of the Company's business strategy are as
follows:
Expand Banking Locations and Product Offerings. An integral part of the
Company's strategy is to increase the Bank's emphasis on
opportunistically expanding products, services and banking locations for
business and retail customers in markets where the Company's management
and directors have market knowledge and customer relationship potential.
A total of six new banking locations were opened since May 1994, with
three being opened in fiscal year 1998. 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 $41.6 million
during fiscal 1996 to $87.7 million during fiscal 1998. See "- Lending
Activities." In addition, the Company's retail deposits (including
transaction accounts and retail certificates of deposit) have increased
from $112.4 million or 83.1% of total deposits at June 30, 1996 to $166.8
million or 93.6% of total deposits at June 30, 1998. See "- Sources of
Funds - Deposits." The Company believes that single-family residential
loan originations generally offer attractive risk adjusted returns and,
with respect to direct originations, allow the Company to establish a
relationship with the underlying borrower which the Company can utilize
to cross-sell additional products and services. In addition, the Company
believes that retail deposits are a cost-effective source of funds,
provide an additional source of fee income, and also permit the further
cross-selling of additional products and services. Consequently, the
Company expects to continue to focus on increasing its retail deposit
base and its portfolio of single-family residential loans. Furthermore,
the Company has developed a commercial lending division to provide
funding to commercial borrowers and to increase business deposits. Since
1994, the Company has also offered trust and investment services for
individuals and retirement vehicles.
Control Interest Rate Risk. The Company attempts to manage its assets and
liabilities in order to maintain a portfolio which produces positive
returns in either an increasing or decreasing interest rate environment.
The Company has sought to control interest rate risk both internally
through the management of the composition of its assets and liabilities
and externally through the utilization of interest rate contracts.
Interest rate contracts, along with mortgage backed derivative
securities, are purchased with the intention of protecting the market
value of the Bank's portfolio and net interest income.
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, 1998, the Company's
investment in mortgage-backed and related securities amounted to $287.0
million or 98.4% of the Company's securities portfolio (both held for
trading and available for sale) and 59.2% of the Company's total assets.
In addition, as of such date, the Company's investment in single-family
residential loans amounted to $154.3 million or 31.9% of total assets.
See "- Lending" and "- Investment Activities."
<PAGE>
Utilize Excess Capital Balances. The Company utilizes excess capital
balances through the management of a hedged investment portfolio
primarily consisting of mortgage backed securities. Although
mortgage-backed securities often carry lower yields than traditional
mortgage loans, such securities generally increase the quality of the
Company's assets, as they have underlying insurance or guarantees, are
more liquid than individual mortgage loans, and may be used to
collateralize borrowings or other obligations of the Company. The funds
invested in the securities portfolio can be quickly redeployed to pursue
community bank expansion opportunities as they arise.
The Company, as a registered savings and loan holding company, is
subject to examination and regulation by the Office of Thrift Supervision
("OTS") and is subject to various reporting and other requirements of the
Securities and Exchange Commission ("SEC"). The Bank, as a federally chartered
savings bank, is subject to comprehensive regulation and examination by the OTS,
as its chartering authority and primary regulator, and by the Federal Deposit
Insurance Corporation ("FDIC"), which administers the Savings Association
Insurance Fund ("SAIF"), which insures the Bank's deposits to the maximum extent
permitted by law. The Bank is a member of the Federal Home Loan Bank ("FHLB") of
Indianapolis, which is one of the 12 regional banks which comprise the FHLB
System. The Bank is further subject to regulations of the Board of Governors of
the Federal Reserve System ("Federal Reserve Board") governing reserves required
to be maintained against deposits and certain other matters. See "- Supervision
and Regulation."
Investment Advisor
Smith Breeden is a money management and consulting firm involved in (1)
money management for separate accounts such as corporate, state and municipal
pensions, endowments and mutual funds, (2) financial institution consulting and
investment advice, and (3) 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 approximately $22
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 and Gregory
Smith, who retired in 1988. Dr. Breeden is Chairman of the Board of the Company.
He previously served on the faculty at Massachusetts Institute of Technology,
the University of Chicago, Stanford University, where he obtained his Ph.D. in
Finance, and Duke University's Fuqua School of Business. He is editor of the
Journal of Fixed Income.
- ------------------------
Since 1988, Smith Breeden and certain of its principals have been
involved in making equity investments in financial institutions in tandem with
the application of its expertise in banking and investment management. Certain
of the principals of Smith Breeden are investors in other banks and thrift
institutions.
<PAGE>
Smith Breeden is based in Chapel Hill, North Carolina, and employs
approximately 75 people in its main office and its offices in Overland Park,
Kansas, Dallas, Texas and Boulder, Colorado.
Lending Activities
General. At June 30, 1998, the Bank's net loan portfolio totaled $163.5
million, representing approximately 33.8% of the Company's $484.4 million of
total assets at that date. In addition to utilizing option-adjusted pricing
analysis in order to manage the Company's investment portfolio, the Company also
uses such analysis to price its loan originations and ascertain the net spread
expected to be earned with respect to the Bank's loan portfolio. The Bank's
primary focus with respect to its lending operations continues to be in the
direct origination and servicing of single-family residential mortgage loans.
Since fiscal 1995, the Bank has also been active in originating whole
residential mortgage loans through correspondents which meet its pricing and
credit quality objectives. In the latter part of fiscal year 1998, the Company
initiated the development of a commercial loan division to broaden and diversify
its product offerings and customer base. The Company anticipates that the
commercial loan portfolio, consisting of real estate and business lending, will
expand during the upcoming fiscal years. Currently, 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 residential 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, 1998, approximately 78% 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, Hamilton and
Marion 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, 1998, the Bank's
regulatory limit on loans-to-one borrower was $5.0 million and its five largest
<PAGE>
loans or groups of loans-to-one borrower, including related entities, aggregated
$2.1 million, $743,000, $725,000, $650,000 and $635,000. All five of the Bank's
largest loans or groups of loans are secured primarily by commercial or
single-family residential real estate and were performing in accordance with
their terms at June 30, 1998.
<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,
---------------------------------------------------------------------------------
1998 1997 1996
-------------------------- --------------------------- --------------------
Amount Percent Amount Percent Amount Percent
------ ------- ------ ------- ------ -------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C> <C>
Single-family residential (1) $154,336 94.6% $91,140 97.2% $64,899 97.8%
Commercial real estate (2) 3,522 2.2 258 0.3 441 0.7
-------- ---- -------- ----- ------- -----
Total real estate loans 157,858 96.8 91,398 97.5 65,340 98.5
Collateralized commercial loans 1,201 0.7 -- -- -- --
Consumer loans:
Deposit secured 221 0.1 252 0.2 267 0.4
Home improvement/equity 3,536 2.2 2,136 2.3 732 1.1
Other 253 0.2 -- -- -- --
-------- ---- -------- ----- ------- -----
Total consumer loans 4,010 2.5 2,388 2.5 999 1.5
-------- ---- -------- ----- ------- -----
Total loans 163,069 100.0% 93,786 100.0% 66,339 100.0%
===== ===== =====
Less:
Unamortized push-down
accounting adjustment (3) (113) (136) (182)
Unamortized discount on loans -- -- (7)
Undisbursed funds (4) (6) (9) (420)
Deferred loan origination
(fees) costs 956 530 315
Allowance for loan losses (360) (213) (120)
-------- -------- -------
Net loans $163,546 $93,958 $65,925
======== ======== =======
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
June 30,
------------------------------------------------
1995 1994
---------------------- --------------------
Amount Percent Amount Percent
<S> <C> <C> <C> <C>
Single-family residential (1) $35,998 96.1% $20,525 96.6%
Commercial real estate (2) 711 1.9 349 1.6
------- ----- ------- -----
Total real estate loans 36,709 98.0 20,874 98.2
Collateralized commercial loans -- -- -- --
Consumer loans:
Deposit secured 255 0.7 150 0.7
Home improvement/equity 498 1.3 210 1.0
Other -- -- 17 0.1
------- ----- ------- -----
Total consumer loans 753 2.0 377 1.8
------- ----- ------- -----
Total loans 37,462 100.0% 21,251 100.0%
===== =====
Less:
Unamortized push-down
accounting adjustment (3) (350) (419)
Unamortized discount on loans (13) (19)
Undisbursed funds (4) (43) (8)
Deferred loan origination
(fees) costs 75 (17)
Allowance for loan losses (121) (106)
------- -------
Net loans $37,010 $20,682
======= =======
</TABLE>
- ---------
(1) Includes single-family residential construction loans. At June 30, 1998,
the Bank had no construction loans in process.
(2) Includes $224,000, $258,000, $291,000, $321,000, and $349,000 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.
<PAGE>
Contractual Principal Repayments and Interest Rates. The following
table sets forth certain information at June 30, 1998 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.
<TABLE>
<CAPTION>
Due After Due After
Due in One One to Five Five or More
Year or Less Years Years Total
------------ ----- ----- -----
(In Thousands)
<S> <C> <C> <C> <C>
Single-family residential $ 21 $ 418 $153,897 $154,336
Commercial .............. 681 568 3,474 4,723
Consumer ................ 395 340 3,275 4,010
-------- -------- -------- --------
Total .............. $ 1,097 $ 1,326 $160,646 $163,069
======== ======== ======== ========
</TABLE>
The following table sets forth the dollar amount of all loans, before
net items, due after one year from June 30, 1998, which have fixed interest
rates or which have floating or adjustable interest rates.
<TABLE>
<CAPTION>
Floating or
Fixed Rates Adjustable-Rates Total
----------- ---------------- -----
(In Thousands)
<S> <C> <C> <C>
Single-family residential ...... $112,072 $ 42,243 $154,315
Commercial ..................... 3,940 102 4,042
Consumer ....................... 1,471 2,144 3,615
-------- -------- --------
Total ...................... $117,483 $ 44,489 $161,972
======== ======== ========
</TABLE>
Origination, Purchase and Sale of Loans. The lending activities of the
Bank are subject to the written, non-discriminatory underwriting standards and
loan origination procedures established by the Bank's Board of Directors and
management. Loan originations are obtained by a variety of sources, including
referrals from real estate brokers, builders, existing customers, walk-in
customers, loan officers and advertising. In its marketing, the Bank emphasizes
its community ties, customized personal service, competitive rates, and an
efficient underwriting and approval process. Property valuations are performed
by independent outside appraisers approved by the Bank's Board of Directors. The
Bank requires title, hazard and, to the extent applicable, flood insurance on
all security property.
Mortgage loan applications are reviewed by Bank employees who have
approval authority up to designated limits. All loans in excess of an
individual's designated limits are referred to the Bank's Loan Committee, which
has approval authority for all loans up to $1.0 million. Any loans exceeding
$1.0 million (of which, at June 30, 1998, there was one) 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
<PAGE>
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, 1998, the Company was servicing
$3.4 million of loans for others.
During fiscal year 1994, the Bank initiated programs to increase its
portfolio of single-family residential loans in accordance with its community
banking expansion. In addition, during fiscal 1995, the Bank began originating
single-family residential loans through a correspondent mortgage banking company
headquartered in Indianapolis, Indiana. During fiscal 1997, the Bank expanded
its correspondent relationships with an additional mortgage banking company in
Indianapolis, Indiana and a company in Overland Park, Kansas. 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 for adherence to its underwriting standards prior to acceptance from the
correspondent. Such loans are obtained with servicing released.
The following table sets forth the loan origination activity of the
Company during the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
------------------------------------------
1998 1997 1996
-------- -------- --------
(Dollars in Thousands)
<S> <C> <C> <C>
Direct loan originations:
Single-family residential .. $ 39,772 $ 12,615 $ 18,895
Commercial ................. 4,506 -- --
Consumer ................... 4,355 2,931 1,246
-------- -------- --------
Total loans originated
directly ............... 48,633 15,546 20,141
Originations by
correspondents (1) ......... 47,921 24,545 22,721
-------- -------- --------
Total loans originated ... 96,554 40,091 42,862
Loan principal reductions .... (27,271) (12,644) (13,985)
-------- -------- --------
Net increase in loan portfolio $ 69,283 $ 27,447 $ 28,877
======== ======== ========
</TABLE>
- --------
(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
<PAGE>
primarily by first mortgage liens on existing single-family residences. At June
30, 1998, $154.3 million or 94.6% of the Bank's total loan portfolio consisted
of single-family residential real estate loans, substantially all of which are
conventional loans.
The Bank offers fixed-rate single family residential loans with terms
of 10 to 30 years. Such loans are amortized on a monthly basis with principal
and interest due each month. Generally, the value of fixed-rate loans fluctuates
inversely with changes in interest rates. Consequently, if left unhedged,
long-term fixed-rate single-family residential loans would increase the Bank's
interest rate risk. However, the Bank believes that its sophisticated asset and
liability management techniques provide the Bank with a competitive advantage
and allow for the Bank to continue to offer fixed-rate residential mortgage
loans over a variety of interest rate scenarios.
Since the early 1980s, the Bank has also been offering adjustable-rate
single-family residential mortgage loans. Such loans generally have up to
30-year terms and an interest rate which adjusts after one, three or five years
in accordance with a designated index (the weekly average yield on U.S. Treasury
securities adjusted to a constant comparable maturity of one year, as made
available by the Federal Reserve Board). Such loans currently have a 2% cap on
the amount of any increase or decrease in the interest rate per year, and a 6%
limit on the amount by which the interest rate can increase or decrease over the
life of the loan. In addition, the Bank's adjustable-rate loans are currently
not convertible into fixed-rate loans and do not contain prepayment penalties.
Approximately 25.9% of the single-family residential loans in the Bank's loan
portfolio at June 30, 1998 had adjustable interest rates.
Adjustable-rate mortgage loans decrease but do not eliminate the risks
associated with changes in interest rates. Because periodic and lifetime caps
limit the interest rate adjustments, the value of adjustable-rate mortgage loans
also fluctuates inversely with changes in interest rates. In addition as
interest rates increase, the required payments by the borrower increase, thus
increasing the potential for default.
The demand for adjustable-rate loans in the Bank's primary market area
has been a function of several factors, including the level of interest rates,
the expectations of changes in the level of interest rates and the difference
between the interest rates and loan fees offered for fixed-rate loans and
adjustable-rate loans. The relative amount of fixed-rate and adjustable-rate
residential loans that can be originated at any time is largely determined by
the demand for each in a competitive environment.
Pursuant to underwriting guidelines adopted by the Board of Directors,
the Bank will generally lend up to 95% of the appraised value of the property
securing a single-family residential loan. However, the Bank generally obtains
private mortgage insurance on the principal amount that exceeds 80% of appraised
value of the security property.
Although the Bank does not emphasize the origination of residential
construction loans, in recent years the Bank has occasionally originated loans
in its primary market area to construct single-family residences. At June 30,
1998, the Bank had no construction loans in process.
<PAGE>
Commercial Real Estate Loans. At June 30, 1998, $3.5 million or 2.2% of
the Bank's total loan portfolio consisted of loans secured by commercial real
estate. At June 30, 1998, the Bank's commercial real estate loan portfolio
included term loans secured by commercial buildings located within the Company's
primary market areas.
Commercial real estate lending entails different and significant risks
when compared to single-family residential lending because such loans typically
involve large loan balances to single borrowers and because the payment
experience on such loans is typically dependent on the successful operation of
the project or the borrower's business. During the latter part of the fiscal
year, the Bank developed a commercial lending division by implementing the
necessary policies, operating procedures, loan systems and hiring support
personnel. These loans are made in conformance with strict underwriting
guidelines and adherence to the Bank's policies.
Collateralized Commercial Loans. At June 30, 1998, $1.2 million or 0.7%
of the Bank's total loan portfolio consisted of collateralized commercial loans.
These collateralized loans consist of both term loans as well as lines of credit
which are secured by business assets or stock.
As previously mentioned, the Bank's recent development of the
commercial lending division allows for the origination of non-real estate
business loans in strict compliance with the Bank's underwriting standards.
Collateralized commercial lending also entails different and significant risks
in relation to single-family residential lending,
Consumer Loans. The Bank is authorized to make loans for a wide variety
of personal or consumer purposes. The Bank has been originating consumer loans
in recent years in order to provide a wider range of financial services to its
customers and because such loans generally have higher interest spreads than
mortgage loans. The consumer loans offered by the Bank include home equity loans
and lines of credit, home improvement loans and deposit account secured loans.
At June 30, 1998, $4.0 million or 2.5% of the Bank's total loan portfolio
consisted of consumer loans.
Home equity loans and lines of credit are originated by the Bank for up
to 90% of the appraised value, less the amount of any existing prior liens on
the property. The Bank also offers home improvement loans in amounts up to 95%
of the appraised value, less the amount of any existing prior liens on the
property, provided the loan is guaranteed by an approved insurer. Home equity
loans and home improvement loans have a maximum term of twenty years and carry
fixed interest rates. Home equity lines of credit have a maximum repayment term
of 10 years, a five-year term with respect to draws, and carry interest rates
which adjust monthly in accordance with a designated prime rate. The Bank will
secure each of these types of loans with a mortgage on the property (generally a
second mortgage) and will originate the loan even if another institution holds
the first mortgage. At June 30, 1998, home equity loans and lines of credit and
home improvement loans totaled $3.5 million or 88.2% of the Bank's total
consumer loan portfolio.
The Bank currently offers loans secured by deposit accounts, which
amounted to $221,000 or 5.5% of the Bank's total consumer loan portfolio at June
30, 1998. Such loans
<PAGE>
are originated for up to 95% of the deposit account balance, with a hold placed
on the account restricting the withdrawal of the account balance.
During fiscal year 1998, the Bank expanded its consumer loan products
to include automobile and personal loans. As of June 30, 1998, these other loans
amounted to $253,000 or 6.3% of the Bank's total consumer loan portfolio.
Consumer loans generally have shorter terms and higher interest rates
than mortgage loans but generally involve more credit risk than mortgage loans
because of the type and nature of the collateral. In addition, consumer lending
collections are dependent on the borrower's continuing financial stability, and
thus are more likely to be adversely affected by job loss, divorce, illness and
personal bankruptcy. The Bank believes that the generally higher yields earned
on consumer loans compensate for the increased credit risk associated with such
loans, and the Company intends to continue to offer consumer loans in order to
provide a full range of services to its customers.
Asset Quality
Loan Delinquencies. When a borrower fails to make a required payment on
a loan, the Bank attempts to cure the deficiency by contacting the borrower and
seeking payment. Contacts are generally made following the fifteenth day after a
payment is due, at which time a late payment is assessed. In most cases,
deficiencies are cured promptly. If a delinquency extends beyond 15 days, the
loan and payment history is reviewed and efforts are made to collect the loan.
While the Bank generally prefers to work with borrowers to resolve such
problems, when the account becomes 90 days delinquent, the Bank does institute
foreclosure or other proceedings, as necessary, to minimize any potential loss.
Non-Performing Assets. All loans are reviewed on a regular basis and
are placed on non-accrual status when, in the opinion of management, the
probability of collection of additional interest is deemed insufficient to
warrant further accrual. As a matter of policy, the Bank does not accrue
interest on loans past due 90 days or more except when the estimated value of
the collateral and collection efforts are deemed sufficient to ensure full
recovery. The Bank provides an allowance for the loss of uncollected interest on
all non-accrual loans. Impaired loans covered under Statement of Financial
Accounting Standards ("SFAS") No. 114 and No. 118 are defined by the Company to
consist of non-accrual commercial loans which have not been collectively
evaluated for impairment. The allowance is established by a charge to interest
income equal to all interest previously accrued, and income is subsequently
recognized only to the extent that cash payments are received until, in
management's judgment, the borrower's ability to make periodic interest and
principal payments returns to normal, in which case the loan is returned to
accrual status.
Real estate acquired through foreclosure is carried at the lower of the
loan's unpaid principal balance (cost) or fair value less estimated selling
expenses at the date of transfer. A loan charge-off is recorded for any
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
<PAGE>
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.
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,
--------------------------------------------------------------------------------
1998 1997 1996 1995 1994
------------- ------------- ------------- -------------- -------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
Non-accruing loans:
Single-family residential $ 285 $ 336 $ 261 $ 350 $ 559
Commercial real estate -- -- -- -- --
---- ------ ------ ------ ------
Total non-accruing loans 285 336 261 350 559
Accruing loans greater than
90 days delinquent -- -- -- -- --
---- ------ ------ ------ ------
Total non-performing loans 285 336 261 350 559
Real estate owned 18 -- -- -- --
Other non-performing assets (1) 587 789 1,088 1,415 2,282
---- ------ ------ ------ ------
Total non-performing assets $ 890 $1,125 $1,349 $1,765 $2,841
===== ====== ====== ====== ======
Total non-performing loans
as a percentage of total loans 0.17% 0.36% 0.40% 0.95% 2.70%
==== ==== ==== ==== ====
Total non-performing assets
as a percentage of total assets 0.18% 0.25% 0.32% 0.59% 1.34%
==== ==== ==== ==== ====
</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, 1998, 1997, 1996, 1995 and 1994 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 $15,000, $6,000, $6,000, $13,000 and $26,000,
respectively.
Classified Assets. Federal regulations require that each insured
savings institution classify its assets on a regular basis. In addition, in
connection with examinations of insured institutions, federal examiners have
authority to identify problem assets and, if appropriate, classify them. There
are three classifications for problem assets: "substandard," "doubtful" and
"loss." Substandard assets have one or more defined weaknesses and are
characterized by the distinct possibility that the insured institution will
sustain some loss if the deficiencies are not corrected. Doubtful assets have
the weaknesses of substandard assets with the additional characteristic that the
weaknesses make collection or liquidation in full on the basis of currently
existing facts, conditions and values questionable, and there is a high
possibility of loss. An asset classified loss is considered uncollectible and of
such little value that continuance as an asset of the institution is not
warranted. Another category designated "special mention" also must be
established and maintained for assets which do not currently expose an insured
institution to a sufficient degree of risk to warrant classification as
substandard, doubtful or loss. Assets classified as substandard or doubtful
require the institution to establish general allowances for loan losses. If an
asset or portion thereof is classified loss, the insured institution must either
establish specific allowances for loan losses in the amount of 100% of the
portion of the asset classified loss, or charge-off such amount.
<PAGE>
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, 1998 consisted of $817,000 of
assets classified as substandard (including $230,000 of loans and $587,000 of
securities) and no loans classified as doubtful. In addition, at June 30, 1998,
$1.9 million of the Bank's loans were designated special mention.
The $587,000 of securities classified as substandard at June 30, 1998
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, 1998,
approximately 23.9% 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, 1998, the pool had cumulative realized losses of
$23.0 million which were initially absorbed by certain credit supports and
subsequently absorbed by subordinate certificate holders. Currently, senior
certificate holders (such as the Bank) are having to absorb the losses. The
credit supports, which totaled $11.0 million at the date of issuance, had been
depleted as of June 30, 1998. The security is currently held in the Bank's
available for sale portfolio and its $587,000 carrying value at June 30, 1998
reflects $18,000 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 Statement"). The Policy Statement includes guidance (1) on the
responsibilities of management for the assessment and establishment of an
adequate allowance and (2) for the agencies' examiners to use in evaluating the
adequacy of such allowance and the policies utilized to determine such
allowance. The Policy Statement also sets forth quantitative measures for the
allowance with respect to assets classified substandard and doubtful and with
respect to the remaining portion of an institution's loan portfolio.
Specifically, the Policy Statement sets forth the following quantitative
measures which examiners may use to determine the reasonableness of an
allowance: (1) 50% of the portfolio that is classified doubtful; (2) 15% of the
portfolio that is
<PAGE>
classified substandard and (3) for the portions of the portfolio that have not
been classified (including loans designated special mention), estimating credit
losses over the upcoming twelve months based on facts and circumstances
available on the evaluation date. While the Policy Statement sets forth this
quantitative measure, such guidance is not intended as a "floor" or "ceiling."
The following table sets forth an analysis of the Bank's allowance for
loan losses during the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
----------------------------------------------------------------------------------
1998 1997 1996 1995 1994
------------- ------------- ------------ --------------- --------------
(Dollars in Thousands)
<S> <C> <C> <C> <C> <C>
Total loans outstanding, net $163,546 $93,958 $65,925 $37,010 $20,682
======== ======= ======= ======= =======
Average loans outstanding, net $116,982 $78,545 $52,399 $25,467 $19,369
======== ======= ======= ======= =======
Balance at beginning of period $ 213 $ 120 $ 121 $ 106 $ 156
Charge-offs:
Single-family residential -- -- -- -- 2
Commercial real estate (1) -- -- -- -- 45
Consumer -- -- -- -- --
------- ------- ------- ------- -------
Total charge-offs -- -- -- -- 47
Recoveries:
Single-family residential -- 1 -- -- --
Consumer -- -- -- -- --
------- ------- ------- ------- -------
Total recoveries -- 1 -- -- --
------- ------- ------- ------- -------
Net charge-offs -- (1) -- -- 47
Provision (recovery) for loan 147 92 (1) 15 (3)
-------- ------- ------- ------- -------
losses
Balance at end of period $ 360 $ 213 $ 120 $ 121 $ 106
======== ======= ======= ======== =======
Allowance for loan losses as a
percent of total loans
outstanding 0.2% 0.2% 0.2% 0.3% 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.
The Bank established provisions (recoveries) for loan losses of
$147,000, $92,000, $(1,000), $15,000 and $(3,000) during the years ended June
30, 1998, 1997, 1996, 1995 and 1994 respectively. During such periods, loan
charge-offs (net of recoveries) amounted to $0, $(1,000), $0, $0, and $47,000,
respectively. The increases in the provision for loan losses during the periods
presented were due to substantial growth in the Company's mortgage loan
portfolio.
<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,
--------------------------------------------------------------------------------
1998 1997 1996
------------------------ ----------------------- -----------------------
Percent of Percent of Percent of
Loans in Loans in Loans in
Each Each 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. $302 83.9% $188 97.2% $ 95 97.8%
Commercial real estate loans .... 43 11.9 10 0.3 10 0.7
Consumer loans .................. 15 4.2 15 2.5 15 1.5
Total ...................... $360 100.0% $213 100.0% $120 100.0%
==== ===== ==== ===== ==== =====
<CAPTION>
------------------------------------------------------
1995 1994
------------------------- --------------------------
Percent of Percent of
Loans in Loans in
Each Each
Category to Category to
Amount Total Loans Amount Total Loans
------ ----------- ------ -----------
<S> <C> <C> <C> <C>
Single-family residential loans.
