First Bancshares, Inc. ("First Bancshares" or the "Company"), a Missouri corporation, was incorporated on September 30, 1993 for the purpose of becoming the holding company for First Home Savings Bank ("First Home" or the "Savings Bank") upon the Savings Bank's conversion from a state-chartered mutual to a state-chartered stock savings and loan association ("Conversion"). The Conversion was completed on December 22, 1993. At June 30, 2006, the Company had consolidated total assets of $228.4 million, total customer deposits of $179.1 million and stockholders' equity of $26.3 million. The Company is not engaged in any significant activity other than holding the stock of First Home. Accordingly, the information set forth in this report, including consolidated financial statements and related data, relates primarily to operations of the Savings Bank. The Company's common shares trade on The Nasdaq Stock Market LLC under the symbol "FBSI."
The Savings Bank is a Missouri-chartered, federally insured stock savings and loan association organized in 1911. The Savings Bank conducts its business from its home office in Mountain Grove and nine full service branch facilities in Marshfield, Ava, Gainesville, Sparta, Theodosia, Crane, Galena, Kissee Mills and Rockaway Beach, Missouri. In July 2006, a full service branch was opened in Springfield, Missouri. The deposits of the Savings Bank are insured up to applicable limits by the Federal Deposit Insurance Corporation ("FDIC"). As a Missouri-chartered savings and loan association, First Home derives its authority from, and is governed by, the provisions of the Missouri Savings and Loan Law ("Missouri Law") and regulations of the Missouri Division of Finance ("Division") and the Office of Thrift Supervision ("OTS"). See "-Regulation and Supervision" below.
The Savings Bank provides its customers with a full array of community banking services. The Savings Bank is primarily engaged in the business of attracting deposits from the general public and using such deposits, together with other funding sources, to invest primarily in residential mortgage loans, commercial real estate loans, land loans, second mortgage loans and commercial business loans and consumer loans, for its loan portfolio. Excess funds are typically invested in securities and other assets. At June 30, 2006, the Savings Bank's net loans were $142.0 million, or 62.2% of consolidated total assets, including $82.5 million, or 55.6% of total loans, for residential mortgage, $37.1 million or 25.0% of total loans for commercial real estate, $8.0 million or 5.4% of total loans for land loans, $3.7 million, or 2.5% of total loans, for second mortgage loans and $17.2 million of consumer and commercial business loans, or 11.6% of total loans. Of loans maturing after June 30, 2007, adjustable rate mortgage ("ARM") loans account for approximately 95% of loans secured by real estate and 87% of the total loan portfolio. See "-- Lending Activities" below.
Risk Factors
An investment in our common stock is subject to risks inherent in our business. Before making an investment decision, you should carefully consider the risks and uncertainties described below together with all of the other information included or incorporated by reference in this report. The risks and uncertainties described below are not the only ones that affect us. Additional risks and uncertainties that we are not aware of or focused on or that we currently deem immaterial may also impair the Company's business operations. This report is qualified in its entirety by these risk factors.
If any of the circumstances described in the following risk factors actually occur, our financial condition and results of operations could be materially and adversely affected. If this were to happen, the value of our common stock could decline significantly, and you could lose all or part of your investment.
Our loan portfolio includes loans with a higher risk of loss. We originate residential mortgage loans (including second mortgage loans), construction loans, commercial mortgage and land loans, commercial loans and consumer loans primarily within our market area. Generally, the types of loans other than residential mortgage loans have a higher risk of loss than residential mortgage loans. We had $62.3 million or 41.9% of our total loan portfolio outstanding in these higher risk loans at June 30, 2006. We have had a significant increase in these types of loans since 1999. Construction, commercial mortgage and land, commercial, and consumer loans may expose a lender to greater credit risk than loans secured by residential real estate because the collateral securing these loans may not be sold as easily as residential real estate. These loans also have greater credit risk than residential real estate for the following reasons and as discussed in detail under "-- Lending Activities":
. Commercial Mortgage and Land Loans. These loans typically involve higher principal amounts than other types of loans and repayment is dependent upon income being generated in amounts sufficient to cover operating expenses and debt service. Loans on land under development or held for future construction also poses additional risk because of the lack of income being produced by the property and the potential illiquid nature of the security. The repayment of loans secured by farm properties is dependent upon the successful operation of the farming operations, which is contingent on many things outside the control of either us or the borrowers. These factors include adverse weather conditions, fluctuating market prices of both final product and production costs, factors affecting the physical condition of the cattle and government regulations.
. Commercial Loans. Repayment is dependent upon the successful operation of the borrower's business.
. Consumer Loans. Consumer loans (such as personal lines of credit) are collateralized, if at all, with assets that may not provide an adequate source of payment of the loan due to depreciation, damage, or loss.
. Construction Loans. This type of lending contains the inherent difficulty in estimating both a property's value at completion of the project and the estimated cost of the project. If the estimate of construction cost proves to be inaccurate, we may be required to advance funds beyond the amount originally committed to permit completion of the project. If the estimate of value upon completion proves to be inaccurate, we may be confronted at, or prior to, the maturity of the loan with a project the value of which is insufficient to assure full repayment.
Strong competition within our market area has limited our growth and profitability. Competition in the banking and financial services industry is intense. We compete in our market area with numerous commercial banks, savings institutions, mortgage brokerage firms, credit unions, finance companies, mutual funds, insurance companies, and brokerage and investment banking firms operating locally and elsewhere. Some of these competitors have substantially
greater resources and lending limits than we have, have greater name recognition and market presence that benefit them in attracting business, and offer certain services that we do not or cannot provide. In addition, larger competitors may be able to price loans and deposits more aggressively than we do. Our profitability depends upon the Company's continued ability to successfully compete in its market area. The greater resources and deposit and loan products offered by some of our competitors may limit the Company's ability to increase its interest-earning assets. For additional information see "-- Competition."
As a result of this competition, our loan portfolio declined $15.7 million, or 9.6%, from June 30, 2005 to June 30, 2006. The reason for the decline is that we do not offer many of fixed rate products offered by our competitors and in the current low interest rate environment many of our competitors are offering these and other loans and at interest rates that are lower than we are able to offer. The decline in loans reduces our interest income and therefore decreases our profitability.
We have had a significant decline in our profitability. We experienced a net loss of $173,000 for the year ended June 30, 2006 compared to net income of $1.3 million during the year ended June 30, 2005. This decline was the result of reduced interest income from loans receivable and losses on property, including property that had been acquired for a branch expansion and a loss on the sale and impairment of securities. Also contributing to the decline was a reduction in our non-interest income. During the year ended June 30, 2005 we had non-interest income in connection with the receipt of insurance proceeds with no comparable amount received during the year ended June 30, 2006.
We have a significant amount of problem loans and losses related to these loans. Since 1999 we focused our efforts in increasing our commercial loan and commercial real estate loan portfolios. However, as a result we have recognized substantial losses in the past years. The volume of classified loans remains high relative to our peers. At June 30, 2006 classified loans were $8.3 million, an increase of $2.2 million, or 36.1%, from $6.1 million at June 30, 2005. This increase is, in part, attributable to our new stricter internal policies relating to the identification and monitoring of our problem loans as well as the problems experienced in the commercial, commercial business and consumer loan portfolios. In addition to the classified loans, we identified an additional $7.1 million of loans at June 30, 2006 on our internal watch list including $5.1 million, $700,000, $1.0 million and $300,000 of commercial real estate, commercial business, one-to-four family and consumer loans, respectively. We identified these loans as high risk loans and any deterioration in their financial condition could further increase our classified loans.
Our ratio of non-performing assets to total assets has decreased from 2.2% at June 30, 2005 to 0.6% at June 30, 2006. The decrease in non- performing assets does not indicate an improvement in the quality of our loan portfolio as evidenced by the increase in our classified loans. The decrease was primarily the result of payoffs and charge-offs on impaired loans (which includes nonaccrual loans) identified in 2005.
During the year ended June 30, 2006 we had loan charge-offs, net of recoveries, of $1.9 million compared to $722,000 for the fiscal year ended June 30, 2005. Of the charge-offs during the current year, $1.7 million, or 89.5%, related to commercial business loans.
If our allowance for loan losses is not sufficient to cover actual loan losses, our earnings could decrease further. We make various assumptions and judgments about the collectibility of our loan portfolio, including the
creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans. In determining the amount of the allowance for loan losses, we review our loans and the loss and delinquency experience, and evaluates economic conditions. If our assumptions are incorrect, the allowance for loan losses may not be sufficient to cover losses inherent in the loan portfolio, resulting in the need for additions to our allowance. Material additions to the allowance could materially decrease our net income. Our allowance for loan losses was 1.7% of total loans and 184.5% of non-performing assets at June 30, 2006, however, at June 30, 2006 our allowance was only 29.8% of total classified loans.
In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs. Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory authorities may have a material adverse effect on our financial condition and results of operations.
We are subject to extensive government regulation and supervision. We are subject to extensive federal and state regulation and supervision. Banking regulations are primarily intended to protect depositors' funds, federal deposit insurance funds and the banking system as a whole, not shareholders. These regulations affect our lending practices, capital structure, investment practices, dividend policy and growth, among other things. Congress and federal regulatory agencies continually review banking laws, regulations and policies for possible changes. Changes to statutes, regulations or regulatory policies, including changes in interpretation or implementation of statutes, regulations or policies, could affect the Company in substantial and unpredictable ways. Such changes could subject us to additional costs, limit the types of financial services and products we may offer and/or increase the ability of non-banks to offer competing financial services and products, among other things. Failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies, civil money penalties and/or reputation damage, which could have a material adverse effect on our business, financial condition and results of operations. While we have policies and procedures designed to prevent any such violations, there can be no assurance that such violations will not occur. For additional information, see the section in this Item 1 captioned "Regulation of First Home."
We have had turnover in a senior management and as a result our growth and profitability could be adversely affected. Our success is, and is expected to remain, highly dependent on our executive management team. This is particularly true because, as a community bank, we depend on management's ties to the community to generate business for us. Our growth will continue to place significant demands on our management. Our operations have been affected by changes in senior management. In September 2005 our Chief Executive Officer resigned and we hired a new Chief Executive Officer on December 16, 2005. On September 18, 2006 our Chief Financial Officer left the Company and the Chief Executive Officer became the acting interim Chief Financial Officer.
