First Fed Sav Bk Siouxland (FFSX) - Description of business

Conduct.

First Federal Bank

The Bank is a federally-chartered stock savings bank headquartered in Sioux City, Iowa. Founded in 1923, First Federal’s deposits are federally insured by the Deposit Insurance Fund (“DIF”). The Bank is also a member of the Federal Home Loan Bank System (“FHLB”).

The Bank’s primary business is community banking which is attracting retail and commercial deposits from the general public and originating mortgage, consumer, commercial, and other loans within its primary market areas. The Bank’s primary lending area includes northwest and central Iowa and contiguous portions of Nebraska and South Dakota. In addition, the Bank also purchases and/or participates in loans from third-party financial institutions and invests in mortgage-backed and related securities, securities issued by the U.S. government or government-sponsored entities, local governments, and private entities. In addition to customer deposits, the Bank obtains funding from the FHLB of Des Moines.

 

The Bank conducts operations through its 15 branches in northwest Iowa, central Iowa, and northeast Nebraska. Of the branches located in northwest Iowa, six are located in Sioux City, one in Le Mars, and one in Onawa. In central Iowa, the Company has locations in Grinnell, Johnston, Monroe, West Des Moines, and two locations in Newton. The company also operates one branch in South Sioux City, Nebraska. The Company’s business and operating results are significantly affected by the general economic conditions prevalent in its primary market area. The Company’s primary market area is projected to experience low to moderate population growth in northwest Iowa, central Iowa, and northeast Nebraska, but strong growth in the Des Moines market area.

The Bank’s principal executive office is located at 329 Pierce Street, Sioux City, Iowa 51101, and its telephone number at that address is (712) 277-0200. The Bank’s internet site is www.firstfederalbank.com

Lending Activities

General The principal lending activities of the Company are the origination or purchase of mortgage loans secured by one-to-four family residential properties, loans secured by multifamily and non-residential real estate, loans to consumers, and loans and lines of credit to business entities. As of June 30, 2006, loans held for investment purposes were $462.5 million or 76 % of the Company’s total assets.

The Company has sought to make its interest earning assets more interest rate sensitive by actively originating variable-rate loans, such as adjustable-rate mortgage (“ARM”) loans, adjustable-rate second mortgage loans, shorter-term commercial real estate and commercial business loans, and medium-term consumer loans.

The Company actively originates fixed-rate mortgage loans, generally with 10 to 30 year terms to maturity secured by one-to-four family residential properties. One-to-four family fixed-rate loans generally are originated and underwritten for resale in the secondary mortgage market on a servicing-released basis. The Company also actively originates loans insured or guaranteed by the U.S. Government or agencies thereof, such as Veterans Administration, Iowa Rural Development, and Federal Housing Authority loans. The Company also originates interim construction loans on one-to-four family residential properties, multi-family units, and non-residential properties.

 

Residential Real Estate Loans   The Company originates one-to-four family, owner-occupied, residential mortgage loans secured by property located in its primary market area. However, the Company, from time-to-time has also purchased one-to-four family loans originated by others with an emphasis on single-family ARM loans at terms similar to loans originated by the Company. As of June 30, 2006, the Company had $133.6 million, or 29% of its total loan portfolio invested in first mortgage loans secured by one-to-four family residences.

 

The Company currently offers residential mortgage loans for terms ranging from 10 to 30 years, and with adjustable or fixed interest rates. Origination of fixed-rate mortgage loans versus ARM loans is significantly affected by the level of market interest rates, customer preference, the Company’s interest rate risk position, and loan products offered by the Company’s competitors.

The Company’s long-term fixed-rate loans generally are originated and underwritten for resale in the secondary mortgage market on a servicing-released basis. Servicing-release premium is determined at loan closing, thus assuring the fee at current market rates.

The Company’s ARM loans are typically retained and serviced by the Company. These loans generally adjust annually with interest rate adjustment limitations ranging from one to two percentage points per year and with a cap on total rate increases over the life of the loan. A portion of these loans may guarantee borrowers a fixed rate of interest for the first one to five years of the loan’s term. While the company has used different interest indexes over the years, the primary index for ARM loans is the one-year Treasury Constant Maturity. The Company also has purchased ARM loans with various interest rate indexes, but with terms that are otherwise similar to the loans originated by the Company.