Commercial real estate loans..... $ 96 96.1% $ 91 96.6%
Consumer loans .................. 10 1.9 -- 1.6
Total ...................... 15 2.0 15 1.8
$121 100.0% $106 100.0%
==== ===== ==== =====
</TABLE>
<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 the direction
of the Bank's Investment Committee. In addition, the Bank has entered into an
agreement with Smith Breeden whereby Smith Breeden has been appointed as
investment advisor with respect to the management of the Bank's securities
portfolio. With the assistance of Smith Breeden, the Bank's Chief Executive
Officer and Chief Investment Officer execute various transactions with respect
to the portfolio and are responsible for informing the Investment Committee of
the types of investments available, the status and performance of the portfolio
and current market conditions. The investment officers are authorized to:
purchase or sell any securities as well as commitments to hedge eligible
investments; purchase or sell eligible investments under repurchase or reverse
repurchase agreements; execute hedging strategies approved by the Investment
Committee; pledge securities owned as collateral for public agency deposits or
repurchase accounts or agreements; and lend securities to approved dealers in
government securities or approved commercial banks. Any one investment officer
has the authority to purchase or sell securities up to $5.0 million in any one
transaction and acting together, two members of the Investment Committee have
authority to purchase or sell securities up to $10.0 million in any one
transaction. For purchases or sales greater than $10.0 million, the prior
approval of a majority of the Investment Committee is required. Investment
officers are also authorized to invest excess liquidity in approved liquid
investment vehicles. In addition, both the Investment Committee and the Board of
Directors of the Bank ratify all securities purchased and sold by the Bank.
The Company invests in a portfolio of mortgage-backed securities,
mortgage-backed derivative securities, interest rate risk management contracts,
equity securities and municipal bonds. In selecting securities for its
portfolio, the Company employs option-adjusted pricing analysis with the
assistance of Smith Breeden in order to ascertain the net risk-adjusted spread
expected to be earned with respect to the various investment alternatives. The
nature of this analysis is to quantify the costs embedded in the yield of an
investment, such as the duration matched funding cost, the costs of the options
embedded in the investment's cash flows (such as a borrower's ability to prepay
a mortgage) and servicing costs. The objective of the Company's investment
management process is to select investments with the greatest net spreads and
actively manage the underlying risks of these investments.
The Company actively manages its securities portfolio in order to
enhance net interest and net market value on a risk-adjusted basis. As a result,
the Company continuously monitors the net risk-adjusted spreads of its
investments and compares them with the spreads available with respect to other
securities in the market. Accordingly, as market conditions fluctuate (e.g., as
risk-adjusted spreads narrow), the Company will sell individual securities prior
to their maturity and reinvest the proceeds into new investments which generally
carry wider risk-adjusted spreads. The Company's securities portfolio also
contains various interest rate risk management contracts (such as interest
<PAGE>
rate swaps, collars, caps, floors, options and futures) which are primarily
utilized to hedge the Company's interest rate exposure in the trading portfolio
and which require active management in order to respond to changing prepayment
rates on the mortgage securities. The investment portfolio, although hedged for
interest rate risk, is still susceptible to adverse changes in the spreads
between the yields on mortgage securities and the related Treasury and LIBOR
based hedges with the potential for significant earnings volatility from net
mark-to-market changes. That is, the Company designates substantially all of the
investment portfolio as securities held for trading and, therefore, reflects the
market value changes of these investments, net of hedges, in the statement of
operations.
In recognition of the Company's business strategy of actively managing
its securities portfolio, during fiscal 1994, the Company reclassified
substantially all of its securities as held for trading. Pursuant to SFAS No.
115, securities classified as trading securities are reported at fair value with
unrealized gains and losses included in earnings, and securities classified as
available for sale are similarly reported at fair value, but with unrealized
gains and losses excluded from earnings and instead reported as a separate
component of stockholders' equity.
Mortgage-Backed and Related Securities. At June 30, 1998, the Company's
mortgage-backed and related securities portfolio (including $12.3 million of
mortgage-backed derivative securities) amounted to $287.0 million or 98.4% of
the Company's securities portfolio (both held for trading and available for
sale) and 59.2% 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.
<PAGE>
The Company's mortgage-backed derivative securities include CMOs, which
include securities issued by entities which have qualified under the Internal
Revenue Code as REMICs. CMOs and REMICs (collectively CMOs) have been developed
in response to investor concerns regarding the uncertainty of cash flows
associated with the prepayment option of the underlying mortgagor and are
typically issued by governmental agencies, government sponsored enterprises and
special purpose entities, such as trusts, corporations or partnerships,
established by financial institutions or other similar institutions. A CMO can
be collateralized by loans or securities which are insured or guaranteed by
FNMA, FHLMC or GNMA. In contrast to pass-through mortgage-backed securities, in
which cash flow is received pro rata by all security holders, the cash flow from
the mortgages underlying a CMO is segmented and paid in accordance with a
predetermined priority to investors holding various CMO classes. By allocating
the principal and interest cash flows from the underlying collateral among the
separate CMO classes, different classes of bonds are created, each with its own
stated maturity, estimated average life, coupon rate and prepayment
characteristics.
The Company's mortgage-backed derivative securities also include
mortgage-backed residuals and interest-only and principal-only strips.
Mortgage-backed residuals consist of certificates of particular tranches of a
CMO whereby the principal repayments and prepayments with respect to the
underlying pool of loans are generally not allocated to the residual until all
other certificates or tranches have been fully paid and retired. Interest-only
strips are a particular class of mortgage-backed derivative security which
receives and pays only interest with respect to the underlying pool of loans,
while principal-only strips receive and pay only principal repayments and
prepayments. As a result of the foregoing, mortgage-backed derivative securities
often exhibit elasticity and convexity characteristics (i.e., respond
differently to changes in interest rates) which the Company can utilize to
internally hedge other components of the Company's portfolio of assets against
interest rate risk.
The OTS has issued a statement of policy which states, among other
things, that mortgage derivative products (including CMOs and CMO residuals and
stripped mortgage-backed securities such as interest-only and principal-only
strips) which possess average life or price volatility materially different from
benchmark fixed-rate 30-year mortgage-backed securities are "high risk mortgage
securities," and must be carried in the institution's trading account or as
assets held for sale, and therefore marked to market on a regular basis. At June
30, 1998, $12.7 million or 4.4% 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
<PAGE>
sensitive to changes in interest rates and prepayments than traditional
mortgage-backed securities and are, therefore, even more volatile. Nevertheless,
the Company attempts to hedge against both interest rate and prepayment risk.
Although, as stated, no assurances can be given that these hedges will be
effective.
Although mortgage-backed and related securities often carry lower
yields than traditional mortgage loans, such securities generally increase the
quality of the Company's assets by virtue of the securities' underlying
insurance or guarantees, are more liquid than individual mortgage loans (which
enhances the Company's ability to actively manage its portfolio) and may be used
to collateralize borrowings or other obligations of the Company. At June 30,
1998, $248.5 million or 85.3% of the Company's mortgage-backed and related
securities were pledged to secure various obligations of the Company (such as
reverse repurchase agreements and interest rate swaps). In addition, in relation
to the Company maintaining a substantial portion of its assets in
mortgage-backed and related securities, the Company has been able to maintain a
relatively low level of operating expenses. Furthermore, mortgage-backed
derivative securities are often utilized by the Company to internally hedge its
interest rate exposure and can be attractive alternatives to other hedge
vehicles when their option-adjusted spreads are abnormally wide.
<PAGE>
The following table sets forth information relating to the amortized
cost and fair value of the Company's securities held for trading and securities
available for sale portfolios.
<TABLE>
<CAPTION>
June 30,
----------------------------------------------------------------------------------
1998 1997 1996
------------------------- ------------------------- ------------------------
Amortized Fair Amortized Fair Amortized Fair
Cost Value Cost Value Cost Value
--------- --------- --------- --------- --------- ---------
(In Thousands)
<S> <C> <C> <C> <C> <C> <C>
Securities held for trading:
FHLMC participation ................. $ 50,555 $ 51,229 $ 41,194 $ 41,516 $ 83,329 $ 83,384
certificates
FNMA participation .................. 57,252 58,244 68,800 69,355 66,182 65,997
certificates
GNMA participation .................. 142,951 144,219 165,894 168,102 153,048 154,240
certificates
Commercial participation
certificates ...................... 17,540 17,788 -- -- -- --
--------- --------- --------- --------- --------- ---------
Non-agency participation
certificates ...................... 1,884 1,875 2,545 2,502 3,209 3,154
--------- --------- --------- --------- --------- ---------
Total mortgage-backed securities... 270,182 273,355 278,433 281,475 305,768 306,775
--------- --------- --------- --------- --------- ---------
Collateralized mortgage obligations.. 10,930 11,414 25,789 26,032 6,131 6,379
Residuals ........................... 309 364 508 1,036 707 778
Interest-only strips ................ 1,118 518 2,028 1,449 3,442 2,792
Principal only strips ............... 599 718 821 860 1,028 1,010
--------- --------- --------- --------- --------- ---------
Total mortgage-backed
derivative securities ........... 12,956 13,014 29,146 29,377 11,308 10,959
--------- --------- --------- --------- --------- ---------
Interest rate swaps ................. -- (397) -- 581 -- 620
Interest rate collar ................ 38 (22) 50 (8) 83 (8)
Interest rate caps .................. 2,384 227 3,025 1,545 3,692 3,074
Interest rate floors ................ 3,410 4,440 3,916 3,541 2,535 2,970
Options ............................. 68 50 78 24 54 65
Futures ............................. -- (257) -- 356 -- (784)
--------- --------- --------- --------- --------- ---------
Total interest rate contracts...... 5,900 4,041 7,069 6,039 6,364 5,937
--------- --------- --------- --------- --------- ---------
Equity securities ................... 99 199 305 464 496 550
--------- --------- --------- --------- --------- ---------
Total securities held for trading . $ 289,137 $ 290,609 $ 314,953 $ 317,355 $ 323,936 $ 324,221
========= ========= ========= ========= ========= =========
Securities available for sale:
Non-agency participation
certificates ...................... $ 605 $ 587 $ 866 $ 790 $ 1,141 $ 1,088
--------- --------- --------- --------- --------- ---------
Total mortgage-backed securities .. 605 587 866 790 1,141 1,088
Municipal bonds .................... 319 335 317 335 921 962
--------- --------- --------- --------- --------- ---------
Total securities available for sale $ 924 $ 922 $ 1,183 $ 1,125 $ 2,062 $ 2,050
========= ========= ========= ========= ========= =========
</TABLE>
<PAGE>
The following table sets forth the fair value of the Company's securities
activities (both held for trading and available for sale) for the periods
indicated:
<TABLE>
<CAPTION>
At or For the Years
Ended June 30,
----------------------------------------
1998 1997 1996
--------- --------- ---------
(In Thousands)
<S> <C> <C> <C>
Beginning balance ........................ $ 318,480 $ 321,897 $ 249,274
--------- --------- ---------
Mortgage-backed securities purchased ... 653,403 890,623 385,542
held for trading
Collateralized mortgage obligations
purchased - held for trading ......... -- 19,823 --
Mortgage-backed derivative securities .. -- -- 495
purchased - held for trading
Interest rate contracts purchased - held
for trading .......................... 1,808 3,320 4,161
Equity securities purchased -
held for trading ..................... 2,000 -- 545
--------- --------- ---------
---------
Total securities purchased ........... 657,211 913,766 390,743
--------- --------- ---------
Less:
Sale of mortgage-backed securities -
held for trading .................... 634,099 887,468 276,482
Sale of collateralized mortgage
obligations - held for trading ....... 15,335 -- 7,798
Sale of mortgage-backed derivative
securities - held for trading ........ 628 625 3,642
Sale of interest rate contracts -
held for trading ..................... 113 132 1,973
Sale of equity securities -
held for trading ..................... 2,205 204 314
--------- --------- ---------
Total securities sold ................ 652,380 888,429 290,209
--------- --------- ---------
Less proceeds from maturities of
securities 28,697 27,277 25,829
Realized gain (loss) on sale of
securities held for trading ............ (775) (1,623) 1,834
Unrealized gain (loss) on securities
held for trading ....................... (930) 2,117 (1,960)
Change in net unrealized gain (loss) on
securities available for sale .......... 56 (46) (69)
Amortization of premium (1,434) (1,925) (1,887)
--------- --------- ---------
Ending balance ........................... $ 291,531 $ 318,480 $ 321,897
========= ========= =========
</TABLE>
<PAGE>
At June 30, 1998, the contractual maturity of substantially all of the
Company's mortgage-backed or related securities was in excess of twenty years.
The actual maturity of a mortgage-backed or related security is usually less
than its stated maturity due to prepayments of the underlying mortgages.
Prepayments that are faster than anticipated may shorten the life of the
security and affect its yield to maturity. The yield to maturity is based upon
the interest income and the amortization of any premium or discount related to
the security. In accordance with generally accepted accounting principles,
premiums and discounts are amortized over the estimated lives of the loans,
which decrease and increase interest income, respectively. The prepayment
assumptions used to determine the amortization period for premiums and discounts
can significantly affect the yield of the mortgage-backed or related security,
and these assumptions are reviewed periodically to reflect actual prepayments.
Although prepayments of underlying mortgages depend on many factors, including
the type of mortgages, the coupon rate, the age of mortgages, the geographical
location of the underlying real estate collateralizing the mortgages and general
levels of market interest rates, the difference between the interest rates on
the underlying mortgages and the prevailing mortgage interest rates generally is
the most significant determinant of the rate of prepayments. During periods of
falling mortgage interest rates, if the coupon rate of the underlying mortgages
exceeds the prevailing market interest rates offered for mortgage loans,
refinancing generally increases and accelerates the prepayment of the underlying
mortgages and the related security. At June 30, 1998, of the $287.0 million of
mortgage-backed and related securities held by the Company, an aggregate of
$120.4 million were secured by fixed-rate mortgage loans and an aggregate of
$166.6 million were secured by adjustable-rate mortgage loans.
Other Securities. Other securities owned by the Company at June 30,
1998 include various interest rate risk management contracts, including interest
rate swaps, collars, caps, floors, options and futures, equity securities and
municipal bonds. At June 30, 1998, the carrying value of the Company's interest
rate contracts, equity securities and municipal bonds amounted to $4.0 million,
$199,000 and $335,000, respectively. The municipal bonds held by the Company at
June 30, 1998 were scheduled to mature between two and three 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, securities sold
under agreements to repurchase, advances from the FHLB of Indianapolis, notes
payable, and sales, maturities and principal repayments on loans and securities
have been the major sources of funds for use in the Company's lending and
investing activities, and for other general business purposes. Management of the
Company closely monitors rates and terms of competing sources of funds on a
daily basis and utilizes the source which it believes to be cost effective.
Deposits. The Bank attempts to price its deposits in order to promote
deposit growth and offers a wide array of deposit products in order to satisfy
its customers' needs. The Bank's current deposit products include statement
savings accounts, negotiable order of withdrawal ("NOW") and
<PAGE>
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. Management estimates that as of June 30, 1998, non-retail
deposit accounts totaled $11.5 million or 6.5% 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 the three
month LIBOR rate. For example, if LIBOR rates of interest increase, the rates on
the inverse variable-rate certificates would decrease, while if market rates of
interest decrease, the rates on the inverse variable-rate certificates would
increase. As a result, the Bank would generally be paying a higher rate on such
certificates during a declining interest rate environment. The Bank offers
inverse variable-rate certificates when they represent a lower cost source of
funds to comparable duration funding sources.
The following table shows the distribution of and certain other
information relating to the Bank's deposits by type as of the dates indicated.
<TABLE>
<CAPTION>
June 30,
-------------------------------------------------------------------------
1998 1997 1996
---------------------- ----------------------- -----------------------
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 ............ $ 8,202 4.6% $ 4,778 3.5% $ 4,529 3.4%
Savings accounts ............ 31,076 17.4 20,523 15.1 17,342 12.8
Money market deposit accounts 2,705 1.5 1,930 1.4 1,576 1.2
-------- ----- -------- ----- -------- -----
Total transaction accounts. 41,983 23.5 27,231 20.0 23,447 17.4
-------- ----- -------- ----- -------- -----
Certificates of deposit:
Within 1 year ............... 113,237 63.5 74,586 54.8 75,343 55.7
1-2 years ................... 13,169 7.4 19,437 14.3 19,890 14.7
2-3 years ................... 3,570 2.0 7,486 5.5 8,093 6.0
3-4 years ................... 3,198 1.8 1,845 1.3 2,636 2.0
Over 4 years ................ 3,154 1.8 5,590 4.1 5,734 4.2
-------- ----- -------- ----- -------- -----
Total certificate accounts 136,328 76.5 108,944 80.0 111,696 82.6
-------- ----- -------- ----- -------- -----
Total deposits ............ $178,311 100.0% $136,175 100.0% $135,143 100.0%
======== ===== ======== ===== ======== =====
</TABLE>
<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,
-------------------------------------------------------------------
1998 1997 1996
--------------------- --------------------- ---------------------
Percent of Percent of Percent of
Amount Deposits Amount Deposits Amount Deposits
------ -------- ------ -------- ------ --------
<S> <C> <C> <C> <C> <C> <C>
Total retail certificates .. $126,096 70.7% $ 96,946 71.2% $ 89,462 66.2%
-------- ---- -------- ---- -------- ----
Non-retail certificates:
Jumbo certificates ...... 2,752 1.5 2,420 1.8 6,041 4.4
Inverse variable-rate
certificates .......... 5,250 3.0 6,218 4.6 8,423 6.2
Non-brokered out-of-state
deposits .............. 2,131 1.2 3,064 2.2 7,276 5.4
Brokered deposits ....... 99 0.1 296 0.2 494 0.4
-------- ---- -------- ---- -------- ----
Total non-retail
certificates (1) ..... 10,232 5.8 11,998 8.8 22,234 16.4
-------- ---- -------- ---- -------- ----
Total certificates of
deposit .................... $136,328 76.5% $108,944 80.0% $111,696 82.6%
======== ==== ======== ==== ======== ====
</TABLE>
- --------
(1) Of the Company's $10.2 million of non-retail certificates as of June
30, 1998, $2.7 million was scheduled to mature in six months or less,
$2.9 million was scheduled to mature in 7-12 months, $1.2 million was
scheduled to mature in 13-36 months and $3.4 million was scheduled to
mature in over 36 months.
The following table presents the average balance of each deposit type
and the average rate paid on each deposit type for the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
--------------------------------------------------------------------------------
1998 1997 1996
-------------------------- --------------------------- ------------------------
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 $ 6,788 2.5% $ 4,697 2.6% $ 3,813 2.9%
Savings accounts 25,666 4.4 20,463 4.1 15,922 3.9
Money market deposit
accounts 2,235 4.5 1,886 4.4 1,777 4.3
Certificates of deposit 117,073 5.9 109,756 5.9 103,981 6.1
-------- -------- --------
Total deposits $151,762 5.5% $136,802 5.5% $125,493 5.7%
======== === ======== === ======== ===
</TABLE>
<PAGE>
The following table sets forth the deposit account activities of the
Bank during the periods indicated.
<TABLE>
<CAPTION>
Year Ended June 30,
--------------------------------------
1998 1997 1996
--------- --------- ---------
(In Thousands)
<S> <C> <C> <C>
Deposits ............................ $ 264,182 $ 208,032 $ 213,601
Withdrawals ......................... 230,421 212,517 197,550
--------- --------- ---------
Net increase (decrease) before
interest credited .............. 33,761 (4,485) 16,051
Interest credited ................... 8,375 5,517 3,780
--------- --------- ---------
Net increase in deposits ............ $ 42,136 $ 1,032 $ 19,831
========= ========= =========
</TABLE>
The following table shows the interest rate and maturity information
for the Bank's certificates of deposit at June 30, 1998.
<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 $ -- $ -- $ -- $ 9 $ 9
3.01 - 5.00% 9,877 953 55 172 11,057
5.01 - 7.00% 100,665 11,050 2,725 3,757 118,197
7.01 - 9.00% 2,384 1,158 117 2,414 6,073
9.01% or greater 311 8 673 -- 992
--------- -------- ------- ------- ---------
Total $ 113,237 $ 13,169 $ 3,570 $ 6,352 $ 136,328
========= ======== ======= ======= =========
</TABLE>
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,
1998.
<TABLE>
<CAPTION>
Certificates of deposit maturing
in quarter ending: Amount
------------------ ------
(In Thousands)
<S> <C>
September 30, 1998 $ 10,942
December 31, 1998 5,700
March 31, 1999 2,907
After March 31, 1999 5,554
--------
Total certificates of deposit with
balances of $100,000 or more $ 25,103
========
</TABLE>
<PAGE>
Borrowings. The following table sets forth certain information
regarding the borrowings of the Company at or for the dates indicated.
<TABLE>
<CAPTION>
At or For the Year Ended June 30,
-------------------------------------
1998 1997 1996
-------- -------- --------
(Dollars in Thousands)
<S> <C> <C> <C>
FHLB advances:
Average balance outstanding ................. $ 27,488 $ 26,089 $ 27,586
Maximum amount outstanding at
any month-end during the period ........... 64,000 29,300 31,000
Balance outstanding at end of period ........ 26,000 26,000 26,000
Average interest rate during the
period .................................... 6.7% 6.3% 5.8%
Average interest rate at end of period ...... 5.6% 5.8% 5.4%
Securities sold under agreements to repurchase:
Average balance outstanding ................. $319,579 $306,034 $148,523
Maximum amount outstanding at
any month-end during the period ........... 342,094 343,427 219,067
Balance outstanding at end of period ........ 240,396 245,571 219,067
Average interest rate during the
period .................................... 5.6% 5.4% 5.6%
Average interest rate at end of period ...... 5.7% 5.5% 5.2%
</TABLE>
The Company obtains both fixed-rate and variable-rate long-term and
short-term advances from the FHLB of Indianapolis upon the security of certain
of its residential first mortgage loans and other assets, provided certain
standards related to creditworthiness of the Bank have been met. FHLB of
Indianapolis advances are available for general business purposes to expand
lending and investing activities. Borrowings have generally been used to fund
the purchase of mortgage-backed and related securities or lending activities and
have been collateralized with a blanket pledge agreement of the Bank's assets.
Advances from the FHLB of Indianapolis are made pursuant to several
different credit programs, each of which has its own interest rate and range of
maturities. The Company currently has one variable-rate advance from the FHLB of
Indianapolis which matures in 1998. At June 30, 1998, the Company had a FHLB of
Indianapolis advance in the amount of $26.0 million at a weighted average
interest rate of 5.7%.
<PAGE>
The Company also obtains funds from the sales of securities to
investment dealers under agreements to repurchase ("reverse repurchase
agreements"). In a reverse repurchase agreement transaction, the Company will
generally sell a mortgage-backed security agreeing to repurchase either the same
or a substantially identical security (i.e., "dollar rolls") on a specified
later date (generally not more than 90 days) at a price that is generally less
than the original sales price. The difference in the sale price and purchase
price is the spread between the mortgage cash flows and the implied financing
rate. The mortgage-backed securities underlying the agreements are delivered to
the dealers who arrange the transactions. For agreements in which the Company
has agreed to repurchase substantially identical securities, the dealers may
sell, loan or otherwise dispose of the Company's securities in the normal course
of their operations; however, such dealers or third party custodians safe-keep
the securities which are to be specifically repurchased by the Company. Reverse
repurchase agreements represent a competitive cost funding source for the
Company. Nevertheless, the Company is subject to the risk that the lender may
default at maturity and not return the collateral. The amount at risk is the
value of the collateral which exceeds the balance of the borrowing. In order to
minimize this potential risk, the Company normally deals with large, established
investment brokerage firms when entering into these transactions. Reverse
repurchase transactions are accounted for as financing arrangements rather than
as sales of such securities, and the obligation to repurchase such securities is
reflected as a liability in the Consolidated Financial Statements.
In April 1993, the Company entered into a $10.0 million loan facility
with an unrelated financial institution. This facility, as amended in 1997,
includes a $10.0 million term loan (the "Refinancing Loan") and a non-revolving
line of credit of $5.0 million. Proceeds from the Refinancing Loan were utilized
to repay the unpaid balance of a $10.0 million loan that the Company obtained in
1988 in connection with its acquisition of the Bank, reduce the average interest
rate paid on such indebtedness and increase the capitalization of the Bank. The
loan facility matures in June 2000 and carries an interest rate equal to the
prime rate published in the Wall Street Journal. The loan facility requires
quarterly interest-only repayments with the unpaid principal balance outstanding
payable in full at maturity. The loan facility is secured by (1) a general
pledge agreement between the parties pursuant to which the Company has pledged
100% of the outstanding stock of the Bank; (2) a security agreement between the
parties pursuant to which the Company has provided a blanket security interest
in all of its assets; and (3) the assignment of life insurance policies on
Messrs. Breeden and Cerny by the Company in the aggregate amount of $1.25
million. At June 30, 1998, the total balance of the loan facility was $13.5
million.
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,
<PAGE>
1998, the Trust Department administered approximately 54 trust/fiduciary
accounts, with aggregate assets of $37.4 million at such date.
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.
The Company
General. The Company is a registered savings and loan holding company
within the meaning of the Home Owners' Loan Act ("HOLA"), and is subject to OTS
regulations, examinations, supervision and reporting requirements. As a
subsidiary of a savings and loan holding company, the Bank is subject to certain
restrictions in its dealings with the Company and affiliates thereof.
Activities Restrictions. Although there are generally no restrictions
on the activities of a savings and loan holding company which holds only one
subsidiary savings institution under applicable OTS regulations, the Company may
be considered to be a multiple savings and loan holding company because
principals and affiliates of Smith Breeden may be deemed for regulatory purposes
to control both the Company and Harrington West Financial Group, a savings and
loan holding company which owns all of the outstanding common stock of Los
Padres Savings Bank, F.S.B., Los Padres, California.
