First Federal Financial Services, Inc. is a federal corporation that was organized in 2001 as part of the mutual holding company reorganization of First Federal Savings & Loan Association of Edwardsville. Our principal asset is our ownership of 100% of the outstanding common stock of First Federal Savings & Loan Association of Edwardsville ("First Federal"). We are a majority- owned subsidiary of First Federal Financial Services, MHC, a federally chartered mutual holding company. In June 2004, we sold 1,764,027 shares of our common stock; the remaining 2,156,033 shares are held by our mutual holding company parent. The net proceeds from our stock offering totaled $16.0 million, after offering costs and unearned compensation related to shares issued to our employee stock ownership plan.
At December 31, 2005, we had total assets of $140.2 million, total deposits of $102.1 million and stockholders' equity of $37.7 million. Our net income for the year ended December 31, 2005 was $1.9 million.
On January 31, 2006, the Boards of Directors of First Federal Financial Services, MHC (the "MHC") and First Federal Financial Services, Inc. (the "Company") adopted a Plan of Conversion and Reorganization pursuant to which the MHC will convert from the mutual to stock form ("the Conversion"). In connection with the Conversion, a new Maryland corporation named First Clover Leaf Financial Corp. ("First Clover Leaf") has been formed as the holding company for First Federal, and will offer common stock representing the ownership interest of the MHC in the Company to eligible depositors of First Federal and the public ("the Offering"). Upon completion of the Conversion and Offering, the MHC will cease to exist and First Clover Leaf will succeed to all of the business and operations of the Company and will be the holding company of First Federal. Current stockholders of the Company, other than the MHC, will have their existing shares exchanged for shares of First Clover Leaf based on an exchange ratio yet to be determined, but is expected to range between 1.518 and 2.054 shares for each share held. The Conversion is subject to approval by the OTS and is subject to the approval of the shareholders of the Company and the members of the MHC and is expected to be completed in the third quarter of 2006.
On February 3, 2006, the Company entered into a definitive merger agreement to acquire (the "Acquisition") Clover Leaf Financial Corp., the holding company of Clover Leaf Bank, an Illinois bank located in Edwardsville, Illinois (collectively, "Clover Leaf"). The completion of the Acquisition is contingent upon the successful completion of the Conversion. Under the terms of the merger agreement, at the effective time of the Acquisition, Clover Leaf will merge with and into First Clover Leaf. The merger agreement provides that each share of Clover Leaf Financial Corp. common stock will be converted into the right to receive merger consideration of between $40.00 and $43.00 per share. The appraised pro forma market value of the common stock of First Clover Leaf will determine the value between $40.00 and $43.00 per share of merger consideration to which stockholders of Clover Leaf will be entitled in the merger. If the Conversion closes at the minimum of the valuation range, Clover Leaf stockholders will receive a combination of First Clover Leaf stock and cash valued at $40 per share. If the Conversion closes at the maximum of the valuation range, Clover Leaf stockholders will receive a combination of First Clover Leaf stock and cash valued at $42 per share. If the Conversion closes at the adjusted maximum of the valuation range, Clover Leaf stockholders will receive a combination of First Clover Leaf stock and cash valued at $43 per share. Between the minimum and the maximum of the valuation range, and between the maximum and
adjusted maximum of the valuation range, the value of the merger consideration for Clover Leaf stockholders will be prorated. In exchange for their shares, stockholders of Clover Leaf will have the right to elect either all First Clover Leaf stock, all cash, or a combination of First Clover Leaf stock and cash, provided that, in the aggregate, 70% of the Clover Leaf shares are exchanged for First Clover Leaf stock and 30% are exchanged for cash.
Our executive office and branch office is located at 300 St. Louis Street, Edwardsville, Illinois 62025, and our telephone number is (618) 656-6200.
First Federal Savings & Loan Association of Edwardsville
General
Our principal business consists of attracting retail deposits from the general public in the areas surrounding our office location in Edwardsville, Illinois and investing those deposits, together with funds generated from operations, primarily in one- to four-family residential mortgage loans, multifamily mortgage loans, non-residential mortgage loans, construction loans and consumer loans, and in investment securities. Our revenues are derived principally from interest on loans and securities, and from loan origination fees. Our primary sources of funds are deposits and principal and interest payments on loans and securities.
Competition
We face intense competition within our market area both in making loans and attracting deposits. The City of Edwardsville and the surrounding area have a high concentration of financial institutions, including large commercial banks, community banks and credit unions. We face additional competition for deposits from short-term money market funds, brokerage firms, mutual funds and insurance companies. Some of our competitors offer products and services that we currently do not offer, such as trust services, private banking, internet banking, and business and individual checking accounts. Based on Federal Deposit Insurance Corporation data as of June 30, 2005, our market share of deposits was 2.7% of all deposits in Madison County. Our primary focus is to build and develop profitable customer relationships across all lines of business while maintaining our role as a community bank.
Market Area
We operate in a primarily suburban market area that has a stable population and household base. According to the 2005 U.S. Census Report, during the past five years the population of Madison County increased by approximately 3.6% to 268,191 while the population of the City of Edwardsville increased 5.0% to 22,571. During the same period, the number of households in Madison County and in the City of Edwardsville increased 5.0% and 6.6%, respectively. In 2005, per capita income for Madison County and the City of Edwardsville was $23,851 and $28,974, respectively, and the median household income was $46,761 and $53,711, respectively. This compares to per capita income for the State of Illinois and the United States of $27,097 and $26,228, respectively, and median household income of $53,053 and $49,747, respectively, according to the 2005 U.S. Census Report.
Our primary lending area is concentrated in Madison County and the southern portion of Macoupin County, Illinois. The City of Edwardsville is the County Seat of Madison County and is considered a "bedroom community" for St. Louis, Missouri, approximately 20 miles southwest of Edwardsville. The economy of our market area is characterized by a large number of small retail establishments and small industry. Additionally, major employers in our immediate market area include Southern Illinois University-Edwardsville, ConocoPhillips, the local school district and the Madison County government. Our customer base is comprised primarily of middle-income families.
Lending Activities
Historically, our principal lending activity has been the origination of first mortgage loans for the purchase or refinancing of one- to four-family residential real property. Generally, we retain all loans that we originate. One- to four-family residential real estate mortgage loans represented $99.9 million, or 84.9%, of our loan portfolio at December 31, 2005. We also offer multifamily real estate loans, non-residential mortgage loans and construction
loans secured by single-family properties. Multi-family real estate loans represented $5.4 million, or 4.6%, of our loan portfolio at December 31, 2005. Non-residential mortgage loans, comprised principally of loans secured by places of worship and land development loans for subdivisions, represented $11.1 million, or 9.4%, of our loan portfolio at December 31, 2005. On a limited basis, we have originated loans that are not secured by real estate, such as consumer loans, primarily as an accommodation to our customers.
Loan Portfolio Composition. The following table sets forth the composition of our loan portfolio by type of loan at the dates indicated.
------- (1) Includes land development loans of $1.8 million and $1.1 million and construction loans of $2.3 million and $5.0 million, at December 31, 2005 and 2004, respectively.
Loan Portfolio Maturities and Yields. The following table summarizes the scheduled repayments of our loan portfolio at December 31, 2005.
------------------------------- (1) Includes demand loans, loans having no stated repayment schedule or maturity, and overdraft loans. (2) Includes land acquisition loans.
The following table sets forth the scheduled repayments of fixed- and adjustable-rate loans at December 31, 2005 that are contractually due after December 31, 2006.