If we fail to maintain an effective system of internal control over financial reporting, we may not be able to accurately report our financial results or prevent fraud, and, as a result, investors and depositors could lose confidence in our financial reporting, which could adversely affect our business, the trading price of our stock and our ability to attract additional deposits. In connection with the enactment of the Sarbanes-Oxley Act of 2002 and the implementation of the rules and regulations promulgated by the SEC, the Company evaluates its internal control over financial reporting. If the Company fails to identify and correct any significant deficiencies in the
design or operating effectiveness of its internal control over financial reporting or fail to prevent fraud, current and potential shareholders and depositors could lose confidence in our internal controls and financial reporting, which could adversely affect our business, financial condition and results of operations, the trading price of our stock and our ability to attract additional deposits.
We determined that at June 30, 2006 our disclosure procedures and controls were not effective. More specifically, at June 30, 2006 we did not properly identify or record certain transactions related to the other than temporary impairment of two equity securities. For further information see "Item 8A Controls and Procedures - Evaluation of Disclosure Controls and Procedures" included herein.
Market Area
The Savings Bank is headquartered in the town of Mountain Grove, in Wright County, Missouri. Wright County has a population of approximately 17,000 and its economy is highly diversified, with an emphasis on the beef and dairy industry. The Savings Bank's market area is predominantly rural in nature and its deposit taking and lending activities primarily encompass Wright, Webster, Douglas, Christian, Ozark, Stone and Taney counties. Significant companies in the area include Hutchens Steel, Bore Flex, Inc., Copeland Corporation, Dairy Farmers of America and WoodPro Cabinetry. The Savings Bank also transacts a significant amount of business in Texas and Greene Counties, Missouri. The Savings Bank's market area, especially Ozark County because of its proximity to Norfolk and Bull Shoals lakes, has experienced a rather slow but steady growth from retirees. Economic conditions in the Savings Bank's market area have been relatively stable.
Selected Consolidated Financial Information
This information is incorporated by reference to pages 4 and 5 of the 2006 Annual Report to Stockholders ("Annual Report") attached hereto as Exhibit 13.
Average Balances, Yields Earned and Rates Paid
This information is incorporated by reference to page 13 of the Annual Report attached hereto as Exhibit 13.
Yields Earned and Rates Paid
This information is incorporated by reference to page 15 of the Annual Report attached hereto as Exhibit 13.
Rate/Volume Analysis
This information is incorporated by reference to page 16 of the Annual Report attached hereto as Exhibit 13.
Lending Activities
General. The principal lending activity of the Savings Bank is the origination of conventional mortgage loans for the purpose of purchasing, constructing or refinancing one-to-four family owner occupied homes within its primary market area. In an attempt to diversify its lending portfolio, however, the Savings Bank also originates commercial real estate loans, land loans, commercial business loans and consumer loans such as mobile home loans, automobile and loans secured by savings accounts. The ratios of residential and commercial real estate loans to total loans has shifted gradually in recent years as a result of a significant decrease in one-to-four family residential
portfolio and the Savings Bank's increase in commercial and agricultural lending. Additionally, the Savings Bank has used the S Administration's ("SBA") guaranteed programs since September 2000. As of June 30, 2006, 38 commercial business and commercial real estate loans with an aggregate balance of $8.7 million have SBA guarantees.
In addition to loans within the Savings Bank's primary market area, the Savings Bank also has originated five one-to-four family loans and eight commercial real estate loans in Arkansas, California, Colorado, Nebraska, and Oregon. The 13 loans had an aggregate balance of $3.3 million at June 30, 2006. These loans were performing according to their scheduled terms at June 30, 2006.
At June 30, 2006, the Savings Bank's net loans receivable totaled $142.0 million representing 62.2% of consolidated total assets. Historically, the Savings Bank has primarily originated ARM loan products. At June 30, 2006, ARM loans with a maturity date after June 30, 2007 accounted for $118.4 million or 83.4% of the total loan portfolio and 90.2% of loans secured by real estate. The Savings Bank focuses on serving the needs of its local community and strongly believes in a lending philosophy that emphasizes individual customer service and flexibility in meeting the needs of its customers. During the past four years the Savings Bank has experienced a significant decline in its one-to-four family loan portfolio. As a result, subsequent to June 30, 2006 the Savings Bank began offering long-term fixed rate loans that qualify for sale in the secondary market to better meet the needs of its customers in the current interest rate environment. While the sale of loans in the secondary market will not increase the Savings Bank's loan portfolio, it will afford the Savings Bank the opportunity to generate fee income and to maintain a relationship with its customers who want a fixed rate product. In addition, the Savings Bank currently anticipates that it will retain a few fixed rate mortgage loans in its portfolio. The loans that are retained in the Savings Bank's portfolio are expected to have a higher interest rate than the loans that are sold in the secondary market. Generally, loans that are retained in the Savings Bank's portfolio will be small loans ($50,000 or less) where the costs of selling such loans in the secondary market is too great or loans where the value of the acreage is too great for the residence to qualify under the secondary market standard. Both of these are common occurrences in the Savings Bank's primary trade market in rural Missouri.
Loan Portfolio Analysis. The following table sets forth the composition of the Savings Bank's loan portfolio by type of loan as of the dates indicated. Construction loans are included in residential and commercial loans depending on the type of security as these loans are typically made with the intent to convert to permanent financing. At June 30, 2006, the Savings Bank had $5.1 million, or 3.4% of total loans, in interim construction loans in its portfolio of which all were for residential construction, as described below. Because of the long-term nature and amount of its construction loans, the Savings Bank does not separately account for these types of loans.
At June 30, --------------------------------------- 2006 2005 ----------------- ---------------- Amount Percent Amount Percent ------ ------- ------ ------- (Dollars in thousands) Type of Loan: Residential $ 82,519 55.59% $ 89,220 54.36% Commercial real estate (1) 37,097 24.99 41,492 25.28 Land 7,949 5.36 9,450 5.76 Second mortgage loans 3,659 2.47 4,161 2.54 -------- ------ -------- ------ Total mortgage loans 131,224 88.41 144,323 87.94 -------- ------ -------- ------ Other Loans: Automobile loans 3,467 2.34 4,910 2.99 Savings account loans 1,709 1.15 1,709 1.04 Mobile home loans 2,438 1.64 2,139 1.30 Other consumer 1,060 0.71 979 .60 Commercial business 8,532 5.75 10,057 6.13 -------- ------ -------- ------ Total other loans 17,206 11.59 19,794 12.06 -------- ------ -------- ------ Total loans 148,430 100.00% 164,117 100.00% ====== ======== Add: Unamortized deferred loan costs, net of origination fees 184 201 Less: Undisbursed loans in process 4,153 3,324 Allowance for possible loan losses 2,474 2,851 -------- -------- Total loans receivable, net $141,987 $158,143 ======== ======== -------------- (1) Includes multi-family residential loans.
One-to-Four Family Residential Loans. The primary lending activity of the Savings Bank has been the origination of residential mortgage loans to enable borrowers to purchase existing homes, to construct new one-to-four family homes or refinance existing debt on their homes. Management believes that this policy of focusing on one-to-four family residential mortgage loans has been successful in contributing to interest income. The increases in delinquencies and losses over the last three years have primarily been the result of other lending activities rather than one-to-four family residential mortgage lending. At June 30, 2006, $82.5 million, or 55.6% of the Savings Bank's gross loan portfolio, consisted of residential mortgage loans (almost all of which are non-indexed ARMs, with the principal amortizing over loan terms ranging from 10 to 30 years). Since 1973 until the current year, the Savings Bank had originated almost exclusively ARM loan products. Initially, ARM loans were indexed to the Savings Bank's cost of funds. In 1979, the Savings Bank discontinued the use of the indexed ARM loans and changed to its current policy of non-indexed ARMs, which generally allows, but does not require, the Savings Bank to adjust the interest rate once a year, up or down, not to exceed 1% per year. Loans of this nature originated after 1988 generally were limited to a 6% maximum increase over the life of the loan. During the current year, the Savings Bank began offering fixed rate one-to-four family residential mortgage lending in an effort to compete with products offered by other lenders.
The Savings Bank's lending policies generally limit the maximum loan-to- value ratio on mortgage loans to 100% of the lesser of the appraised value or purchase price of the underlying residential property. Loans exceeding 80% loan to value have a higher interest rate (portfolio loans) and loans exceeding 90% loan to value have private mortgage insurance, which reduces the loan-to-value ratio to 78%. Reducing the loan to value ratio of these loans limits the Savings Bank's exposure and allows these loans to qualify for sale in the secondary market. The Savings Bank requires title insurance, fire and casualty coverage and a flood zone determination on all mortgage loans originated or purchased. All of the Savings Bank's real estate loans contain "due on sale" clauses. In prior years, the Savings Bank's personnel prepared all property evaluations at no expense to the borrower unless the property is outside its normal lending territory or the loan exceeds $250,000, in which event, independent appraisers are utilized. During the current year, the Savings Bank changed its practice and now obtains independent appraisals on all mortgage loans.
At June 30, 2006, the Savings Bank had $5.1 million in residential construction loans in its portfolio with maximum loan to value ratios of 85% based upon the estimated value upon completion. Typically, the Savings Bank limits its construction lending to individuals who are building their primary residences. Generally, loan proceeds are disbursed in increments as construction progresses based on invoices presented to the Savings Bank. Construction financing generally is considered to involve a higher degree of loss than long-term financing on improved, occupied real estate. Risk of loss on a construction loan is dependent largely upon the accuracy of the initial estimate of the property's value at completion of construction or development and the estimated cost of construction. During the construction phase, a number of factors could result in delays and cost overruns. The Savings Bank has sought to minimize this risk by primarily limiting construction lending to qualified borrowers in the Savings Bank's market area. At June 30, 2006, speculative construction loans amounted to $726,000, or 0.5% of the total loan portfolio and custom construction loans amounted to $4.4 million, or 2.9% of the total loan portfolio. The majority of these loans are converted into permanent residential real estate loans. During construction, these loans typically require monthly interest-only payments. Once construction is completed, these loans convert to monthly principal and interest based on amortization schedules for conventional residential or commercial buildings.