Regulations limit the amount that a savings bank may lend relative to the appraised value of the real estate securing the loan, as determined by an appraisal at the time of loan origination. Such regulations permit a maximum loan-to-value ratio of 100% for residential property and 90% for all other real estate loans. If the loan-to-value ratio is in excess of 80%, private mortgage insurance is generally required to limit the Company’s exposure to loss. The Company also requires fire and casualty insurance, as well as, title insurance or an opinion of counsel regarding good title, on all properties securing real estate loans made by the Company. The Company also purchases blanket insurance coverage to protect its interests in one-to-four family residential properties collateral to the extent that the borrower lets such insurance lapse.

The Company also originates loans to finance the construction of one-to-four family residential property. However, construction lending is not a significant part of the Company’s overall lending activities because of the low level of new home construction in the Company’s primary market areas. Loans for construction of single family residential property are made with either adjustable- or fixed-rate terms. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. Construction loans are structured to be converted to permanent loans originated by the Company at the end of the construction period, which is generally six months, but not to exceed 12 months.

 

Multi-Family Residential Real Estate Loans The Company’s multi-family real estate loans are secured by structures such as apartment buildings and condominiums. At June 30, 2006, the Company had $52.0 million or 11% of its total loan portfolio in multi-family residential real estate loans. The terms of each multi-family residential real estate loan are negotiated on a case by case basis, although such loans typically have adjustable interest rates tied to a market index or fixed rates to amortize over 10 to 20 years with a three to ten year balloon or call option.

Loans secured by multi-family residential real estate generally involve a greater degree of credit risk than one-to-four family residential mortgage 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 is typically dependent upon the successful operation of the related real estate property. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired.

When making multi-family residential real estate loans, the Company considers the financial statements of the borrower, the Company’s lending history with the borrower, the debt service capabilities of the borrower, the projected cash flows of the business and the value of the collateral, These types of loans are generally supported by personal guarantees. The borrower must provide proof of the necessary insurance on the property serving as collateral. Title insurance or an attorney’s opinion based on a title search of the property is required on all first lien loans secured by real property.

The Company’s commercial loan department also originates loans for construction of multi-family properties. Construction loans generally have adjustable rates and proceeds are disbursed in increments as construction progresses subject to inspections. Construction loans on multi-family real estate are often structured to convert to permanent loans originated by the Company at the end of the construction period, which is generally 12 to 24 months.

Non-Residential Real Estate Loans   The Company’s non-residential real estate loans are secured by improved property such as office buildings, industrial facilities, warehouses, retail/shopping structures, and other non-residential buildings. Loans secured by non-residential real estate constituted $157.1 million or 34%, of the Company’s total loan portfolio at June 30, 2006. Fixed-rate non-residential real estate loans are offered with amortizations up to 20 years with balloon terms up to five years. Adjustable-rate non-residential real estate loans also have amortizations up to 20 years and the rate typically adjusts with changes in the Prime Rate as published daily in the Wall Street Journal .

When making non-residential real estate loans, the Company considers the financial statements of the borrower, the Company’s lending history with the borrower, the debt service capabilities of the borrower, the projected cash flows of the business, and the value of the collateral. These types of loans are generally supported by personal guarantees. The borrower must provide proof of the necessary insurance on the property serving as collateral. Title insurance or an attorney’s opinion based on a title search of the property is required on all first lien loans secured by real property. Insurance coverage for non-residential properties is required and monitored throughout the term of the loan.

 

Loans secured by non-residential real estate generally involve a greater degree of credit risk than residential mortgage 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 non-residential real estate is typically dependent upon the successful operation of the related real estate project and/or the underlying business in the case of owner-occupied structures. If the cash flow from the project or underlying business is reduced, the borrower’s ability to repay the loan may be impaired.

The Company’s also originates loans for construction of non-residential properties. Construction loans generally have adjustable rates and proceeds are disbursed in increments as construction progresses subject to inspections. Construction loans on non-residential real estate are often structured to convert to permanent loans originated by the Company at the end of the construction period, which is generally 12 to 24 months.

Commercial Business Loans The Company makes commercial business loans primarily in its market area to a variety of professionals, sole proprietorships, and small- to medium-sized businesses. The Company offers term loans for fixed assets and working capital, revolving lines of credit, letters of credit, and S Administration (“SBA”) guaranteed loans. At June 30, 2006, commercial business loans constituted $54.6 million, or 12%, of the Company’s total loan portfolio. Commercial business term loans are generally offered with initial fixed rates of interest for the first one to three years and with terms of up to ten years. Business lines of credit have floating rates of interest and are payable on demand, subject to annual review and renewal. Commercial business loans with variable rates of interest are generally indexed to the highest Prime Rate as published daily in the Wall Street Journal .