Due After December 31, 2006 ------------------------------ Fixed Adjustable Total -------- -------- -------- (In thousands)
One- to four-family residential loans $ 84,584 $ 15,321 $ 99,905 Multi-family ........................ 320 5,070 5,390 Non-residential ..................... 2,722 8,080 10,802 -------- -------- -------- Total mortgage loans ....... 87,626 28,471 116,097
Consumer loans ...................... 1,188 -- 1,188 -------- -------- --------
Total loans ................ $ 88,814 $ 28,471 $117,285 ======== ======== ========
One- to Four-Family Residential Mortgage Loans. Our primary lending activity consists of the origination of one- to four-family residential loans that are primarily secured by properties located in Madison County and the southern portion of Macoupin County. At December 31, 2005, $99.9 million, or 84.9% of our loan portfolio, consisted of one- to-four family residential mortgage loans. Included within these one-to-four-family loans at December 31, 2005 were $2.0 million in second mortgage loans and $2.3 million in home construction loans. At December 31, 2005, the average balance of our one- to four-family residential mortgage loans was $77,000. Generally, one- to four-family residential mortgage loans are originated in amounts up to 95% of the lesser of the appraised value, tax assessment value, or purchase price of the property, with private mortgage insurance required on loans with a loan-to-value ratio in excess of 90%. We will not make loans with a loan-to-value ratio in excess of 95% for loans secured by single-family homes. Fixed-rate loans generally are originated for terms of 15, 20 and 30 years. At December 31, 2005, our largest loan secured by one- to four-family real estate had a principal balance of $549,000 and was secured by a residence and adjoining acreage. This loan was performing in accordance with its repayment terms.
We also offer adjustable-rate mortgage loans with one, two, three, five and seven year adjustment periods based on changes in either a designated United States Treasury index or a quarterly average national Cost of Funds Index. We originated $5.5 million in adjustable-rate one- to four-family residential loans during the year ended December 31, 2005. Currently, our adjustable-rate mortgage loans generally provide for maximum rate adjustments of 200 basis points per adjustment, with a lifetime maximum adjustment to 13.75%, regardless of the initial rate. Our adjustable-rate mortgage loans amortize over terms of up to 30 years.
Adjustable-rate mortgage loans decrease the risk associated with changes in market interest rates by periodically re-pricing, but involve other risks because, as interest rates increase, the underlying payments by the borrower increase, thus increasing the potential for default by the borrower. At the same time, the marketability of the underlying collateral may be adversely affected by higher interest rates. Upward adjustment of the contractual interest rate is also limited by the maximum periodic and lifetime interest rate adjustments permitted by our loan documents, and therefore, is potentially limited in effectiveness during periods of rapidly rising interest rates. At December 31, 2005, $15.3 million, or 15.3%, of our one- to four-family residential loans had adjustable rates of interest.
All one- to four-family residential loans that we originate include "due-on-sale" clauses, which give us the right to declare a loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the real property subject to the mortgage and the loan is not repaid.
We currently offer adjustable-rate or fixed-rate residential construction loans for the construction of owner-occupied, single-family residences. These loans generally are offered to borrowers who have a contract for construction of a single-family residence on property they own at the time of the loan origination in an amount up to 80% of the value upon completion of construction. These owner-occupied construction loans are not separate loans that are paid off and then converted to permanent mortgage loans. Rather, these construction loans become permanent loans at the time the loan is originated, thereby, at times, creating loans that may have terms exceeding 30 years (e.g., 30 years and 9 months). At December 31, 2005, we had $2.3 million of one- to four-family construction loans, of which $1.2 million were for pre-sold residences. The remaining $1.1 million in construction loans were made to builders to finance the construction of residences that were not pre-sold. Because of the uncertainties inherent in estimating construction costs, as well as the market value of the completed project, the repayment of construction loans that are not pre-sold is dependent, in part, on the success of the ultimate project and the ability of the borrower to sell or lease the property, rather than the ability of the borrower or guarantor to repay principal and interest.
Our second mortgage loans generally have adjustable interest rates and are offered in amounts up to 80% of the appraised value of the property securing the loan (including prior liens). Our second mortgage loans are generally made with maturities of less than ten years and are secured by the borrower's principal residence. Our procedures for underwriting these loans include an assessment of an applicant's credit history and an assessment of the value of the collateral in relation to the proposed loan amount.
Regulations limit the amount that a savings association may lend relative to the appraised value of the real estate securing the loan, as determined by an appraisal of the property at the time the loan is originated. For all
loans over $250,000, we utilize outside independent appraisers approved by our board of directors. All one- to four-family loans below $250,000 must have either an independent appraisal or opinion of value, which, generally, is the property's tax bill. All borrowers are required to obtain title insurance. We also require homeowner's insurance and fire and casualty insurance and, where circumstances warrant, flood insurance on properties securing real estate loans.
Non-Residential Real Estate Loans. At December 31, 2005, $11.1 million, or 9.4%, of our total loan portfolio consisted of non-residential real estate loans. Non-residential real estate loans are secured by places of worship, mixed-use properties and other commercial office buildings, or raw land held for future development or in the process of being developed. We generally originate adjustable-rate non-residential real estate loans with maximum terms of up to 15 years. In some cases, we originate such loans with up to 30-year terms. Generally, the maximum loan-to-value ratio of non-residential real estate loans is 80%, and 90% of the income from the property must be sufficient to cover the monthly mortgage payment, taxes, insurance and maintenance expense. At December 31, 2005, we had 41 non-residential real estate loans with an average outstanding balance of $270,000. At December 31, 2005, our largest loan secured by non-residential real estate was $1.6 million and was secured by land to be developed for a multi-phase subdivision. At December 31, 2005, none of our loans secured by non-residential real estate were classified as non-performing.
We consider a number of factors in originating non-residential real estate loans. We evaluate the qualifications and financial condition of the borrower (including credit history), profitability and expertise, as well as the value and condition of the mortgaged property securing the loan. When evaluating the qualifications of the borrower, we consider the financial resources of the borrower, the borrower's experience in owning or managing similar property and the borrower's payment history with us and other financial institutions. In evaluating the property securing the loan, the factors we consider include the net operating income of the mortgaged property before debt service and depreciation, the debt service coverage ratio (the ratio of net operating income to debt service), and the ratio of the loan amount to the appraised value of the mortgaged property. Generally, non-residential real estate loans are originated in amounts up to 80% of the lower of the sale price or the appraised value of the mortgaged property securing the loan. All non-residential real estate loans over $250,000 are appraised by outside independent appraisers approved by the board of directors. All non-residential real estate loans below $250,000 must have either an independent appraisal or opinion of value, which, generally, is the property's tax bill. Borrowers are required to sign non-residential notes in their individual (not corporate) capacity.
We also make construction loans to area builders to finance the cost of completing homes on improved property. Construction loans are generally structured to become permanent mortgage loans once the construction is completed. At December 31, 2005, our largest construction loan was $360,000 of which $352,000 was advanced. The loan was performing in accordance with its repayment terms. Construction loans require the payment of interest only during the construction period. Construction loans will generally be made in amounts of up to 80% of the lower of the appraised value of the property or the actual cost of the improvements. Funds are disbursed in accordance with a schedule reflecting the completion of portions of the project. At December 31, 2005, all of our construction loans were secured by properties located in our primary lending area.
Construction loans generally involve a greater degree of credit risk than one- to four-family residential loans. The risk of loss on a construction loan depends upon the accuracy of the initial estimate of the value of the property at completion of construction compared to the estimated cost of construction. If the estimated cost of construction is inaccurate we may have to advance funds beyond the original amount committed in order to protect the value of the property.