Second Mortgage Loans. The Savings Bank offers fixed and adjustable rate second mortgage loans that are usually made on the security of the borrower's residence. Loans normally do not exceed 80% of the appraised value of the residence, less the outstanding principal of the first mortgage, and have terms of up to 10 years requiring monthly payments of principal and interest. At June 30, 2006, second mortgage loans amounted to $3.7 million, or 2.5% of total loans of the Savings Bank.
Land and Commercial Real Estate Loans. The Savings Bank had loans outstanding secured by land and commercial real estate of $45.0 million, or 30.4% of the Savings Bank's gross loan portfolio, at June 30, 2006. The commercial real estate loans originated by the Savings Bank amounted to $37.1 million, or 25.0%, and are primarily located in the Savings Bank's market area. The average size of these loans is $143,000. These loans typically are made with a fixed rate for one to five years and then adjust at least annually, thereafter based on prime rate or the Constant Maturity Treasury Index ("CMT"). The Savings Bank's commercial real estate portfolio consists of loans on a variety of property types with no large concentrations by property type. Land loans amounted to $7.9 million, or 5.4% of the total loan portfolio at June 30, 2006 and are secured primarily by property located in the Savings Bank's primary market area. The Savings Bank's land loans generally are secured by farm land used in beef or dairy operations and involve the risks associated
with general agricultural or ranching operations. These risks include adverse weather conditions, fluctuating market prices of both final product and production costs, factors affecting the physical condition of the cattle and government regulations.
The Savings Bank's largest commercial real estate loan at June 30, 2006 was a $1.9 million loan. The loan is for a term of 15 years and is collateralized by an industrial commercial building located in Mountain Grove, Missouri. At June 30, 2006, the loan was performing according to its repayment terms.
Loans secured by farm properties are of particular concern since repayment is dependent upon the successful operation of the farming operations, which is greatly contingent on various factors outside the control of the Savings Bank or the borrower. These factors include adverse weather conditions, fluctuating market prices of both final product and production costs, factors affecting the physical condition of the cattle and government regulations.
Of primary concern in commercial real estate lending is the feasibility and cash flow potential of the property along with the borrower's creditworthiness and the value of the underlying collateral. Loans secured by income properties are generally larger and involve greater risks than residential mortgage loans because payments on loans secured by income properties are often dependent on successful operation or management of the properties. As a result, repayment of such loans may be subject, to a greater extent than residential real estate loans, to supply and demand in the market in the type of property securing the loan and therefore, may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced, the borrowers' ability to repay the loan may be impaired. Commercial real estate loans also tend to have shorter maturities than residential mortgage loans and may not be fully amortizing, meaning that they may have a significant principal balance or "balloon" payment due on maturity. In addition, commercial real estate properties, particularly industrial properties, are generally subject to relatively greater environmental risks than non-commercial properties and to the corresponding burdens and costs of compliance with environmental laws and regulations. Also, there may be costs and delays involved in enforcing rights of a property owner against tenants in default under the terms of leases with respect to commercial properties. For example, tenants may seek the protection of the bankruptcy laws, which could result in termination of lease contracts, reducing cash flow.
At June 30, 2006, multi-family residential loans were approximately $1.4 million, or 1.0% of the Savings Bank's gross loan portfolio consisted of five loans secured by multi-family residential real estate. Multi-family real estate loans are generally originated at 80% of the appraised value of the property or selling price, whichever is less, and carry interest rates that are fixed for 1-5 years and then adjust annually based on the CMT with the principal amortized over 15 to 30 years. Loans secured by multi-family real estate are generally larger and involve a greater degree of risk than one-to- four family residential loans. In addition, multi-family real estate loans carry risks similar to those associated with commercial real estate lending. For a discussion of these risks, see " -- Consumer and Commercial Business Loans." At June 30, 2006, four of the loans were performing according to payment terms and one loan was delinquent by one monthly payment.
Consumer. The Savings Bank's consumer loans consist of automobile loans, recreational vehicles, mobile home loans, savings account loans, and various other consumer loans. At June 30, 2006, the Savings Bank's consumer loans totaled $8.7 million, or 5.8% of the Savings Bank's total loans. Subject to
market conditions, management expects to continue to market and originate consumer loans as part of its strategy to provide a wide range of personal financial services to its depository customer base and as a means to enhance the interest rate sensitivity of the Savings Bank's interest-earning assets and its interest rate spread.
At June 30, 2006, the Savings Bank's loan portfolio secured by automobiles amounted to $3.5 million, or 2.3% of total loans. These loans are originated directly with the borrower with a maximum term of 60 months. The Savings Bank may lend up to 100% of the purchase price of a new automobile or up to the National Automobile Dealers Association published loan value for a used vehicle. The Savings Bank requires all borrowers to maintain automobile insurance, including collision, fire and theft insurance, with the Savings Bank listed as loss payee.
Loans secured by mobile homes at June 30, 2006 were $2.4 million, or 1.6% of total loans. These loans are generally considered to involve relatively higher credit risk as compared with conventional one-to-four family residential mortgage loans. The age, size and overall condition of the mobile home are additional factors in the mobile home loan underwriting consideration process. The Savings Bank's procedures for underwriting consumer loans include an assessment of the applicant's payment history on other debts and ability to meet existing obligations and payments on the proposed loan. Although the borrower's creditworthiness is a primary consideration, the underwriting process also includes a comparison of the value of the security, if any, to the proposed loan amount.
Consumer loans are considered a greater risk than residential mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles, mobile homes, boats and recreational vehicles. Any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance. The remaining deficiency often does not warrant further substantial collection efforts against the borrower. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. Consumer loans may also give rise to claims and defenses by a borrower against an assignee of such loans such as the Savings Bank, and a borrower may be able to assert against the assignee claims and defenses that it has against the seller of the underlying collateral. The largest balance of consumer loans are loans for automobiles, boats , recreational vehicles, mobile homes and small unsecured loans. The Savings Bank's delinquency levels for these types of loans are reflective of these risks. Several factors which contributed to the increase in delinquencies and charge-offs of consumer loans during fiscal 2006 were that the Savings Bank did not include all relevant parties on note agreements and related documents, lack of regular monitoring procedures on delinquent or problem loans, and lack of prompt or no repossession of underlying collateral on seriously delinquent loans. At June 30, 2006, only $3,000 of the Savings Bank's consumer loan portfolio was 90 days or more past due. However, $148,000 was on nonaccrual status at June 30, 2006.
Commercial Business Loans. Commercial business loans consist of loans to businesses with no real estate as security, such as business equipment loans, farm equipment loans and cattle loans. As of June 30, 2006, these loans totaled $8.5 million See "-- Non-Performing Assets and Delinquencies" and "
Reserve for Loan Losses" for data on loans originated by the Savings Bank and categorized as "other loans" in the past three fiscal years.
At June 30, 2006, the average size of a loan in the commercial business category was $43,000. These loans are typically structured with maturities of five years or less and have variable interest rates based on the prime rate. The largest commercial loan at June 30, 2006 was a line of credit loan to an area family-owned automobile dealership. At June 30, 2006 the balance of this loan was $408,000 and it was performing according to its repayment terms.
Commercial business loans are often larger and may involve greater risk than other types of lending. Because payments on such loans are often dependent on successful operation of the business involved, repayment of such loans may be subject to adverse conditions in the economy. In recognition of this risk, the Savings Bank attempts to make loans secured by adequate collateral to provide the majority of repayment of the principal balance when business operations are not successful. However, collateral for these types of loans may quickly decline in market value through normal usage and changes in technology and may fluctuate in value based on the success of the business. In addition, the Savings Bank limits this type of lending to its market area and to borrowers with which it has prior experience or who are otherwise well known to the Savings Bank.
The substantial increase in non-performing loans and delinquencies, as well as charge-offs, in the Savings Bank's commercial business loans during the year ended June 30, 2006 reflects underwriting and credit analysis weaknesses rather than weaknesses in the overall economic condition of the Savings Bank's market area. In addition to the problems experienced by the borrowers, the collateral underlying these loans was in many instances not properly securitized by the Savings Bank and regular inspections were not performed. Also, the collateral was not adequately analyzed at the time of the loan origination. The Savings Bank has recently implemented procedures to monitor the financial performance of its commercial portfolio.
Loan Maturity and Repricing
The following table sets forth scheduled contractual amortization of loans at June 30, 2006 and the dollar amount of such loans at that date which are scheduled to mature after one year and have fixed or adjustable interest rates. Demand loans, loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less.
At June 30, 2006 ------------------------------------------------------ Non- Commercial Commercial Real Commercial Mortgage Estate Consumer Business Total Loans Loans Loans Loans Loans ----- ----- ----- ----- -----
Amounts due: Within one year $ 4,202 $ 2,492 $ 2,358 $ 3,591 $ 12,643 After one year through three years 752 1,532 2,566 1,229 6,079 After three years through five years 1,595 237 1,385 2,127 5,344 After five years 87,578 32,836 2,365 1,585 124,364 -------- ------- ------- ------- -------- Total $ 94,127 $37,097 $ 8,674 $ 8,532 $148,430 ======== ======= ======= ======= ========
(table continued on following page)
At June 30, 2006 ------------------------------------------------------ Non- Commercial Commercial Real Commercial Mortgage Estate Consumer Business Total Loans Loans Loans Loans Loans ----- ----- ----- ----- -----
Interest rate terms on amounts due after one year: Fixed $ 3,872 $ 2,243 $ 4,292 $ 3,978 $ 14,385 Adjustable 86,053 32,362 2,024 963 121,402 -------- -------- ------- ------- -------- Total $ 89,925 $ 34,605 $ 6,316 $ 4,941 $135,787 ======== ======== ======= ======= ========
Mortgage Loan Solicitation and Processing. The Savings Bank's main source of loans is from contact and relationships with real estate agents, referrals from customers, and to a lesser extent walk-in applicants. Once a loan application is received, a credit report, along with verification of income is obtained. Then asset and liability verification as an appraisal of the proposed collateral is ordered. Real estate appraisals are completed by independent appraisers on all one-to four family loans originated after March 2006 and on all other real estate secured loans. The application is then reviewed by the loan officer and action is taken or loan write-up is presented to the Savings Bank's loan committee if the amount is greater than the loan officer's lending authority.