When making commercial business loans, the Company considers the financial statements of the borrower, the Company’s lending history with the borrower, the debt service capabilities of the borrower, the projected cash flows of the business, and the value of the collateral, if any. Commercial business loans are generally secured by a variety of collateral including accounts receivable, inventory, and equipment, and are generally supported by personal guarantees.

Commercial business loans are considered to involve more risk than loans secured by real estate. Because commercial business loans often depend on the successful operation or management of the business, repayment of such loans may be affected by adverse conditions in the economy. Moreover, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business, and, therefore, depend substantially on the success of the business itself. Any collateral securing commercial business loans may depreciate over time, may be difficult to appraise and to liquidate, and may fluctuate in value.

Consumer Loans The Company offers consumer loans in order to provide a full range of financial services to its customers. Consumer loans totaled $65.6 million and accounted for approximately 14% of total loans as of June 30, 2006. Most of the consumer loans that the Company originates include second mortgage loans, home equity lines of credit, automobile loans, recreational vehicle loans, loans secured by deposit accounts and unsecured loans. Consumer loans are offered primarily on a fixed rate basis and at for terms of 6 to 120 months. The Company’s home equity loans, second mortgage loans, and home improvement loans, are generally secured by the borrower’s principal residence.

 

The underwriting standards employed by the Company for consumer loans include a determination of the applicant’s credit history and an assessment of ability to meet existing obligations and payments on the proposed loan. The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment and additionally from any verifiable secondary income. Creditworthiness of the applicant is of primary consideration; however, the underwriting process also includes a comparison of the value of the collateral in relation to the proposed loan amount. The Company also requires fire and casualty insurance, as well as, title insurance or an opinion of counsel regarding good title, on all properties securing real estate loans made by the Company. The Company also purchases blanket insurance coverage to protect its interests in consumer real estate collateral to the extent that the borrower lets such insurance lapse.

Consumer loans generally have shorter terms and higher rates of interest than real estate loans, but typically involve more credit risk than such loans because of the nature of the collateral and, in some instances, the absence of collateral. In general, consumer loans are more dependent upon the borrower's continuing financial stability, are more likely to be affected by adverse personal circumstances, and are often secured by rapidly depreciating personal property such as automobiles. In addition, various laws, including bankruptcy and insolvency laws, may limit the amount that may be recovered from a borrower. However, such risks are mitigated to some extent in the case of second mortgage loans and home-equity lines of credit. These types of loans are secured by a second mortgage on the borrower's residence for which the total principal balance outstanding (including the first mortgage) does not generally exceed 100% of the property's value, although exceptions are sometimes made for high net worth or other qualifying borrowers. Second mortgage loans are generally fixed-rate and may have terms of up to fifteen years.

The Company believes that the higher yields earned on consumer loans compensate for the increased risk associated with such loans and that consumer loans are important to the Company's efforts to increase the interest rate sensitivity and shorten the average maturity of its loan portfolio. In conjunction with its consumer lending activities, the Company offers customers credit life and disability insurance products underwritten and administered by an independent insurance provider. The Company receives commission revenue related to the sales of these products.

Loan Solicitation and Processing   Loan originations are derived from a number of sources such as third party referrals, existing customers, and calling programs. Upon receipt of a loan application, a credit report is obtained to verify specific information relating to the applicant’s credit standing. In the case of a real estate loan, an appraisal of the real estate intended to secure the proposed loan is made by an independent appraiser approved by the Company. For those loans that are sold to investors, an automated underwriting system provided by either Federal National Mortgage Association (“FNMA”) or the Federal Home Loan Mortgage Corporation (“FHLMC”) is used in many cases. On occasion, a private mortgage insurance contract underwriter approved by the investor may be used. Loans that are not sold or loans that are not underwritten by a contract underwriter are reviewed by an underwriter in the Company’s loan department and/or at least one member of the Company’s internal loan committee. One-to-four family residential mortgage loans with principal balances in excess of $1.0 million and multi-family, non-residential real estate, and commercial business loans with principal balances in excess of $2.0 million must be submitted by the loan department directly to a committee of the Board of Directors for approval. Approvals subsequently are ratified by the full Board of Directors. Once the loan is approved, a loan commitment is promptly issued to the borrower. If the loan is approved, the commitment letter specifies the terms and conditions of the proposed loan including the amount of the loan, interest rate, amortization term, a brief description of the required collateral, and required insurance coverage.