Loans secured by non-residential real estate generally are larger than one- to four-family residential loans and involve greater credit risk. Non-residential real estate loans often involve large loan balances to single borrowers or groups of related borrowers. Repayment of these loans depends to a large degree on the results of operations and management of the properties securing the loans or the businesses conducted on such property, and may be affected to a greater extent by adverse conditions in the real estate market or the economy in general. Accordingly, the nature of these loans makes them more difficult for management to monitor and evaluate.
Multi-Family Real Estate Loans. Loans secured by multi-family real estate totaled $5.4 million, or 4.6%, of our total loan portfolio at December 31, 2005. Multi-family real estate loans generally are secured by apartment
buildings and rental properties. All of our multi-family real estate loans are secured by properties located within our lending area. At December 31, 2005, we had 14 multi-family real estate loans with an average principal balance of $385,000, and the largest multi-family real estate loan had a principal balance of $3.5 million. The loan is secured by ten, twelve-unit apartment buildings. As of December 31, 2005, none of our loans secured by multi-family real estate were non-performing. Multi-family real estate loans generally are offered with adjustable interest rates that adjust after one, three or five years. The interest rate adjustments are tied to either a Treasury Bill Index tied to the adjustment period, or to a Cost of Funds Index. Multi-family loans generally are originated for terms of up to 15 years, but in some cases, we will make multi-family loans with terms of up to 30 years.
We consider a number of factors in originating multi-family real estate loans. We evaluate the qualifications and financial condition of the borrower (including credit history), profitability and expertise, as well as the value and condition of the mortgaged property securing the loan. When evaluating the qualifications of the borrower, we consider the financial resources of the borrower, the borrower's experience in owning or managing similar property and the borrower's payment history with us and other financial institutions. In evaluating the property securing the loan, the factors we consider include the net operating income of the mortgaged property before debt service and depreciation, the debt service coverage ratio (the ratio of net operating income to debt service), and the ratio of the loan amount to the appraised value of the mortgaged property. Multi-family real estate loans are originated in amounts up to 80% of the lower of the sale price or the appraised value of the mortgaged property securing the loan. All multi-family real estate loans over $250,000 are appraised by outside independent appraisers approved by the board of directors. All multi-family real estate loans below $250,000 must either have an independent appraisal or an opinion of value, which, generally, is the property's tax bill. Borrowers are required to sign multi-family notes in their individual (not corporate) capacity.
Loans secured by multi-family real estate generally involve a greater degree of credit risk than one- to four-family residential loans and carry larger loan balances. This increased credit risk is a result of several factors, including the concentration of principal in a limited number of loans and borrowers, the effects of general economic conditions on income producing properties, and the increased difficulty of evaluating and monitoring these types of loans. Furthermore, the repayment of loans secured by multi-family real estate typically depends upon the successful operation of the real estate property securing the loan. If the cash flow from the project is reduced, the borrower's ability to repay the loan may be impaired.
Consumer Loans. We offer a small number of consumer loans, principally to existing customers residing in our primary market area with above-average credit ratings. Our consumer loans are generally made on new and used automobiles and amounted to $1.3 million, or 1.1%, of our total loan portfolio at December 31, 2005. We also originate share loans secured by deposit accounts.
Origination and Servicing of Loans. Loan origination activities are primarily concentrated in Madison County and the southern portion of Macoupin County, Illinois. New loans are generated primarily from walk-in customers, customer referrals, attorneys, and other parties with whom we do business, and from the efforts of employees and advertising. Loan applications are underwritten and processed at our single banking office. We service all loans that we originate.
Loan Approval Procedures and Authority. The loan approval process is intended to assess the borrower's ability to repay the loan, the viability of the loan, and the adequacy of the value of the property that will secure the loan. To assess the borrower's ability to repay, we review the employment and credit history and information on the historical and projected income and expenses of mortgagors. All one- to four-family loans up to $400,000 may be approved by either our President, Vice President/Treasurer or Loan Officer. All other loans (except for consumer loans) and all one- to four-family loans in excess of $400,000 must be approved by the board of directors. In addition, the board of directors ratifies all loans (except consumer loans) approved by management.
We generally require appraisals of all real property securing loans, although one- to four-family residential loans up to $250,000 can be approved without an appraisal. Appraisals are performed by independent licensed appraisers. All appraisers are approved by the board of directors annually. We require fire and extended coverage insurance in amounts at least equal to the principal amount of the loan.
Non-performing and Problem Assets
A computer-generated delinquency notice is mailed monthly to all delinquent borrowers, advising them of the amount of their delinquency. When a loan becomes 60 days delinquent, a letter from our attorney is sent advising the borrower of his or her failure to make payments as required. The borrower is given 30 days to make up the delinquent payments or to contact us to make arrangements to bring the loan up to date over a longer period of time. If the borrower fails to bring the loan current in 30 days or to make arrangements to cure the delinquency over a longer period of time, foreclosure proceedings are started. We may consider forbearance in cases of a temporary loss of income if a plan is presented by the borrower to cure the delinquency in a reasonable period of time after his or her income resumes.
Mortgage loans are reviewed on a regular basis and such loans are placed on non-accrual status when they become more than 90 days delinquent unless the credit is well-secured and in the process of collection. When loans are placed on a non-accrual status, unpaid accrued interest is fully reserved, and further income is recognized only to the extent received.
Non-Performing Loans and Non-Performing Assets. At December 31, 2005 and 2004, our non-performing loans and non-performing assets were as shown in the table below. At each date presented, we had no troubled debt restructurings (loans for which a portion of interest or principal has been forgiven and loans modified at interest rates materially less than current market rates).
At December 31, --------------- 2005 2004 ------ ------ (Dollars in thousands) Non-accrual loans: One- to four-family ................................. $ -- $ -- Multi-family ........................................ -- -- Non-residential ..................................... -- -- Consumer ............................................ 4 -- ------ ------ Total non-accrual loans ........................... 4 -- ------ ------
Accruing loans delinquent 90 days or more: One- to four-family ................................. $ -- $ -- Multi-family ........................................ -- -- Consumer ............................................ 11 3 ------ ------ Total accruing loans delinquent 90 days or more ... 11 3 ------ ------ Total non-performing loans ........................ 15 3 ------ ------
Real estate owned: One- to four-family ................................. -- -- Commercial real estate .............................. -- -- ------ ------ Total real estate owned ........................... -- -- ------ ------
Total non-performing assets ............................ $ 15 $ 3 ====== ====== Allowance for loan losses attributable to non-performing loans ............................................... $ 4 $ --
Ratios: Non-performing loans to total loans ................. 0.01% 0.00% Non-performing assets to total assets ............... 0.01 0.00
The following table sets forth certain information with respect to our loan portfolio delinquencies at the dates indicated.
Loans Delinquent For ---------------------------------- 60-89 Days 90 Days and Over Total --------------- ---------------- --------------- Number Amount Number Amount Number Amount ------ ------ ------ ------- ------ ------ (Dollars in thousands) At December 31, 2005 One- to four-family 1 $ 52 -- $ -- 1 $ 52 Multi-family ...... 1 2 -- -- 1 2 Non-residential ... -- -- -- -- -- -- Consumer .......... -- -- 4 15 4 15 ------ ------ ------ ------ ------ ------ Total ........... 2 $ 54 4 $ 15 6 $ 69 ====== ====== ====== ====== ====== ======
At December 31, 2004 One- to four-family 2 $ 152 -- $ -- 2 $ 152 Multi-family ...... -- -- -- -- -- -- Non-residential ... -- -- -- -- -- -- Consumer .......... -- -- 1 3 1 3 ------ ------ ------ ------ ------ ------ Total ........... 2 $ 152 1 $ 3 3 $ 155 ====== ====== ====== ====== ====== ======
Classified Assets. Office of Thrift Supervision regulations provide that loans and other assets considered to be of lesser quality be classified as "substandard," "doubtful" or "loss" assets. An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the institution will sustain "some loss" if the deficiencies are not corrected. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified as "loss" are those considered "uncollectible" and of such little value that their continuance as assets without the establishment of a specific loss reserve is not warranted. The regulations also provide for a "special mention" category, described as assets that do not currently expose the institution to a sufficient degree of risk to warrant classification, but do possess credit deficiencies or potential weaknesses deserving close attention.