Commercial and commercial real estate loans are also primarily obtained through referrals or loan officer contacts. While loan officers are delegated reasonable commitment authority based on their qualification, credit decisions on significant commercial loans and commercial real estate loans are made by the loan committee, which is made up of senior loan officers and members of the Board of Directors.
Consumer loans are originated through referrals and existing deposit and loan customers of the Savings Bank. Consumer loan applications below set limits may be processed at branch locations or by loan documentation personnel at the main office.
Loan Originations, Purchases and Sales. The Savings Bank has never sold loans in the secondary market.
The following table shows total mortgage loans originated, purchased, sold and repaid during the periods indicated.
Years Ended June 30, -------------------- 2006 2005 ---- ---- (In thousands)
Total mortgage loans at beginning of period $ 144,323 $ 148,436 --------- --------- Loans originated: One-to-four family residential 27,839 23,711 Multi-family residential and commercial real estate 7,715 10,709 Land 2,612 3,334 --------- --------- Total loans originated 38,166 37,754 --------- --------- Loans purchased: Participation loans-commercial real estate - - --------- --------- Total loans purchased - -
Mortgage loan principal repayments 50,839 40,926 --------- --------- Other-loans charged-off or transferred to other real estate(1) 426 941 --------- --------- Total other activity 426 941 --------- --------- Total gross mortgage loans at end of period $ 131,224 $ 144,323 ========= ========= ------------ (1) Loans transferred to real estate owned amounted to $323,000 and $754,000 during fiscal 2006 and 2005, respectively. Mortgage loans charged-off amounted to $103,000 and $187,000 during fiscal 2006 and 2005, respectively.
Loan Commitments. The Savings Bank issues commitments for one-to-four family residential loans that are honored for up to a maximum of 60 days from approval. If the commitment expires, it is generally renewed upon request without penalty or expense to the borrower at the current market rate. The Savings Bank had outstanding net loan commitments of $1.9 million at June 30, 2006. See Note 13 of the Notes to the Consolidated Financial Statements contained in the Annual Report.
Non-Performing Assets and Delinquencies. The Savings Bank generally institutes collection procedures when a monthly payment is two to four weeks delinquent. A first notice is generally mailed to the borrower, or a phone call is made. If necessary, a second notice follows at the end of the next two week period. In most cases, delinquencies are cured promptly; however, if the Savings Bank is unable to make contact with the borrower to obtain full payment, or, full payment is not possible, and the Savings Bank cannot work out a repayment schedule, a notice to commence foreclosure may be mailed to the borrower. The Savings Bank makes every reasonable effort, however, to work with delinquent borrowers. Understanding that borrowers sometimes cannot make payments because of illness, loss of employment, etc., the Savings Bank will attempt to work with delinquent borrowers who are communicating and cooperating with the Savings Bank.
The Savings Bank institutes the same collection procedures for non- mortgage loans.
The Savings Bank has implemented several new procedures between March 31, 2006 and June 30, 2006 in identifying watch list credits. All loans greater than $50,000 that are 30 days or more past due or loans that have had events occur that raise questions as to the ability of the loan to perform in the future, is added to the watch list. On a quarterly basis, the account officer must complete a write-up on the credit giving an update and outlining the status of the credit and what is expected to remove the credit from the watch list. Classified assets increased significantly at June 30, 2006 in part as a result of implementing this procedure March 31, 2006.
The Board of Directors is informed on a monthly basis as to the status of all mortgage and non-mortgage loans that are delinquent, as well as the status on all loans currently in foreclosure or real estate owned by the Savings Bank through foreclosure.
The table below sets forth the amounts and categories of non-performing assets in the Savings Bank's loan portfolio at the dates indicated. Loans are placed on nonaccrual status when it is determined that the payment of interest or principal is doubtful of collection, or when interest or principal is past- due 90 days or more. Any accrued but uncollected interest previously recorded on such loans is generally reversed in the current period and interest income is subsequently recognized upon collection. The Savings Bank would have recorded interest income on nonaccrual loans of $117,000 and $167,000 during the years ended June 30, 2006 and 2005, respectively, if such loans had been performing during such periods.
Nonaccrual loans decreased from $2.9 million at June 30, 2005 to $841,000 at June 30, 2006. The balance of nonaccrual loans at June 30, 2005 consisted primarily of commercial loans to one borrower and related companies that had filed for protection under Chapter 11 bankruptcy. During fiscal 2006, these loans were either charged-off or refinanced under the bankruptcy plan. Loans past due 90 days or more and still accruing interest have decreased from $148,000 at June 30, 2005 to $3,000 at June 30, 2006.
The Savings Bank considers all nonaccrual loans and loans past due 90 days or more to be impaired. Subsequent to June 30, 2006, one of these loans underwent foreclosure proceeding with a subsequent charge-off of $50,000. The remaining loans are being closely monitored and necessary action will be taken if they become more seriously delinquent or the Savings Bank obtains information of probable significant loss.
One-to-four family loans which are 60 or more days but less than 91 days past due have decreased during the fiscal year 2006. This is partially attributable to Savings Bank personnel's concentrated efforts on working with borrowers who were past due in fiscal 2005. Not only did this process reduce the amount of residential loans past due 60 days or more during fiscal 2006, it also moved a number of these loans into the current category.
The following table sets forth information with respect to the Savings Bank's non-performing assets at the dates indicated. At June 30, 2005, there was one restructured loan of $428,000 which is included in the commercial business line item as a nonaccrual loan. During 2006, this loan resulted in a charge-off of $396,000. At June 30, 2006, there were two restructured loans totaling $37,000 which are included in the commercial business line item as nonaccrual loans. The decrease in total loans, net loans and total consolidated assets was also a factor in the percentage increases in nonperforming loans.
At June 30, ------------------- 2006 2005 ------ ------ Loans accounted for on a nonaccrual basis (Dollars in thousands) Real estate: Residential $ 322 $ 221 Commercial 306 1,112 Commercial business 65 1,502 Consumer 148 19 ------ ------ Total $ 841 $2,854 ====== ======
Accruing loans which are contractually Past due 90 days or more: Real estate: Residential $ - $ 63 Commercial - 30 Commercial business - - Consumer 3 55 ------ ------ Total $ 3 $ 148 ====== ====== Total of nonaccrual and 90 days past due loans $ 844 $3,002
Real estate owned 497 340 Other non-performing assets Impaired loans not past due or past due less than 60 days - 2,044
------ ------ Total non-performing assets $1,341 $5,386 ====== ====== Total loans delinquent 90 days or more to net loans 0.59% 1.90%
Total loans delinquent 90 days or more to total consolidated assets 0.37% 1.23%
Total non-performing assets to total consolidated assets 0.59% 2.21%
As of June 30, 2006, the Savings Bank had loans with an aggregate outstanding balance of $8.3 million with respect to which known information concerning possible credit problems with the borrowers or the cash flows of the properties securing the respective loans has caused management to be concerned about the ability of the borrowers to comply with present loan repayment terms, which may result in the future inclusion of such loans in the nonaccrual loan category. In addition, the Savings Bank has identified an additional $7.1 million of loans on its internal watch list to review quarterly for any deterioration in their capacity to perform as agreed.
Asset Classification. The OTS has adopted various regulations regarding problem assets of savings institutions. The regulations require that each insured institution review and classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, OTS
examiners have authority to identify problem assets and, if appropriate, require them to be classified. There are three classifications for problem assets: substandard, doubtful and loss. An asset is classified substandard when it is inadequately protected by the current new worth and paying capacity of the borrower or by the collateral pledged, if any. Assets so classified must 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. The Savings Bank's policy is to classify as substandard, for example, any loan, irrespective of payment record or collateral value, when a bankruptcy filing occurs, the pay record becomes erratic (i.e., miss several monthly payments, but make double payments in the future), or a loan becomes contractually delinquent by three monthly payments. 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. If an asset or portion thereof is classified loss, the insured institution must either establish specific allowances for loan losses for the full amount of the portion of the asset classified as loss or charge-off such amount. All or a portion of general loan 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 generally do not qualify as regulatory capital. During a State of Missouri Division of Finance regulatory examination which began in June 2005, several loans, which the Savings Bank had not previously identified as classified assets, were identified as classified assets by the examiners. In light of this, an extensive review was conducted by an outside consultant of the majority of outstanding loans and current underwriting and monitoring procedures in the fall of 2005. This review noted several weaknesses in the internal monitoring procedures of the Savings Bank. This report was also critical of the underwriting of some of the credits. Management is taking steps to address these weaknesses. A follow-up review is scheduled with the same consultant for the fall of 2006. The Savings Bank also utilizes an internal classification of "special mention" for those loans requiring additional monitoring, as described below.
At June 30, 2006 and 2005 the aggregate amounts of the Savings Bank's classified assets as determined by the Savings Bank, and of the Savings Bank's general and specific loss allowances and charge-offs, were as follows:
At June 30, -------------------- 2006 2005 ------ ------ (In thousands) Loss $ - $1,122 Doubtful 686 1,087 Substandard assets 5,898 3,841 Special mention 1,681 - ------ ------ Total classified assets $8,265 $6,050 ====== ======
General loss allowances $2,474 $1,729 Specific loss allowances - 1,122 ------ ------ Total loss allowances $2,474 $2,851 ====== ======
Net charge-offs $1,897 $ 722
Prior to fiscal 2006, the Savings Bank did not use a special mention category in its loan classification process. A category titled 'watch' is used by the Savings Bank to monitor loans which are not typical in their repayment terms, collateral, or a situation with the borrower that may create repayment difficulties in the future. Loans classified as special mention are designated when the ability to meet current payment schedules is questionable, even though interest and principle are still being paid as agreed. Loans classified as substandard, therefore, have one or more defined weaknesses and are characterized by the distinct possibility the Savings Bank will sustain some loss if the deficiencies are not corrected. The Savings Bank's policy is to classify as substandard, for example, any loan, irrespective of payment record or collateral value, when a bankruptcy filing occurs, the pay record becomes erratic (i.e., miss several monthly payments, but make double payments in the future), or a loan becomes contractually delinquent by three monthly payments. The $2.1 million increase in substandard assets to $5.9 million at June 30, 2006 from $3.8 million at June 30, 2005 was the result of the classification of certain loans with erratic payment histories and the possibility of inadequate collateral. The decrease in specific loss allowances was attributable to the charge-off of commercial loans to one borrower and related companies that had filed for protection under Chapter 11 bankruptcy.