 

Loan Commitments The Company issues standby loan origination commitments to qualified borrowers primarily for the construction and purchase of residential and non-residential real estate. Such commitments are made on specified terms and conditions and are made for periods of up to 60 days, during which time the interest rate is locked-in. The Company generally charges a loan fee based on a percentage of the loan amount. The Company also charges a commitment fee for single-family residential properties if the borrower receives the loan from the Company. Commitment fees are generally not charged for multi-family, non-residential real estate, and commercial business loans. The Company’s experience has been that few commitments for loans on one-to-four family residential properties expire without being funded by the Company. However, commitments to originate multi-family, non-residential real estate, and commercial business loans may not be funded.

Loan Origination and Other Fees In addition to interest earned on loans, the Company generally receives loan origination fees. To the extent that loans are originated or acquired for the Company’s portfolio, the Company defers loan origination fees and costs and amortizes such amounts as yield adjustments over the life of the loans using the interest method of amortization. Fees and costs deferred are recognized into income immediately upon the sale of the related loan. In addition to loan origination fees, the Company also receives other fees and service charges that consist primarily of late charges and loan servicing fees on loans sold. Loan origination and commitment fees are volatile sources of income. Such fees vary with the volume and type of loans and commitments made and purchased and with competitive conditions in the Company’s mortgage markets, which in turn respond to the demand for and availability of money.

 

Non-Performing Loans Loans are generally placed on non-accrual status and considered "non-performing" when, in the judgment of management, the probability of collection of principal or interest is deemed to be insufficient to warrant further accrual of interest. As of June 30, 2006 $6.5 million or 1.41% of gross loans were considered non-performing. When a loan is placed on non-accrual and/or non-performing status, previously accrued but unpaid interest is deducted from interest income. In general, the Company does not record accrued interest on loans 90 or more days past due. Refer to Notes 1, 3, and 4 of the Company's Audited Consolidated Financial Statements, included herein under Part II, Item 8, "Financial Statements and Supplementary Data".

When a loan is placed on non-accrual and/or non-performing status, the Company generally institutes restructuring, foreclosure, or other collection proceedings. Real estate property acquired by the Company as a result of foreclosure or deed-in-lieu of foreclosure is classified as "real estate" and is considered "non-performing" until it is sold. Other property acquired through adverse judgment, such as automobiles, equipment, and other depreciable assets, are generally classified as an "other asset." The amount of foreclosed real estate and other repossessed property has not been material to the Company in recent years. Restructured loans are included in loans receivable and may or may not be included in non-performing assets depending on if the borrower can adhere to the terms of the restructure for a period of time. Restructured loans are accounted for in accordance with Generally Accepted Accounting Principles (“GAAP”)

Classified Loans Federal regulations require thrift institutions to classify their loans on a regular basis. Accordingly, the Company has internal policies and procedures in place to evaluate risk ratings on all loans. In addition, in connection with examinations of thrift institutions, federal examiners have authority to classify problem assets as "Substandard", "Doubtful", or "Loss". As of June 30, 2006, $7.6 million or 1.64% of gross loans were adversely classified, which includes non-performing loans. A loan is classified as "Substandard" if it is determined to involve a distinct possibility that the Company could sustain some loss if deficiencies associated with the loan are not corrected. A loan is classified as "Doubtful" if full collection is highly questionable or improbable. A loan is classified as "Loss" if it is considered uncollectible, even if a partial recovery could be expected in the future. If a loan or portion thereof is classified as "Loss", the Company must either establish a specific allowance for the portion of the asset classified as "Loss" or charge off such amount. Refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations", for additional discussion.

Allowances for Losses on Loans and Real Estate   The Company's policy is to establish allowances for estimated losses on specific loans and real estate when it determines that losses are probable and estimable. In addition, the Company maintains a general loss allowance against its loan and real estate portfolios that is based on its own loss experience, management's ongoing assessment of current economic conditions, the credit risk inherent in the portfolios, and the experience of the financial services industry. For additional information, refer to Part II, Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations" and Notes 1, 3 and 4 of the Company's Audited Consolidated Financial Statements, included herein under Part II, Item 8, "Financial Statements and Supplementary Data."