An insured institution is required to establish general allowances for loan losses in an amount deemed prudent by management for loans classified substandard or doubtful, as well as for other problem loans. General allowances represent loss allowances which have been established to recognize the inherent losses associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an insured institution classifies problem assets as "loss," it is required either to establish a specific allowance for losses equal to 100% of the amount of the asset so classified or to charge off such amount. An institution's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the Office of Thrift Supervision which can order the establishment of additional general or specific loss allowances.
On the basis of management's review of its assets, at December 31, 2005 we had classified $4,000 of our assets as substandard (which consisted of three consumer loans) and none as doubtful, special mention, or loss. Of the loans classified by management, $4,000 was included in the above loan delinquency table. The allowance for loan losses related to classified assets totaled $4,000 at December 31, 2005.
The loan portfolio is reviewed on a regular basis to determine whether any loans require classification in accordance with applicable regulations. Not all classified assets constitute non-performing assets.
Allowance for Loan Losses
Our allowance for loan losses is maintained at a level necessary to absorb loan losses that are both probable and reasonably estimable. Management, in determining the allowance for loan losses, considers the losses inherent
in our loan portfolio and changes in the nature and volume of loan activities, along with the general economic and real estate market conditions. We utilize a two-tier approach: (1) identification of impaired loans and establishment of specific loss allowances on such loans; and (2) establishment of general valuation allowances on the remainder of our loan portfolio. Once a loan becomes delinquent, we may establish a specific loan loss allowance based on a review of among other things, delinquency status, size of loans, type and market value of collateral and financial condition of the borrowers. A loan evaluated for impairment is considered to be impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement. All loans identified as impaired are evaluated independently. We do not aggregate such loans for evaluation purposes. Loan impairment is measured based on the present value of expected future cash flows discounted at the loan's effective interest rate or, as a practical expedient, at the loan's observable market price or the fair value of the collateral if the loan is collateral dependent. General loan loss allowances are based upon a combination of factors including, but not limited to, actual loan loss experience, composition of the loan portfolio, current economic conditions, management's judgment and losses which are probable and reasonably estimable. The allowance is increased through provisions charged against current earnings and recoveries of previously charged-off loans. Loans that are determined to be uncollectible are charged against the allowance. While management uses available information to recognize probable and reasonably estimable loan losses, future loss provisions may be necessary based on changing economic conditions. Payments received on impaired loans are applied first to accrued interest receivable and then to principal. The allowance for loan losses as of December 31, 2005 was maintained at a level that represented management's best estimate of losses inherent in the loan portfolio, and such losses were both probable and reasonably estimable.
In addition, the Office of Thrift Supervision and Federal Deposit Insurance Corporation, as an integral part of their examination process, periodically review our allowance for loan losses. Such agencies may require that we recognize additions to the allowance based on their judgments of information available to them at the time of their examination.
The following table sets forth activity in our allowance for loan losses for the years indicated.
At or For the Years Ended December 31, ---------------------- 2005 2004 --------- --------- (Dollars in thousands)
Balance at beginning of year .................... $ 428 $ 429 --------- ---------
Charge-offs: One- to four-family .......................... -- -- Multi-family ................................. -- -- Non-residential .............................. -- -- Consumer ..................................... -- (1) --------- --------- Total charge-offs .......................... -- (1)
Recoveries: One- to four-family .......................... -- -- Multi-family ................................. -- -- Non-residential .............................. -- -- Consumer ..................................... -- -- --------- --------- Total recoveries ........................... -- --
Net (charge-offs) recoveries .................... -- (1) Provision for loan losses ....................... -- -- --------- ---------
Balance at end of year .......................... $ 428 $ 428 ========= =========
Ratios: Net charge-offs to average loans outstanding .... 0.00% 0.00% Allowance for loan losses to non-performing loans 2,853.33 14,266.67 Allowance for loan losses to total loans ........ 0.37 0.38
Allocation of Allowance for Loan Losses. The following tables set forth the allowance for loan losses allocated by loan category, the total loan balances by category, and the percent of loans in each category to total loans at the dates indicated. The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories.
Each quarter, management evaluates the total balance of the allowance for loan losses based on several factors that are not loan specific, but are reflective of the inherent losses in the loan portfolio. This process includes, but is not limited to, a periodic review of loan collectibility in light of historical experience, the nature and volume of loan activity, conditions that may affect the ability of the borrower to repay, underlying value of collateral, if applicable, and economic conditions in our immediate market area. First, we group loans by delinquency status. All loans 90 days or more delinquent are evaluated individually, based primarily on the value of the collateral securing the loan. Specific loss allowances are established as required by this analysis. All loans for which a specific loss allowance has not been assigned are segregated by type and delinquency status and a loss allowance is established by using loss experience data and management's judgment concerning other matters it considers significant. The allowance is allocated to each category of loan based on the results of the above analysis. Small differences between the allocated balances and recorded allowances are reflected as unallocated to absorb losses resulting from the inherent imprecision involved in the loss analysis process.
This analysis process is inherently subjective, as it requires us to make estimates that are susceptible to revisions as more information becomes available. Although we believe that we have established the allowance at levels to absorb probable and estimable losses, future additions may be necessary if economic or other conditions in the future differ from the current environment.
Investments
Investments and Mortgage-Backed Securities. Our investment portfolio at December 31, 2005 consisted of $8.2 million in federal agency obligations and $4.7 million in investment grade corporate debt securities, all of which were classified as available for sale. Our investment policy objectives are to maintain liquidity within the guidelines established by the board of directors.
We also invest in mortgage-backed securities, all of which are guaranteed by the United States Government or government-sponsored agencies, and all of which are classified as held to maturity. At December 31, 2005, our mortgage-backed securities portfolio totaled $353,000, or 0.3% of total assets, and consisted of $328,000 in fixed-rate mortgage-backed securities guaranteed by Freddie Mac, and $25,000 in fixed-rate mortgage-backed securities guaranteed by Ginnie Mae.
Available-for-Sale Portfolio. The following table sets forth the composition of our available-for-sale portfolio at the dates indicated.
Held-to-Maturity Portfolio. The following table sets forth the composition of our held-to-maturity portfolio at the dates indicated.
Portfolio Maturities and Yields. The composition and maturities of the investment securities portfolio and the mortgage-backed securities portfolio at December 31, 2005 are summarized in the following table. Maturities are based on the final contractual payment dates, and do not reflect the impact of prepayments or early redemptions that may occur.
Sources of Funds
General. Deposits have traditionally been our primary source of funds for use in lending and investment activities. In addition to deposits, funds are derived from scheduled loan payments, investment maturities, loan prepayments, retained earnings and income on earning assets. While scheduled loan payments and income on earning assets are relatively stable sources of funds, deposit inflows and outflows can vary widely and are influenced by prevailing interest rates, market conditions and levels of competition. Borrowings from the Federal Home Loan Bank of Chicago may be used in the short-term to compensate for reductions in deposits and to fund loan growth.