Multiple savings and loan holding companies are subject to restrictions
which do not apply to unitary savings and loan holding companies. Among other
things, no multiple savings and loan holding company or subsidiary thereof which
is not a savings institution shall commence or continue for a limited period of
time after becoming a multiple savings and loan holding company or subsidiary
thereof any business activity, upon prior notice to, and no objection by the
OTS, other than: (1) furnishing or performing management services for a
subsidiary savings institution; (2) conducting an insurance agency or escrow
business; (3) holding, managing, or liquidating assets
<PAGE>
owned by or acquired from a subsidiary savings institution; (4) holding or
managing properties used or occupied by a subsidiary savings institution; (5)
acting as trustee under deeds of trust; (6) engaging in those activities
authorized by regulation as of March 5, 1987 to be permissible for multiple
savings and loan holding companies; or (7) unless the Director of the OTS by
regulation prohibits or limits such activities for savings and loan holding
companies, those activities authorized by the Federal Reserve Board as
permissible for bank holding companies. Those activities described in (7) above
also must be approved by the Director of the OTS prior to being engaged in by a
multiple savings and loan holding company. The Company does not believe that if
the OTS designates it as a multiple thrift holding company, such a designation
will limit its ability to conduct its normal business operations.
In addition, if the Director of the OTS determines that there is
reasonable cause to believe that the continuation by a savings and loan holding
company of an activity constitutes a serious risk to the financial safety,
soundness or stability of its subsidiary savings institution, the Director may
impose such restrictions as deemed necessary to address such risk, including
limiting (1) payment of dividends by the savings institution; (2) transactions
between the savings institution and its affiliates; and (3) any activities of
the savings institution that might create a serious risk that the liabilities of
the holding company and its affiliates may be imposed on the savings
institution.
Limitations on Transactions with Affiliates. Transactions between
savings institutions and any affiliate are governed by Sections 23A and 23B of
the Federal Reserve Act. An affiliate of a savings institution is any company or
entity which controls, is controlled by or is under common control with the
savings institution. In a holding company context, the parent holding company of
a savings institution (such as the Company) and any companies which are
controlled by such parent holding company are affiliates of the savings
institution. Generally, Sections 23A and 23B (1) limit the extent to which the
savings institution or its subsidiaries may engage in "covered transactions"
with any one affiliate to an amount equal to 10% of such institution's capital
stock and surplus, and contain an aggregate limit on all such transactions with
all affiliates to an amount equal to 20% of such capital stock and surplus and
(2) require that all such transactions be on terms substantially the same, or at
least as favorable, to the institution or subsidiary as those provided to a
non-affiliate. The term "covered transaction" includes the making of loans,
purchase of assets, issuance of a guarantee and other similar transactions. In
addition to the restrictions imposed by Sections 23A and 23B, no savings
institution may (1) loan or otherwise extend credit to an affiliate, except for
any affiliate which engages only in activities which are permissible for bank
holding companies, or (2) purchase or invest in any stocks, bonds, debentures,
notes or similar obligations of any affiliate, except for affiliates which are
subsidiaries of the savings institution.
In addition, Sections 22(h) and (g) of the Federal Reserve Act places
restrictions on loans to executive officers, directors and principal
stockholders. Under Section 22(h), loans to a director, an executive officer and
to a greater than 10% stockholder of a savings institution, and certain
affiliated interests of either, may not exceed, together with all other
outstanding loans to such person and affiliated interests, the savings
institution's loans to one borrower limit (generally equal to 15% of the
institution's unimpaired capital and surplus). Section 22(h) also requires that
loans to directors, executive officers and principal stockholders be made on
terms substantially the same as
<PAGE>
offered in comparable transactions to other persons unless the loans are made
pursuant to a benefit or compensation program that (1) is widely available to
employees of the institution and (2) does not give preference to any director,
executive officer or principal stockholder, or certain affiliated interests of
either, over other employees of the savings institution. Section 22(h) also
requires prior board approval for certain loans. In addition, the aggregate
amount of extensions of credit by a savings institution to all insiders cannot
exceed the institution's unimpaired capital and surplus. Furthermore, Section
22(g) places additional restrictions on loans to executive officers. At June 30,
1998, the Bank was in compliance with the above restrictions.
Restrictions on Acquisitions. Except under limited circumstances,
savings and loan holding companies are prohibited from acquiring, without prior
approval of the Director of the OTS, (1) control of any other savings
institution or savings and loan holding company or substantially all the assets
thereof or (2) more than 5% of the voting shares of a savings institution or
holding company thereof which is not a subsidiary. Except with the prior
approval of the Director of the OTS, no director or officer of a savings and
loan holding company or person owning or controlling by proxy or otherwise more
than 25% of such company's stock, may acquire control of any savings
institution, other than a subsidiary savings institution, or of any other
savings and loan holding company.
The Director of the OTS may only approve acquisitions resulting in the
formation of a multiple savings and loan holding company which controls savings
institutions in more than one state if (1) the multiple savings and loan holding
company involved controls a savings institution which operated a home or branch
office located in the state of the institution to be acquired as of March 5,
1987; (2) the acquirer is authorized to acquire control of the savings
institution pursuant to the emergency acquisition provisions of the Federal
Deposit Insurance Act ("FDIA"); or (3) the statutes of the state in which the
institution to be acquired is located specifically permit institutions to be
acquired by the state-chartered institutions or savings and loan holding
companies located in the state where the acquiring entity is located (or by a
holding company that controls such state-chartered savings institutions).
Under the Bank Holding Company Act of 1956, the Federal Reserve Board
is authorized to approve an application by a bank holding company to acquire
control of a savings institution. In addition, a bank holding company that
controls a savings institution may merge or consolidate the assets and
liabilities of the savings institution with, or transfer assets and liabilities
to, any subsidiary bank which is a member of the BIF with the approval of the
appropriate federal banking agency and the Federal Reserve Board. As a result of
these provisions, there have been a number of acquisitions of savings
institutions by bank holding companies in recent years.
The Bank
General. The OTS has extensive authority over the operations of
federally chartered savings institutions. As part of this authority, savings
institutions are required to file periodic reports with the OTS and are subject
to periodic examinations by the OTS. The last regulatory examination of the Bank
by the OTS was conducted beginning on May 27, 1997. The Bank was
<PAGE>
not required to make any material changes to its operations as a result of such
examination. The investment and lending authority of savings institutions are
prescribed by federal laws and regulations, and such institutions are prohibited
from engaging in any activities not permitted by such laws and regulations.
Those laws and regulations generally are applicable to all federally chartered
savings institutions and may also apply to state-chartered savings institutions.
Such regulation and supervision is primarily intended for the protection of
depositors.
The OTS' enforcement authority over all savings institutions and their
holding companies includes, among other things, the ability to assess civil
money penalties, to issue cease and desist or removal orders and to initiate
injunctive actions. In general, these enforcement actions may be initiated for
violations of laws and regulations and unsafe or unsound practices. Other
actions or inactions may provide the basis for enforcement action, including
misleading or untimely reports filed with the OTS.
Insurance of Accounts. The deposits of the Bank are insured to the
maximum extent permitted by the SAIF, which is administered by the FDIC, and are
backed by the full faith and credit of the U.S. Government. As insurer, the FDIC
is authorized to conduct examinations of, and to require reporting by,
FDIC-insured institutions. It also may prohibit any FDIC-insured institution
from engaging in any activity the FDIC determines by regulation or order to pose
a serious threat to the FDIC. The FDIC also has the authority to initiate
enforcement actions against savings institutions, after giving the OTS an
opportunity to take such action.
Both the SAIF and Bank Insurance Fund ("BIF") are statutorily required
to be capitalized to a ratio of 1.25% of insured reserve deposits. The BIF met
its required capitalization levels in 1995 and, as a result, most BIF insured
banks have been paying significantly lower premiums than SAIF institutions. The
legislation enacted by the U.S. Congress, which was signed by the President on
September 30, 1996, has recapitalized the SAIF by a one-time charge of $0.657
for each $100 of assessable deposits held at March 31, 1995. Although this
resulted in pre-tax expense of $830,000 recognized in the Company's earnings in
fiscal year 1997, future earnings will be enhanced due to lower insurance
premiums. The Bank's insurance premiums, which had amounted to $0.23 for every
$100 of assessable deposits, were reduced to $0.065 for every $100 of assessable
deposits beginning on January 1, 1997.
The FDIC may terminate the deposit insurance of any insured depository
institution, including the Bank, if it determines after a hearing that the
institution has engaged or is engaging in unsafe or unsound practices or is in
an unsafe or unsound condition to continue operations, or if the insured
depository institution or any of its directors or trustees have violated any
applicable law, regulation, order or any condition imposed by an agreement with
the FDIC. It also may suspend deposit insurance temporarily during the hearing
process for the permanent termination of insurance, if the institution has no
tangible capital. If insurance of accounts is terminated, the accounts at the
institution at the time of the termination, less subsequent withdrawals, shall
continue to be insured for a period of six months to two years, as determined by
the FDIC. Management is aware of no existing circumstances which would result in
termination of the Bank's deposit insurance.
<PAGE>
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 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, 1998. 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, 1998, 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 (1) 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; (2)
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;
(3) 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 (4) 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.
<PAGE>
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.
Liquidity Requirements. The Bank is required under applicable federal
regulations to maintain specified levels of "liquid" investments as defined by
the OTS. As of November 24, 1997, the required level of such liquid investments
was changed from 5% to 4% of certain liabilities as defined by the OTS. In
addition to the change in the percentage of required level of liquid assets, the
OTS also modified its definition of investments that are considered liquid. As a
result of this change, the level of assets eligible for regulatory liquidity
calculations increased considerably. At June 30, 1998, the Bank's liquidity
ratio was 15.6%.
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 (1) 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 (2) 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.
On January 7, 1998, the OTS published a notice of proposed rulemaking
to amend its capital distribution regulation. Under the proposal, a savings
institution that would remain at least "adequately capitalized" following the
capital distribution and that meets other specified requirements, would not be
required to provide any notice or application to the OTS for cash dividends
below a specified amount. A savings institution is "adequately capitalized" if
it has a
<PAGE>
total risk-based capital ratio of 8.0% or more, a Tier 1 risk-based capital
ratio of 4.0% or more, a Tier 1 leverage capital ratio of 4.0% or more (or 3% or
more if the savings institution is assigned a composite rating of 1), and does
not meet the definition of "well capitalized." Because the Bank is a subsidiary
of the Company, the proposal, however, would require the Bank to provide notice
to the OTS of its intent to make a capital distribution, unless an application
is otherwise required. The Bank does not believe that the 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
15% of unimpaired capital and unimpaired surplus. Loans in an amount equal to an
additional 10% of unimpaired capital and unimpaired surplus also may be made to
a borrower if the loans are fully secured by readily marketable securities. If a
savings institution's aggregate lending limitation is less than $500,000, then,
notwithstanding the aforementioned aggregate limitation, such savings
institution may have total loans and extensions of credit, for any purpose, to
one borrower outstanding at one time not to exceed $500,000. For information
about the largest borrowers from the Bank, see "- Lending Activities."
Branching by Federal Savings Institutions. OTS policy permits
interstate branching to the full extent permitted by statute (which is
essentially unlimited). Generally, federal law prohibits federal savings
institutions from establishing, retaining or operating a branch outside the
state in which the federal institution has its home office unless the
institution meets the IRS' domestic building and loan test (generally, 60% of a
thrift's assets must be housing-related) ("IRS Test"). The IRS Test requirement
does not apply if, among other things, the law of the state where the branch
would be located would permit the branch to be established if the federal
savings institution were chartered by the state in which its home office is
located. Furthermore, the OTS will evaluate a branching applicant's record of
compliance with the Community Reinvestment Act of 1977 ("CRA"). An
unsatisfactory CRA record may be the basis for denial of a branching
application.
Qualified Thrift Lender Test. All savings institutions are required to
meet a QTL test to avoid certain restrictions on their operations. Under Section
2303 of the Economic Growth and Regulatory Paperwork Reduction Act of 1996, a
savings association can comply with the QTL test by either meeting the QTL test
set forth in the HOLA and implementing regulations or qualifying as a domestic
building and loan association as defined in Section 7701(a)(19) of the Internal
Revenue Code of 1986, as amended ("Code"). The QTL test set forth in the HOLA
requires a thrift institution to maintain 65% of portfolio assets in Qualified
Thrift Investments ("QTIs"). Portfolio assets are defined as total assets less
intangibles, property used by a savings institution in its business and
liquidity investments in an amount not exceeding 20% of assets. Generally, QTIs
are residential housing related assets. At June 30, 1998, the qualified thrift
investments of the Bank were approximately 94.3% of its portfolio assets.
<PAGE>
A savings institution that does not meet the QTL test must either
convert to a bank charter or comply with the following restrictions on its
operations: (1) the institution may not engage in any new activity or make any
new investment, directly or indirectly, unless such activity or investment is
permissible for a national bank; (2) the branching powers of the institution
shall be restricted to those of a national bank; (3) the institution shall not
be eligible to obtain any advances from its FHLB; and (4) payment of dividends
by the institution shall be subject to the rules regarding payment of dividends
by a national bank. Upon the expiration of three years from the date the savings
institution ceases to be a QTL, it must cease any activity and not retain any
investment not permissible for a national bank and immediately repay any
outstanding FHLB advances (subject to safety and soundness considerations).
Accounting Requirements. Applicable OTS accounting regulations and
reporting requirements apply the following standards: (1) regulatory reports
will incorporate generally accepted accounting principles ("GAAP") when GAAP is
used by federal banking agencies; (2) savings institution transactions,
financial condition and regulatory capital must be reported and disclosed in
accordance with OTS regulatory reporting requirements that will be at least as
stringent as for national banks; and (3) the Director of the OTS may prescribe
regulatory reporting requirements more stringent than GAAP whenever the Director
determines that such requirements are necessary to ensure the safe and sound
reporting and operation of savings institutions.
Federal Home Loan Bank System. The Bank is a member of the FHLB of
Indianapolis, which is one of 12 regional FHLBs that administers the home
financing credit function of savings institutions. Each FHLB serves as a reserve
or central bank for its members within its assigned region. It is funded
primarily from proceeds derived from the sale of consolidated obligations of the
FHLB System. It makes loans to members (i.e., advances) in accordance with
policies and procedures established by the Board of Directors of the FHLB. At
June 30, 1998, the Company had a $26.0 million FHLB advance. See "- Sources of
Funds Borrowings."
As a member, the Bank is required to purchase and maintain stock in the
FHLB of Indianapolis in an amount equal to at least 1% of its aggregate unpaid
residential mortgage loans, home purchase contracts or similar obligations at
the beginning of each year. At June 30, 1998, the Bank had $4.9 million in FHLB
stock, which was in compliance with this requirement.
The FHLBs are required to provide funds for the resolution of troubled
savings institutions and to contribute to affordable housing programs through
direct loans or interest subsidies on advances targeted for community investment
and low- and moderate-income housing projects. These contributions have
adversely affected the level of FHLB dividends paid in the past and could
continue to do so in the future. These contributions also could have an adverse
effect on the value of FHLB stock in the future.
Federal Reserve System. The Federal Reserve Board requires all
depository institutions to maintain reserves against their transaction accounts
(primarily NOW and Super NOW checking accounts) and non-personal time deposits.
As of June 30, 1998, the Bank was in compliance with this requirement. Because
required reserves must be maintained in the form of vault cash or a
<PAGE>
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.
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, 1995 forward are open under the statute
of limitations and are subject to review by the IRS.
Bad Debt Reserves. Prior to the enactment, on August 20, 1996, of the
Small Business Job Protection Act of 1996 (the "Small Business Act"), for
federal income tax purposes, thrift institutions such as the Bank, which met
certain definitional tests primarily relating to their assets and the nature of
their business, were permitted to establish tax reserves for bad debts and to
make annual additions thereto, which additions could, within specified
limitations, be deducted in arriving at their taxable income. The Bank's
deduction with respect to "qualifying loans," which are generally loans secured
by certain interest in real property, could be computed using an amount based on
a six-year moving average of the Bank's actual loss experience (the "Experience
Method"), or a percentage equal to 8.0% of the Bank's taxable income (the "PTI
Method"), computed without regard to this deduction and with additional
modifications and reduced by the amount of any permitted addition to the
non-qualifying reserve.
Under the Small Business Act, the PTI Method was repealed and the Bank
will be required to use the Experience Method of computing additions to its bad
debt reserve for taxable years beginning with the Bank's taxable year beginning
July 1, 1996. In addition, the Bank will be required to recapture (i.e., take
into taxable income) over a six-year period, beginning with the Bank's taxable
year beginning July 1, 1996, the excess of the balance of its bad debt reserves
(other than the supplemental reserve) as of June 30, 1996 over (a) the greater
of the balance of such reserves as of June 30, 1988 or (b) an amount that would
have been the balance of such reserves as of June 30, 1996 had the Bank always
computed the additions to its reserves using the Experience Method. However,
under the Small Business Act such recapture requirements will be suspended for
each of the two successive taxable years beginning July 1, 1996 in which the
Bank originates a minimum amount of certain residential loans during such years
that is not less than the average of the principal amounts of such loans made by
the Bank during its six taxable years preceding July 1, 1996. The Bank has
delayed the timing of this recapture for taxable years 1998 and 1997 as certain
residential loan test requirements were met. The six year recovery period for
the excess reserves will begin in taxable year 1999.
<PAGE>
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.
<PAGE>
Item 2. Properties
The Company's principal executive office is located at 722 East Main
Street, Richmond, Indiana, 47374. The following table sets forth certain
information with respect to the offices and other properties of the Bank at June
30, 1998.
<TABLE>
<CAPTION>
Net Book Value
Description/Address Leased/Owned of Property(1) Deposits
------------------- ------------ -------------- --------
(In Thousands)
<S> <C> <C> <C>
Main Office Owned $ 1,679 $63,269
722 East Main Street
Richmond, Indiana
Carmel Branch (2) Leased (3) 96 59,175
11592 Westfield Boulevard
Carmel, Indiana
Fishers Branch (4) Owned 904 20,722
7150 East 116th Street
Fishers, Indiana
Noblesville Branch (5) Owned 895 11,792
107 West Logan Street
Noblesville, Indiana
Geist Branch (6) Owned 954 7,050
9775 Fall Creek Road
Indianapolis, Indiana
Thompson Road Branch (7) Leased (8) 32 5,976
5249 East Thompson Road
Indianapolis, Indiana
Stop 11 Branch (9) Leased (10) 155 10,327
1121 East Stop 11 Road
Indianapolis, Indiana
Shawnee Mission Branch (11) Leased (12) 16 --
6300 Nall Road
Shawnee Mission, Kansas
Chapel Hill Branch (13) Leased (14) 4 --
Suite 271 The Europa Center
Chapel Hill, NC
</TABLE>
-------------------------
(1) Includes leasehold improvements.
(2) Branch opened in May 1994.
<PAGE>
(3) The lease expires in June 2008 and may be extended for an additional
ten years provided that proper notice is timely given.
(4) Branch opened in December 1995.
(5) Branch opened in June 1997.
(6) Branch opened in December 1997
(7) Branch opened in January 1998.
(8) The lease expires in January 2003 and has three options for additional
terms of five years each.
(9) Branch opened in February 1998.
(10) The lease expires in November 2000 and has three options for additional
terms of five years each.
(11) In process; branch opened in August 1998.
(12) The lease expires in December 2010 and has four options for additional
terms of five years each.
(13) Branch is expected to open in March 1999.
(14) The lease expires five years after branch opens for business.
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. The following table sets forth the
high, low and closing sales prices for the common stock as reported by the
Nasdaq Stock Market, as well as the dividends paid, for fiscal years 1998 and
1997:
<TABLE>
<CAPTION>
Stock Price per Share
------------------------------------------
High Low Close Dividends
---- --- ----- ---------
<S> <C> <C> <C> <C>
1998
First quarter $13.50 $ 11.00 $13.00 $0.03
Second quarter 13.75 12.00 13.00 0.03
Third quarter 13.125 11.125 11.375 0.03
Fourth quarter 11.75 10.75 11.25 0.03
1997
First quarter $11.00 $ 9.50 $10.125 --
Second quarter 10.75 10.00 10.75 --
Third quarter 11.00 9.75 11.00 --
Fourth quarter 12.375 10.50 12.125 $0.03
</TABLE>
<PAGE>
There have been no stock dividends, stock splits or reverse stock
splits. Payment of future dividends is subject to a declaration by the Company's
Board of Directors. Factors considered in determining the size of dividends are
the amount and stability of profits, adequacy of capitalization and expected
asset and liability growth of the Bank.
At September 18, 1998 the Company had approximately 65 stockholders of
record.
Item 6. Selected Financial Data.
The information required herein is incorporated by reference from page
14 of the Registrant's 1998 Annual Report.
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 28 of the Registrant's 1998 Annual Report.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk
The information required herein is incorporated by reference from pages
16 to 20 of the Registrant's 1998 Annual Report.
Item 8. Financial Statements and Supplementary Data.
The information required herein is incorporated by reference from pages
29 to 56 of the Registrant's 1998 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
2 to 10, and 12 of the Registrant's Proxy Statement dated September 22, 1998
("Proxy Statement").
<PAGE>
Item 11. Executive Compensation.
The information required herein is incorporated by reference from pages
13 to 21 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
10 to 12 of the Registrant's Proxy Statement.
Item 13. Certain Relationships and Related Transactions.
The information required herein is incorporated by reference from pages
18 and 19 of the Registrant's Proxy Statement.
<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 1998 Annual Report.
Independent Auditors' Report.
Consolidated Balance Sheets as of June 30, 1998 and 1997.
Consolidated Statements of Operations for the Years Ended June 30, 1998,
1997 and 1996.
Consolidated Statements of Changes in Stockholders' Equity for the Years
Ended June 30, 1998, 1997 and 1996.
Consolidated Statements of Cash Flows for the Years Ended June 30, 1998,
1997 and 1996.
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.
<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
(now Mercantile Bancorporation, Inc.), 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 (now Mercantile Bancorporation, Inc.), dated July 26,
1996 (modifies version set forth in Exhibit 10.2) 2/
10.2.2 Third Amendment and Loan Modification Agreement between
Harrington Financial Group, Inc. and Mark Twain Kansas City
Bank (now Mercantile Bancorporation, Inc.), dated January
13, 1997 (modifies version set forth in Exhibits 10.2 and
10.2.1)3/
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/
10.6 Trust Services Agreement dated April 30, 1998 by and between
Harrington Bank, FSB and INFOVISA. 13 1998 Annual Report to
Stockholders specified portion (pp. 12-56) of the
Registrant's Annual Report to Stockholders for the year
ended June 30, 1998.
21 Subsidiaries of the Registrant - Reference is made to Item
1. "Business" for the Required information
23 Consent of Deloitte & Touche LLP
27 Financial Data Schedule
<PAGE>
- ---------------
1/ Incorporated by reference from the Registration Statement on Form S-1
(Registration No. 333-1556) filed by the Registrant with the Securities and
Exchange Commission ("SEC") on February 20, 1996, as amended.
2/ Incorporated by reference from the Form 10-K for the fiscal year ended June
30, 1996 filed by the Registrant with the SEC on September 30, 1996. -
3/ Incorporated by reference from the Form 10-K for the fiscal year ended June
30, 1997 filed by the Registrant with the SEC on September 29, 1997. -
*/ Management contract or compensatory plan or arrangement.
(3)(b) Reports filed on Form 8-K.
None.
<PAGE>
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 24, 1998
- ------------------
Craig J. Cerny
President (Principal Executive Officer)
/s/ Twana L. Cheek September 24, 1998
- ------------------
Twana L. Cheek
Principal Financial & Accounting Officer
/s/ Douglas T. Breeden September 24, 1998
- ----------------------
Douglas T. Breeden
Chairman of the Board
/s/ Russell Breeden III September 24, 1998
- -----------------------
Russell Breeden III
Director
<PAGE>
/s/ William F. Quinn September 24, 1998
- --------------------
William F. Quinn
Director
/s/ Daniel C. Dektar September 24, 1998
- --------------------
Daniel C. Dektar
Director
/s/ Marianthe Mewkill September 24, 1998
- ---------------------
Marianthe Mewkill
Director
/s/ Michael J. Giarla September 24, 1998
- ---------------------
Michael J. Giarla
Director
/s/ Stephen A. Eason September 24, 1998
- ---------------------
Stephen A. Eason
Director
/s/ Lawrence E. Golaszewski September 24, 1998
- ---------------------------
Lawrence E. Golaszewski
Director
/s/ David F. Harper September 24, 1998
- -------------------
David F. Harper
Director
/s/ Stanley J. Kon September 24, 1998
- ------------------
Stanley J. Kon
Director
/s/ John J. McConnell September 24, 1998
- ---------------------
John J. McConnell
Director
Exhibit 10.6
Trust Services Agreement dated April 30, 1998 by and
between Harrington Bank, FSB and INFOVISA
<PAGE>
SOFTWARE LICENSE AGREEMENT
MAUI ( Multiple Application User Interface )
This Software License Agreement (the "Agreement") made this the 30th day of
April, 1998, is by and among INFOVISA ("Licensor"), and Harrington Bank, FSB,
("Licensee").
The terms of this Software License Agreement apply to Licensor's software known
as Multiple Application User Interfaces which includes Enhanced Trust Accounting
and Enhanced Trust Reporting (Software), which is owned by UniPac Service
Corporation ("Unipac"). INFOVISA warrants it has the right to sublicense the
Software.
NOW, THEREFORE, in consideration of the mutual promises in this document, the
parties agree as follows:
1. Grant. Subject to all the terms and conditions of this Software License
Agreement, Licensor hereby grants the Licensee a personal, non-exclusive,
non-transferable right and license to use the Software and any documents,
manuals or other material provided in support of the software. No transfer
of ownership is intended by this Software License Agreement.
2. Term. This Agreement shall be in force beginning on the date accepted by
the President of Infovisa and shall continue for a period of sixty (60)
months commencing upon billing of the first months maintenance.