Management of the Company believes that the current allowances established by the Company are adequate to cover probable and estimable losses in the Company's loan and real estate portfolios. However, future adjustments to these allowances may be necessary and the Company's results of operations could be adversely affected if circumstances differ substantially from the assumptions used by management in making its determinations in this regard.

Investment and Mortgage-Related Securities

The Company periodically invests in collateralized mortgage obligations (“CMOs”) and mortgage backed securities (“MBSs”) (collectively “mortgage-backed and related securities”) and other types of investment securities, including U.S. and state government obligations, securities of various federal agencies, and debt issues by various corporations. As of June 30, 2006, total investment securities represented $60.4 million or 10% of total assets.  

The Company’s MBS portfolio is primarily issued or guaranteed by FNMA, FHLMC, and the Government National Mortgage Association (“GNMA”). The Company’s objective in investing in mortgage-backed and related securities varies from time to time depending upon market interest rates, local mortgage loan demand, and the Company’s level of liquidity. The Company’s fixed-rate MBSs are primarily held for investment and management has the intent and ability to hold such securities on a long-term basis or to maturity. Adjustable-rate MBSs are available for sale and are carried at estimated fair value. MBSs have lower credit risk than direct loans because principal and interest on the securities are either insured or guaranteed by the U.S. Government or agencies thereof.

Management believes CMOs represent attractive investment alternatives relative to other investment vehicles, due to the variety of maturity and repayment options available through such investments and due to the limited credit risk associated with such securities. CMOs purchased by the Company represent a participation interest in a pool of single-family residential mortgage loans and are generally rated triple-A by independent credit-rating agencies. In addition, such investments are secured by credit enhancements and/or subordinated tranches or are collateralized by U.S. government agency MBSs. The Company generally invests only in sequential-pay, planned amortization class ("PAC"), and targeted amortization class ("TAC") tranches that, at the time of their purchase, are not considered to be high-risk derivative securities, as defined in applicable regulations. The Company does not invest in support-, companion-, or residual-type tranches. Furthermore, the Company does not invest in interest-only, principal-only, inverse-floating-rate CMO tranches, or similar complex securities.

Other securities held by the company that are not guaranteed by the federal government or a government sponsored agency are limited to the four highest credit categories as established by the major independent credit rating agencies. From time to time the Company will also purchase securities issued by local governments in order to support the primary market area of the Company.

Sources of Funds

General   Customer deposits are the major source of the Company’s funds for lending and other investment purposes. In addition to deposits, the Company derives funds from the amortization and prepayment of loans and mortgage-related securities, the sale or maturity of investment securities, operations and, if needed, borrowings from the FHLB and other sources. Scheduled loan principal repayments are a relatively stable source of funds, while deposit inflows and outflows and loan and security prepayments are influenced significantly by general interest rates and market conditions. FHLB and other borrowings may be used on a short-term basis to compensate for reductions in the availability of funds from other sources or on a longer term basis for general business purposes.

Deposits Consumer and commercial deposits are attracted principally from within the Company’s primary market area through the offering of a broad selection of deposit instruments including checking, regular savings, money market deposits, term certificate accounts, and individual retirement accounts. On a limited basis, the Company will negotiate interest rates to attract jumbo certificates and institutional deposits. 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. The Company regularly evaluates the internal cost of funds, surveys rates offered by its competitors, and its internal requirements for lending and liquidity, and executes rate changes as deemed appropriate. As of June 30 2006, deposits accounted for $446.1 million or 73% of total liabilities and equity.

From time to time, the Company has also used certificates of deposits sold through third-party brokers (broker deposits) as an alternative to borrowings from the FHLB. FDIC regulations govern the acceptance of brokered deposits by insured depository institutions. As of June 30, 2006, the Company had $3.5 million in brokered deposits outstanding.

FHLB Advances and Other Borrowings The Company may rely upon borrowings from the FHLB to supplement its supply of lendable funds and to meet deposit withdrawal requirements. Borrowings from the FHLB are secured by certain portion of the Company’s home mortgage loans and its mortgage-related securities, as well as stock in the FHLB, a minimum amount of which the Company is required to own. The Company’s other borrowings consist of repurchase agreements made with its commercial business customers. As of June 30, 2006, FHLB advances and other borrowings were $92.8 million and accounted for approximately 15% of the Company’s total liabilities and equity. Borrowings from the FHLB are made pursuant to several different programs. Each credit program has its own interest rate and range of maturities.