Deposits. Deposits are not solicited outside of the Edwardsville area, and a majority of our depositors are persons who work or reside in Madison County, Illinois. We offer a selection of deposit instruments, including passbook savings, money market deposit accounts (without check-drawing features) and fixed-term certificates of deposit. Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds must remain on deposit and the interest rate. We do not currently offer checking accounts. We do not accept brokered deposits.
Interest rates paid, maturity terms, service fees and withdrawal penalties are established on a periodic basis. Deposit rates and terms are based primarily on current operating strategies and market rates, liquidity requirements, rates paid by competitors and growth goals. To attract and retain deposits, we rely upon personalized customer service, long-standing relationships and rates near the upper-end of those offered in our market area.
The flow of deposits is influenced significantly by general economic conditions, changes in money market and other prevailing interest rates and competition. The variety of deposit accounts that we offer allows us to be competitive in obtaining funds and responding to changes in consumer demand. Based on historical experience, management believes our deposits are relatively stable. However, the ability to attract and maintain certificates of deposit, and the rates paid on these deposits, have been and will continue to be significantly affected by market conditions. At December 31, 2005, $78.3 million, or 76.7% of our deposit accounts were certificates of deposit, of which $35.7 million had maturities of one year or less.
The following table sets forth the distribution of average deposit accounts, by account type, for the years indicated.
The following table sets forth certificates of deposit by time remaining until maturity as of December 31, 2005.
----------------------- (1) The weighted average interest rates for these accounts, by maturity period, were: 3.16% for 3 months or less; 3.49% for over 3 to 6 months; 3.53% for over 6 to 12 months; and 4.30% for over 12 months. The overall weighted average interest rate for accounts of $100,000 or more was 3.93%.
The following table sets forth, by interest rate ranges, information concerning certificates of deposit at December 31, 2005.
Borrowings. We may obtain advances from the Federal Home Loan Bank of Chicago upon the security of the common stock we own in the Federal Home Loan Bank and our qualifying residential mortgage loans and mortgage-backed securities, provided certain standards related to creditworthiness are met. These advances are made pursuant to several credit programs, each of which has its own interest rate and range of maturities. At December 31, 2005, we had no advances outstanding. At that date, we had access to Federal Home Loan Bank advances of up to $47.0 million. The following table sets forth information concerning balances and interest rates on our Federal Home Loan Bank advances at the dates and for the periods indicated.
Subsidiary Activities
First Federal Financial Services, Inc.'s only subsidiary is First Federal Savings & Loan Association of Edwardsville. First Federal Savings & Loan Association of Edwardsville does not have any subsidiaries.
Personnel
As of December 31, 2005, we had nine full-time employees and one part-time employee. Our employees are not represented by any collective bargaining group. Management believes that we have good relations with our employees.
SUPERVISION AND REGULATION
General
First Federal is a federally chartered savings association. First Federal will be the surviving financial institution following the proposed merger with Clover Leaf Bank and will remain a federally chartered savings association (although it will be renamed "First Clover Leaf Bank").
First Federal is regulated and supervised by the Office of Thrift Supervision and the Federal Deposit Insurance Corporation. This regulation and supervision establishes a comprehensive framework of activities in which a financial institution may engage and is intended primarily for the protection of the Federal Deposit Insurance Corporation's deposit insurance funds and depositors. Under this system of federal regulation, financial institutions are periodically examined to ensure that they satisfy applicable standards with respect to their capital adequacy, assets, management, earnings, liquidity and sensitivity to market interest rates. After completing an examination, the federal agency critiques the financial institution's operations and assigns its rating (known as an institution's CAMELS). Under federal law, an institution may not disclose its CAMELS rating to the public. First Federal also is a member of, and owns stock in, the Federal Home Loan Bank of Chicago, which is one of the twelve regional banks in the Federal Home Loan Bank System. First Federal also is regulated to a lesser extent by the Board of Governors of the Federal Reserve System, governing reserves to be maintained against deposits and other matters. The Office of Thrift Supervision examines First Federal and prepares reports for the consideration of its board of directors on any operating deficiencies.
Any change in these laws or regulations, whether by the Federal Deposit Insurance Corporation, the Office of Thrift Supervision, or Congress, could have a material adverse impact on us and our operations.
Supervisory Agreement
On December 16, 2004, First Federal Savings & Loan Association of Edwardsville entered into a Supervisory Agreement with the Office of Thrift Supervision. The Supervisory Agreement, previously disclosed on a Current Report on Form 8-K filed on February 2, 2005, facilitates corrective actions concerning certain regulatory compliance issues, including violations of the Bank Secrecy Act. In addition, the Office of Thrift Supervision assessed civil money penalties against First Federal Savings & Loan Association of Edwardsville in the amount of $7,700 for its failure to purchase and maintain flood insurance in an appropriate amount on 14 loans and its failure to obtain signed and dated flood notices from the borrowers on eight loans.
The Supervisory Agreement was based upon First Federal Savings & Loan Association of Edwardsville's August 2004 Report of Examination in which the Office of Thrift Supervision concluded that grounds existed for the initiation of an administrative proceeding against First Federal Savings & Loan Association of Edwardsville. Without admitting or denying that such grounds existed, First Federal Savings & Loan Association of Edwardsville determined to enter into the Supervisory Agreement to cooperate with the Office of Thrift Supervision and as evidence of First Federal Savings & Loan Association of Edwardsville's intent to comply with all applicable laws and regulations and engage in safe and sound practices.
Pursuant to the terms of the Supervisory Agreement, First Federal Savings & Loan Association of Edwardsville agreed as follows:
(1) to adopt an anti-money laundering and Bank Secrecy Act compliance program that ensures compliance with its requirements and that, among other things, requires the accurate and timely completion and filing of currency transaction reports, designates a primary Bank Secrecy Act officer, provides for annual independent testing by a qualified third party of the Bank Secrecy Act compliance program, provides First Federal Savings & Loan Association of Edwardsville personnel with comprehensive Bank Secrecy Act training, and provides for internal controls to ensure First Federal's ongoing compliance with its Bank Secrecy Act compliance program.
(2) to adopt a Customer Identification Program and an Office of Foreign Assets Control policy.
(3) to develop and implement a comprehensive training program for operational and supervisory adherence to the requirements of the Bank Secrecy Act and regulations thereunder.
(4) to review and amend its Flood Disaster Protection Act policies and procedures to ensure that appropriate flood insurance is obtained and maintained upon all properties securing a loan from First Federal Savings & Loan Association of Edwardsville. The board of directors will review all loans made on or after March 1, 2001 to ensure that all loans subject to the Flood Disaster Protection Act and regulations thereunder comply with such laws and regulations.
(5) to comply with the requirement of the Equal Credit Opportunity Act, including the nondiscriminatory loan underwriting standards thereunder, and to review its business practices at least annually to ensure compliance therewith.
(6) at least annually, to require First Federal Savings & Loan Association of Edwardsville's security officer to report to the board of directors on the administration and effectiveness of First Federal Savings & Loan Association of Edwardsville's security program as required by the Bank Protection Act.
(7) for the board of directors of First Federal Savings & Loan Association of Edwardsville to appoint a regulatory compliance committee of at least three directors, the majority of whom must be independent, to monitor and coordinate compliance with the Supervisory Agreement and to submit to the full board quarterly written progress reports and actions taken to comply with the Supervisory Agreement. The progress reports must be signed by each director and filed with the Regional Director of the Office of Thrift Supervision.
The Supervisory Agreement will remain in effect until terminated, modified or suspended in writing by the Office of Thrift Supervision.