At June 30, 2006, the Savings Bank's largest substandard loans to one borrower consisted of five loans to an individual and related interests with a collective outstanding balance of $1.8 million. These loans were past due less than 60 days. The borrower had experienced cash flow difficulties several times in the last twelve months. The loans are collateralized by first deeds of trust on real estate and a security interest in equipment and inventory.
During the year ended June 30, 2006, the Company made a number of announcements with respect to the decline in its asset quality and the effect on its earnings.
On September 9, 2005, the Company disclosed its earnings for the quarter and the year ended June 30, 2005 and announced that it had a net loss of $652,000 for the quarter. Included in the net loss for the quarter ended June 30, 2005 was a provision for the increase in allowance for loan losses of $1.8
million, as previously announced. The increase in the allowance for loan losses was in connection with the Savings Bank's determination that there had been further adverse developments with respect to certain loans in its loan portfolio. The approximate after tax effect of the provision to increase the allowance for loan losses was a $1.1 million reduction in net income for the quarter ended June 30, 2005.
On October 21, 2005, the Company announced it would increase its allowance for loan losses by $791,000 as a result of adverse developments with respect to certain loans in its portfolio. The determination was the result of an examination of the loan portfolio by a third party and the implementation of stricter standards in identifying and analyzing classified assets. The decrease in earnings on an after tax basis was $498,000.
On July 20, 2006, the Company reported a $407,000 increase in its allowance for loan losses as a result of additional adverse developments identified in its loan portfolio. A loss of $234,000 was also recorded on the write-down of land owned for future expansion and a $161,000 loss on the sales of securities. The after tax effect on earnings was a decrease of $506,000.
Finally on September 25, 2006, the Company became aware after the September 1, 2006 release of earnings, that as of June 30, 2006, the Company had not identified or recorded certain transactions related to the other than temporary impairment of two equity securities. These transactions resulted in a charge to earnings of $260,260 and were identified after discussion with the Company's independent registered public accounting firm and were corrected after the September 1, 2006 release of the Company's earnings for the fourth quarter and year ended June 30, 2006. The provision for impairment of securities available-for-sale resulted in a reduction of net income totaling $219,827.
Real Estate Owned. Real estate owned includes real estate held for sale and real estate acquired in the settlement of loans, which, is recorded at the lower of the remaining loan balance or estimated fair value less the estimated costs to sell the asset. Any write down at the time of foreclosure is charged against the allowance for loan losses. Subsequently, net expenses related to holding the property and declines in the market value are charged against income. At June 30, 2006, five properties were held as real estate owned with a total value of $497,000. At June 30, 2005, nine properties were held as real estate owned with a total value of $340,000.
Allowance for Loan Losses
Management recognizes that loan losses may occur over the life of a loan and that the allowance for loan losses must be maintained at a level necessary to absorb specific losses on impaired loans and probable losses inherent in the loan portfolio.
The Savings Bank's Asset Classification Committee assesses the allowance for loan losses on a quarterly basis. The Committee analyzes several different factors including delinquency, charge-off rate and the changing risk profile of the Company's loan portfolio, as well as local economic conditions such as unemployment rates, bankruptcies and vacancy rates of business and residential properties.
Management believes that the accounting estimate related to the allowance for loan losses is a critical accounting estimate because it is highly susceptible to change from period to period. This may require management to make assumptions about losses on loans; and the impact of a sudden large loss
could deplete the allowance and potentially require increased provisions to replenish the allowance, which would negatively affect earnings.
The allowance for loan losses is evaluated on a regular basis by management and is based on management's periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower's ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as either doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based on historical loss experience adjusted for qualitative factors. An unallocated component is maintained to cover uncertainties that could affect management's estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
The allowance is increased by the provision for loan losses, which is charged against current period operating results and decreased by the amount of actual loan charge-offs, net of recoveries.
The Savings Bank had an allowance for loan losses at June 30, 2006 and 2005 of $2.5 million and $2.9 million, respectively. The Savings Bank began experiencing an increase in problem loans during fiscal year 2005. This increase required a significant increase in the allowance for loan losses. At June 30, 2004 the allowance for loan losses was $1.2 million, or .7%, of gross loans compared to $2.9 million, or 1.7%, of gross loans at June 30, 2005. The allowance for loan losses was $2.5 million, or 1.7%, of gross loans at June 30, 2006.
Management believes that the allowance for loan losses was adequate at June 30, 2006 to absorb the known and inherent risks of loss in the loan portfolio at that date. While management believes the estimates and assumptions used in its determination of the adequacy of the allowance are reasonable, there can be no assurance that such estimates and assumptions will not be proven incorrect in the future, or that the actual amount of future provisions will not exceed the amount of past provisions or that any increased provisions that may be required will not adversely impact our financial condition and results of operations. In addition, the determination of the amount of the Savings Bank's allowance for loan losses is subject to review by bank regulators, as part of the routine examination process, which may result in the establishment of additional provision based upon their judgment of information available to them at the time of their examination. Any material increase in the allowance may adversely affect the Savings Bank's financial condition and earnings.
The following table sets forth an analysis of the Savings Bank's allowance for loan losses for the periods indicated.
At June 30, ------------------- 2006 2005 ------ ------ (Dollars in thousands)
Allowance at beginning of period $2,851 $1,240 ------ ------
Provision for loan losses 1,520 2,333 ------ ------
Recoveries: Residential real estate 5 1 Commercial real estate - 9 Consumer 48 62 Commercial business 50 15 ------ ------ Total recoveries 103 87 ------ ------
Charge-offs: Residential real estate 26 110 Commercial real estate 88 77 Consumer 223 415 Commercial business 1,663 207 ------ ------ Total charge-offs 2,000 809 ------ ------ Net charge-offs 1,897 722 ------ ------ Allowance at end of period $2,474 $2,851 ====== ======
Ratio of allowance to total loans Outstanding at the end of the period 1.67% 1.74% Ratio of net charge-offs to average loans Outstanding during the period 1.29% 0.44%
Allowance for Loan Losses by Category
At June 30, 2006 ------------------------------------------------------------ 2006 2005 ---------------------------- ----------------------------- Percent Percent Percent Percent Of of Gross of of Gross Allowance Loans in Allowance Loans in to Gross Category to Gross Category Loans in to Gross Loans in to Gross Amount Category Loans Amount Category Loans ------ -------- -------- ------ -------- -------- (Dollars in Thousands) Real estate -- mortgage:
Residential $ 222 0.27% 55.59% $ 217 0.24% 54.36% Commercial 726 1.96 24.99 759 1.83 25.28 Land 25 0.31 5.36 26 0.28 5.76 Second mortgage loans 31 0.86 2.47 32 0.76 2.54 Consumer 82 0.95 5.84 177 1.82 5.93 Commercial business 1,388 16.27 5.75 1,640 16.30 6.13 ------ ------ ------ ------ Total allowance for loan losses $2,474 1.67 100.00% $2,851 1.74% 100.00% ====== ====== ====== ======
Securities Activity
Savings and loan associations have authority to invest in various types of liquid assets, including United States Treasury obligations, securities of various Federal agencies and of state and municipal governments, deposits at the FHLB-Des Moines, certificates of deposit of federally insured institutions, certain bankers' acceptances and federal funds. Subject to various restrictions, savings institutions may also invest a portion of their assets in commercial paper, corporate debt securities and mutual funds, the assets of which conform to the investments that federally chartered savings institutions are otherwise authorized to make directly. Savings institutions are also required to maintain minimum levels of liquid assets which vary from time to time. See "REGULATION OF FIRST HOME -- Federal Home Loan Bank System." The Savings Bank may decide to increase its liquidity above the required levels depending upon the availability of funds and comparative yields on securities in relation to return on loans.
Routine short-term investment decisions, which are reported monthly to the Board of Directors, are made by the President and Chief Executive Officer and Chief Financial Officer, who act within policies established by the Board. Those securities include federally insured certificates of deposit, FHLB term time obligations, bankers acceptances, treasury obligations, U.S. Government agency obligations, mortgage-backed securities, bank qualifying municipal tax exempt bonds, and corporate bonds. Securities not within the parameters of the policies require prior Board approval. Securities are purchased for investment purposes. The goals of the Savings Bank's investment policy are to select securities based on safety first, flexibility second and diversification third. In addition, as a result of the concern with interest rate risk exposure, there has been a focus on short-term investments. At June 30, 2006, the Company's and the Savings Bank's securities portfolio totaled $41.7 million (of which $20.9 million were available for sale) and consisted primarily of federal agency obligations securities, federal agency mortgage-backed securities, common and preferred stocks, and municipal bonds. For further information concerning the Savings Bank's securities portfolio, see Note 2 of the Notes to the Consolidated Financial Statements included in the Annual Report.
Securities Analysis
The following table sets forth the Company's and the Savings Bank's securities portfolio at carrying value at the dates indicated. Securities that are held-to-maturity are shown at amortized cost, and securities that are available-for-sale are shown at the current market value.