3. Product Provided. Licensor will provide an executable module in machine
readable form for that version of the software licensed to the Licensee.
Licensor will provide installation, installation training, and maintenance
of the software on Licensee's machine, along with sufficient testing to
insure that the software is "up and running" and performing all tasks
specified by the Licensor, and is functioning in accordance with Licensor's
own specifications. Maintenance shall be defined in this case, and in any
and all other instance, as consisting of installing and maintaining the
Software. The Licensee is not permitted to modify or re-engineer the
Software without the Licensor's written consent, although any additional
modifications and services not pertaining to installation of the Software
requested by the Licensee will be provided for on a pay for basis by
Licensor. Licensor shall have a right to a copy of all modifications and
all modifications shall be owned by UNIPAC.
4. Consideration. In consideration of the license, Licensee shall pay to
Licensor a "license fee" and a "maintenance fee" as set forth in ATTACHMENT
A.
5. Interest. Interest on all past due amounts under this Agreement shall
accrue from the date due at an annual interest rate equal to the lessor of
18% per annum or the maximum interest rate permitted by law.
6. Acceptance/Notice. Licensee agrees to use the Software according to the
instructions supplied by Licensor. Licensee shall notify the Licensor of
all instances where the Licensee believes that (1) the program is not
functioning, or (2) the program is not functioning in accordance with the
documentation and/or manuals. For each such instance, Licensee agrees to
provide notice to Licensor. Each such notice shall explain, as well as
Licensee can, the step-by-step process leading up to the instance itself,
any subsequent actions taken by Licensee, and the results of such action.
The notice shall be completed and sent to Licensor in a reasonable time (in
most cases within three (3) days after the instance first occurs).
7. Software from Other Vendors. In any other instance in which the Software
modifies in any way other software licensed from any other vendor, the
Licensee shall be responsible for keeping a copy of the unmodified software
readily available, and this unmodified copy shall be the copy of that
software which shall be returned to its vendor if such is required. The
Licensor assumes no responsibility with regard to the Licensee's use of any
software other than its own.
8. Taxes and other costs. All prices quoted by Licensor are exclusive of
taxes, duties, assessments, and other, all of which shall be paid solely by
the Licensee.
Page: 1
<PAGE>
9. Trade Secrecy. The Licensee recognizes that the Software is the trade
secret and exclusive property of UNIPAC; therefore, the Licensee shall take
special care to preserve its confidentiality. In particular, the Licensee
shall not sell, distribute, or transfer, in any manner, any copy of the
Software in whatever form to any other party without the express written
authorization of Licensor. The Licensee shall not allow access to the
Software by any third parties. The Licensee shall take care that any copies
of any materials that it makes for its own use will be clearly labeled as
copyrighted materials using the form,
CONFIDENTIAL AND TRADE SECRETS MATERIALS
Notwithstanding anything in this Agreement to the contrary, it is the express
intention of the parties to this Agreement that all right, title and interest of
whatever nature in Licensor's users manuals, training materials, all computer
programs, routines, structures, layout, report formats, together with all
subsequent versions, enhancements and supplements to said programs, all
copyrights (including both source and object code) and all oral or written
information relating to the Software conveyed in confidence by Licensor to
Licensee pursuant to this Agreement, and all other forms of intellectual
property of whatever nature is and shall remain the sole and exclusive property
of the UNIPAC.
10. Licensee's Responsibilities.
A. The Licensee will provide the Licensor a contact person to be the data
administrator for the Software;
B. The data administrator should have knowledge of investments and trust
operations;
C. The Licensee will supply and input the comparison index information
into the Software;
D. The Licensee will make changes to the data that has been downloaded
into the Software when necessary;
E. The Licensee will provide at a minimum weekly backups of the software
and data;
F. The Licensee will provide computer equipment and software to run the
Maui software programs as specified in ATTACHMENT B. The Licensee will
maintain computer equipment and software compatible with the
Licensor's modifications and therefore, agrees to purchase new
equipment and software as may reasonably be required by the Licensor.
11. Warranties and Disclaimers. Licensor warrants that it has used its best
efforts and skill in the production of the Software, provided that the
software is run according to the instructions and using the kind of
equipment required for the Software and operated by persons with reasonable
skill.
12. Liability for Damages. The Licensee understands that the Licensor will not
be in a position to control the use which the Licensee makes of its
computer system or the other software and peripherals the Licensee uses
thereon, or the procedures the Licensee employs in its computer operation.
All claims with regard to the Software by the Licensee against the Licensor
must be made within one (1) year of Licensee's awareness of such error or
forever be barred.
Except for the express warranties set forth in this Agreement, Licensor
makes no representations of warranties of any nature, oral or written,
express or implied regarding the Software, the documentation, the services
provided under this Agreement, or any other matter, INCLUDING, BUT NOT
LIMITED TO, THE IMPLIED WARRANTIES OF MERCHANTABILITY AND FITNESS FOR A
PARTICULAR PURPOSE. This Agreement does not constitute a joint account
either expressed or implied between Licensor and Licensee. Licensor is
acting as an independent contractor and not as an agent of the Licensee
organization. Any liability of Licensor to Licensee, whether for breach of
this Agreement, negligence, or otherwise, shall be specifically subject to
the limitations of paragraph 13, and in no event shall its liability exceed
the actual amount of payments made by Licensee to Licensor during the
then-existing term of this Agreement.
Pursuant to this Agreement, Licensor may use third parties to assist it in
providing its services to Licensee. No such third party makes any
warranties whatsoever, whether expressed or implied, to the Licensee as to
fitness, merchantability or any other matter; no such third party shall
have any liability to the Licensee or any other person or entity in any way
arising out of any error or omission in the services provided by such
third-party, or a delay in providing those services. In no event shall any
third-party providing services to Licensor be liable to any Licensee or
other person or entity for any loss, injury, or damages, including
incidental or consequential damages or for anything beyond such third
party's reasonable control.
13. Limitation of Liability. Because software is inherently complex and may not
be completely free of errors, Licensee is advised to verify Licensee's work
and to make backup copies. In no event will Licensor be liable for
indirect, special, incidental, economic, cover, or consequential damages
arising out of the use of or inability to use the software or user
documentation, even if advised of the possibility of such damages.
Licensor's liabilities in tort contract or
Page: 2
<PAGE>
otherwise shall not exceed the total moneys the Licensee paid to Licensor
for the use of the software up to the time that the claim accrued.
14. Site Specification. The Licensee's use of the Software is restricted to
unlimited concurrent user(s) having access to an unlimited number of
accounts on the Licensee's existing database, at the site(s) at which
Licensee conducts its day-to-day trust operations, said site(s) being
located at Richmond, IN. The Software is to be used by Licensee to process
accounts of Licensee only, and acknowledges that Licensor will suffer
damage is Licensee permits the Software to be used to process accounts of
unrelated third parties not expressly covered by this License Agreement.
Licensee grants to Licensor the right to inspect its computer operations to
determine if it is in compliance with this Agreement; however, the Licensor
agrees that it will act reasonably in the exercise of this right and
cooperate with the Licensee to avoid disruption of its computer operations
and to preserve the confidentiality of any of its files. Should Licensee be
found to be using the Software in violation of this Agreement, Licensee
agrees to pay any and all additional fees Licensor determines due and owing
under the current fee schedule, accruing from the original date of this
Agreement.
15. Operating System Specification. Licensee recognizes the need to maintain on
the microcomputer operating system software compatible with Licensor's
enhancements to the Software and therefore, Licensee agrees to purchase,
install and maintain new versions of the applicable operating system as
recommended by Licensor within the time frame specified by Licensor.
16. Remedies Cumulative; No Waiver. No remedy of Licensor contained in this
Agreement shall be considered exclusive of any other remedy; but rather,
each remedy shall be distinct, separate and cumulative, and in addition to
any other right or remedy provided in this Agreement or by applicable law.
Each such right or remedy may be pursued singularly, successively or
together in the sole discretion of Licensor and the failure to exercise any
such right or remedy shall in no event be construed as a waiver or release
of the same. Licensor may waive any right or remedy available to it, but
any such waiver is not continuing, is limited to the specific act or
omission waived and shall not affect any other rights or remedies.
17. Default by Licensee. In the event Licensee fails to perform any of the
obligations under this Agreement, including but not limited to the failure
to make any payment required under paragraph 4 with attachments, and this
failure continues for a period of ten (10) days from the date when
performance should have been rendered, Licensee shall be deemed to be in
default of its obligations hereunder.
18. Right to Suspend Performance Without Terminating. In the event of a default
in any terms of this Agreement by Licensee, then, in addition to Licensor's
right to terminate this Agreement and any other rights and remedies
Licensor may have, Licensor may suspend performance of all services under
this Agreement (and deny Licensee access to Software updates) until the
default is cured; in such event, Licensee shall remain liable to Licensor
under the terms of this Agreement, including all payments required under
paragraph 4 until the default is cured.
19. Renewal. This Agreement shall automatically renew itself for additional
successive five year terms, unless at least ninety (90) days prior to the
end of the original term or any renewal term, Licensee gives Licensor, or
Licensor gives Licensee, written notice of its intent to cancel this
Agreement at the end of the then current term.
20. Right to Terminate; Damages Upon Termination. In the event a default by
Licensor shall occur hereunder, the Licensee may, at its option,
immediately terminate this Agreement. In the event a default by Licensee
shall occur hereunder, Licensor may, at its option, immediately terminate
this Agreement. Licensee acknowledges that Licensor will incur great
initial costs and expense to install the Software and to provide training
and customer support for Licensee's personnel, the recovery of said costs
and expenses by Licensor are to take place over the term of this Agreement
and any renewal. Therefore, in the event of default of this Agreement by
Licensee, Licensee agrees to pay to Licensor an amount equal to the
maintenance fees due for the remaining balance of the term of this
Agreement or any renewal thereof, so that Licensor may recoup its initial
costs and expenses. In addition, all Software, equipment, manuals and other
property of Licensor in Licensee's possession shall immediately be returned
to Licensor, at Licensee's expense. Notwithstanding the foregoing, nothing
herein shall limit Licensor's legal and equitable remedies against Licensee
in the event of a breach by Licensee of the terms, conditions and
protective covenants contained in this Agreement, including, but not
limited to, injunctive relief in the event UNIPAC or Licensor's proprietary
interests in the Software are threatened or infringed.
Page: 3
<PAGE>
21. Compensation in Subsequent Years. At any time upon thirty (30) days prior
written notice to Licensee, Licensor, at its sole option may increase its
Maintenance Fee, without Licensee's specific consent. The Maintenance Fee
may not be increased by more than five percent (5%) per calendar year from
the Maintenance Fee payable the previous calendar year.
22. Binding Effect; Assignability. This Agreement shall be binding upon and
shall inure to the benefits of the parties hereto and their respective
heirs, representatives, successors and assigns, Licensee may not assign,
delegate or otherwise transfer any of its or his rights, duties or
obligations hereunder or interest herein without written consent of
Licensor. In the event of any such assignment, delegation, or other
transfer by Licensee, whether or not Licensor has consented, the Licensee
shall remain liable for all amounts due hereunder and all other obligations
of Licensee pursuant to this Agreement, whether the Assignor or Transferee
is or may also be liable to Licensor.
Licensor may transfer or assign its rights, duties and obligations
hereunder or interest herein to any entity related to Licensor by
substantially similar ownership or control, or to a successor in interest
pursuant to a merger, reorganization, stock sale or other transaction,
without consent of user.
23. Governing Law. This agreement shall be governed by the laws of the State of
Colorado.
24. Jurisdiction, Venue. The parties hereto agree that, in the event either
party elects to pursue legal action against the other for default of any
obligation under this Agreement, such legal action shall be brought in the
State of Colorado, unless Licensor, at its sole option, elects to bring
action in the county and state of residence of the Licensee.
25. Severability. If any part of this agreement is held void for any reason,
the balance of this Agreement shall continue to be valid and binding.
26. Violation. Licensee agrees to take all reasonable steps necessary to ensure
that none of its employees nor any related third party violate the terms of
this Agreement.
27. Merger Clause. This Agreement and any appendices or other writings signed
by both parties associated herein constitutes the entire Agreement between
the parties hereto and supersedes all proposals, prior negotiations, and
agreements, whether oral or written.
WITNESS the due execution hereof the day and date first written above.
DATED this the 30th day of April, 1998.
INFOVISA, Inc. - Licensor Harrington Bank, FSB-Licensee
Cornelius, NC (A Colorado Corporation) Richmond, IN
Signed: /s/ Joseph W. Brown Signed: /s/ Catherine A. Habschmidt
------------------- ---------------------------
PLEASE PRINT OR TYPE:
NAME: JOSEPH W. BROWN NAME: Catherine A. Habschmidt
TITLE: PRESIDENT TITLE: SVP & CFO
DATE: 5/14/98 DATE: 4/30/98
Signed: /s/ Daniel H. Haglund
---------------------
PLEASE PRINT OR TYPE:
NAME: Daniel H. Haglund
TITLE: SVP & Treasurer
DATE 4/30/98
Page: 4
<PAGE>
ATTACHMENT A:
Licensing, Maintenance Fees and Other Terms
In consideration of the software license and maintenance, Licensee shall pay to
Licensor the following fees:
INITIAL SOFTWARE LICENSE:
1. $7,000 One Time License Fee. Payment is due upon delivery of this Agreement
to INFOVISA.
2. $7,000 One Time Installation ion Fee. Payment is due upon installation.
MONTHLY MAINTENANCE FEES:
1. $1,200 Per Month for ETA in Years 1 & 2.
2. $1,500 Per Month for ETA in Years 3, 4, 5.
3. $0 Per Month for ETR.
4. $0 Per Month for Custody Interface.
$1,200 Total Per Month for Years 1 & 2.
$1,500 Total Per Month for Years 3, 4, 5.
2. The aforementioned fee schedule assumes services are provided to a single
ETA processing unit located at the site at which Licensee conducts its
day-to-day trust operations. If additional sites are required in the
future, additional fees will apply.
OPTIONAL SERVICES:
1. Printing, Collating, and Stapling of statements are $0.09 per page.
Envelopes and stuffing of statements are $0.12 per page.
2. Disaster Recovery service includes delivery of file server loaded with
software, which must be loaded at client site with backup tapes: $6,000 per
disaster (delivered).
3. Security Pricing not Included.
4. $100 Per Month forAMS (Realignment & Modeling).
5. $20 Per Month for Indices.
6. $100 Per Month for Common Trust Fund Module.
Page: 5
<PAGE>
ATTACHMENT B
ETA Hardware Configuration
FILE SERVER:
Manufacturer, network certified, with:
Pentium 200 Processor
128 MB RAM
3 -4 GB Hard Drives
Monitor
4/8 GB Tape Drive which writes DDS2
Uninterruptable Power Supply
Ethernet Network Card
Work Stations:
* Work stations should be Pentium 133 or greater with 32 MB RAM and 1 GB
Harddrive.
* Windows NT 4.0 Workstation software.
* Ethernet Network Card
Network:
* Windows NT network is required with Ethernet connectivity recommended.
* Ethernet 24 Port Hub and Patch Panel.
* Category 5 Plenum Data Cable is recommended for the network wiring
SOFTWARE:
* Windows NT 4.0 with 10 or 25 Station User License is required
* SQL Server 6.5 with 10 or 25 Station User License is required
* Cheyenne ArcServe 6.0 Software is required for system backup.
* Carbon Copy 32 Version 4.0 is required on one work station for trouble
shooting.
* MS Access for one work station WinZip Version 6.3 SR-1 (32 Bit version)
Modems
* An external V.34 compatible modem which is on the NT Hardware Compatibility
list is required on the file server (33.6 or faster baud rate). This will
be used for system interfaces.
* An external V.34 compatible modem which is compatible with Carbon Copy 32
and Microsoft RAS is also required on one workstation. This allows INFOVISA
technical support people access to your ETA system should trouble shooting
be required
* A US Robotics(TM) or Practical Peripherals(TM) modem is recommended.
Printers:
* A laser printer is required for printing checks on the system. A Hewlett
Packard(TM) Laserjet 5N is recommended. Note: The Laserjet 5N has been
discontinued and HP is coming out with a replacement.
* A laser printer is required for printing statements and reports on the
system. A Hewlett Packard(TM) 5 SI is recommended.
TELECOMMUNICATIONS LINES:
* A standard analog phone line is required for the file server.
* A standard analog phone line, which can receive calls, is required for one
workstation for trouble shooting by INFOVISA.
* A telephone set placed near the workstation with the external modem is
required. We want to talk to you at the same time we dial in during trouble
shooting.
NOTE: Manufacturers who have network certified machines include: IBM, Dell,
Compaq and Hewlett Packard
Page: 6
Exhibit 13
1998 Annual Report to Stockholders
<PAGE>
FINANCIAL HIGHLIGHTS
(Dollars in thousands except per share amounts)
<TABLE>
<CAPTION>
For the Years Ended June 30, 1998 1997
- ------------------------------------------------------------------------------------------------------
<S> <C> <C>
Net interest income ............................................. $ 4,924 $ 8,066
Income (loss) before tax provision and gain (loss) on securities (1,388) 2,769
Net realized and unrealized gain (loss) on securities ........... (1,705) 494
Special SAIF assessment ......................................... 830
Net income (loss) ............................................... (1,859) 2,002
Return on average assets before special SAIF assessment ...... (0.34%) 0.50%
Return on average assets after special SAIF assessment .......... (0.34%) 0.39%
Return on average equity before special SAIF assessment ......... (7.56%) 10.52%
Return on average equity after special SAIF assessment .......... (7.56%) 8.34%
At June 30
Total assets .................................................... $ 484,397 $ 446,797
Total loans ..................................................... 163,546 93,958
Total securities ................................................ 291,531 318,480
Total deposits .................................................. 178,311 136,175
Stockholders' equity ............................................ 22,664 24,994
Common shares outstanding ....................................... 3,275,886 3,256,738
Average Balances
Assets .......................................................... $ 538,981 $ 507,407
Loans ........................................................... 116,982 78,545
Core retail deposits ............................................ 136,594 116,210
Other deposits .................................................. 15,168 20,592
Total deposits .................................................. 151,762 136,802
Per Share
Basic earnings (loss) per share ................................. $ (0.57) $ 0.61
Diluted earnings (loss) per share ............................... (0.57) 0.61
After tax basic earnings (loss) excluding special SAIF assessment (0.57) 0.78
Book value, fiscal year end Market price, fiscal year end ....... 6.92 7.67
11.250 12.125
Asset Quality at June 30
Non-performing assets to total assets ........................ 0.18% 0.25%
Loan loss reserves to non-performing loans ..................... 126.32% 63.39%
Capital Ratios at June 30 (Harrington Bank)
Tangible capital ................................................ 6.88% 6.96%
Core capital .................................................... 6.88% 6.96%
Risk-based capital .............................................. 21.92% 31.14%
</TABLE>
<PAGE>
Financial Review
- ----------------
14 Selected Consolidated Financial Data
15 Management's Discussion and Analysis
of Financial Condition and Results of Operations
29 Consolidated Balance Sheets
30 Consolidated Statements of Operations
31 Consolidated Statements of Changes in
Stockholders' Equity
32 Consolidated Statements of Cash Flows
34 Notes to Consolidated Financial Statements
56 Independent Auditors' Report
<PAGE>
Selected Consolidated Financial Data
The following table presents selected consolidated financial and other data of
the Company for the five years in the period ended June 30, 1998. 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 Years Ended June 30, 1998 1997 1996 1995 1994
--------- --------- --------- --------- ---------
<S> <C> <C> <C> <C> <C>
Balance Sheet Data
Securities held for trading and available for sale ......... $ 291,531 $ 318,480 $ 321,897 $ 249,274 $ 174,347
Loans receivable-net ....................................... 163,546 93,958 65,925 37,010 20,682
Total assets ............................................... 484,397 446,797 418,196 300,174 211,688
Deposits ................................................... 178,311 136,175 135,143 115,312 108,300
Securities sold under agreements to repurchase ............. 240,396 245,571 219,067 130,217 54,651
Federal Home Loan Bank advances ............................ 26,000 26,000 26,000 31,000 31,000
Note payable ............................................... 13,495 9,995 8,998 9,200 7,880
Stockholders' equity ....................................... 22,664 24,994 23,117 10,361 5,926
Stockholders' equity per share ............................. 6.92 7.67 7.10 5.28 4.20
Income Statement Data
Interest income ............................................ $ 33,956 $ 34,474 $ 23,484 $ 17,560 $ 13,607
Interest expense ........................................... 29,032 26,408 18,004 12,779 8,284
--------- --------- --------- --------- ---------
Net interest income ...................................... 4,924 8,066 5,480 4,781 5,323
Provision for loan losses .................................. 147 92 (1) 15 (3)
--------- --------- --------- --------- ---------
Net interest income after provision for loan losses ........ 4,777 7,974 5,481 4,766 5,326
Retail banking fees and other income ....................... 295 239 256 238 267
--------- --------- --------- --------- ---------
Total net revenue .......................................... 5,072 8,213 5,737 5,004 5,593
Operating expenses ......................................... 6,460 5,444 3,740 3,167 2,519
--------- --------- --------- --------- ---------
Income before tax provision and gain (loss) on securities .. (1,388) 2,769 1,997 1,837 3,074
Gain (loss) on sale of securities held for trading ......... (775) (1,623) 1,834 66 (2,169)
Gain on sale of securities available for sale .............. 392
Unrealized gain (loss) on securities held for trading ...... (930) 2,117 (1,960) 1,535 710
Permanent impairment of securities available for sale ...... (414) (610)
--------- --------- --------- --------- ---------
Net gain (loss) on securities ............................ (1,705) 494 (126) 1,187 (1,677)
--------- --------- --------- --------- ---------
Income before income tax provision and cumulative effect
of change in accounting for deferred income taxes ........ (3,093) 3,263 1,871 3,024 1,397
Income tax provision ....................................... (1,234) 1,261 648 1,171 391
Income (loss) before cumulative effect of change in
accounting for deferred income taxes ..................... (1,859) 2,002 1,223 1,853 1,006
--------- --------- --------- --------- ---------
Cumulative effect of change in accounting for deferred
income taxes (2) ......................................... (79)
Net income (loss) .......................................... $ (1,859) $ 2,002 $ 1,223 $ 1,853 $ 927
--------- --------- --------- --------- ---------
Basic earnings (loss) per share ............................ $ (0.57) $ 0.61 $ 0.57 $ 1.20 $ 0.66
--------- --------- --------- --------- ---------
Diluted earnings (loss) per share .......................... $ (0.57) $ 0.61 $ 0.56 $ 1.20 $ 0.66
--------- --------- --------- --------- ---------
Cash dividends per share ................................... $ 0.12 $ 0.03 N/A N/A N/A
--------- --------- --------- --------- ---------
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
<S> <C> <C> <C> <C> <C>
Performance Ratios
Return on average assets (3) ............................... (0.34%) 0.50% 0.37% 0.76% 0.44%
Return on average equity (3) ............................... (7.56) 10.52 9.49 22.24 14.98
Interest rate spread ....................................... 0.79 1.43 1.64 2.13 2.63
Net interest margin ........................................ 0.94 1.62 1.73 2.10 2.64
Average interest-earning assets to average interest
bearing liabilities ...................................... 102.73 103.67 101.55 99.57 100.25
Net interest income after provision for loan losses to total
other expenses (3) ....................................... 73.95 172.82 146.55 150.49 211.43
Total other expenses to average total assets (3) ........... 1.20 0.91 1.13 1.30 1.19
Full service offices ....................................... 7 4 3 2 2
Asset Quality Ratios (at end of period)
Non-performing loans to total loans (4) .................... 0.17 0.36 0.40 0.95 2.70
Non-performing assets to total assets (4) .................. 0.18 0.25 0.32 0.59 1.34
Allowance for loan losses to total loans ................... 0.22 0.23 0.18 0.33 0.51
Allowance for loan losses to total non-performing loans .... 126.32 63.39 45.98 34.57 18.96
Capital Ratios (5)
Tangible capital ratio ..................................... 6.88 6.96 6.27 6.12 6.07
Core capital ratio ......................................... 6.88 6.96 6.27 6.12 6.07
Risk-based capital ratio ................................... 21.92 31.14 30.10 24.62 21.40
Equity to assets at end of period .......................... 4.68 5.59 5.53 3.45 2.80
</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) Reflects the Company's adoption of Statement of Financial Accounting
Standards ("SFAS") No. 109, "Accounting for Income Taxes," effective July
1, 1993.
(3) For comparability purposes, the 1997 fiscal year ratios exclude the effect
of the special SAIF assessment of $830,000.
(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 (1) expanding its banking locations and product offerings in order
to build a strong community banking franchise through de novo branching and the
pursuit of acquisition opportunities; (2) controlling interest rate risk by
matching the interest rate sensitivity of its assets to that of its liabilities;
(3) controlling credit risk by maintaining a substantial portion of the
Company's assets in mortgage-backed securities and single-family residential
loans and by applying conservative underwriting standards and credit risk
monitoring; and (4) utilizing excess capital balances through the management of
a hedged investment portfolio.
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 Indiana and the Kansas City
metropolitan area. While Harrington has greatly expanded its portfolio of
originated mortgage loans, approximately 60% of its assets currently consist of
purchased mortgage-backed and related securities that are hedged to reduce
interest rate risk. 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. The funds invested
in the securities portfolio can be quickly redeployed to pursue retail expansion
opportunities as they arise. Furthermore, in March 1998, the Company commenced
the origination of commercial mortgage and commercial and industrial loans
through a newly developed commercial loan division. This activity provides
further diversification of business lines and fulfills a critical component of
the Company's community banking strategy.
Harrington's funding strategy focuses on accessing cost-efficient funding
sources, including securities sold under agreements to repurchase, retail and
non-retail deposits and Federal Home Loan Bank ("FHLB") advances. The Company
continues to build a community-oriented banking operation in order to sustain
loan originations and deposit growth, benefit from economies of scale, 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.
<PAGE>
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 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.