First Federal Savings & Loan Association of Edwardsville believes that it has adopted and implemented the various plans, policies and procedures required by the Supervisory Agreement. However, a failure to comply with the Supervisory Agreement could result in the initiation of a formal enforcement action by the Office of Thrift Supervision, including the imposition of additional civil money penalties. While the Supervisory Agreement has resulted in additional regulatory compliance expenses for First Federal Savings & Loan Association of Edwardsville, the amount of such expenses have not had a material financial impact on First Federal.
Federal Banking Regulation
Business Activities. A federal savings association derives its lending and investment powers from the Home Owners' Loan Act, as amended, and the regulations of the Office of Thrift Supervision. Under these laws and regulations, First Federal may invest in mortgage loans secured by residential and commercial real estate, commercial business and consumer loans, certain types of debt securities and certain other loans and assets. First Federal Savings & Loan Association of Edwardsville also may establish subsidiaries that may engage in activities not otherwise permissible for First Federal Savings & Loan Association of Edwardsville directly, including real estate investment, securities brokerage and insurance agency.
Capital Requirements. Office of Thrift Supervision regulations require savings associations to meet three minimum capital standards: a 1.5% tangible capital ratio, a 4% leverage ratio (3% for institutions receiving the highest rating on the CAMELS rating system) and an 8% risk-based capital ratio. The prompt corrective action standards discussed below, in effect, establish a minimum 2% tangible capital standard.
The risk-based capital standard for savings associations requires the maintenance of Tier 1 (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,
are multiplied by a risk-weight factor of 0% to 100%, assigned by the Office of Thrift Supervision capital regulation based on the risks inherent in the type of asset. Core 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, allowance for loan and lease losses up to a maximum of 1.25% of risk-weighted assets, and up to 45% of net 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.
At December 31, 2005, First Federal's capital exceeded all applicable requirements.
Loans to One Borrower. A federal savings association generally may not make a loan or extend credit to a single or related group of borrowers in excess of 15% of unimpaired capital and surplus on an unsecured basis. An additional amount may be loaned, equal to 10% of unimpaired capital and surplus, if the loan is secured by readily marketable collateral, which generally does not include real estate. As of December 31, 2005, First Federal was in compliance with the loans-to-one-borrower limitations.
Qualified Thrift Lender Test. As a federal savings association, First Federal is subject to a qualified thrift lender, or "QTL," test. Under the QTL test, First Federal must maintain at least 65% of its "portfolio assets" in "qualified thrift investments" in at least nine months of the most recent 12-month period. "Portfolio assets" generally means total assets of a savings institution, less the sum of specified liquid assets up to 20% of total assets, goodwill and other intangible assets, and the value of property used in the conduct of the savings association's business.
"Qualified thrift investments" include various types of loans made for residential and housing purposes, investments related to such purposes, including certain mortgage-backed and related securities, and loans for personal, family, household and certain other purposes up to a limit of 20% of portfolio assets. "Qualified thrift investments" also include 100% of an institution's credit card loans, education loans and s loans. First Federal also may satisfy the QTL test by qualifying as a "domestic building and loan association" as defined in the Internal Revenue Code of 1986.
A savings association that fails the QTL test must either convert to a bank charter or operate under specified restrictions. At December 31, 2005, First Federal maintained virtually all of its portfolio assets in qualified thrift investments, and therefore satisfied the QTL test.
Capital Distributions. Office of Thrift Supervision regulations govern capital distributions by a federal savings association, which include cash dividends, stock repurchases and other transactions charged to the institution's capital account. A savings association must file an application for approval of a capital distribution if:
o the total capital distributions for the applicable calendar year exceed the sum of the savings association's net income for that year to date plus the savings association's retained net income for the preceding two years; o the savings association would not be at least adequately capitalized following the distribution; o the distribution would violate any applicable statute, regulation, agreement or Office of Thrift Supervision-imposed condition; or o the savings association is not eligible for expedited treatment of its filings.
Even if an application is not otherwise required, every savings association that is a subsidiary of a holding company must still file a notice with the Office of Thrift Supervision at least 30 days before the board of directors declares a dividend or approves a capital distribution.
The Office of Thrift Supervision may disapprove a notice or application if:
o the savings association would be undercapitalized following the distribution; o the proposed capital distribution raises safety and soundness concerns; or o the capital distribution would violate a prohibition contained in any statute, regulation or agreement.
Liquidity. A federal savings association is required to maintain a sufficient amount of liquid assets to ensure its safe and sound operation.
Community Reinvestment Act and Fair Lending Laws. All savings associations have a responsibility under the Community Reinvestment Act and related regulations of the Office of Thrift Supervision to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In connection with its examination of a federal savings association, the Office of Thrift Supervision is required to assess the savings association's record of compliance with the Community Reinvestment Act. In addition, the Equal Credit Opportunity Act and the Fair Housing Act prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. A savings association's failure to comply with the provisions of the Community Reinvestment Act could, at a minimum, result in regulatory restrictions on its activities. The failure to comply with the Equal Credit Opportunity Act and the Fair Housing Act could result in enforcement actions by the Office of Thrift Supervision, as well as other federal regulatory agencies and the Department of Justice. First Federal received a "satisfactory" Community Reinvestment Act rating in its most recent federal examination.
Transactions with Related Parties. A federal savings association's authority to engage in transactions with its "affiliates" is limited by Office of Thrift Supervision regulations and by Sections 23A and 23B of the Federal Reserve Act. The term "affiliates" for these purposes generally means any company that controls or is under common control with an institution. First Federal and its non-savings institution subsidiaries will be affiliates of First Federal. In general, transactions with affiliates must be on terms that are as favorable to the savings association as comparable transactions with non-affiliates. In addition, certain types of these transactions are restricted to an aggregate percentage of the savings association's capital. Collateral in specified amounts must usually be provided by affiliates in order to receive loans from the savings association. In addition, Office of Thrift Supervision regulations prohibit a savings association from lending to any of its affiliates that are engaged in activities that are not permissible for bank holding companies and from purchasing the securities of any affiliate, other than a subsidiary.
First Federal's authority to extend credit to its directors, executive officers and 10% stockholders, as well as to entities controlled by such persons, is currently governed by the requirements of Sections 22(g) and 22(h) of the Federal Reserve Act and Regulation O of the Federal Reserve Board. Among other things, these provisions require that extensions of credit to insiders (i) be made on terms that are substantially the same as, and follow credit underwriting procedures that are not less stringent than, those prevailing for comparable transactions with unaffiliated persons and that do not involve more than the normal risk of repayment or present other unfavorable features, and (ii) not exceed certain limitations on the amount of credit extended to such persons, individually and in the aggregate, which limits are based, in part, on the amount of First Federal Savings & Loan Association of Edwardsville's capital. In addition, extensions of credit in excess of certain limits must be approved by First Federal Savings & Loan Association of Edwardsville's board of directors.
Enforcement. The Office of Thrift Supervision has primary enforcement responsibility over federal savings institutions and has the authority to bring enforcement action against all "institution-affiliated parties," including stockholders, and attorneys, appraisers and accountants who knowingly or recklessly participate in wrongful action likely to have an adverse effect on an insured institution. Formal enforcement action may range from the issuance of a capital directive or cease and desist order to removal of officers and/or directors of the institution, receivership, conservatorship or the termination of deposit insurance. Civil penalties cover a wide range of violations and actions, and range up to $25,000 per day, unless a finding of reckless disregard is made, in which case penalties may be as high as $1 million per day. The Federal Deposit Insurance Corporation also has the authority to recommend to the Director of the Office of Thrift Supervision that enforcement action be taken with
respect to a particular savings institution. If action is not taken by the Director, the Federal Deposit Insurance Corporation has authority to take action under specified circumstances.