At June 30, ------------------------------------------- 2006 2005 -------------------- -------------------- Percent Percent Book of Book of Value(1) Portfolio Value(1) Portfolio -------- --------- -------- --------- (Dollars in thousands) Debt securities: United States Government and Federal agencies obligations $23,564 56.50% $26,426 58.72% Obligations of state and political subdivisions 3,782 9.07 3,431 7.62 ------- ------ ------- ------ Federal agency mortgage- backed securities 10,451 25.06 10,792 23.98 ------- ------ ------- ------ Total debt securities 37,797 90.63 40,649 90.32 ------- ------ ------- ------
Equity securities: FHLB stock 1,612 3.87 1,904 4.23 Other (2) 2,297 5.50 2,454 5.45 ------- ------ ------- ------ Total equity securities 3,909 9.37 4,358 9.68 ------- ------ ------- ------ Total investment securities $41,706 100.00% $45,007 100.00% ======= ====== ======= ====== ------------ (1) The market value of the Company's and the Savings Bank's securities portfolio amounted to $41.3 million and $44.9 million at June 30, 2006 and 2005, respectively. At June 30, 2006, the market value of the principal component of the Company's and the Savings Bank securities portfolio which were obligations of U.S. government and federal agencies was $33.6 million. (2) Other equity securities at June 30, 2006 was comprised of Federal National Mortgage Association ("FNMA") and Federal Home Loan Mortgage Corporation ("FHLMC") preferred stock totaling $1.8 million and preferred stock totaling $204,000 in other financial institutions in Missouri.
The following table sets forth the maturities and weighted average yields of the debt securities (not including federal agency mortgage-backed securities) in the Company's and the Savings Bank's investment securities portfolio at June 30, 2006.
At June 30, 2006, the Savings Bank held no security which had an aggregate book value in excess of 10% of the Company's stockholders' equity.
To supplement lending activities in periods of deposit growth and/or declining loan demand, the Savings Bank has invested in residential mortgage- backed securities. Although such securities are held for investment, they can serve as collateral for borrowings and, through repayments, as a source of liquidity. For information regarding the carrying and market values of the Savings Bank's mortgage-backed securities portfolio, see Note 2 of the Notes to Consolidated Financial Statements included in the Annual Report. The Savings Bank has invested in federal agency securities issued by FHLMC, FNMA and Government National Mortgage Association ("GNMA"). As of June 30, 2006, 23.1% of the outstanding balance of the mortgage-backed securities had adjustable rates of interest that adjust within the next two years. As of June 30, 2006, the Savings Bank's portfolio included $10.5 million of mortgage-backed securities purchased as investments to supplement the Savings Bank's mortgage lending activities.
The FHLMC, FNMA and GNMA certificates are modified pass-through mortgage- backed securities that represent undivided interests in underlying pools of fixed-rate, or certain types of adjustable-rate, one-to-four family residential mortgages issued by these government-sponsored entities. As a result, the interest rate risk characteristics of the underlying pool of mortgages, such as fixed- or adjustable-rate, as well as prepayment risk, are passed on to the certificate holder. FHLMC and FNMA provide the certificate holder a guarantee of timely payments of interest and ultimate collection of principal, whether or not they have been collected. GNMA's guarantee to the holder of timely payments of principal and interest is backed by the full faith and credit of the U.S. government. Mortgage-backed securities generally yield less than the loans that underlie such securities, because of the cost of payment guarantees or credit enhancements that reduce credit risk. In addition, mortgage-backed securities are
more liquid than individual mortgage loans and may be used to collateralize obligations of the Savings Bank.
The Savings Bank has incorporated into its investment policy the regulatory requirements set forth in the OTS Thrift Bulletin 52, which addresses the selection of securities dealers, securities policies, unsuitable investment practices and mortgage derivative products. At June 30, 2006, the Savings Bank owned no mortgage derivative products.
Deposit Activities and Other Sources of Funds
General. Deposits and loan repayments are the major source of the Savings Bank's funds for lending and other investment purposes. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows and loan prepayments are significantly influenced by general interest rates and money market conditions. Borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources. They may also be used on a longer term basis for general business purposes.
Deposit Accounts. Deposits are attracted from within the Savings Bank's primary market area through the offering of a broad selection of deposit instruments, including negotiable order of withdrawal ("NOW") accounts, money market accounts, regular savings accounts, certificates of deposit and retirement savings plans. Deposit account terms vary according to the minimum balance required, the time periods the funds must remain on deposit and the interest rate, among other factors. In determining the terms of its deposit accounts, the Savings Bank considers the rates offered by its competition, profitability to the Savings Bank, matching deposit and loan products and its customer preferences and concerns. The Savings Bank generally reviews its deposit mix and pricing at least weekly, and adjusts it as necessitated by liquidity needs, the gap position and competition.
The Savings Bank experienced significant decreases in regular savings accounts and interest-bearing checking accounts during the year ended June 30, 2006. During the majority of the fiscal year ended June 30, 2006, the rates paid by the Savings Bank were below the rates offered by competitors as the Savings Bank managed its deposits consistent with the reduction in its assets. Beginning in September 2006, rates on the Savings Bank's deposit accounts were increased to be at the median or higher end of the rates paid by area financial institutions.
The following table sets forth information concerning the Savings Bank's time deposits and other interest-bearing deposits at June 30, 2006.
Weighted Average Percentage Interest Minimum of Total Rate Term Category Amount Balance Deposits -------- ----- ----------------------- ------- ------- ---------- (Dollars in thousands) 0.00% None Non-interest bearing $ - $12,745 7.11% 1.01% None NOW accounts 25 34,879 19.47 2.37% None Super Saver accounts 1 23,420 13.08 1.50% None Savings accounts - 16,886 9.43
Certificates of deposit ----------------------- 3.09% 3 months Fixed term, fixed rate 500 1,293 0.72 4.25% 6 months Fixed term, fixed rate 500 12,904 7.20 3.54% 12 months Fixed term, fixed rate 500 18,848 10.52 3.86% 18 months Fixed term, fixed rate 500 1,359 0.76 3.55% 24 months Fixed term, fixed rate 500 3,033 1.69 3.40% 30 months Fixed term, fixed rate 500 956 0.53 3.25% 36 months Fixed term, fixed rate 500 1,329 0.74 3.66% 48 months Fixed term, fixed rate 500 769 0.43 3.98% 60 months Fixed term, fixed rate 500 3,168 1.77 4.02% 72 months Fixed term, fixed rate 500 10 0.01 5.22% 120 months Fixed term, fixed rate 500 21 0.01 various Various Fixed term, adjustable rate 500 23,274 12.99 various Various Jumbo certificates 100,000 24,247 13.54 -------- ------ $179,141 100.00% ======== ======
The following table indicates the amount of the Savings Bank's jumbo certificates of deposit by time remaining until maturity as of June 30, 2006. Jumbo certificates of deposit require minimum deposits of $100,000 and rates paid on such accounts are negotiable.
Jumbo Certificates Maturity Period Of Deposit ------------------------------------ ------------ (In thousands) Three months or less $ 5,143 After three through six months 5,937 After six through twelve months 5,806 After twelve months 7,361 ------- Total $24,247 =======
Time Deposits by Rates
The following table sets forth the time deposits in the Savings Bank classified by rates as of the dates indicated.
At June 30, ---------------------- 2006 2005 ------- ------- (In thousands) 0.00 - 1.49% $ 18 $ 916 1.50 - 2.49% 1,217 29,595 2.50 - 3.49% 9,610 36,780 3.50 - 4.49% 37,985 18,957 4.50 - 5.49% 42,145 2,566 5.50 - 6.49% 236 492 6.50 - 7.49% - 325 Over 7.49% - - ------- ------- Total $91,211 $89,631 ======= =======
Deposit Flow
The following table sets forth the balances of savings deposits in the various types of savings accounts offered by the Savings Bank at the dates indicated.
At June 30, ----------------------------------------------------------- 2006 2005 ----------------------------- ---------------------------- Percent Percent Of Increase Of Increase Amount Total (Decrease) Amount Total (Decrease) ------ ----- ---------- ------ ----- ---------- (Dollars in thousands) Non-interest bearing $ 12,745 7.11% $ 929 $ 11,816 6.31% $ 1,854 NOW checking 34,879 19.47 (3,359) 38,238 20.43 1,047 Regular savings accounts 23,420 13.08 (6,454) 29,874 15.96 13,122 Super Saver accounts 16,886 9.43 (698) 17,584 9.40 (21,261) Fixed-rate certificates which mature (1): Within 1 year 51,186 28.57 2,825 48,361 25.85 (10,041) After 1 year, but within 2 years 5,520 3.08 1,158 4,362 2.33 (980) After 2 years, but within 5 years 3,294 1.84 (1,857) 5,151 2.75 (241) Adjustable-rate certificates 31,211 17.42 (546) 31,757 16.97 (3,604) -------- ------ ------- -------- ------ -------- Total certificates 91,211 50.91 1,580 89,631 47.90 (14,866) -------- ------ ------- -------- ------ -------- Total $179,141 100.00 $(8,002) $187,143 100.00% $(20,104) ======== ====== ======= ======== ====== ========
----------- (1) At June 30, 2006 and 2005, jumbo certificates of deposit amounted to $24.2 million and $24.4 million, respectively, and IRAs amounted to $24.7 million and $25.1 million at those dates, respectively.
The following table sets forth the savings activities of the Savings Bank for the periods indicated.
Years Ended June 30, ---------------------- 2006 2005 -------- -------- (In thousands) Beginning balance $187,143 $207,247 -------- -------- Net increase (decrease) before interest credited (12,245) (23,188) Interest credited 4,243 3,084 -------- -------- Net increase/(decrease) in savings deposits (8,002) (20,104) -------- -------- Ending balance $179,141 $187,143 ======== ========
In the unlikely event the Savings Bank is liquidated, depositors will be entitled to full payment of their deposit accounts prior to any payment being made to the stockholders of the Savings Bank. Substantially all of the Savings Bank's depositors are residents of the State of Missouri.
Borrowings. Savings deposits are the primary source of funds for the Savings Bank's lending and investment activities and for its general business purposes. The Savings Bank also relies on advances from the FHLB-Des Moines to supply funds and to act as a source of liquidity, if needed. The FHLB-Des Moines has served as the Savings Bank's primary borrowing source. Advances from the FHLB-Des Moines are typically secured by the Savings Bank's first mortgage loans. These advances require monthly payments of interest only with principal due at maturity and have fixed rates. These advances were obtained in response to the Savings Bank's previous strong loan demand and limited deposit growth experienced during fiscal years 2001 and 2000. At June 30, 2006, the Savings Bank had $22.0 million in advances from the FHLB-Des Moines.