"Safe Harbor" Statement under the Private Securities Litigation Reform Act of
1995
In addition to historical information, forward-looking statements contained in
this annual report are subject to risks and uncertainties that could cause
actual results to differ materially from those reflected in the forward-looking
statements. Factors that could cause future results to vary from current
expectations include, but are not limited to, the impact of economic conditions
(both generally and more specifically in the markets in which Harrington
operates), the impact of competition for Harrington's customers from other
providers of financial services, the impact of government legislation and
regulation (which changes from time to time and over which Harrington has no
control), and other risks detailed in the Annual Report and in Harrington's
other Securities and Exchange Commission ("SEC") filings. Readers are cautioned
not to place undue reliance on these forward-looking statements, which reflect
management's analysis only as of the date hereof. Harrington undertakes no
obligation to publicly revise these forward-looking statements to reflect events
or circumstances that arise after the date hereof. Readers should carefully
review the risk factors described in other documents Harrington files from time
to time with the SEC, including the Quarterly Reports on Form 10-Q to be filed
by Harrington in 1998 and 1999 and any Current Reports on Form 8-K filed by
Harrington.
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 the cashflows from 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 MVPE in times of declining interest rates,
such an asset/liability mismatch is generally detrimental during periods of
rising interest rates.
The Company's management 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 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,
investment opportunities and the performance of the investment portfolios, and
the past month's purchase and sale activity of securities. The Committee also
provides guidance to management on reducing interest rate risk and on investment
strategy and 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, Smith Breeden's mutual funds, and
government agencies nationally. Certain directors of the Company and the Bank
are principals of Smith Breeden.
<PAGE>
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 MVPE. 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.
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 and
origination of 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
16
<PAGE>
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 or less sensitive non-defined maturity
(transaction) 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 necessarily
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 could 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 or money center bank) 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, 1998, Harrington was a party to four interest rate swap agreements
held in its trading portfolio. The agreements had an aggregate notional amount
of $121.0 million and maturities from January 1999 to April 2001. With respect
to these agreements, Harrington makes fixed interest payments ranging from 6.12%
to 6.58% and receives payments based upon the three-month London Interbank
Offered Rate ("LIBOR").
The net expense (income) relating to Harrington's interest rate swaps held in
the trading portfolio was $313,000, $330,000 and $(168,000) during the years
ended June 30, 1998, 1997 and 1996, respectively. The approximate market value
of the interest rate swaps which are maintained in the trading portfolio was
$(397,000) and $581,000 as of June 30, 1998 and 1997, respectively.
The Company also has one swap whereby it pays a floating rate (based on
three-month LIBOR) and receives a fixed rate of 6.96%. Harrington's floating-pay
swap, which has a notional amount of $7.5 million, is not included in the
Company's trading portfolio. This swap is used to modify the interest rate
sensitivity of certain certificates of deposit issued by the Bank.
The net income relating to Harrington's floating-pay swap was $70,000, $130,000
and $129,000 during the years ended June 30, 1998, 1997 and 1996, 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 swap (which is not reflected in the Company's financial
statements) was $137,000 and $91,000 as of June 30, 1998 and 1997, respectively.
<PAGE>
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, 1998, Harrington held seven interest rate cap agreements, twelve
interest rate floor agreements and one interest rate collar in its trading
portfolio. These contracts, which expire from October 1998 to June 2004, have an
aggregate notional amount of approximately $391.1 million. The interest rate cap
agreements provide for a payment, depending on the particular contract, whenever
the defined floating rate exceeds 6.50% to 9.00%. The interest rate floor
agreements provide for a payment, depending on the particular contract, whenever
the defined floating rate is less than 5.00% to 7.00%. The interest rate collar
provides for a payment whenever the defined floating rate is greater than 10.25%
or less than 5.25%.
17
<PAGE>
The aggregate net expense (income) relating to the Company's interest rate caps,
collars and floors held in the trading portfolio was $223,000, $(370,000) and
$(220,000) during the years ended June 30, 1998, 1997 and 1996, respectively.
The approximate market value of Harrington's interest rate caps, collars and
floors which are maintained in the trading portfolio was $4.6 million and $5.1
million as of June 30, 1998 and 1997, respectively.
Harrington also has four interest rate caps with aggregate notional amounts of
$90.0 million which are not held in the Company's trading portfolio. These caps,
which mature from May 2001 to May 2008, provide for a payment, depending on the
particular contract, whenever the defined floating rate exceeds 6.00% to 7.00%.
The instruments are used to effectively cap the interest rate on a portion of
the Company's securities sold under agreements to repurchase and the Company's
floating-rate borrowing from the FHLB. Net expense on the caps was $257,000,
$178,000 and $25,000 for the years ended June 30, 1998, 1997 and 1996,
respectively. The approximate market value of the caps, which is not reflected
in the Company's financial statements, was $2.5 million and $351,000 at June 30,
1998 and 1997, respectively.
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 are 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 and Bond 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, 1998, Harrington had sold Eurodollar and
Treasury Note futures contracts with an aggregate notional amount of
approximately $2.8 billion. The Company had total gains (losses) on its futures
contracts of $(8.6) million, $(3.9) million and $1.9 million for the fiscal
years ended June 30, 1998, 1997 and 1996, 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, 1998, Harrington had 660 purchased
options contracts with an aggregate notional amount of approximately $66.0
million. The net expense relating to the Company's options contracts was
$943,000, $770,000 and $640,000 during the years ended June 30, 1998, 1997 and
1996, respectively. The approximate market value of the Company's options
contracts which are maintained in the trading portfolio was $50,000 and $24,000
as of June 30, 1998 and 1997, respectively.
<PAGE>
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.
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
Interest rate contract
(income) expense:
Swaps ........................... $ 313 $ 330 $ (168)
Caps, floors, and collars ....... 223 (370) (220)
Options ......................... 943 770 640
------ ------ ------
Net interest expense on
interest rate contracts ........ $1,479 $ 730 $ 252
====== ====== ======
</TABLE>
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 Operations.
Harrington is subject to the risk that its counter-parties with respect to
various interest rate contracts (such as swaps, collar, 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.
18
<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. The Company retains Smith Breeden to assist in
performing the required calculation of the sensitivity of its market value to
changes in interest rates.
In estimating the market value of mortgage loans and mortgage-backed securities,
the Company utilizes various prepayment assumptions which vary, in accordance
with historical experience, based upon the term, interest rate and other factors
with respect to the underlying loans. At June 30, 1998, these prepayment
assumptions varied from 5% to 36% for fixed-rate mortgages and mortgage-backed
securities and varied from 14% to 31% for adjustable rate mortgages and
mortgage-backed securities.
The following table sets forth at June 30, 1998 the estimated sensitivity of the
Bank's MVPE to parallel yield curve shifts using Harrington's internal market
value calculation. The table demonstrates the sensitivity of the Bank's assets
and liabilities both before and after the inclusion of its interest rate
contracts.
The table set forth below 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 (1) to the extent the affected instruments are marked to market, and (2)
over the life of the instruments as an impact on recorded yields.
<TABLE>
<CAPTION>
(Dollars in thousands)
Change in
<S> <C> <C> <C> <C> <C> <C> <C>
Interest Rates (In Basis Points)(1) .... -400 -300 -200 -100 -- +100 +200
Market value gain (loss) of assets ..... $ 34,498 $ 25,182 $ 17,057 $ 10,498 -- $(17,232) $(38,546)
Market value gain (loss) of liabilities (4,698) (3,576) (2,451) (1,279) -- 1,436 3,064
-------- -------- -------- -------- ---- -------- --------
Market value gain (loss) of net
assets before interest rate contracts 29,800 21,606 14,606 9,219 -- (15,796) (35,482)
Market value gain (loss)
of interest rate contracts ......... (22,328) (18,097) (13,535) (8,070) -- 12,845 30,307
-------- -------- -------- -------- ---- -------- --------
Total change in MVPE(2) ................ $ 7,472 $ 3,509 $ 1,071 $ 1,149 -- $ (2,951) $ (5,175)
-------- -------- -------- -------- ---- -------- --------
Change in MVPE as a percent of:
MVPE(2) ............................. 21.2% 9.9% 3.0% 3.3% -- (8.4)% (14.7)%
Total assets of the Bank ............ 1.5% 0.7% 0.2% 0.2% -- (0.6)% (1.1)%
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Change in
<S> <C> <C>
Interest Rates (In Basis Points)(1) .... +300 +400
Market value gain (loss) of assets ..... $(61,294) $(83,934)
Market value gain (loss) of liabilities 4,825 6,624
Market value gain (loss) of net
assets before interest rate contracts (56,469) (77,310)
Market value gain (loss)
of interest rate contracts ......... 49,820 69,985
Total change in MVPE(2) ................ $ (6,649) $ (7,325)
Change in MVPE as a percent of:
MVPE(2) ............................. (18.8)% (20.8)%
Total assets of the Bank ............ (1.4)% (1.5)%
</TABLE>
(1) Assumes an instantaneous parallel change in interest rates at all
maturities.
(2) Based on the Bank's pre-tax MVPE of $35.3 million at June 30, 1998.
19
<PAGE>
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 instantaneous, parallel shifts in the yield curve, and constant option
adjusted spreads on assets and liabilities. 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 39.0%.
<TABLE>
<CAPTION>
(Dollars in thousands)
Change in
Interest Rates (In Basis Points) -400 -300 -200 -100 -- +100 +200
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C>
After tax market value gain (loss) of assets $ 16,770 $ 12,180 $ 8,161 $ 4,788 -- $ (7,051) $(15,600)
After tax market value gain (loss) of interest (12,283) (9,681) (6,998) (4,050) -- 6,287 14,889
rate contacts --------- --------- --------- --------- -------- --------
After tax gain (loss) in equity $ 4,487 $ 2,499 $ 1,163 $ 738 -- $ (764) $ (711)
--------- --------- --------- --------- -------- --------
After tax gain (loss) in equity as a percent of
the Company's equity at June 30, 1998 19.8% 11.0% 5.1% 3.3% -- (3.4)% (3.1)%
<CAPTION>
Change in
Interest Rates (In Basis Points) +300 +400
- ---------------------------------------------------------------------------
<S> <C> <C>
After tax market value gain (loss) of assets $ (24,792) $ (34,012)
After tax market value gain (loss) of interest 24,588 34,729
rate contacts --------- ---------
After tax gain (loss) in equity $ (204) $ 717
--------- ---------
After tax gain (loss) in equity as a percent of
the Company's equity at June 30, 1998 (0.9)% 3.2%
</TABLE>
Changes in Financial Condition
General. At June 30, 1998, Harrington's total assets amounted to $484.4 million,
as compared to $446.8 million at June 30, 1997. The increase in total assets was
primarily due to a $70.0 million increase in the Bank's loan portfolio which was
partially offset by a $38.3 million decrease in the securities portfolio and due
from broker account.
Cash and Interest-Bearing Deposits. Cash and interest-bearing deposits amounted
to $11.8 million and $9.5 million at June 30, 1998 and 1997, 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 in higher yielding assets such as loans or securities.
<PAGE>
Securities Held for Trading and Available for Sale. In order to reduce the
Company's credit risk exposure, to enhance balance sheet liquidity, and to
utilize excess capital balances, Harrington maintains a substantial portion of
its assets in a hedged mortgage-backed and related securities portfolio, the
securities of 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 $290.6 million and $317.4 million at June 30, 1998 and
1997, respectively. Securities classified as available for sale (consisting of a
non-agency mortgage-backed security and municipal bonds) declined from $1.1
million at June 30, 1997 to $922,000 at June 30, 1998.
Loans Receivable. At June 30, 1998, loans receivable (net of the Company's
allowance for loan losses) amounted to $163.5 million, an increase of 74.1% over
the June 30, 1997 total of $94.0 million. Harrington has significantly increased
its community banking operations, particularly the origination (both directly
and through correspondent mortgage banking companies) of single-family
residential loans. Loans originated through correspondents must meet the same
pricing and underwriting standards as loans originated internally.
Allowance for Loan Losses. At June 30, 1998, Harrington's allowance for loan
losses totaled $360,000, compared to $213,000 at June 30, 1997. At June 30,
1998, the Company's allowance represented approximately 0.2% of the total loan
portfolio and 126.3% of total non-performing loans, as compared to 0.2% and
63.4% at June 30, 1997. The ratio of total non-performing loans to total loans
amounted to 0.2% at June 30, 1998 compared to 0.4% at June 30, 1997, which
reflects Harrington's emphasis on maintaining low credit risk with respect to
its operations.
20
<PAGE>
Although Harrington management believes that its allowance for loan losses at
June 30, 1998 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, 1998, deposits totaled $178.3 million, as compared to
$136.2 million as of June 30, 1997. Retail deposits increased $43.3 million,
from $123.5 million at June 30, 1997 to $166.8 million at June 30, 1998,
primarily due to Harrington's strategy of rapidly building a community banking
franchise. Non-retail deposits declined by $1.2 million during the same period,
for a total increase in deposits of $42.1 million.
Borrowings. At June 30, 1998, reverse repurchase agreements and dollar rolls
(both of which are securities sold under agreements to repurchase and are
accounted for as a financing) totaled $240.4 million, as compared to $245.6
million as of June 30, 1997.
Advances from the FHLB of Indianapolis remained stable at $26.0 million as of
June 30, 1998 and 1997. At June 30, 1998, the FHLB advance was scheduled to
mature in fiscal 1999, with an average interest rate thereon of 5.6%, as
compared to 5.8% at June 30, 1997.
The Company's note payable amounted to $13.5 million and $10.0 million at June
30, 1998 and 1997, 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.
Stockholders' Equity. Stockholders' equity decreased from $25.0 million at June
30, 1997 to $22.7 million at June 30, 1998. This decrease was due primarily to
the $1.9 million of net loss recognized during fiscal 1998, the purchase of
treasury stock amounting to $1.5 million and the payment of the Company's
quarterly dividends of $.03 per share, or $395,000 in total. This decrease was
partially offset by the $1.1 million raised in connection with the exercise of
existing stock options during fiscal 1998 and the $283,000 tax benefit from the
exercise of non-qualified stock options.
Results of Operations
Summary of Operations. Harrington reported net loss of $1.9 million or $0.57
basic loss per share for the year ended June 30, 1998 compared to net income of
$2.0 million or $0.61 basic earnings per share for the year ended June 30, 1997.
This $3.9 million or 192.9% decrease in net income was due primarily to a $3.1
million decrease in net interest income, a $2.1 million decrease in other income
(loss) and a $1.0 million increase in operating expenses, which was partially
offset by a $2.5 million decrease in the income tax provision.
Net income for the year ended June 30, 1997 was $2.0 million or $0.61 basic
earnings per share, compared to $1.2 million or $0.57 basic earnings per share
for the year ended June 30, 1996. The $779,000 or 63.7% increase in net income
was due primarily to a $2.6 million increase in net interest income, which was
partially offset by a $1.7 million increase in operating expenses which includes
the Savings Association Insurance Fund ("SAIF") special assessment of $830,000,
and a $613,000 increase in the income tax provision.
21
<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)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------------------------------------
Average Yield/ Average Yield/
Interest Rate (1) Balance Interest Rate Balance Interest Rate
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Interest-Earning Assets:
Interest-bearing deposits ................ $ 14,590 $ 792 5.43% $ 22,727 1,197 5.27%
Securities held for trading (2) .......... 386,640 23,947 6.19 390,867 26,808 6.86
Securities available for sale (3) ........ 1,039 91 8.76 1,375 133 9.67
Loans receivable, net (4) ................ 116,982 8,734 7.47 78,545 6,087 7.75
Federal Home Loan Bank stock ............. 4,858 392 8.07 3,179 249 7.83
-------- ------- ------ --------- ------- ------
Total interest-earning assets ............ 524,109 33,956 6.48% 496,693 34,474 6.94%
-------- ------- ------ --------- ------- ------
Non-interest-earning assets ................. 14,872 10,714
-------- --------
Total assets ............................. $538,981 $507,407
-------- --------
Interest-Bearing Liabilities:
Deposits:
NOW and checking accounts .............. $ 6,788 166 2.45% $ 4,697 124 2.64%
Savings accounts ....................... 25,666 1,117 4.35 20,463 844 4.12
Money market deposit accounts .......... 2,235 101 4.52 1,886 82 4.35
Certificates of deposit ................ 117,073 6,919 5.91 109,756 6,416 5.85
-------- ------- ---- -------- ------ ------
Total deposits .......................... 151,762 8,303 5.47 136,802 7,466 5.46
Securities sold under agreements
to repurchase ........................ 319,578 17,905 5.60 306,034 16,391 5.36
Federal Home Loan Bank advances ......... 27,488 1,843 6.70 26,089 1,644 6.30
Note payable ............................ 11,355 981 8.64 10,168 907 8.92
-------- ------- ---- -------- ------ ------
Total interest-bearing liabilities ....... 510,183 29,032 5.69% 479,093 26,408 5.51%
-------- ------- ----- -------- ------ ------
Non-interest bearing liabilities ............ 4,200 4,307
-------- --------
Total liabilities ........................... 514,383 483,400
Stockholders' equity ........................ 24,598 24,007
-------- --------
Total liabilities and stockholders' equity .. $538,981 $507,407
-------- --------
Net interest income; interest rate spread (5) $ 4,924 0.79% $ 8,066 1.43%
-------- ------ -------- ------
Net interest margin (5)(6) .................. 0.94% 1.62%
Average interest-earning assets to ------ ------
average interest-bearing liabilities ..... 102.73% 103.67%
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
1996
------------------------------------
Average Yield/
Balance Interest Rate
------------------------------------
<S> <C> <C> <C>
Interest-Earning Assets:
Interest-bearing deposits ................ $ 14,520 $ 780 5.37%
Securities held for trading (2) .......... 243,862 18,034 7.40
Securities available for sale (3) ........ 2,672 194 7.26
Loans receivable, net (4) ................ 52,399 4,276 8.16
Federal Home Loan Bank stock ............. 2,533 200 7.90
--------- --------- ------
Total interest-earning assets ............ 315,986 23,484 7.43%
--------- --------- ------
Non-interest-earning assets ................. 13,952
Total assets ............................. $ 329,938
--------- --------- ------
Interest-Bearing Liabilities:
Deposits:
NOW and checking accounts .............. 3,813 110 2.88%
Savings accounts ....................... 15,922 613 3.85
Money market deposit accounts .......... 1,777 77 4.33
Certificates of deposit ................ 103,981 6,351 6.11
--------- --------- ------
Total deposits .......................... 125,493 7,151 5.70
Securities sold under agreements
to repurchase ........................ 148,523 8,352 5.62
Federal Home Loan Bank advances ......... 27,586 1,596 5.79
Note payable ............................ 9,553 905 9.47
--------- --------- ------
Total interest-bearing liabilities ....... 311,155 18,004 5.79%
Non-interest bearing liabilities ............ 5,894
--------- --------- ------
Total liabilities ........................ 317,049
Stockholders' equity ........................ 12,889
--------- --------- ------
Total liabilities and stockholders' equity .. $329,938
--------- --------- ------
Net interest income; interest rate spread (5) $ 5,480 1.64%
--------- --------- ------
Net interest margin (5)(6) .................. 1.73%
--------- --------- -------
Average interest-earning assets to
average interest-bearing liabilities ..... 101.55%
--------- --------- -------
</TABLE>
<PAGE>
(1) At June 30, 1998, the yields earned and rates paid were as follows:
interest-bearing deposits, 5.34%; securities held for trading, 6.10%;
securities available for sale, 7.77%; loans receivable, net 7.37%; FHLB
stock, 8.00%; total interest-earning assets, 6.55%; deposits, 5.50%;
securities sold under agreements to repurchase, 5.65%; FHLB advances,
5.64%; note payable, 8.64%; total interest-bearing liabilities, 5.68%;
interest rate spread, 0.87%.
(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, 1998, 1997 and 1996, the net
costs of hedging the Company's interest rate exposure with respect to its
securities held for trading amounted to $1.5 million or 0.77%, $730,000 or
0.37% and $252,000 or 0.21%, respectively.
(3) The average balance reflects the carrying value of available for sale
investments net of the average valuation allowance related to a single
non-agency participation certificate of $155,000, $276,000 and $447,000 for
the years ended June 30, 1998, 1997 and 1996, 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 1.07%, 1.58% and
1.72%, and the Company's net interest margin amounted to 1.22%, 1.77% and
1.81% for the years ended June 30, 1998, 1997 and 1996, respectively.
(6) Net interest margin is net interest income divided by average
interest-earning assets.
22
<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
(1) changes in volume (change in volume multiplied by prior year rate), (2)
changes in rate (change in rate multiplied by prior year volume), and (3) 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)
Years Ended June 30, 1998 vs. 1997 1997 vs. 1996
- --------------------------------------- ----------------------------------- ----------------------------------
Increase Increase
(Decrease) Total (Decrease)
Due to Increase Due to Total
Rate Volume (Decrease) Rate Volume Increase
---- ------ ---------- ---- ------ --------
<S> <C> <C> <C> <C> <C> <C>
Interest-earning assets:
Interest-bearing deposits ........... $ 36 $ (441) $ (405) $ (16) $ 433 $ 417
Securities held for trading and
securities available for sale .... (2,593) (310) (2,903) (1,377) 10,090 8,713
Loans receivable, net ............... (230) 2,877 2,647 (225) 2,036 1,811
Federal Home Loan Bank stock ........ 8 135 143 (2) 51 49
-------- -------- ---- -------- -------- ------
Total interest-earning assets .... $ (2,779) $ 2,261 (518) $ (1,620) $ 12,610 10,990
-------- -------- ---- -------- -------- ------
Interest-bearing liabilities:
NOW and checking accounts .......... $ (10) $ 52 42 $ (10) $ 24 14
Savings accounts ................... 49 224 273 46 185 231
Money market deposit accounts ...... 3 16 19 -- 5 5
Certificates of deposit ............ 71 432 503 (279) 344 65
-------- -------- ---- -------- -------- ------
Total deposits ................... 113 724 837 (243) 558 315
Securities sold under agreements
to repurchase .................... 772 742 1,514 (415) 8,454 8,039
Federal Home Loan Bank advances .... 108 91 199 138 (90) 48
Note payable ....................... (29) 103 74 (54) 56 2
-------- -------- ---- -------- -------- ------
Total interest-bearing liabilities $ 964 $ 1,660 2,624 $ (574) $ 8,978 8,404
-------- -------- ---- -------- -------- ------
Increase (decrease) in net
interest income .................. $ (3,142) $ 2,586
-------- --------
</TABLE>
<PAGE>
Interest Income. For the year ended June 30, 1998, Harrington's interest income
decreased by $518,000 or 1.5% to $34.0 million, compared to the year ended June
30, 1997. This decrease was primarily due to a $2.9 million decrease in interest
income on the Company's investment portfolio including the increase in the net
interest expense on interest rate contracts maintained in the trading portfolio.
This decrease was partially offset by a $2.6 million increase in interest income
from the loan portfolio. The 67 basis point decline in interest income from the
investment portfolio was largely a result of the Company's shifting of assets to
low initial rate GNMA one-year adjustable rate mortgage securities and the
shifting of the portfolio's fixed rate mortgage investments to lower coupons
with lower accounting yields but higher option adjusted spreads. The increase in
interest income on the loan portfolio was a direct result of the $38.4 million
increase in the level of the average loan portfolio which was partially offset
by a 28 basis point decline in the interest yield earned caused primarily by an
overall decline in the level of interest rates during fiscal 1998.
For the year ended June 30, 1997, Harrington's interest income increased by
$11.0 million or 46.8% to $34.5 million, compared to the year ended June 30,
1996. This increase was primarily due to an $8.7 million increase in interest
income on the Company's investment portfolio, including the increase in the net
interest expense on interest rate contracts maintained in the trading portfolio,
and a $1.8 million increase in interest income from the loan portfolio. The
increase in interest income
23
<PAGE>
from the Company's investment portfolio was a direct result of deploying capital
raised in the Company's initial public offering (IPO) which increased the
average portfolio by $145.7 million which was partially offset by a 53 basis
point decline in the interest yield earned. The increase in interest income on
the loan portfolio was a direct result of the $26.1 million increase in the
level of the average loan portfolio which was partially offset by a 41 basis
point decline in the interest yield earned. The decreases in interest yields
earned were primarily caused by an overall decline in the level of interest
rates during fiscal 1997.
Interest Expense. For the year ended June 30, 1998, Harrington's interest
expense increased by $2.6 million or 9.9% to $29.0 million, compared to the year
ended June 30, 1997. This increase was primarily due to a $31.1 million increase
in the level of average interest-bearing liabilities and an 18 basis point
increase in the cost of interest-bearing liabilities resulting mainly from an
increase in the funding costs for securities sold under agreements to
repurchase.
For the year ended June 30, 1997, Harrington's interest expense increased by
$8.4 million or 46.7% to $26.4 million, compared to the year ended June 30,
1996. This increase was primarily due to a $167.9 million increase in the level
of average interest-bearing liabilities which was partially offset by a 28 basis
point decrease in the cost of interest-bearing liabilities resulting mainly from
an overall decrease in the interest rates during fiscal year 1997.
Net Interest Income. Net interest income decreased by $3.1 million or 39.0% to
$4.9 million during fiscal year 1998 as compared to fiscal year 1997. For the
year ended June 30, 1997, Harrington's net interest income amounted to $8.1
million, compared to $5.5 million for the year ended June 30, 1996.
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
areas, historical loan loss experience and other factors related to the
collectibility 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 $147,000,
$92,000 and $(1,000) during the years ended June 30, 1998, 1997 and 1996,
respectively. During such respective periods, loan charge-offs (net of
recoveries) amounted to $0, $(1,000) and $0, respectively. Although the
Company's non-performing loans remain low, given the growth in the mortgage loan
portfolio and the initial production of commercial related loans, the Company's
analysis of loan reserve requirements indicated that additional reserves were
prudent. The allowance for loan losses as a percentage of total non-performing
loans was 126.3% and 63.4% at June 30, 1998 and 1997, respectively. The
allowance for loan losses as a percentage of total loans was 0.2% at June 30,
1998 and 1997.