Standards for Safety and Soundness. Federal law requires each federal banking agency to prescribe certain standards for all insured depository institutions. These standards relate to, among other things, internal controls, information systems and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, and other operational and managerial standards as the agency deems appropriate. The federal banking agencies adopted Interagency Guidelines Prescribing Standards for Safety and Soundness to implement the safety and soundness standards required under federal law. 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. The guidelines address internal controls and information systems, internal audit systems, credit underwriting, loan documentation, interest rate risk exposure, asset growth, compensation, fees and benefits. If the appropriate federal banking agency determines that an institution fails to meet any standard prescribed by the guidelines, the agency may require the institution to submit to the agency an acceptable plan to achieve compliance with the standard. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan.
Prompt Corrective Action Regulations. Under the prompt corrective action regulations, the Office of Thrift Supervision is required and authorized to take supervisory actions against undercapitalized savings associations. For this purpose, a savings association is placed in one of the following five categories based on the savings association's capital:
o well-capitalized (at least 5% leverage capital, 6% tier 1 risk-based capital and 10% total risk-based capital); o adequately capitalized (at least 4% leverage capital, 4% tier 1 risk-based capital and 8% total risk-based capital); o undercapitalized (less than 3% leverage capital, 4% tier 1 risk-based capital or 8% total risk-based capital); o significantly undercapitalized (less than 3% leverage capital, 3% tier 1 risk-based capital or 6% total risk-based capital); and o critically undercapitalized (less than 2% tangible capital).
Generally, the banking regulator is required to appoint a receiver or conservator for a savings association that is "critically undercapitalized." The regulation also provides that a capital restoration plan must be filed with the Office of Thrift Supervision within 45 days of the date a bank receives notice that it is "undercapitalized," "significantly undercapitalized" or "critically undercapitalized." In addition, numerous mandatory supervisory actions become immediately applicable to the savings association, including, but not limited to, restrictions on growth, investment activities, capital distributions and affiliate transactions. The Office of Thrift Supervision may also take any one of a number of discretionary supervisory actions against undercapitalized savings associations, including the issuance of a capital directive and the replacement of senior executive officers and directors.
At December 31, 2005, First Federal met the criteria for being considered "well-capitalized."
Insurance of Deposit Accounts. Deposit accounts in First Federal are insured by the Federal Deposit Insurance Corporation, generally up to a maximum of $100,000 per separately insured depositor. First Federal Savings & Loan Association of Edwardsville's deposits, therefore, are subject to Federal Deposit Insurance Corporation deposit insurance assessments. The Federal Deposit Insurance Corporation has adopted a risk-based system for determining deposit insurance assessments. The Federal Deposit Insurance Corporation is authorized to raise the assessment rates as necessary to maintain the required ratio of reserves to insured deposits of 1.25%. In addition, all Federal Deposit Insurance Corporation-insured institutions must pay assessments to the Federal Deposit Insurance Corporation at an annual rate of approximately .0212% of insured deposits to fund interest payments on bonds maturing in 2017 that were issued by a federal agency to recapitalize the predecessor to the Savings Association Insurance Fund.
On February 15, 2006, federal legislation to reform federal deposit insurance was enacted. This new legislation requires, among other things, the merger of the Savings Association Insurance Fund and the Bank Insurance Fund into a unified insurance deposit fund and an increase in the amount of federal deposit insurance coverage from $100,000 to $130,000 (with a cost of living adjustment to become effective in five years). The Act also requires the reserve ratio to be modified to provide for a range between 1.15% and 1.50% of estimated insured deposits. The new legislation requires the Federal Deposit Insurance Corporation to issue regulations implementing the law. The changes required by the law will not become effective until final regulations have been issued, which must be no later than 270 days from the date of the enactment of the legislation.
Prohibitions Against Tying Arrangements. Federal savings associations are prohibited, subject to some exceptions, from extending credit to or offering any other service, or fixing or varying the consideration for such extension of credit or service, on the condition that the customer obtain some additional service from the institution or its affiliates or not obtain services of a competitor of the institution.
Federal Home Loan Bank System. First Federal is a member of the Federal Home Loan Bank System, which consists of 12 regional Federal Home Loan Banks. The Federal Home Loan Bank System provides a central credit facility primarily for member institutions. As a member of the Federal Home Loan Bank of Chicago, First Federal is required to acquire and hold shares of capital stock in the Federal Home Loan Bank in an amount at least equal to 1% of the aggregate principal amount of its unpaid residential mortgage loans and similar obligations at the beginning of each year, or 1/20 of its borrowings from the Federal Home Loan Bank, whichever is greater. As of December 31, 2005, First Federal was in compliance with this requirement.
Federal Reserve System
Federal Reserve Board regulations require savings associations to maintain non-interest-earning reserves against their transaction accounts, such as negotiable order of withdrawal and regular checking accounts. As of December 31, 2005, First Federal was in compliance with these reserve requirements. The balances maintained to meet the reserve requirements imposed by the Federal Reserve Board may be used to satisfy liquidity requirements imposed by the Office of Thrift Supervision.
The USA PATRIOT Act
In response to the events of September 11th, the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, was enacted. The Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and broadened anti-money laundering requirements. The Act also requires the federal banking regulators to take into consideration the effectiveness of controls designed to combat money-laundering activities in determining whether to approve a merger or other acquisition application of an FDIC-insured institution. As such, if First Federal or First Federal Savings & Loan Association of Edwardsville were to engage in a merger or other acquisition, the effectiveness of its anti-money-laundering controls would be considered as part of the application process. First Federal Savings & Loan Association of Edwardsville believes it has established policies, procedures and systems that comply with the applicable requirements of the law.
Holding Company Regulation
General. First Federal Financial Services, Inc. is a unitary savings and loan holding company, subject to regulation and supervision by the Office of Thrift Supervision. The Office of Thrift Supervision has enforcement authority over First Federal Financial Services, Inc. and its non-savings institution subsidiaries. Among other things, this authority permits the Office of Thrift Supervision to restrict or prohibit activities that are determined to be a risk to First Federal.
Under prior law, a unitary savings and loan holding company generally had no regulatory restrictions on the types of business activities in which it could engage, provided that its subsidiary savings association was a
qualified thrift lender. The Gramm-Leach-Bliley Act of 1999, however, restricts unitary savings and loan holding companies not existing on, or applied for before, May 4, 1999 to those activities permissible for financial holding companies or for multiple savings and loan holding companies. First Federal Financial Services, Inc. will not be a grandfathered unitary savings and loan holding company and, therefore, will be limited to the activities permissible for financial holding companies or for multiple savings and loan holding companies. A financial holding company may engage in activities that are financial in nature, including underwriting equity securities and insurance, incidental to financial activities or complementary to a financial activity. A multiple savings and loan holding company is generally limited to activities permissible for bank holding companies under Section 4(c)(8) of the Bank Holding Company Act, subject to the prior approval of the Office of Thrift Supervision, and certain additional activities authorized by Office of Thrift Supervision regulations.
Federal law prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from acquiring control of another savings institution or holding company thereof, without prior written approval of the Office of Thrift Supervision. It also prohibits the acquisition or retention of, with specified exceptions, more than 5% of the equity securities of a company engaged in activities that are not closely related to banking or financial in nature or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the Office of Thrift Supervision must consider the financial and managerial resources and future prospects of the savings institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors.
Waivers of Dividends by First Federal Financial Services, MHC. Office of Thrift Supervision regulations require First Federal Financial Services, MHC to notify the Office of Thrift Supervision of any proposed waiver of its receipt of dividends from First Federal Financial Services, Inc. The Office of Thrift Supervision reviews dividend waiver notices on a case-by-case basis, and, in general, does not object to any such waiver if the dividend waiver is not detrimental to the safe and sound operation of First Federal and the mutual holding company's board of directors determines that such waiver is consistent with such directors' fiduciary duties to the mutual holding company's members.