The following tables set forth certain information concerning the Savings Bank's borrowings at the dates and for the periods indicated.
At June 30, --------------------- 2006 2005 ------ ------ Weighted average rate paid on FHLB advances 5.74% 5.50%
Years Ended June 30, --------------------- 2006 2005 ------ ------ (Dollars in thousands) Maximum amounts of FHLB advances Outstanding at any month end $28,394 $29,121 Approximate average FHLB advances Outstanding 27,653 29,111 Approximate weighted average rate paid on FHLB advances 5.59% 5.59%
The FHLB-Des Moines functions as a central reserve bank providing credit for savings and loan associations and other member financial institutions. As a member, the Savings Bank is required to own capital stock in the FHLB-Des Moines and is authorized to apply for advances on the security of such stock and certain of its mortgage loans and other assets (principally securities which are obligations of, or guaranteed by, the United States) provided certain standards related to creditworthiness have been met. Advances are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities. Depending on the program, limitations on the amount of advances are based either on a fixed percentage of an institution's retained earnings or on the FHLB's assessment of the institution's creditworthiness. The FHLB-Des Moines determines specific lines of credit for each member institution. Because of their prepayment penalties, it is not currently economical to prepay any of these advances prior to maturity.
Subsidiary Activities
Fybar Service Corporation ("Fybar") is a Missouri corporation wholly-owned by the Savings Bank. Fybar owns five rental properties. One is an office building in Mountain Grove, Missouri called "The Shannon Centre" which is
adjacent to the Savings Bank's drive-in and is currently 71% occupied. The second is a single family residence in Gainesville, Missouri which is currently occupied. The third property is a commercial building in Mountain Grove, Missouri which is currently fully occupied. The fourth is a single family residence in Mountain Grove, Missouri which is currently occupied. The fifth is a commercial building in Sparta, Missouri which is fully occupied.
Fybar serves as Trustee on all the Savings Bank's deeds of trust, is a registered agent and receives limited income from credit life and accident and health policies written in conjunction with the Savings Bank's loans.
At June 30, 2006, the Savings Bank had an investment in Fybar of $576,000.
First Home Investments, Inc. is a wholly owned subsidiary of the Savings Bank that offers fixed and variable annuities as well as mutual funds to it customers and members of the general public. First Home Investments, Inc. also processes stock and bond trades and provides credit life, disability and health insurance services to the Savings Bank's customers as well as group and individual coverages.
REGULATION OF FIRST HOME
As a Missouri-chartered and federally insured savings and loan association, First Home is subject to extensive regulation. Lending activities and other investments must comply with various statutory and regulatory capital requirements. The Savings Bank is regularly examined by its state and federal regulators and files periodic reports concerning the Savings Bank's activities and financial condition. The Savings Bank's relationship with its depositors and borrowers is also regulated to a great extent by federal and state laws, especially in such matters as the ownership of savings accounts and the form and content of the Savings Bank's mortgage documents.
Missouri Savings and Loan Law
General. As a Missouri-chartered savings and loan association, First Home derives its authority from, and is governed by, the provisions of the Missouri Savings and Loan Law ("Missouri Law") and regulations of the Missouri Division of Finance ("Division"). The Director of the Missouri Division of Finance ("Director") proposes regulations which must then be approved, amended, modified or disapproved by the State Savings and Loan Commission ("Commission"). Missouri Law and the resulting regulations are administered by the Director.
Investments and Accounts. Missouri Law and regulations impose restrictions on the types of investments and loans that may be made by a Missouri-chartered institution, generally bringing these restrictions into parity with the regulation of federally chartered institutions. The manner of establishing accounts and evidencing the same is prescribed, as are the obligations of the institution with respect to withdrawals from accounts and redemption of accounts. The Director may also impose or grant the same restrictions, duties and powers concerning deposits as are applicable to federal institutions under federal rules and regulations.
Branch Offices. Under Missouri Law, no institution may establish a branch office or agency without the prior written approval of the Director. The Director reviews the proposed location, the functions to be performed at the office, the estimated volume of business, the estimated annual expense of the office and the mode of payments. Decisions of the Director may be appealed to the Commission. The relocation or closing of any office is subject to additional regulation and in certain circumstances may require prior approval.
Merger or Consolidation. Missouri Law permits the merger or consolidation of savings institutions, subject to the approval by the Director, when the Director finds that such merger or consolidation is equitable to the members or account holders of the institutions and will not impair the usefulness and success of other properly conducted institutions in the community. Mergers or consolidations of mutual institutions must also be approved by a majority of the members of each institution. Stock institutions must obtain shareholder approval pursuant to the Missouri statutes relating to general and business corporations.
Holding Companies. Missouri Law requires a savings and loan holding company and its subsidiaries to register with the Director within 60 days of becoming a savings and loan holding company. Following registration it is subject to examination by the Division and thereafter must file certain reports with the Director. A savings and loan holding company may acquire control of an institution of another savings and loan holding company upon application and prior written approval of the Director. The Director, in reviewing the application, must determine if such acquisition is consistent with the interests of maintaining a sound financial system and that the acquisition does not afford a basis for supervisory objection.
Examination. Periodic reports to the Division must be made by each Missouri-chartered institution. The Division conducts and supervises the examination of state-chartered institutions.
Supervision. The Director has general supervisory authority over Missouri-chartered institutions and upon the Director's finding that an institution is violating the provisions of its articles of incorporation, its bylaws or any law of the state, or is conducting business in an unsafe or injurious manner, the Director may order the institution to discontinue such violation or practice, and to conform with all the requirements of law. The Director may demand and take possession of the institution, if the institution fails to comply with the Director's order, if the Director determines that the institution is insolvent, in an unsafe condition or conducting business in an unsafe manner, or if the institution refuses to submit to examination or inspection by the Division.
Federal Regulation of Savings Banks
Office of Thrift Supervision. The OTS is an office in the Department of the Treasury subject to the general oversight of the Secretary of the Treasury. Among other functions, the OTS issues and enforces regulations affecting federally-insured savings associations and regularly examines these institutions.
The OTS has extensive authority over the operations of all insured savings associations. As part of this authority, First Home is required to file periodic reports with the OTS District Director and is subject to periodic examinations by the OTS and the FDIC. The OTS and FDIC have extensive discretion in their supervisory and enforcement activities and examination policies, including policies with respect to the classification of assets and the establishment of adequate loan loss reserves for regulatory purposes. Any change in these policies, whether by the OTS, the FDIC or Congress, could have a material adverse impact on the Company.
The OTS has established a schedule for the assessment of fees upon all savings associations to fund the operations of the OTS. A schedule of fees has also been established for the various types of applications and filings made by savings associations with the OTS. The general assessment, to be paid on a semi-annual basis, is determined based upon the savings association's total assets, including consolidated subsidiaries, as reported in the association's
latest quarterly thrift financial report. For the first half of 2006, the Savings Bank's assessment under the semi-annual assessment procedure was $33,000. Based on the current assessment rates published by the OTS and First Home's total assets of approximately $235.6 million at March 31, 2006, First Home will be required to pay a semi-annual assessment of approximately $33,000 for the second half of calendar year 2006.
Federal law provides that savings institutions are generally subject to the national bank limit on loans to one borrower. A savings institution may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of its unimpaired capital and surplus. An additional amount may be lent, equal to 10% of unimpaired capital and surplus, if secured by specified readily marketable collateral. At June 30, 2006, the Savings Bank's limit on loans to one borrower was $4.0 million. At June 30, 2006, the Savings Bank's largest loan commitment to a related group of borrowers was eight loans totaling $3.9 million, which were all fully funded. These loans are performing according to their original terms.
The OTS, as well as the other federal banking agencies, has adopted guidelines establishing safety and soundness standards on such matters as loan underwriting and documentation, asset quality, earnings, internal controls and audit systems, interest rate risk exposure and compensation and other employee benefits. Any institution that fails to comply with these standards must submit a compliance plan.
Federal Deposit Insurance Reform Act of 2005. The Federal Deposit Insurance Reform Act of 2005 ("Reform Act") was signed into law on February 8, 2006 and amended current laws regarding the federal deposit insurance system. Pursuant to the Reform Act, the FDIC merged the Bank Insurance Fund and the Savings Association Insurance Fund into one deposit insurance fund, the DIF, on March 31, 2006. The new legislation also abolished the prior minimum 1.25% reserve ratio and the mandatory assessments when the ratio falls below 1.25%. Under the Reform Act, the FDIC, at the beginning of each year, has the flexibility to adjust the DIF's reserve ratio between 1.15% and 1.50% depending upon a variety of factors, including projected losses, economic considerations and assessment rates.
Pursuant to the Reform Act, effective April 1, 2006, deposit insurance coverage limits were increased from $100,000 to $250,000 for certain types of Individual Retirement Accounts, 401(k) plans and other retirement savings accounts, including Keogh accounts and "457 plan" accounts, among others. The current $100,000 limit continues to apply to individual accounts and municipal deposits; however, the Reform Act authorizes the FDIC to review all levels of insurance coverage every five years beginning in 2011, and index such insurance coverage to inflation. Additionally, under the Reform Act, undercapitalized financial institutions are restricted from accepting employee benefit plan deposits. Certain one-time deposit premium assessment credits are also authorized under the Reform Act, and regulations related to the allotment of such credits have recently been issued by the FDIC. To date, however, the credit program has not been finalized and the credits will not be rebated but instead may be applied against premiums at any time, subject to limited exceptions.
The Reform Act also provides that the FDIC must promulgate final regulations implementing the Reform Act no later than 270 days after its enactment, or by November 5, 2006. Because the FDIC has not promulgated these final regulations, it is difficult to predict the effect, if any, such regulations will have on the Savings Bank's operations.
Insurance of Accounts and Regulation by the FDIC. The Savings Bank is a member of the DIF, which is administered by the FDIC. The FDIC insures deposits up to the applicable limits and this insurance is backed by the full faith and credit of the United States government. As insurer, the FDIC imposes deposit insurance premiums and 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 risk 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, and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.