Other Income (Loss). Other income (loss) is comprised of two distinct
components: gains and losses on the Company's investment securities and hedging
instruments, and fee and other income from retail bank operations. Gains or
losses on investments and hedges which have been sold are reported as realized
gains or losses, and market value gains or losses on investments and hedges
which remain in the Company's portfolio are reported as unrealized gains or
losses.
<PAGE>
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).
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 and it allows flexibility to
grow or reduce investments as opportunities allow.
The following table sets forth information regarding other income (loss) for the
periods shown.
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- -------------------------------------------------------------------------------
<S> <C> <C> <C>
Gain (loss) on sale of
securities held for trading ....... $ (775) $(1,623) $ 1,834
Unrealized gain (loss) on
securities held for trading ....... (930) 2,117 (1,960)
Other (1) ............................ 295 239 256
------- ------- -------
Total other income (loss) ............ $(1,410) $ 733 $ 130
======= ======= =======
</TABLE>
(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.
24
<PAGE>
Total other income (loss) amounted to $(1.4) million for the year ended June 30,
1998. This total consisted of a net realized and unrealized loss of $1.7 million
on the trading portfolio, plus fee and other retail bank income of $295,000. The
loss on the trading portfolio, net of hedges, reflects only a portion of the
total income (loss) produced from this portfolio in fiscal 1998. Total income
from this portfolio consists of both interest income and net realized and
unrealized gains and losses on the investments and hedges.
The Company seeks to produce a positive spread between the total income of this
portfolio and one month LIBOR, the Company's marginal cost of borrowing. In the
fiscal years 1998, 1997, and 1996, this portfolio produced a net hedged spread
to one month LIBOR of 0.15%, 1.47% and 1.44%, respectively. The weaker
investment performance of the Company's hedged mortgage securities portfolio in
fiscal year 1998 can be attributed to the low interest rate and flat yield curve
environment which, together with the associated prepayment uncertainty, caused
investors to demand a larger spread between the rates on mortgage securities and
comparable duration securities. Management expects that this situation, although
negatively affecting the returns in fiscal 1998, to provide favorable investment
management opportunities for Harrington in future periods.
Total other income amounted to $733,000 for the year ended June 30, 1997. This
total consisted of a net realized and unrealized gain of $494,000 on the trading
portfolio, plus fee and other retail bank income of $239,000. The net gain in
fiscal 1997 can be attributed to such factors as opportunistic trades between
fixed and adjustable rate securities at favorable relative option adjusted
spreads, the general tightening of mortgage spreads to the related hedge
instruments, and the use of a higher mix of interest rate swaps to financial
futures in hedging that shifts a portion of hedge expense from the trading
portfolio gain to net interest income.
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.
Other Expense. In order to enhance the Company's profitability, management
strives to maintain a favorable level of operating expenses relative to its peer
group. During the years ended June 30, 1998, 1997 and 1996, total other expense,
excluding the special SAIF assessment, as a percentage of average total assets
amounted to 1.2%, 0.9% and 1.1%, respectively. The following table sets forth
certain information regarding other expense for the periods shown.
<PAGE>
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Salaries and employee benefits ............. $3,295 $2,174 $1,776
Premises and equipment ..................... 805 532 466
Special SAIF assessment ................... 830
FDIC insurance premiums .................... 86 180 276
Marketing ................................. 183 136 200
Computer services .......................... 243 165 143
Consulting fees ............................ 287 281 232
Other (1) .................................. 1,561 1,146 647
------ ------ ------
Total other expense ..................... $6,460 $5,444 $3,740
====== ====== ======
</TABLE>
(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 $1.1 million or 51.6% and $398,000 or 22.4% during
fiscal 1998 and 1997, respectively. A major cause of these increases was the
continuing implementation of Harrington's community bank expansion strategy. A
total of six new banking locations were opened since May 1994, with three being
opened in the third quarter of fiscal year 1998, and the administrative support
at the home office was increased as well. In addition, new employees were hired
in connection with the growth in the Bank's mortgage lending operations and the
development of the Bank's commercial loan department.
Premises and equipment expense increased by $273,000 or 51.3% and $66,000 or
14.2% during fiscal 1998 and 1997, respectively. The increase in premises and
equipment expense during the periods was primarily due to the opening of new
branches during fiscal years 1998 and 1997.
During the year ended June 30, 1997, all SAIF-insured financial institutions
were required to pay a special assessment to recapitalize that fund.
Harrington's special assessment, which was based on the Bank's level of deposits
at March 31, 1995, was $830,000. However, beginning January 1, 1997, the Bank's
Federal Deposit Insurance Corporation ("FDIC") insurance rate dropped from 23
basis points to 6 basis points on its deposits. Excluding the special SAIF
assessment, FDIC insurance premiums decreased $96,000 or 34.8% for fiscal 1997
compared to fiscal 1996. During fiscal 1998, FDIC insurance premiums decreased
$94,000 or 52.2% primarily due to the decrease in the FDIC insurance rate which
was offset by an increase in deposit base.
Harrington incurred marketing expense of $183,000, $136,000 and $200,000 during
the years ended June 30, 1998, 1997 and 1996, 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 1998 and 1997.
25
<PAGE>
Computer services expense increased by $78,000 or 47.3% and $22,000 or 15.4%
during fiscal 1998 and 1997, 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. 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, 1998, 1997 and 1996, which are
based on the Company's asset size, amounted to $287,000, $281,000 and $232,000,
respectively.
Income Tax Provision. The Company received an income tax benefit of $1.2 million
during fiscal 1998 as compared to income tax expense of $1.3 million and
$648,000 during the years ended June 30, 1997 and 1996, respectively. The
Company's effective tax rate amounted to 39.9%, 38.6% and 34.6% during the years
ended June 30, 1998, 1997 and 1996, respectively. The Company's effective tax
rate for the year ended June 30, 1996 was lower than the effective rates for
fiscal years 1998 and 1997 primarily due to increased permanent differences
relative to the level of pre-tax income in fiscal 1996.
Liquidity
- ---------
The Bank is required under applicable federal regulations to maintain specified
levels of "liquid" investments as defined by the OTS. As of November 24, 1997,
the required level of such liquid investments was changed from 5% to 4% of
certain liabilities as defined by the OTS. In addition to the change in the
percentage of required level of liquid assets, the OTS also modified its
definition of investments that are considered liquid. As a result of this
change, the level of assets eligible for regulatory liquidity calculations
increased considerably.
The total eligible regulatory liquidity of the Bank was 15.58% at June 30, 1998,
as compared to 5.25% at June 30, 1997. At June 30, 1998, the Bank's liquid
assets as defined by the OTS totaled approximately $82.2 million, which was
$61.1 million in excess of the current OTS minimum requirement.
The Bank maintains liquid assets at a level believed adequate to support its
normal operations, including funding loans and paying deposit withdrawals. Cash
flow projections are regularly reviewed and updated to ensure that adequate
liquidity is maintained. Cash for these purposes is generated through the sale
or maturity of securities, the receipt of loan payments, and increases in
deposits and borrowings. While the level of loan and deposit activity is not
entirely under the control of the Bank, the sale of securities and increases in
borrowings are entirely at the Bank's discretion and thus provide a ready source
of cash when needed.
As a member of the FHLB System, the Bank may borrow from the FHLB of
Indianapolis. FHLB advances may be obtained on very short notice due to the
Bank's blanket collateral agreement with the FHLB. In addition, the Bank can
pledge securities for collateralized borrowings such as reverse repurchase
agreements and quickly obtain cash whenever needed. In the opinion of
management, Harrington has sufficient cash flow and borrowing capacity to meet
current and anticipated funding commitments.
<PAGE>
The Bank's liquidity, represented by cash and cash equivalents, is a result of
its operating, investing and financing activities. During the year ended June
30, 1998, there was a net increase of $2.3 million in cash and cash equivalents.
The major sources of cash during the year included $680.8 million in proceeds
from sales and maturities of securities held for trading, a $42.1 million net
increase in deposits and an $11.3 million decrease in amounts due from brokers.
Partially offsetting these sources of cash, the major uses of cash during the
fiscal year were purchases of securities for the trading portfolio of $657.2
million and loan originations, net of repayments, of $70.0 million.
Year 2000
- ---------
The Year 2000 issue is the result of computer programs being written using two
digits rather than four to define the applicable year. The Company's computer
programs and those of third-party computer related providers may recognize a
date using "00" as the year 1900 rather than the year 2000. This situation could
result in system failures or miscalculations causing disruption of operations
that could affect the ability of the Company to operate effectively and service
customers.
The Company's State of Readiness. The company is preparing for the year 2000 by
testing and evaluating both its information technology (IT) and non-information
technology systems. The Company does not have any mission critical processes
that are dependent on non-IT systems. The non-IT systems, such as the telephone
system, are either currently compliant or are expected to be compliant in fiscal
year 1999. The IT systems used by the Company have been or are being tested. The
components of the IT systems being examined are: 1) personal computers (PCs),
hardware and software, 2) data service bureau, and 3) other service providers.
26
<PAGE>
Hardware and software on all PCs have been inventoried and tested. The limited
number of PCs and software that were not Year 2000 compliant have been replaced
or are scheduled to be replaced in the fourth quarter of calendar year 1998.
Given the expiration of the Bank's data processing agreement with its current
service provider in early calendar year 1999, the Company has been evaluating
its data processing requirements under its strategic plan and considering
alternative solutions to meet these requirements. The Company has recently
selected another data service provider, FISERV Vision, to replace its current
provider. The conversion to this system is expected to be accomplished in March
of 1999. FISERV has provided the Company with assurances that the Vision product
is Year 2000 compliant, and the Company will be conducting tests on this
software system to confirm this compliance.
If, for some unexpected reason, the Company is unable to accomplish this
conversion to FISERV, then it would retain its current vendor and ensure
compliance with Year 2000 through written assurance from the vendor and adequate
testing of the operating system. The existing data service vendor is making
progress toward making its operating systems Year 2000 complaint and expects
this objective to be achieved in the third quarter of calendar year 1998.
Other service providers, such as the Company's financial advisors or the FHLB of
Indianapolis, are either Year 2000 compliant or are keeping the Company apprised
of their progress towards being Year 2000 compliant. As part of the Company's
Year 2000 compliance program, the Company will be monitoring the vendors'
progress toward compliance and, if necessary, testing systems to help ensure
compliance.
The Costs to Address the Company's Year 2000 Issues. The limited number of PCs
and software that were not Year 2000 compliant have been replaced or are
scheduled to be replaced in the fourth quarter of calendar year 1998. The cost
of replacing these machines and software is estimated to be $43,500 in
capitalized fixed assets in fiscal year 1999.
The Risks of the Company's Year 2000 Issues. The Company has established
parameters and processes for management to identify material customers, evaluate
their preparedness, assess their credit risk and implement controls to manage
the risk arising from their failure to properly address Year 2000 technology
issues. The Company faces increased credit, liquidity, or counterparty trading
risk when customers encounter Year 2000-related problems. Customers that must be
evaluated and monitored are those that, if adversely impacted by Year 2000
technology issues, represent a significant financial exposure to the Company in
terms of either credit loss or liquidity. The organizations that have been
identified as material customers of the Company will be monitored because of
their reliance on technology for their successful business operations.
Failure of borrowers, counterparties or servicers to address Year 2000 problems
may increase credit risk to the Company through the inability of these parties
to meet the terms of their contracts and make timely payments of principal and
interest to the Company. Liquidity risk may result if depositors, lenders or
counterparties experience Year 2000-related business disruption or operational
failures and are unable to provide funds or fulfill funding commitments to the
Company. Capital market counterparties, such as trading counterparties or
interest rate swap or interest rate cap/floor counterparties, provide contracts
that allow the Company to enter into forward commitments to purchase or sell
securities or to use hedges to reduce interest rate risk. Liquidity and credit
risk may result if capital market counterparties are unable to fulfill
contractual commitments due to operational problems caused by the Year 2000 date
change.
<PAGE>
In those cases where the Company is not fully satisfied that its counterparties
will be Year 2000 ready, mitigating controls will be established such as early
termination agreements, additional collateral, netting arrangements, and
third-party payment arrangements or guarantees. In cases where the Company has a
high degree of uncertainty regarding a counterparty's ability to address its
Year 2000 problems, the Company will avoid all transactions with that
counterparty that mature on or after January 1, 2000 with liquidity, credit, or
settlement risk. The Company will not resume normal transaction activities until
the counterparty has demonstrated that it is prepared for the Year 2000.
The Company's Contingency Plan-Data Service Bureau. In the event, the data
service bureau used by the Bank fails to operate satisfactorily after the turn
of the century, the Bank would be forced to operate on a manual system until a
conversion could be made to a different service bureau or the existing service
bureau corrects its problems. The Bank would establish ledger cards for each
customer account and would manually post transactions to the cards each day.
Transactions would also be batched and manually posted to the general ledger.
The ledger cards would be balanced to the general ledger. The ledger cards would
be balanced to the general ledger frequently to provide some assurance that the
manual system is functioning accurately.
The Bank would have to make some temporary changes in its product menu during
the time operating on a manual system. For instance, the Bank would probably
discontinue originating mortgage loans because of the complexities involved with
them. The Bank would also stop opening new checking accounts. The Bank might
have to convert its existing checking accounts to savings accounts (with
appropriate advance
27
<PAGE>
notice and disclosures to the customers) so that the Bank could more efficiently
process these accounts. The Bank would also have to put a temporary moratorium
on ATM transactions because the Bank would be effectively running in an off-line
mode.
Undoubtedly, the Bank would experience significant deposit run-off were the Bank
to function in such a limited capacity for any length of time. However, the Bank
has a substantial mortgage-backed security portfolio which provides the Bank
with ready liquidity should the need arise to liquidate deposits.
Investment Securities. The Company has received assurances that most major
brokers with which it trades are Year 2000 compliant. Many smaller regional
brokers have yet to provide these assurances. Beginning in November 1999, the
Company will no longer enter into any transactions with regional brokers that
are not Year 2000 compliant. In this way, the Company will control its exposure
to Year 2000 risks with these brokers. After the turn of the millennium, the
Company will carefully evaluate regional brokers individually before resuming
business with them.
Most of the Company's securities are in safekeeping at the FHLB of Indianapolis,
which is progressing towards being Year 2000 compliant. If the FHLB is not Year
2000 compliant by 1999, the Company will engage a new safekeeping agent that is
compliant. Similarly, if any assets are pledged with brokers, the Company will
verify well before the end of 1999 that those brokers are already Year 2000
compliant and if not, these assets will be pledged only with Year 2000 compliant
brokers.
Personal Computers. By the end of calendar year 1998, the Company will have
replaced or upgraded all of its personal computers which failed Year 2000
compliance tests. Thus, it is expected that the Company's PCs will be in
compliance when the century turns. The Company has previously tested the
software used on its PCs, and those software packages that did not properly
handle the Year 2000 have been replaced.
Other Vendors and Service Providers. The Company is closely monitoring all of
its other vendors and service providers to determine if they will be Year 2000
compliant on a timely basis. If any vendors or service providers have not yet
become Year 2000 compliant by the end of the first quarter of calendar year
1999, the Bank will immediately find a replacement vendor or service provider
who is compliant. It is possible, although unlikely, that increased cost to the
institution could result from engaging replacement vendors.
General. The costs of the project and the date on which the Company plans to
complete the Year 2000 compliance program are based on management's best
estimates which were derived utilizing numerous assumptions of future events
including the continued availability of certain resources, third party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved, and actual results could differ materially
from these estimates.
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
<PAGE>
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. 130, 131, and
133 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.
28
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED BALANCE SHEETS
(Dollars in thousands except share data)
June 30, 1998 1997
- ----------------------------------------------------------------------------------------------------------
ASSETS
<S> <C> <C>
Cash ...................................................................... $ 1,567 $ 1,207
Interest-bearing deposits (Note 13) ....................................... 10,212 8,309
--------- ---------
Total cash and cash equivalents ......................................... 11,779 9,516
Securities held for trading - at fair value (amortized cost of
$289,137 and $314,953) (Notes 2, 8, 13) ................................. 290,609 317,355
Securities available for sale - at fair value (amortized cost of
$924 and $1,183) (Note 2) ............................................... 922 1,125
Due from brokers .......................................................... 11,308
Loans receivable (net of allowance for loan losses of
$360 and $213) (Note 3) ................................................. 163,546 93,958
Interest receivable, net (Note 4) ......................................... 2,318 2,080
Premises and equipment, net (Note 5) ...................................... 5,614 4,424
Federal Home Loan Bank of Indianapolis stock - at cost .................... 4,878 4,852
Deferred income taxes, net (Note 10) ...................................... 240
Income taxes receivable (Note 10) ......................................... 435 1,118
Other ..................................................................... 4,056 1,061
========= =========
TOTAL ASSETS ................................................................. $ 484,397 $ 446,797
========= =========
LIABILITIES AND STOCKHOLDERS' EQUITY
Deposits (Note 6) ......................................................... $ 178,311 $ 136,175
Securities sold under agreements to repurchase (Note 7) ................... 240,396 245,571
Federal Home Loan Bank advances (Note 8) .................................. 26,000 26,000
Note payable (Note 9) ..................................................... 13,495 9,995
Interest payable on securities sold under agreements to repurchase (Note 7) 282 300
Other interest payable .................................................... 1,596 787
Advance payments by borrowers for taxes and insurance ..................... 785 585
Deferred income taxes, net (Note 10) ...................................... 1,249
Accrued expenses payable and other liabilities ............................ 868 1,141
--------- ---------
Total liabilities ....................................................... 461,733 421,803
--------- ---------
COMMITMENTS AND CONTINGENCIES (Notes 13, 14, 16)
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
<S> <C> <C>
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 3,399,938 and 3,256,738 shares,
outstanding 3,275,886, and 3,256,738 shares ............................. 425 407
Additional paid-in capital ................................................ 16,962 15,623
Treasury stock, 124,052 shares at cost .................................... (1,467)
Unrealized loss on securities available for sale, net of deferred
taxes of $1 and $23 ..................................................... (1) (35)
Retained earnings ......................................................... 6,745 8,999
--------- ---------
Total stockholders' equity .............................................. 22,664 24,994
========= =========
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ................................... $ 484,397 $ 446,797
========= =========
</TABLE>
See notes to consolidated financial statements.
29
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF OPERATIONS
(Dollars in thousands except share data)
Years Ended June 30, 1998 1997 1996
- ------------------------------------------------------------------------------------------------------------
INTEREST INCOME:
<S> <C> <C> <C>
Securities held for trading ....................................... $ 25,426 $ 27,538 $ 18,286
Net interest expense on interest rate contracts maintained in
the trading portfolio (Note 13) ................................ (1,479) (730) (252)
Securities available for sale ..................................... 91 133 194
Loans receivable (Note 3) ......................................... 8,734 6,087 4,276
Dividends on Federal Home Loan Bank of Indianapolis stock ......... 392 249 200
Deposits .......................................................... 792 1,197 780
-------- -------- --------
33,956 34,474 23,484
-------- -------- --------
INTEREST EXPENSE:
Deposits (Notes 6, 13) ............................................ 8,303 7,466 7,151
Federal Home Loan Bank advances (Note 8) .......................... 1,843 1,644 1,596
Short-term borrowings (Note 7) .................................... 17,905 16,391 8,352
Long-term borrowings (Note 9) ..................................... 981 907 905
-------- -------- --------
29,032 26,408 18,004
-------- -------- --------
NET INTEREST INCOME .................................................. 4,924 8,066 5,480
PROVISION (CREDIT) FOR LOAN LOSSES (Note 3) .......................... 147 92 (1)
-------- -------- --------
NET INTEREST INCOME AFTER PROVISION FOR LOAN LOSSES .................. 4,777 7,974 5,481
-------- -------- --------
OTHER INCOME (LOSS):
Gain (loss) on sale of securities held for trading (Notes 2, 13) .. (775) (1,623) 1,834
Unrealized gain (loss) on securities held for trading (Notes 2, 13) (930) 2,117 (1,960)
Other ............................................................. 295 239 256
-------- -------- --------
(1,410) 733 130
-------- -------- --------
OTHER EXPENSE:
Salaries and employee benefits (Note 12) .......................... 3,295 2,174 1,776
Premises and equipment expense (Note 5) ........................... 805 532 466
SAIF assessment (Note 16) ......................................... 830
FDIC insurance premiums ........................................... 86 180 276
Marketing ......................................................... 183 136 200
Computer services ................................................. 243 165 143
Consulting fees (Note 15) ......................................... 287 281 232
Other ............................................................. 1,561 1,146 647
-------- -------- --------
6,460 5,444 3,740
-------- -------- --------
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
<S> <C> <C> <C>
INCOME (LOSS) BEFORE INCOME TAX PROVISION (BENEFIT) .................. (3,093) 3,263 1,871
INCOME TAX PROVISION (BENEFIT) (Note 10) ............................. (1,234) 1,261 648
======== ======== ========
NET INCOME (LOSS) .................................................... $ (1,859) $ 2,002 $ 1,223
======== ======== ========
BASIC EARNINGS (LOSS) PER SHARE (Note 1) ............................. $ (0.57) $ 0.61 $ 0.57
======== ======== ========
DILUTED EARNINGS (LOSS) PER SHARE (Note 1) ........................... $ (0.57) $ 0.61 $ 0.56
======== ======== ========
</TABLE>
See notes to consolidated financial statements.
30
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS' EQUITY
(Dollars in thousands except share data)
Additional
Shares Common Paid-in Treasury
Outstanding Stock Capital Stock
--------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
BALANCES, JULY 1, 1995 ....................................... 980,813 $ 245 $ 4,183
Stock split 2 for 1 ....................................... 980,813
Stock options exercised (Note 12) ......................... 30,112 4 161
Issuance of common stock under initial public offering .... 1,265,000 158 11,279
(Note 1)
Net income ................................................
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $(4)...........
---------- ---------- ---------- ----------
BALANCES, JUNE 30, 1996 ...................................... 3,256,738 407 15,623
Net income ................................................
Cash dividends declared on common stock ($0.03 per share) .
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $(23).........
---------- ---------- ---------- ----------
BALANCES, JUNE 30, 1997 ...................................... 3,256,738 407 15,623
Stock options exercised (Note 12) ....................... 143,200 18 1,056
Tax benefit from exercise of non-qualified stock options 283
Net loss ................................................
Cash dividends declared on common stock ($0.12 per share)
Purchase of treasury stock .............................. (124,052) $ (1,467)
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $22.........
---------- ---------- ---------- ----------
BALANCES, JUNE 30, 1998 ...................................... 3,275,886 $ 425 $ 16,962 $ (1,467)
========== ========== ========== ==========
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
Unrealized Total
Gain Retained Stockholders'
(Loss) Earnings Equity
---------- ---------- ----------
<S> <C> <C> <C>
BALANCES, JULY 1, 1995 ....................................... $ 61 $ 5,872 $ 10,361
Stock split 2 for 1 .......................................
Stock options exercised (Note 12) ......................... 165
Issuance of common stock under initial public offering .... 11,437
(Note 1)
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 ...................................... (8) 7,095 23,117
Net income ................................................ 2,002 2,002
Cash dividends declared on common stock ($0.03 per share) . (98) (98)
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $(23)......... (27) (27)
---------- ---------- -------
BALANCES, JUNE 30, 1997 ...................................... (35) 8,999 24,994
Stock options exercised (Note 12) ....................... 1,074
Tax benefit from exercise of non-qualified stock options 283
Net loss ................................................ (1,859) (1,859)
Cash dividends declared on common stock ($0.12 per share) (395) (395)
Purchase of treasury stock .............................. (1,467)
Net change in unrealized gain (loss) on securities
available for sale, net of deferred tax of $22......... 34 34
---------- ---------- ----------
BALANCES, JUNE 30, 1998 ...................................... $ (1) $ 6,745 $ 22,664
========== ========== ==========
</TABLE>
See notes to consolidated financial statements.
31
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ---------------------------------------------------------------------------------------------------------
CASH FLOWS FROM OPERATING ACTIVITIES:
<S> <C> <C> <C>
Net income (loss) .......................................... $ (1,859) $ 2,002 $ 1,223
Adjustments to reconcile net income (loss) to net
cash provided by (used) in operating activities:
Provision (credit) for loan losses ....................... 147 92 (1)
Depreciation ............................................. 348 235 210
Premium and discount amortization on securities, net ..... 1,434 1,925 1,887
Amortization of premiums and discounts on loans receivable 150 9 (37)
(Gain) loss on sale of securities held for trading ....... 775 1,623 (1,834)
Unrealized (gain) loss on securities held for trading .... 930 (2,117) 1,960
Loss on disposal of premises and equipment ............... 115
Deferred income tax provision ............................ (1,245) 605 (913)
Increase in interest receivable .......................... (238) (273) (454)
Increase (decrease) in interest payable .................. 791 (883) 278
Decrease in accrued income taxes ......................... (115) (80)
Purchases of securities held for trading ................. (657,211) (913,766) (390,743)
(Increase) decrease in amounts due from brokers .......... 11,308 (6,934) (4,374)
Proceeds from maturities of securities held for trading .. 28,438 26,398 25,407
Proceeds from sales of securities held for trading ....... 652,380 888,429 290,209
(Increase) decrease in other assets ...................... (2,995) 239 640
(Increase) decrease in income taxes receivable ........... 700 (1,118)
Increase (decrease) in accrued expenses .................. (273) (1,590) 2,374
Increase in other liabilities ............................ 200 193 128
--------- --------- ---------
Net cash provided by (used in) operating activities . 33,895 (5,046) (74,120)
--------- --------- ---------
CASH FLOWS FROM INVESTING ACTIVITIES:
Purchase of Federal Home Loan Bank of Indianapolis stock ... (26) (2,207) (145)
Proceeds from maturities of securities available for sale .. 259 879 422
Loan originations, net of principal repayments ............. (69,885) (28,134) (28,877)
Purchases of premises and equipment ........................ (1,653) (1,554) (923)
--------- --------- ---------
Net cash used in investing activities .................. (71,305) (31,016) (29,523)
--------- --------- ---------
</TABLE>
(Continued)
32
<PAGE>
<TABLE>
<CAPTION>
CONSOLIDATED STATEMENTS OF CASH FLOWS (CONTINUED)
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- -----------------------------------------------------------------------------------------------------------------
CASH FLOWS FROM FINANCING ACTIVITIES:
<S> <C> <C> <C>
Net increase in deposits ............................................ 42,136 1,032 19,831
Increase (decrease) in securities sold under agreements to repurchase (5,175) 26,504 88,850
Proceeds from issuance of common stock under initial public offering 11,437
Proceeds from stock options exercised ............................... 1,074 165
Proceeds from Federal Home Loan Bank advances ....................... 99,000 3,300 10,000
Proceeds from note payable .......................................... 3,500 2,300 800
Principal repayments on Federal Home Loan Bank advances ............. (99,000) (3,300) (15,000)
Principal repayments on note payable ................................ (1,303) (1,002)
Dividends paid on common stock ...................................... (395) (98)
Purchase of treasury stock .......................................... (1,467)
--------- --------- ---------
Net cash provided by financing activities ....................... 39,673 28,435 115,081
--------- --------- ---------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ................... 2,263 (7,627) 11,438
CASH AND CASH EQUIVALENTS AT BEGINNING OF YEAR ......................... 9,516 17,143 5,705
--------- --------- ---------
CASH AND CASH EQUIVALENTS AT END OF YEAR ............................... $ 11,779 $ 9,516 $ 17,143
========= ========= =========
SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION:
Cash paid for interest ............................................. $ 29,624 $ 25,434 $ 18,354
Cash paid for income taxes ......................................... 321 1,889 1,600
</TABLE>
Noncash activities occurred consisting of a decrease in current and deferred
income tax payable and a corresponding increase in additional paid in capital
from the tax benefit from exercise of non-qualified stock options of $283 during
fiscal year 1998.