Federal Securities Laws
First Federal Financial Services, Inc.'s common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. First Federal Financial Services, Inc. is subject to the information, proxy solicitation, insider trader restrictions and other requirements under the Securities Exchange of 1934.
First Federal Financial Services, Inc. common stock held by persons who are affiliates (generally officers, directors and principal stockholders) of First Federal Financial Services, Inc. may not be resold without registration or unless sold in accordance with certain resale restrictions. If First Federal Financial Services, Inc. meets specified current public information requirements, each affiliate of First Federal Financial Services, Inc. is able to sell in the public market, without registration, a limited number of shares in any three-month period.
Sarbanes-Oxley Act of 2002
On July 30, 2002, the Sarbanes-Oxley Act of 2002 was enacted, which provides for corporate governance, disclosure and accounting reforms intended to address corporate and accounting fraud. The Act establishes a new accounting oversight board that will enforce auditing, quality control and independence standards, and will be funded by fees from all publicly traded companies. The Act also places certain restrictions on the scope of services that may be provided by accounting firms to their public company audit clients. Any non-audit services being provided to a public company audit client will require preapproval by the company's audit committee. In addition, the Act makes certain changes to the requirements for audit partner rotation after a period of time. The Act also requires chief executive officers and chief financial officers, or their equivalent, to certify to the accuracy of periodic reports filed with the Securities and Exchange Commission, subject to civil and criminal penalties if they knowingly or willingly violate this certification requirement. In addition, under the Act, counsel will be required to report to
the chief executive officer or chief legal officer of the company, evidence of a material violation of the securities laws or a breach of fiduciary duty by a company and, if such officer does not appropriately respond, to report such evidence to the audit committee or other similar committee of the board of directors or the board itself.
Under the Act, longer prison terms will apply to corporate executives who violate federal securities laws; the period during which certain types of suits can be brought against a company or its officers is extended; and bonuses issued to top executives prior to restating a company's financial statements are now subject to disgorgement if such restatement was due to corporate misconduct. Executives are also prohibited from insider trading during retirement plan "blackout" periods, and loans to company executives (other than loans by financial institutions permitted by federal rules and regulations) are restricted. In addition, a provision directs that civil penalties levied by the Securities and Exchange Commission as a result of any judicial or administrative action under the Act be deposited to a fund for the benefit of harmed investors. The Federal Accounts for Investor Restitution provision also requires the Securities and Exchange Commission to develop methods of improving collection rates. The legislation accelerates the time frame for disclosures by public companies, as they must immediately disclose any material changes in their financial condition or operations. Directors and executive officers must also provide information for most changes in beneficial ownership in a company's securities within two business days of the change.
The Act also increases the oversight of, and codifies certain requirements relating to, audit committees of public companies and how they interact with the company's "registered public accounting firm." Audit Committee members must be independent and are absolutely barred from accepting consulting, advisory or other compensatory fees from the public company. In addition, companies must disclose whether at least one member of the committee is an "audit committee financial expert" (as defined by Securities and Exchange Commission regulations) and if not, why not. Under the Act, a company's registered public accounting firm will be prohibited from performing statutorily mandated audit services for a company if such company's chief executive officer, chief financial officer, comptroller, chief accounting officer or any person serving in equivalent positions had been employed by such firm and participated in the audit of such company during the one-year period preceding the audit initiation date. The Act prohibits any officer or director of a company or any other person acting under their direction from taking any action to fraudulently influence, coerce, manipulate or mislead any independent accountant engaged in the audit of the company's financial statements for the purpose of rendering the financial statements materially misleading. The Act also requires the Securities and Exchange Commission to prescribe rules requiring inclusion of any internal control report and assessment by management in the annual report to stockholders. The Act requires the company's registered public accounting firm that issues the audit report to attest to and report on management's assessment of the company's internal controls.
Although we have incurred additional expense in complying with the provisions of the Sarbanes-Oxley Act and the resulting regulations, management does not expect that such compliance will have a material impact on our results of operations or financial condition.
TAXATION
Federal Taxation
General. First Federal Financial Services, Inc. and First Federal are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below. First Federal Financial Services, Inc.'s and First Federal's tax returns have not been audited during the past five years. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to First Federal Financial Services, Inc. or First Federal.
Method of Accounting. For federal income tax purposes, First Federal Financial Services, Inc. and First Federal currently report their income and expenses on the accrual method of accounting and use a tax year ending December 31 for filing its federal income tax returns.
Bad Debt Reserves. Prior to the S Protection Act of 1996 (the "1996 Act"), First Federal was permitted to establish a reserve for bad debts and to make annual additions to the reserve. These additions could,
within specified formula limits, be deducted in arriving at our taxable income. First Federal was required to use the specific charge off method in computing its bad debt deduction beginning with its 1996 federal tax return. Savings institutions were required to recapture any excess reserves over those established as of December 31, 1987 (base year reserve). At December 31, 2005, First Federal had no reserves subject to recapture.
Taxable Distributions and Recapture. Prior to the 1996 Act, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income if First Federal failed to meet certain thrift asset and definitional tests. Federal legislation has eliminated these thrift related recapture rules. At December 31, 2005, our total federal pre-1988 base year reserve was approximately $2.0 million. However, under current law, pre-1988 base year reserves remain subject to recapture if First Federal makes certain non-dividend distributions, repurchases any of its stock, pays dividends in excess of tax earnings and profits, or ceases to maintain a bank charter.
Alternative Minimum Tax. The Internal Revenue Code of 1986, as amended (the "Code") imposes an alternative minimum tax ("AMT") at a rate of 20% on a base of regular taxable income plus certain tax preferences ("alternative minimum taxable income" or "AMTI"). The AMT is payable to the extent such AMTI is in excess of an exemption amount and the AMT exceeds the regular income tax. Net operating losses can offset no more than 90% of AMTI. Certain payments of alternative minimum tax may be used as credits against regular tax liabilities in future years. First Federal Savings & Loan Association of Edwardsville has not been subject to the alternative minimum tax and has no such amounts available as credits for carryover.
Net Operating Loss Carryovers. A financial institution may carry back net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years. At December 31, 2005, First Federal had no net operating loss carryforwards for federal income tax purposes.
Corporate Dividends-Received Deduction. First Federal Financial Services, Inc. may exclude from its income 100% of dividends received from First Federal as a member of the same affiliated group of corporations. The corporate dividends-received deduction is 80% in the case of dividends received from corporations with which a corporate recipient does not file a consolidated return, and corporations which own less than 20% of the stock of a corporation distributing a dividend may deduct only 70% of dividends received or accrued on their behalf.
State Taxation
Illinois State Taxation. First Federal Financial Services, Inc. is required to file Illinois income tax returns and pay tax at a stated tax rate of 7.30% of Illinois taxable income. For these purposes, Illinois taxable income generally means federal taxable income subject to certain modifications, primarily the exclusion of interest income on United States obligations.
Executive Officers of the Company
Listed below is information, as of December 31, 2005, concerning First Federal Financial Services, Inc.'s executive officers. There are no arrangements or understandings between First Federal Financial Services, Inc. and any of the persons named below with respect to which he was or is to be selected as an officer.
Name Age Position and Term ---- --- -----------------
Larry W. Mosby 64 President, Chief Executive Officer and Director
Donald Engelke 42 Vice President, Chief Financial Officer and Director
Linda Werner 54 Secretary