The FDIC's deposit insurance premiums are assessed through a risk- based system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their level of capital and supervisory evaluation. Under the system, institutions classified as well capitalized (i.e., a core capital ratio of at least 5%, a ratio of Tier 1 or core capital to risk-weighted assets ("Tier 1 risk-based capital") of at least 6% and a risk-based capital ratio of at least 10%) and considered healthy pay the lowest premiums while institutions that are less than adequately capitalized (i.e., core or Tier 1 risk-based capital ratios of less than 4% or a risk-based capital ratio of less than 8%) and considered of substantial supervisory concern pay the highest premiums. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period. The Reform Act authorizes the FDIC to revise its current risk-based system, subject to public notice and comment, although no deadline was given by Congress for the creation or implementation of such regulations.
DIF-insured institutions are required to pay a Financing Corporation (FICO) assessment, in order to fund the interest on bonds issued to resolve thrift failures in the 1980s. For the quarter ended June 30, 2006, the FICO assessment was equal to 1.28 basis points for each $100 in domestic deposits. These assessments, which may be revised based upon the level of DIF deposits, will continue until the bonds mature in the years 2017 through 2019.
Federal Home Loan Bank System. The FHLB System, consisting of 12 FHLBs, is under the jurisdiction of the Federal Housing Finance Board ("FHFB"). The designated duties of the FHFB are to: supervise the FHLBs; ensure that the FHLBs carry out their housing finance mission; ensure that the FHLBs remain adequately capitalized and able to raise funds in the capital markets; and ensure that the FHLBs operate in a safe and sound manner.
First Home, as a member of the FHLB-Des Moines, is required to acquire and hold shares of capital stock in the FHLB-Des Moines equal to the greater of (i) 1.0% of the aggregate outstanding principal amount of residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, or (ii) 1/20 of its advances (borrowings) from the FHLB-Des Moines. First Home complied with this requirement with an investment in FHLB-Des Moines stock of $1.6 million at June 30, 2006.
Among other benefits, the FHLB provides a central credit facility primarily for member institutions. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes advances to members in accordance with policies and procedures established by the FHFB and the Board of Directors of the FHLB-Des Moines. At June 30, 2006, the Savings Bank had $22.0 million of advances from the FHLB-Des Moines.
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 do so in the future. These contributions also could have an adverse effect on the value of FHLB stock in the future.
Prompt Corrective Action. The OTS is required to take certain supervisory actions against undercapitalized savings associations, the severity of which depends upon the institution's degree of undercapital- ization. Generally, an institution that has a ratio of total capital to risk-weighted assets of less than 8%, a ratio of Tier I (core) capital to risk-weighted assets of less than 4%, or a ratio of core capital to total assets of less than 4% (3% or less for institutions with the highest examination rating) is considered to be "undercapitalized." An institution that has a total risk-based capital ratio less than 6%, a Tier I capital ratio of less than 3% or a leverage ratio that is less than 3% is considered to be "significantly undercapitalized" and an institution that has a tangible capital to assets ratio equal to or less than 1.5% is deemed to be "critically undercapitalized."
At June 30, 2006, First Home was a "well capitalized" institution under the prompt corrective action regulations of the OTS.
Standards for Safety and Soundness. The federal banking regulatory agencies have prescribed, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; (vi) asset quality; (vii) earnings; and (viii) compensation, fees and benefits ("Guidelines"). The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the OTS determines that the Savings Bank fails to meet any standard prescribed by the Guidelines, ot may require the Savings Bank to submit an acceptable plan to achieve compliance with the standard. Management is aware of no conditions relating to these safety and soundness standards which would require submission of a plan of compliance.
Qualified Thrift Lender Test. All savings associations, including First Home, are required to meet a qualified thrift lender test to avoid certain restrictions on their operations. This test requires a savings association to have at least 65% of its portfolio asset, as defined by regulation, in qualified thrift investments on a monthly average for nine out of every 12 months on a rolling basis. As an alternative, the savings association may maintain 60% of its assets in those assets specified in Section 7701(a)(19) of the Code. Under either test, such assets primarily consist of residential housing related loans and investments. At June 30, 2006, First Home met the test and its qualified thrift lender percentage was 62.6%.
Any savings association that fails to meet the qualified thrift lender test must convert to a national bank charter. Recent legislation has expanded the extent to which education loans, credit card loans and s loans may be considered "qualified thrift investments." As of June 30, 2006, the Savings Bank met the qualified thrift lender test.
Capital Requirements. The OTS's capital regulations require federal savings institutions to meet three minimum capital standards: a 1.5% tangible capital to total assets ratio, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS examination rating system) and an 8% risk-based capital ratio. In addition, the prompt corrective action standards discussed below also establish, in effect, a minimum 2% tangible
capital standard, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS system) and, together with the risk-based capital standard itself, a 4% Tier I risk-based capital standard. The OTS regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions must generally deduct investments in and loans to subsidiaries engaged in activities as principal that are not permissible for a national bank.
The risk-based capital standard requires federal savings institutions to maintain Tier I (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of at least 4% and 8%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, recourse obligations, residual interests and direct credit substitutes, are multiplied by a risk-weight factor of 0% to 100%, assigned by the OTS capital regulation based on the risks believed inherent in the type of asset. Core (Tier I) capital is defined as common stockholders' equity (including retained earnings), certain noncumulative perpetual preferred stock and related surplus and minority interests in equity accounts of consolidated subsidiaries, less intangibles other than certain mortgage servicing rights and credit card relationships. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock, the allowance for loan and lease losses limited to a maximum of 1.25% of risk-weighted assets and up to 45% of unrealized gains on available-for-sale equity securities with readily determinable fair market values. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital.
The OTS also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution's capital level is or may become inadequate in light of the particular circumstances. At June 30, 2006, the Bank met each of these capital requirements.
The following table presents the Savings Bank's capital levels as of June 30, 2006.
At June 30, 2006 ---------------------- Percent of Amount Assets ------ ---------- (Dollars in thousands) Tangible capital $22,706 10.0% Minimum required tangible capital 3,385 1.5 ------- ---- Excess $19,321 8.5% ======= ====
Core capital $22,706 10.0% Minimum required core capital 9,026 4.0 ------- ---- Excess $13,680 6.0% ======= ====
Risk-based capital $24,428 17.5% Minimum risk-based capital requirement 11,190 8.0 ------- ---- Excess $13,238 9.5% ======= ====
Limitations on Capital Distributions. OTS regulations impose various restrictions on savings institutions with respect to their ability to make
distributions of capital, which include dividends, stock redemptions or repurchases, cash-out mergers and other transactions charged to the capital account.
Generally, savings institutions, such as the Savings Bank, that before and after the proposed distribution are well-capitalized, may make capital distributions during any calendar year equal to up to 100% of net income for the year-to-date plus retained net income for the two preceding years. However, an institution deemed to be in need of more than normal supervision by the OTS may have its dividend authority restricted by the OTS. The Savings Bank may pay dividends in accordance with this general authority.
Savings institutions proposing to make any capital distribution need not submit written notice to the OTS prior to such distribution unless they are a subsidiary of a holding company or would not remain well-capitalized following the distribution. Savings institutions that do not, or would not meet their current minimum capital requirements following a proposed capital distribution or propose to exceed these net income limitations, must obtain OTS approval prior to making such distribution. The OTS may object to the distribution during that 30-day period based on safety and soundness concerns.
Loans to One Borrower. Federal law provides that savings institutions are generally subject to the national bank limit on loans to one borrower. Generally, this limit is 15% of the Savings Bank's unimpaired capital and surplus, plus an additional 10% of unimpaired capital and surplus, if such loan is secured by readily-marketable collateral, which is defined to include certain financial instruments and bullion. The OTS by regulation has amended the loans to one borrower rule to permit savings associations meeting certain requirements, including capital requirements, to extend loans to one borrower in additional amounts under circumstances limited essentially to loans to develop or complete residential housing units. At June 30, 2006, the Savings Bank's largest loan outstanding to any one borrower, including related entities, was $3.9 million. At June 30, 2006, that borrower had eight separate loans secured by nine different pieces of real estate. These loans were performing in accordance with their terms at that date.
Activities of Savings Associations and Their Subsidiaries. When a savings association establishes or acquires a subsidiary or elects to conduct any new activity through a subsidiary that the associations controls, the savings association shall notify the FDIC and the OTS 30 days in advance and provide the information each agency may, by regulation, require. Savings associations also must conduct the activities of subsidiaries in accordance with existing regulations and orders.
The OTS may determine that the continuation by a savings association of its ownership control of, or its relationship to, the subsidiary constitutes a serious risk to the safety, soundness or stability of the association or is inconsistent with sound banking practices or with the purposes of the FDIA. Based upon that determination, the FDIC or the OTS has the authority to order the savings association to divest itself of control of the subsidiary. The FDIC also may determine by regulation or order that any specific activity poses a serious threat to the SAIF. If so, it may require that no SAIF member engage in that activity directly.
Accounting and Regulatory Standards. An OTS policy statement applicable to all savings associations clarifies and re-emphasizes that the investment activities of a savings association must be in compliance with approved and documented investment policies and strategies, and must be accounted for in accordance with generally accepted accounting principles (GAAP). Under the policy statement, management must support its classification of an accounting for loans and securities (i.e., whether held for investment, sale or trading)
with appropriate documentation. First Home is in compliance with these amended rules.
The OTS has adopted an amendment to its accounting regulations, which may be made more stringent than generally accepted accounting principles by the OTS, to require that transactions be reported in a manner that best reflects their underlying economic substance and inherent risk and that financial reports must incorporate any other accounting regulations or orders prescribed by the OTS.
Investment Portfolio Policy. OTS supervisory policy requires that securities owned by thrift institutions must be classified and reported in accordance with GAAP which establishes three classifications of investment securities: held-to-maturity, trading and available-for-sale. Trading securities are acquired principally for the purpose of near term sales. Such securities are reported at fair value and unrealized gains and losses are included in income.
Securities which are designated as held-to-maturity are designated as such because the investor has the ability to hold these securities to maturity. S