See notes to consolidated financial statements.
33
<PAGE>
NOTES TO CONSOLIDATED
FINANCIAL STATEMENTS
1. 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 and
Marion 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 operations.
<PAGE>
Premiums and discounts are amortized over the contractual lives of the
related securities using the level yield method. Purchases and sales of
securities are recorded in the balance sheet on the trade date. Gains and
losses from security sales or disposals are recognized as of the trade
date in the statement of operations for the period in which securities are
sold or otherwise disposed of. The Company also enters into forward
contracts to purchase or sell securities held for trading. Changes in the
fair value of the forward contract are recognized in earnings as they
occur. Securities purchased or sold under a forward contract are recorded
at their fair values at the settlement date.
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 operations as a component of net interest
income.
The Company's available for sale portfolio consists of municipal bonds and
a non-agency participation certificate.
Fair values of securities are based on quoted market prices or dealer
quotes. Where such quotes are not available, 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 -
SFAS No. 119, Disclosure About Derivative Instruments and Fair Value of
Financial Instruments, 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
34
<PAGE>
about amounts and the nature and terms of derivative financial instruments
regardless of whether they result in off-balance-sheet risk or 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 the interest rate exposure of its trading portfolio. These
financial instruments are included in the trading portfolio and are
reported at market 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 interest rate cap agreements to
effectively fix the interest rate on a portion of the Bank's floating-rate
securities sold under agreements to repurchase and on the Bank's Federal
Home Loan Bank advance. The premiums paid to enter into such interest rate
cap agreements are included in other assets and are amortized using the
straight-line method over the related term of the agreements. 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 market value of interest rate swaps and of the
interest rate caps 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 caps are designated to a portion of the Bank's
securities sold under agreements to repurchase and the Bank's Federal Home
Loan Bank advance which alter the designated instruments' interest rate
characteristics.
Due from Brokers consists of amounts receivable from sales of securities
in which the transactions have not settled as of the balance sheet date.
Loans Receivable are carried at the principal amount outstanding, adjusted
for premiums or discounts which are amortized or accreted using a
level-yield method. SFAS No. 114 and No. 118, Accounting by Creditors for
Impairment of a Loan and Income Recognition and Disclosures, 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. An impaired loan is charged off by
management as a loss when deemed uncollectible although collection efforts
continue and future recoveries may occur.
<PAGE>
Discounts and premiums on purchased residential real estate loans are
amortized to income using the interest method over the remaining period to
contractual maturity.
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 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 projected cash flows using
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.
35
<PAGE>
Federal Income Taxes - The Company and its wholly-owned subsidiary file a
consolidated tax return. 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.
Earnings Per Share - Earnings per share of common stock is based on the
weighted average number of common shares outstanding during the year. All
per share information has been restated to reflect the Company's
two-for-one stock split in October 1995.
The Company adopted SFAS No. 128, Earnings per Share, for fiscal year 1998
with all prior period earnings per share data restated. This statement
established new accounting standards for the calculation of basic earnings
per share as well as diluted earnings per share. The adoption of this
statement did not have a material effect on the Company's calculation of
earnings per share. The following is a reconciliation of the weighted
average common shares for the basic and diluted earnings per share
computations:
<TABLE>
<CAPTION>
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Basic earnings per share:
Weighted average common shares ....... 3,285,166 3,256,738 2,160,233
--------- --------- ---------
Diluted earnings per share:
Weighted average common shares ....... 3,285,166 3,256,738 2,160,233
Dilutive effect of stock options .... 24,876 42,214 40,914
--------- --------- ---------
Weighted average common and
incremental shares (1) .......... 3,310,042 3,298,952 2,201,147
--------- --------- ---------
</TABLE>
(1) The calculation for diluted earnings per share for the fiscal year
ended June 30, 1998 was based upon the weighted average common shares
as the effect of the stock options were anti-dilutive due to the net
loss for the year.
New Accounting Pronouncements - In June 1997, SFAS No. 130, Comprehensive
Income, was issued and becomes effective for fiscal years beginning after
December 15, 1997 and requires reclassification of earlier financial
statements for comparative purposes. SFAS No. 130 requires that changes in
the amounts of certain items, including gains and losses on certain
securities, be shown in the financial statements. SFAS No. 130 does not
require a specific format for the financial statement in which
comprehensive income is reported, but does require that an amount
representing total comprehensive income be reported in that statement.
This statement will result in additional financial statement disclosures
upon adoption.
<PAGE>
Also in June 1997, SFAS No. 131, Disclosures about Segments of an
Enterprise and Related Information, was issued. This Statement will change
the way public companies report information about segments of their
business in their annual financial statements and requires them to report
selected segment information in their quarterly reports issued to
shareholders. It also requires entity-wide disclosures about the products
and services an entity provides, the material countries in which it holds
assets and reports revenues, and its major customers. SFAS No. 131 is
effective for fiscal years beginning after December 15, 1997. Management
has not yet determined the effect, if any, of SFAS No. 131 on the
consolidated financial statements.
SFAS No. 133, Accounting for Derivative Instruments and Hedging
Activities, was issued in June 1998 and is effective for all fiscal
quarters of all fiscal years beginning after June 15, 1999. This statement
establishes accounting and reporting standards for derivative instruments
and for hedging activities. It requires that an entity recognize all
derivatives as either assets or liabilities in the statement of financial
condition and measure those instruments at fair value. If certain
conditions are met, a derivative may be specifically designated as a fair
value hedge, a cash flow hedge, or a hedge of foreign currency exposure.
The accounting for changes in the fair value of a derivative (that is,
gains and losses) depends on the intended use of the derivative and the
resulting designation. Management has not yet quantified the effect of the
new standard on the financial statements.
Reclassifications of certain amounts in the 1997 and 1996 consolidated
financial statements have been made to conform to the 1998 presentation.
36
<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)
Gross Gross
Amortized Unrealized Unrealized Fair
Year Ended June 30, 1998 Cost Gains Losses Value
- ------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Securities held for trading:
GNMA certificates ................... $142,951 $ 1,282 $ 14 $144,219
FHLMC certificates .................. 50,555 808 134 51,229
FNMA certificates ................... 57,252 1,000 8 58,244
Commercial mortgage backed securities 17,540 248 17,788
Non-agency participation certificates 1,884 33 42 1,875
Collateralized mortgage obligations . 10,930 484 11,414
Residuals ........................... 309 55 364
Interest-only strips ................ 1,118 5 605 518
Principal-only strips ............... 599 119 718
Interest rate swaps ................. 397 (397)
Interest rate collar ................ 38 60 (22)
Interest rate caps .................. 2,384 2,157 227
Interest rate floors ................ 3,410 1,423 393 4,440
Options ............................. 68 19 37 50
Futures ............................. 257 (257)
Equity securities ................... 99 100 199
-------- -------- -------- --------
Totals ................................. $289,137 $ 5,576 $ 4,104 $290,609
======== ======== ======== ========
Securities available for sale:
Municipal bonds ..................... $ 319 $ 16 $ 335
Non-agency participation certificate 605 $ 18 587
-------- -------- -------- --------
Totals ................................. $ 924 $ 16 $ 18 $ 922
======== ======== ======== ========
</TABLE>
The Bank's collateralized mortgage obligation (CMO) portfolio at June 30, 1998
consisted of three agency investments with an estimated remaining weighted
average life of 7.5 years.
37
<PAGE>
<TABLE>
<CAPTION>
Gross Gross
Amortized Unrealized Unrealized Fair
(Dollars in thousands) Cost Gains Losses Value
- -----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Securities held for trading:
GNMA certificates ................... $165,894 $ 2,291 $ 83 $168,102
FHLMC certificates .................. 41,194 401 79 41,516
FNMA certificates ................... 68,800 628 73 69,355
Non-agency participation certificates 2,545 42 85 2,502
Collateralized mortgage obligations . 25,789 295 52 26,032
Residuals ........................... 508 566 38 1,036
Interest-only strips ................ 2,028 41 620 1,449
Principal-only strips ............... 821 42 3 860
Interest rate swaps ................. 626 45 581
Interest rate collar ................ 50 58 (8)
Interest rate caps .................. 3,025 1,480 1,545
Interest rate floors ................ 3,916 572 947 3,541
Options ............................. 78 54 24
Futures ............................. 356 356
Equity securities ................... 305 159 464
-------- -------- -------- --------
Totals ................................. $314,953 $ 6,019 $ 3,617 $317,355
======== ======== ======== ========
Securities available for sale:
Municipal bonds ..................... $ 317 $ 18 $ 335
Non-agency participation certificate 866 $ 76 790
-------- -------- -------- --------
Totals ................................. $ 1,183 $ 18 $ 76 $ 1,125
======== ======== ======== ========
</TABLE>
The Bank's CMO portfolio at June 30, 1997 consisted of four agency investments
with an estimated remaining weighted average life of 16.1 years.
For a complete discussion of the Bank's Risk Management Activities, see Note 13.
38
<PAGE>
The amortized cost and estimated fair values of securities by contractual
maturity are as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Held for Trading Available for Sale
-------------------- -------------------
Amortized Fair Amortized Fair
Year Ended June 30, 1998 Cost Value Cost Value
- -----------------------------------------------------------------------------------------
<S> <C> <C> <C> <C>
Debt securities (due after 1 year through
5 years) ............................. $ 319 $ 335
Mortgage-backed securities .............. $268,298 $271,480
Non-agency participation certificates ... 1,884 1,875 605 587
Collateralized mortgage obligations ..... 10,930 11,414
Mortgage-backed derivatives ............. 2,026 1,600
Interest rate contracts ................. 5,900 4,041
Equity securities ....................... 99 199
-------- -------- -------- --------
$289,137 $290,609 $ 924 $ 922
======== ======== ======== ========
</TABLE>
Securities with a total amortized cost of $245,510,000 and $255,387,000
and a total fair value of $248,537,000 and $257,826,000 were pledged at
June 30, 1998 and 1997, respectively, to secure interest rate swaps and
securities sold under agreements to repurchase. As of June 30, 1998 and
1997, the Bank had a blanket collateral agreement for the Federal Home
Loan Bank advances instead of utilizing specific securities as collateral.
Activities related to the sale of securities are summarized as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Year Ended June 30, 1998 1997 1996
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C>
Proceeds from sales of securities held for trading . $652,380 $888,429 $290,209
Gross gains on sales of securities held for trading 46,537 44,324 30,492
Gross losses on sales of securities held for trading 47,312 45,947 28,658
</TABLE>
39
<PAGE>
3. LOANS RECEIVABLE
----------------
Approximately 78% of the Bank's loans are to customers in Wayne, Hamilton
and Marion counties in Indiana or surrounding counties. The portfolio
consists primarily of owner occupied single family residential mortgages.
Loans receivable are summarized as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
Loans secured by one to four family residences:
Real estate mortgage ............................. $ 154,148 $ 90,914
Participation loans purchased .................... 188 226
Commercial ......................................... 4,723 258
Property improvement ............................... 1,248 690
Loans on savings accounts .......................... 221 252
Consumer and home equity lines of credit ........... 2,288 1,446
Other consumer loans ............................... 253
--------- ---------
Subtotal ........................................... 163,069 93,786
Unamortized push-down accounting adjustment ........ (113) (136)
Undisbursed loan proceeds .......................... (6) (9)
Net deferred loan fees, premiums and discounts ..... 956 530
Allowance for loan losses .......................... (360) (213)
--------- ---------
Loans receivable, net .............................. $ 163,546 $ 93,958
========= =========
</TABLE>
The principal balance of loans on nonaccrual status totaled approximately
$285,000 and $336,000 at June 30, 1998 and 1997, respectively. For the
years ended June 30, 1998, 1997 and 1996, gross interest income which
would have been recorded had the Bank's nonaccruing loans been current
with their original terms amounted to $15,000, $6,000, and $6,000,
respectively. At June 30, 1998 and June 30, 1997, the Company had no
impaired loans required to be disclosed under SFAS No. 114 and No. 118.
The Bank had commitments to originate or purchase loans consisting
primarily of real estate mortgages secured by one to four family
residences approximating $11,863,000 and $3,182,000 excluding undisbursed
portions of loans in-process at June 30, 1998 and 1997, respectively.
The Bank has transactions in the ordinary course of business with
directors, officers, employees and an affiliate (Smith Breeden Associates
Inc., see Note 15). Loans to such individuals totaled $1,927,000 and
$228,000 at June 30, 1998 and 1997, respectively.
The amount of loans serviced for others totaled $3,411,000, $4,657,000,
and $5,587,000 at June 30, 1998, 1997 and 1996, 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 borrowers' escrow balances of $27,000 and $31,000 at June 30,
1998 and 1997, respectively.
<PAGE>
Loan servicing fee income included in other income for the years ended
June 30, 1998, 1997 and 1996 was $15,000, $19,000 and $23,000,
respectively.
An analysis of the allowance for loan losses is as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Beginning balance ...................... $ 213 $ 120 $ 121
Provision for loan losses .............. 147 92 (1)
Recoveries ............................. 1
----- ----- -----
Ending balance ......................... $ 360 $ 213 $ 120
===== ===== =====
</TABLE>
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 $133 and
$124 million at June 30, 1998 and 1997, respectively. Also under FIRREA,
the loans-to-one borrower limitation is generally 15% of unimpaired
capital and surplus which, for the Bank, was approximately $5 million at
June 30, 1998 and 1997. The Bank was in compliance with all of these
requirements at June 30, 1998 and 1997.
40
<PAGE>
4. INTEREST RECEIVABLE
-------------------
Interest receivable is summarized as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
June 30, 1998 1977
- --------------------------------------------------------------------------------
<S> <C> <C>
Loans (less allowance for uncollectibles - $15 and $6) ... $ 744 $ 413
Interest-bearing deposits ................................ 2 34
Securities held for trading .............................. 1,543 1,599
Securities available for sale ............................ 29 34
------ ------
Interest receivable, net ................................. $2,318 $2,080
====== ======
</TABLE>
5. PREMISES AND EQUIPMENT
Premises and equipment are summarized as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
June 30, 1998 1977
- --------------------------------------------------------------------------------
<S> <C> <C>
Land ........................................... $ 1,003 $ 1,003
Buildings and leasehold improvements ........... 4,422 3,510
Furniture, fixtures and equipment .............. 1,673 1,059
------- -------
Total .......................................... 7,098 5,572
Less accumulated depreciation .................. (1,484) (1,148)
------- -------
Premises and equipment, net .................... $ 5,614 $ 4,424
======= =======
</TABLE>
Depreciation expense included in operations during the years ended June
30, 1998, 1997 and 1996 totaled $348,000, $235,000, and $210,000 respectively.
<PAGE>
6. DEPOSITS
--------
<TABLE>
<CAPTION>
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
Weighted Weighted
Average Average
Amount Rate Amount Rate
------ ---- ------ ----
<S> <C> <C> <C> <C>
NOW accounts ................ $ 8,202 2.39% $ 4,778 2.42%
Savings accounts ............ 31,076 4.37 20,523 4.18
Money market deposit accounts 2,705 4.43 1,930 4.00
-------- --------- ----
41,983 27,231
-------- --------- ----
Certificates of deposit:
1 year and less ............. 113,237 74,586
1 to 2 years ................ 13,169 19,437
2 to 3 years ................ 3,570 7,486
3 to 4 years ................ 3,198 1,845
Over 4 years ................ 3,154 5,590
-------- ---------
136,328 5.96 108,944 5.88
-------- ---- --------- ----
Total deposits .............. $178,311 $136,175
======== =========
</TABLE>
Certificates of deposit in the amount of $100,000 or more totaled
approximately $25 million and $18 million at June 30, 1998 and 1997,
respectively.
A summary of certificate accounts by scheduled fiscal year maturities at
June 30, 1998, is as follows:
<TABLE>
<CAPTION>
(Dollars in thousands) 1999 2000 2001 2002 2003 Thereafter Total
-------- -------- -------- -------- -------- -------- --------
<S> <C> <C> <C> <C> <C> <C> <C>
3.00% or less .. $ 1 $ 8 $ 9
3.01%-5.00% .... $ 9,877 $ 953 $ 55 $ 72 100 11,057
5.01%-7.00% .... 100,665 11,050 2,725 1,152 1,863 742 118,197
7.01%-9.00% .... 2,384 1,158 117 1,974 169 271 6,073
9.01% or greater 311 8 673 992
-------- -------- -------- -------- -------- -------- --------
Totals ...... $113,237 $ 13,169 $ 3,570 $ 3,198 $ 2,133 $ 1,021 $136,328
======== ======== ======== ======== ======== ======== ========
</TABLE>
41
<PAGE>
Interest expense on deposits is as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
NOW accounts ............................ $ 166 $ 124 $ 110
Savings accounts ........................ 1,117 844 613
Money market deposit accounts ........... 101 82 77
Certificates of deposit ................. 6,919 6,416 6,351
------ ------ ------
$8,303 $7,466 $7,151
====== ====== ======
</TABLE>
Interest expense on certificates of deposit is net of interest income on
interest rate contracts of $70,000, $130,000, and $129,000 for the years
ended June 30, 1998, 1997 and 1996, respectively.
For a complete discussion of the Bank's Risk Management Activities, see
Note 13.
7. SECURITIES SOLD UNDER AGREEMENTS TO REPURCHASE
----------------------------------------------
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
Securities sold under agreements to repurchase:
Same securities ...................................... $240,396 $191,664
Substantially identical securities ................... 53,907
-------- --------
$240,396 $245,571
-------- --------
Accrued interest on securities sold under agreements
to repurchase ........................................ $ 282 $ 300
======== ========
</TABLE>
At June 30, 1998, securities sold under agreements to repurchase mature
within one month.
An analysis of securities sold under agreements to repurchase, excluding
related accrued interest, is as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Maximum amount outstanding at any month-end . $342,094 $343,427 $219,067
Daily average amount outstanding ............ 319,579 306,034 148,524
Weighted average interest rate at end of year 5.65% 5.47% 5.21%
</TABLE>
<PAGE>
Assets pledged to secure securities sold under agreements to repurchase
are concentrated among six and seven dealers as of June 30, 1998 and 1997,
respectively. The Bank exercises control over the securities pledged when
the same security is repurchased. Assets pledged are as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
Mortgage-backed securities:
At amortized cost ........................ $245,510 $249,018
At fair value ............................ $248,537 $251,317
</TABLE>
An analysis of the amount at risk under repurchase agreements with
counterparties exceeding 10% of stockholders' equity at June 30, 1998 is
as follows:
<TABLE>
<CAPTION>
Weighted
Amount Accrued Average
Outstanding Interest Maturity
(Dollars in thousands) (in days)
- ---------------------------------------------------------------------------------------
<S> <C> <C> <C>
Federal Home Loan Mortgage Corporation $ 34,214 $ 30 11
Federal National Mortgage Association 118,648 136 10
Merrill Lynch ........................ 8,100 8 19
Morgan Stanley Market Products, Inc. . 2,527 3 27
Nomura Securities International, Inc. 42,232 60 16
First Union .......................... 34,675 45 15
-------- --------
$240,396 $ 282
======== ========
</TABLE>
8. FEDERAL HOME LOAN BANK ADVANCES
-------------------------------
Advances from the Federal Home Loan Bank of Indianapolis are as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
Variable Variable
Weighted Weighted
Fiscal Year Average Average
Maturity Amount Rate Amount Rate
-------- ------ ---- ------ ----
<S> <C> <C> <C> <C>
1999 $ 26,000 5.64%
1998 $ 26,000 5.78%
</TABLE>
As of June 30, 1998 and 1997, the Bank had a blanket collateral agreement
for the Federal Home Loan Bank advances instead of utilizing specific
securities as collateral.
42
<PAGE>
9. NOTE PAYABLE
------------
At June 30, 1998, the Company maintained a $15,000,000 loan facility from
Mercantile Bancorporation, Inc. (formerly Mark Twain Bank) consisting of a
revolving line of credit of $5,000,000, of which $3,500,000 was
outstanding as of June 30, 1998, and a $10,000,000 term loan of which
$5,000 had been repaid under the term loan at June 30, 1998. Quarterly
interest-only payments, based on the prime rate published in the Wall
Street Journal (8.50% at June 30, 1998), are payable through maturity of
June 2000. The unpaid principal balance outstanding is payable in full in
June 2000.
As of June 30, 1998, the loan was secured by the Harrington Bank, FSB
stock held by HFG, a blanket security interest in all of the Company's
assets and the assignment of certain life insurance policies owned by HFG.
Under the terms of the agreement, the Company is bound by certain
restrictive debt covenants. As of June 30, 1998, HFG was in compliance
with all such debt covenants.
10. INCOME TAXES
------------
An analysis of the income tax provision (benefit) is as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Current:
Federal ................................ $ 7 $ 451 $ 1,203
State .................................. 4 205 358
Deferred:
Federal ................................ (989) 484 (776)
State .................................. (256) 121 (137)
------- ------- -------
Total income tax provision (benefit) ..... $(1,234) $ 1,261 $ 648
======= ======= =======
</TABLE>
The difference between the financial statement provision (benefit) and
amount computed by using the statutory rate of 34% is reconciled as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Federal statutory income tax at 34% .......... $(1,052) $ 1,109 $ 636
Tax exempt interest and dividends ............ (12) (14) (29)
State income taxes, net of federal tax benefit (166) 185 129
Amortization of fair value adjustments ....... (1) (12) (53)
Other, net ................................... (3) (7) (35)
------- ------- -------
Total income tax provision (benefit) ......... $(1,234) $ 1,261 $ 648
======= ======= =======
</TABLE>
<PAGE>
The Company's deferred income tax assets and liabilities are as follows:
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
Deferred tax assets:
Net operating loss carryforward ....................... $ 1,016
Tax benefit from exercise of non-qualified options .... 266
Bad debt reserves, net ................................ 15
Deferred compensation ................................. 24 $ 35
Deferred loan fees/costs, net ......................... 1 9
Differences in depreciation methods ................... 3 2
Unrealized loss on securities available for sale ...... 1 23
Other ................................................. 57 27
------- -------
1,383 96
------- -------
Deferred tax liabilities:
Bad debt reserves, net ................................ 43
Unrealized gain on securities held for trading ........ 793 951
Differences in income recognition on investments ...... 350 351
------- -------
1,143 1,345
------- -------
Deferred income taxes, net .............................. $ 240 $(1,249)
======= =======
</TABLE>
The Company's net operating loss carryforward expires in fiscal year 2013.
Retained earnings at June 30, 1998 and 1997 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. The Bank has delayed the timing of this recapture for
taxable years 1998 and 1997 as certain residential loan test requirements
were met. The six year recovery period for the excess reserves will begin
in taxable year 1999. The adoption of the act did not have a material
adverse effect on the Company's consolidated financial position.
43
<PAGE>
11. REGULATORY CAPITAL REQUIREMENTS
-------------------------------
The Bank is subject to various regulatory capital requirements
administered by the federal banking agencies. Failure to meet minimum
capital requirements can initiate certain mandatory and possibly
additional discretionary actions by regulators that, if undertaken, could
have a direct material effect on the Bank's financial statements. Under
capital adequacy guidelines and the regulatory framework for prompt
corrective action, the Bank must meet specific capital guidelines that
involve quantitative measures of the Bank's assets, liabilities, and
certain off-balance-sheet items as calculated under regulatory accounting
practices. The Bank's capital amounts and classification are also subject
to qualitative judgments by the regulators about components, risk
weightings, and other factors.
Quantitative measures that have been established by regulation to ensure
capital adequacy require the Bank to maintain minimum capital amounts and
ratios (set forth in the table below). The Bank's primary regulatory
agency, the OTS, currently requires that the Bank maintain minimum ratios
of tangible capital (as defined in the regulations) of 1.5%, core capital
(as defined) of 4%, and total risk-based capital (as defined) of 8%. The
Bank is also subject to prompt corrective action capital requirement
regulations set forth by the Federal Deposit Insurance Corporation
("FDIC"). The FDIC requires the Bank to maintain minimum capital amounts
and ratios of total and Tier I capital (as defined in the regulations) to
risk-weighted assets (as defined), and of Tier I capital (as defined) to
average assets (as defined). Management believes, as of June 30, 1998,
that the Bank meets all capital adequacy requirements to which it is
subject.
As of June 30, 1998 and 1997, the most recent notification from the OTS
categorized the Bank as "well capitalized" under the regulatory framework
for prompt corrective action. To be categorized as "well capitalized" the
Bank must maintain minimum total risk-based, Tier I risk-based and Tier I
leverage ratios as set forth in the table. There are no conditions or
events since that notification that management believes have changed the
institution's category.
<PAGE>
<TABLE>
<CAPTION>
To Be Categorized as
"Well Capitalized"
Under Prompt
For Capital Corrective Action
(Dollars in thousands) Actual Adequacy Purposes Provisions
- -----------------------------------------------------------------------------------------------------------------------
Amount Ratio Amount Ratio Amount Ratio
<S> <C> <C> <C> <C> <C> <C>
As of June 30, 1998:
Tangible capital (to total assets) ........ $33,240 6.88% $ 7,247 1.50% N/A N/A
Core capital (to total assets) ............ 33,240 6.88% 19,326 4.00% N/A N/A
Total risk-based capital (to risk weighted
assets) ................................. 33,596 21.92% 12,262 8.00% $15,328 10.00%
Tier I risk-based capital (to risk weighted
assets) ................................. 33,240 21.69% N/A N/A 9,197 6.00%
Tier I leverage capital (to average assets) 33,240 6.88% N/A N/A 24,158 5.00%
------- ----- ------- ---- ------- -----
As of June 30, 1997:
Tangible capital (to total assets) ........ $31,031 6.96% $ 6,687 1.50% N/A N/A
Core capital (to total assets) ............ 31,031 6.96% 13,375 3.00% N/A N/A
Total risk-based capital (to risk weighted
assets) ................................. 31,239 31.14% 8,025 8.00% $10,032 10.00%
Tier I risk-based capital (to risk weighted 31,031 30.93% N/A N/A 6,020 6.00%
assets)
Tier I leverage capital (to average assets) 31,031 6.96% N/A N/A 22,292 5.00%
------- ----- ------- ---- ------- -----
</TABLE>
44
<PAGE>
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, 1998, 1997 and 1996 were $87,000, $85,000, and $39,000,
respectively.
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 prices at least equal to the
fair market value of the stock on the date of the grant. The options are
nontransferable and are forfeited upon termination of employment, as
applicable. At June 30, 1998, all outstanding stock options were
exercisable through May 2008. The following is an analysis of stock option
activity for each of the three years in the period ended June 30, 1998 and
the stock options outstanding at the end of the respective years:
<TABLE>
<CAPTION>
1998 1997 1996
Weighted Weighted Weighted
Average Average Average
Years Ended June 30, Shares Price Shares Price Shares Price
- -----------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding, beginning of fiscal year .. 176,450 $ 8.08 $ 155,700 $ 7.70 163,200 $ 7.32
Granted ................................ 31,950 12.11 21,000 10.89 26,612 7.51
Exercised .............................. (143,200) 7.50 (30,112) 5.48
Forfeited or expired ................... (5,200) 11.25 (250) 10.00 (4,000) 7.50
-------- --------- --------- --------- --------- -------
Outstanding, end of fiscal year ........ 60,000 $ 11.33 $ 176,450 $ 8.08 $ 155,700 $ 7.70
======== ========= ========= ========= ========= =======
Options exercisable at end of
fiscal year ........................... 8,310 $ 10.42 2,500 $ 10.00 -- --
======== ========= ========= ========= ========= =======
</TABLE>
As of June 30, 1998, options outstanding have exercise prices between
$10.00 and $12.50 and a weighted average remaining contractual life of 9
years.
The Company applies APB Opinion No. 25, Accounting for Stock Issued to
Employees, and related interpretations in accounting for the plans;
accordingly, since the grant price of the stock options is at least 100%
of the fair value at the date of the grant no compensation expense has
been recognized by the Company in connection with the option grants. Had
compensation cost for the plans been determined based on the fair value at
the grant dates for awards under the plan consistent with the fair value
method of SFAS No. 123, Accounting for Stock-Based Compensation, the
Company's net per share would have decreased to the pro forma amounts
indicated below:
<PAGE>
<TABLE>
<CAPTION>
(Dollars in thousands, except per share data)
Years Ended June 30, 1998 1997 1996
- ----------------------------------------------------------------------------
<S> <C> <C> <C>
Net income (loss):
As reported .......................... $ (1,859) $ 2,002 $ 1,223
Pro forma ........................... $ (1,875) $ 1,995 $ 1,221
Basic earnings (loss) per share:
As reported .......................... $ (0.57) $ 0.61 $ 0.57
Pro forma ............................ $ (0.57) $ 0.61 $ 0.57
Diluted earnings (loss) per share:
As reported .......................... $ (0.57) $ 0.61 $ 0.56
Pro forma ............................ $ (0.57) $ 0.60 $ 0.55
</TABLE>
45
<PAGE>
The weighted average fair value of options granted was $3.72, $3.42 and
$1.51 in fiscal years 1998, 1997 and 1996, respectively. The fair value of
the option grants is estimated on the date of grant using the
Black-Scholes option pricing model with the following assumptions:
dividend yields ranging from 0% - 1.04%, risk-free interest rates ranging
from 5.29% - 6.62%, expected volatilities ranging from 0% - 26.83% and
expected lives ranging from 23 days to five years. The pro forma amounts
are not representative of the effects on reported net income for future
years.
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
are eligible to participate in the ESOP. During the 1997 fiscal year, the
ESOP purchased 5,000 shares at $10.25 per share which have been allocated
to eligible employees. During the 1996 fiscal year, the ESOP purchased
7,000 shares in the initial public offering which have been allocated to
eligible employees. Contributions are 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 or
committed to be contributed to the ESOP by the Company) for fiscal years
1998, 1997 and 1996 was $73,000, $51,000 and $70,000, respectively.
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 market value of its
trading portfolio. The interest rate caps and floors generally have
indexes equal to one or three month LIBOR, except for one interest rate
cap which is tied to the five year Constant Maturity Treasury.
<PAGE>
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
repricings.
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 $2,100,000 and $1,300,000 at June
30, 1998 and 1997, 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 hedging activities. The Bank maintains trading positions with a
variety of counterparties or obligors (counterparties). To limit credit
exposure arising from such transactions, the Bank evaluates the credit
standing of counterparties, 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
counterparties and records gains and losses on derivative financial
instruments net in the trading portfolio.
46
<PAGE>
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 counterparties
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. Counterparties 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.
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, 1998
- ------------------------------------------------------------------------------------------------------------------------
Contract or Estimated
Notional Fair Value Weighted Average Interest Rate
Amount Asset Liability Payable Receivable Cap Floor
------ ----- --------- ------- ---------- --- -----
<S> <C> <C> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay fixed rate ... $ 121,000 $ 397 6.16% 5.67% N/A N/A
Interest rate caps . 133,000 $ 227 N/A N/A 7.92% N/A
Interest rate floors 250,000 4,440 N/A N/A N/A 6.25%
Interest rate collar 3,076 22 N/A N/A 10.25% 5.25%
Futures ............ 2,780,300 257 N/A N/A N/A N/A
Options ............ 66,000 50 N/A N/A N/A N/A
----------------------------------------------------------------------------------------------
$3,353,376 $ 4,717 $ 676
========== ========== =========
<CAPTION>
(Dollars in thousands)
June 30, 1997
- -----------------------------------------------------------------------------------------------------------------------
Contract or Estimated
Notional Fair Value Weighted Average Interest Rate
Amount Asset Liability Payable Receivable Cap Floor
------ ----- --------- ------- ---------- --- -----
<S> <C> <C> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay fixed rate ... $ 267,500 $ 581 5.92% 5.80% N/A N/A
Interest rate caps . 133,000 1,545 N/A N/A 7.92% N/A
Interest rate floors 275,000 3,541 N/A N/A N/A 6.38%
Interest rate collar 4,268 $ 8 N/A N/A 10.25% 5.25%
Futures ............ 1,546,400 356 N/A N/A N/A N/A
Options ............ 77,900 24 N/A N/A N/A N/A
---------- ---------- ------ --------------------------------------------------
$2,304,068 $ 6,047 $ 8
========== ========== ======
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
(Dollars in thousands)
Years Ended June 30, 1998 1997
- -----------------------------------------------------------------------------------
Monthly Monthly
Average Average
Fair Value Fair Value
--------------------------------------------
Asset Liability Asset Liability
<S> <C> <C> <C> <C>
Interest rate swaps:
Pay fixed rate .................. $ 376 $ 952 $ 45
Interest rate caps ............... $ 720 2,389
Interest rate floors ............. 4,946 4,945
Interest rate collar ............. 19 13
Futures .......................... 256 95
Options .......................... 125 154
--------------------------------------------
$5,791 $ 651 $8,440 $ 153
--------------------------------------------
</TABLE>
47
<PAGE>
The following table shows the various components of the Company's recorded
net gain on its trading portfolio. All realized and unrealized gains and
losses are reported as other income in the statement of operations. 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 statements of operations as interest income.
<TABLE>
<CAPTION>
(Dollars in thousands)
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
Year Ended June 30, 1998 (Losses) (Losses) (Losses)
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Interest rate contracts:
Swaps ............................. $ 13 $ (978) $ (965)
Caps .............................. (677) (677)
Floors ............................ 1,405 1,405
Collar ............................ (2) (2)
Futures ........................... (7,961) (613) (8,574)
Options ........................... 332 36 368
------- ------- -------
Total ............................. (7,616) (829) (8,445)
MBS and other trading assets ...... 6,841 (101) 6,740
======= ======= =======
Total trading portfolio ........... $ (775) $ (930) $(1,705)
======= ======= =======
<CAPTION>
(Dollars in thousands)
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
Year Ended June 30, 1997 (Losses) (Losses) (Losses)
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
Interest rate contracts:
Swaps ............................. $ (39) $ (39)
Caps .............................. (862) (862)
Floors ............................ (810) (810)
Collar ............................ 32 32
Futures ........................... $(5,045) 1,140 (3,905)
Options ........................... 114 (65) 49
------- ------- -------
Total ............................. (4,931) (604) (5,535)
MBS and other trading assets ...... 3,308 2,721 6,029
------- ------- -------
Total trading portfolio ........... $(1,623) $ 2,117 $ 494
======= ======= =======
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
(Dollars in thousands)
Realized Unrealized Net Trading
Gains/ Gains/ Gains/
Year Ended June 30, 1996 (Losses) (Losses) (Losses)
- --------------------------------------------------------------------------------
<S> <C> <C> <C>
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)
======= ======= =======
</TABLE>
48
<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,
1998.
<TABLE>
<CAPTION>
(Dollars in thousands)
Maturities During Fiscal
Years Ending June 30, 1999 2000 2001 2002 2003 Thereafter
- ------------------------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Interest rate swaps-Pay fixed rate
Notional amount ................. $100,000 $ 16,000 $ 5,000
Weighted average payable rate ... 6.12% 6.27% 6.58%
Weighted average receivable rate 5.66% 5.69% 5.66%
Interest rate caps
Notional amount ................ 37,000 10,000 $ 66,000 $ 20,000
Weighted average cap rate ...... 8.09% 6.50% 7.71% 9.00%
Interest rate floors
Notional amount ................ 60,000 30,000 70,000 $ 20,000 60,000 15,000
Weighted average floor rate .... 6.42% 6.50% 6.50% 6.00% 5.75% 6.50%
Interest rate collar
Notional amount ................ 3,076
Weighted average cap rate ...... 10.25%
Weighted average floor rate .... 5.25%
Futures
Notional amount ................ 766,300 479,000 505,000 475,000 348,000 207,000
Options
Notional amount ................. 66,000
</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, 1998 and 1997, the Bank held approximately $5.2 million and
$6.2 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. The
interest rate swaps protect the Bank against the exposure to falling
interest rates inherent in these CDs.
<PAGE>
The Bank also has interest caps which are used to effectively cap the
interest rates on specific floating-rate borrowings. As of June 30, 1998,
the Bank held three 6% and one 7% interest rate caps which are used to
effectively cap the interest rates on a portion of the Company's
securities sold under agreements to repurchase and the $26 million Federal
Home Loan Bank advance. As of June 30, 1998, the caps had a total notional
amount of $90 million and reprice based on the three month LIBOR. The
repricing characteristics of the Company's floating-rate borrowings are
similar in nature to those of the related interest rate cap agreements.
The securities sold under agreements to repurchase and the Federal Home
Loan Bank advance reach their maturities before the maturities of the
matched interest rate caps; however, it is the Bank's intent to replace
the floating-rate borrowings when they mature with additional
floating-rate liabilities, which will be designated against the interest
rate caps.
The Bank had a 7% interest rate cap as of June 30, 1997, which was used to
effectively cap the interest rate on the Company's floating-rate Federal
Home Loan Bank advances. As of June 30, 1997, the cap had a notional
amount of $30 million and repriced based on the three month LIBOR.
49
<PAGE>
The market values of the following interest rate swaps and interest rate
caps are not reflected in the Company's financial statements. The periodic
exchanges of interest payments and the net expense of the interest rate
caps are included in interest expense in the statements of operations.
<TABLE>
<CAPTION>
(Dollars in thousands)
Contract or Estimated Fair Value Weighted Average Interest Rate
Notional --------------------------------------------------------
June 30, 1998 Amount Asset Liability Payable Receivable
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay floating rate ......... $ 7,500 $ 137 5.74% 6.96%
Interest rate caps .......... $90,000 $ 2,495 N/A N/A
<CAPTION>
(Dollars in thousands)
Contract or Estimated Fair Value Weighted Average Interest Rate
Notional --------------------------------------------------------
June 30, 1997 Amount Asset Liability Payable Receivable
- ---------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Interest rate swaps:
Pay floating rate ........ $ 7,500 $ 91 6.00% 6.96%
Interest rate cap .......... $30,000 $ 351 N/A N/A
</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 caps used to cap a portion of the Bank's securities sold under
agreements to repurchase and the Federal Home Loan Bank advance as of June
30, 1998:
<TABLE>
<CAPTION>
(Dollars in thousands)
Maturities During Fiscal
Years Ending June 30, 1999 2000 2001 2002 2003 Thereafter
- ----------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Interest rate swaps-Pay
floating rate
Notional amount .......................... $ 7,500
Weighted average payable rate ........... 5.74%
Weighted average receivable rate ......... 6.96%
Interest rate caps
Notional amount .......................... $ 30,000 $ 60,000
Weighted average cap rate ................ 7.00% 6.00%
</TABLE>
50
<PAGE>
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.
The following table sets forth the Bank's real estate loan commitments
whose contract amounts represent credit risk and the applicable range of
interest rates for such loan commitments.
<TABLE>
<CAPTION>
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
Interest Interest
Amount Rates Amount Rates
------ ----- ------ -----
<S> <C> <C> <C> <C>
Fixed rate ............ $11,863 6.75-10.00% $ 573 7.625-8.375%
Adjustable Rate ....... 2,609 6.50-7.50%
------- -------
$11,863 $ 3,182
======= =======
</TABLE>
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 and directors of HFG are also principals of SBA. The
amount of consulting expense relating to SBA for fiscal years ending June
30, 1998, 1997 and 1996 was $287,000, $281,000 and $232,000 respectively.
SBA has a commercial loan outstanding with the Bank at June 30, 1998, see
Note 4.
16. STOCKHOLDERS' EQUITY AND REGULATORY MATTERS
-------------------------------------------
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
<PAGE>
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, $7,362,000 was available for
dividends at June 30, 1998.
Reserve Requirements -As of June 30, 1998, the Bank was not required to
maintain reserve balances with the Federal Reserve Bank.
SAIF Assessment -On September 30, 1996, the President signed into law an
omnibus appropriations act for fiscal year 1997 that included, among other
things, the recapitalization of the Savings Association Insurance Fund
(SAIF) in a section entitled "The Deposit Insurance Funds Act of 1996"
(the Act). The Act included a provision where all insured depository
institutions would be charged a one-time special assessment on their SAIF
assessable deposits as of March 31, 1995. The Company recorded a pre-tax
charge of $830,000 during the year ended June 30, 1997.
51
<PAGE>
17. FAIR VALUES OF FINANCIAL INSTRUMENTS
------------------------------------
The following disclosures of the estimated fair value of financial
instruments are made in accordance with the requirements of SFAS No. 107,
Disclosures about Fair Value of Financial Instruments:
<TABLE>
<CAPTION>
(Dollars in thousands)
June 30, 1998 1997
- ------------------------------------------------------------------------------------
Carrying Fair Carrying Fair
Value Value Value Value
--------------------------------------------
<S> <C> <C> <C> <C>
ASSETS:
Cash .............................. $ 1,567 $ 1,567 $ 1,207 $ 1,207
Interest-bearing deposits ........ 10,212 10,212 8,309 8,309
Securities held for trading ....... 290,609 290,609 317,355 317,355
Securities available for sale ..... 922 922 1,125 1,125
Loans receivable, net ............. 163,546 166,400 93,958 94,800
Interest receivable ............... 2,318 2,318 2,080 2,080
Federal Home Loan Bank stock ...... 4,878 4,878 4,852 4,852
Due from brokers .................. 11,308 11,308
LIABILITIES:
Deposits .......................... 178,311 178,400 136,175 136,200
Securities sold under agreements
to repurchase ................... 240,396 240,400 245,571 245,600
Federal Home Loan Bank advances ... 26,000 26,000 26,000 26,000
Interest payable on securities sold
under agreements to repurchase .. 282 282 300 300
Other interest payable ............ 1,596 1,596 787 787
Note payable ...................... 13,495 13,495 9,995 9,995
Advance payments by borrowers for
taxes and insurance ............. 785 785 585 585
OFF BALANCE SHEET HEDGING
INSTRUMENTS:
Interest rate swaps ............... 137 91
Interest rate caps ................ 3,595 2,495 685 351
</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.
<PAGE>
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,
principal-only strips, interest rate swaps, an interest rate collar,
interest rate caps, interest rate floors, options, futures and equity
securities. 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.
52
<PAGE>
Due from brokers consists of amounts receivable from sales of securities
in which the transactions have not settled as of the balance sheet date.
The fair value is determined by the carrying amounts of the securities
sold.
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 NOW, savings and money market deposit
accounts is the amount payable on demand at the reporting date. The fair
value of fixed maturity certificates is estimated using rates currently
offered for deposits of similar remaining maturities.
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
interest rate caps used to modify the interest rate sensitivity of certain
certificates of deposits, a portion of the Bank's securities sold under
agreements to repurchase and the Federal Home Loan Bank advance. 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, 1998 and 1997. 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 such dates,
and therefore, current estimates of fair value may differ significantly
from the amounts presented herein.
53
<PAGE>
18. HARRINGTON FINANCIAL GROUP, INC. FINANCIAL INFORMATION
(PARENT COMPANY ONLY)
------------------------------------------------------
The following condensed balance sheets as of June 30, 1998 and 1997, and
condensed statements of operations and cash flows for the three years in
the period ended June 30, 1998 for Harrington Financial Group, Inc. should
be read in conjunction with the consolidated financial statements and
notes thereto.
<TABLE>
<CAPTION>
CONDENSED BALANCE SHEETS
(Dollars in thousands)
June 30, 1998 1997
- --------------------------------------------------------------------------------
<S> <C> <C>
ASSETS
Cash and cash equivalents .......................... $ 1,944 $ 3,500
Securities held for trading ....................... 199 464
Deferred income taxes, net ......................... 791
Income taxes receivable ............................ 23 124
Other assets ....................................... 146 55
Intercompany receivable (payable) .................. 5 (1)
Investment in subsidiary ........................... 33,240 30,997
-------- --------
TOTAL ASSETS ....................................... $ 36,348 $ 35,139
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Note payable ....................................... $ 13,495 $ 9,995
Deferred income taxes, net ......................... 63
Accrued expenses payable and other liabilities ..... 189 87
-------- --------
Total liabilities .............................. 13,684 10,145
-------- --------
Common stock ....................................... 425 407
Additional paid-in capital ......................... 16,962 15,623
Treasury stock ..................................... (1,467)
Unrealized loss on securities available for sale ... (1) (35)
Retained earnings .................................. 6,745 8,999
-------- --------
Total stockholders' equity ..................... 22,664 24,994
-------- --------
TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY ......... $ 36,348 $ 35,139
======== ========
</TABLE>
<PAGE>
<TABLE>
<CAPTION>
CONDENSED STATEMENTS OF OPERATIONS
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ----------------------------------------------------------------------------------------
<S> <C> <C> <C>
Dividends from subsidiary ........................... $ 4,000 $ 855
Interest income from securities held for trading .... $ 6 76 8
Interest on deposits ................................ 18 8 12
Gain on sale of securities held for trading ......... 94 12 42
Unrealized gain (loss) on securities held for trading (59) 105 28
------- ------- -------
Total income .................................... 59 4,201 945
------- ------- -------
Interest expense on long-term borrowings ............ 981 907 905
Salaries and employee benefits ...................... 263 231 105
Other expenses ...................................... 249 315 12
------- ------- -------
Total expenses .................................. 1,493 1,453 1,022
------- ------- -------
Income (loss) before equity in undistributed earnings (1,434) 2,748 (77)
Income tax provision (benefit) ...................... (566) (509) (359)
Equity in undistributed earnings of subsidiary ...... (991) (1,255) 941
------- ------- -------
Net income (loss) ................................... $(1,859) $ 2,002 $ 1,223
======= ======= =======
</TABLE>
54
<PAGE>
<TABLE>
<CAPTION>
CONDENSED STATEMENTS OF CASH FLOWS
(Dollars in thousands)
Years Ended June 30, 1998 1997 1996
- ---------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
Net income (loss) ........................................... $ (1,859) $ 2,002 $ 1,223
Adjustments to reconcile net income (loss) to net
cash provided by (used
in) operating activities:
Decrease (increase) in other assets ....................... (91) 27 8
Decrease (increase) in income taxes receivable ............ 118 (124)
Decrease (increase) in intercompany receivable ............ (6) 71 (70)
Increase (decrease) in accrued expenses and other
liabilities ............................................. 102 (10) 83
Gain on sale of securities held for trading ............... (94) (12) (42)
Unrealized gain (loss) on securities held for trading ..... 59 (105) (28)
Purchases of securities held for trading .................. (2,000) (545)
Proceeds from sales of securities held for trading ........ 2,300 203 314
Deferred income tax provision ............................. (588) 53 16
Increase in accrued income taxes .......................... 210 211
Decrease (increase) in undistributed earnings of subsidiary 991 1,255 (941)
-------- -------- --------
Net cash provided by (used in)
operating activities ................................. (1,068) 3,570 229
-------- -------- --------
CASH FLOWS FROM INVESTING ACTIVITIES:
Capital contributions to subsidiary ........................ (3,200) (6,240) (6,792)
-------- -------- --------
Net cash used in investing activities .................. (3,200) (6,240) (6,792)
-------- -------- --------
CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from issuance of common stock
under initial public offering ............................ 11,437
Proceeds from stock options exercised ...................... 1,074 165
Proceeds from note payable ................................. 3,500 2,300 800
Principal repayments on note payable ....................... (1,303) (1,002)
Dividends paid on common stock ............................. (395) (98)
Purchase of treasury stock ................................. (1,467)
-------- -------- --------
Net cash provided by financing activities .............. 2,712 899 11,400
-------- -------- --------
NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS ........ (1,556) (1,771) 4,837
CASH AND CASH EQUIVALENTS,
Beginning of year .......................................... 3,500 5,271 434
-------- -------- --------
CASH AND CASH EQUIVALENTS,
End of year ................................................ $ 1,944 $ 3,500 $ 5,271
======== ======== ========
</TABLE>
55
<PAGE>
INDEPENDENT AUDITORS' REPORT
Board of Directors and Stockholders
Harrington Financial Group, Inc.
Richmond, Indiana
- -----------------------------------
We have audited the accompanying consolidated balance sheets of Harrington
Financial Group, Inc. and its subsidiary (the "Company") as of June 30, 1998 and
1997, and the related consolidated statements of operations, changes in
stockholders' equity and cash flows for each of the three years in the period
ended June 30, 1998. 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.
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 consolidated financial statements present fairly, in all
material respects, the financial position of Harrington Financial Group, Inc.
and its subsidiary as of June 30, 1998 and 1997, and the results of their
operations and their cash flows for each of the three years in the period ended
June 30, 1998 in conformity with generally accepted accounting principles.
/s/DELOITTE & TOUCHE LLP
- ------------------------
DELOITTE & TOUCHE LLP
Indianapolis, Indiana
July 27, 1998
56
EXHIBIT 23
Consent of Deloitte & Touche LLP
<PAGE>
EXHIBIT 23
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statement No.'s
333-08481 and 333-42119 of Harrington Financial Group, Inc. on Form S-8 of our
report dated July 27, 1998, appearing in this Annual Report on Form 10-K of
Harrington Financial Group, Inc. for the year ended June 30, 1998.
/s/DELOITTE & TOUCHE LLP
- ------------------------
Deloitte & Touche LLP
Indianapolis, Indiana
September 25, 1998
<TABLE> <S> <C>
<ARTICLE> 9
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> JUN-30-1998
<PERIOD-END> JUN-30-1998
<CASH> 1,567
<INT-BEARING-DEPOSITS> 10,212
<FED-FUNDS-SOLD> 0
<TRADING-ASSETS> 290,609
<INVESTMENTS-HELD-FOR-SALE> 922
<INVESTMENTS-CARRYING> 0
<INVESTMENTS-MARKET> 0
<LOANS> 163,906
<ALLOWANCE> 360
<TOTAL-ASSETS> 484,397
<DEPOSITS> 178,311
<SHORT-TERM> 266,396
<LIABILITIES-OTHER> 3,531
<LONG-TERM> 13,495
0
0
<COMMON> 425
<OTHER-SE> 22,239
<TOTAL-LIABILITIES-AND-EQUITY> 484,397
<INTEREST-LOAN> 8,734
<INTEREST-INVEST> 25,222
<INTEREST-OTHER> 0
<INTEREST-TOTAL> 33,956
<INTEREST-DEPOSIT> 8,303
<INTEREST-EXPENSE> 29,032
<INTEREST-INCOME-NET> 4,924
<LOAN-LOSSES> 147
<SECURITIES-GAINS> (1,410)
<EXPENSE-OTHER> 6,460
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</TABLE>