Subsidiary Activities

The Company has two wholly-owned subsidiaries: First Federal Bank and Equity Services, Inc (“ESI”). Since the Company engages in no other significant activities beyond its ownership of the Bank, the description of the Company’s activities in this Form 10-K effectively represents a description of the activities of the Bank. ESI is in the business of developing residential lots and dwellings in the Company’s primary market area. In its current project, ESI is building a 20-unit condominium in Dakota Dunes, South Dakota. It is anticipated that this is the last project for ESI and once the project is completed, ESI will become inactive. Net income (loss) from ESI was ($185,000) in fiscal 2006, $9,000 in fiscal 2005, and $54,000 in fiscal 2004. Net income (loss) includes management fees paid to the parent of $24,000 in fiscal years 2006, 2005, and 2004.

The Bank has one active wholly-owned subsidiary. First Financial Corporation (“FFC”), an Iowa corporation, operates a title search and abstract continuation business through its wholly-owned Iowa subsidiary, Sioux Financial Company (“SFC”). FFC is also a majority owner of United Escrow, Inc. (“UEI”), which serves as an escrow agent in Woodbury County, Iowa. FFC’s net income for fiscal years 2006, 2005 and 2004 was $124,000, $77,000, and $135,000, respectively. Net income includes management fees of $133,000 in fiscal 2006, $158,000 in fiscal 2005 and $194,000 in fiscal 2004.

 

Personnel

As of June 30, 2006, the Company and its wholly-owned subsidiaries had 198 full-time equivalent employees. None of the Company’s employees is represented by a collective bargaining group. The Company believes its relationship with its employees to be good.

Competition

The Company faces significant competition both in attracting deposits and in originating loans. Its most direct competition for deposits has come historically from commercial banks, other savings associations, credit unions, brokerage houses, and insurance companies in its market area. The Company’s market area includes branches of several financial institutions that are substantially larger than the Company in terms of deposits. In addition, a growing number of the Company’s competitors are utilizing the internet to attract deposits both locally and nationwide. The Company competes for savings by offering depositors a high level of personal service and expertise together with a wide range of financial services. This competition for loans has increased substantially in recent years as a result of the large number of institutions choosing to compete in the Company’s market area. An increasing number of these institutions are using the internet to originate and underwrite loans. The Company offers a competitive internet banking product to its retail and business customers. The Company competes for loans primarily through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers, real estate brokers, and builders.

Competition in recent years has increased as a result of the Gramm-Leach-Bliley Act of 1999, which eased restrictions on entry into the financial services market by insurance companies and securities firms. Moreover, to the extent that these changes permit banks, securities firms, and insurance companies to affiliate, the financial services industry could experience further consolidation. This could result in a growing number of larger financial institutions competing in the Company’s primary market area that offer a wider variety of financial services than the Company currently offers. Competition for deposits, for the origination of loans and the provision of other financial services may limit the Company’s growth and adversely impact its profitability in the future.

 

Regulation

As a federally-chartered, FDIC-insured, savings association, the Bank is subject to examination, supervision, and extensive regulation by the Office of Thrift Supervision (“OTS”) and the Federal Deposit Insurance Corporation (“FDIC”). This regulation and supervision establishes a comprehensive framework of activities in which an institution can engage and is intended primarily for the protection of the insurance fund and depositors. The Bank also is subject to regulation issued by the Board of Governors of the Federal Reserve System (the “Federal Reserve Board”) governing reserves to be maintained against deposits and certain other matters. The OTS examines the Bank and prepares reports for the consideration of the Bank’s Board of Directors on any deficiencies that they may find in the Bank’s operations. The FDIC also regulates the Bank in its role as the administrator of the DIF. The Bank’s relationship with its depositors and borrowers also is affected by other federal and state laws especially in such matters as the ownership of savings accounts and the form and content of the Bank’s mortgage documents. Any change in such regulation, whether by the FDIC, OTS, or the U.S. Congress, could have a material adverse impact on the Company and the Bank and their operations.

The description of certain statutory provisions and regulations applicable to savings associations set forth in the following paragraphs does not purport to be a complete description of such statutes and regulations and their effect on the Bank.

 

Qualified Thrift Lender Test The HOLA requires savings institutions to meet a qualified thrift lender (“QTL”) test. Under the QTL test, a savings association is required to maintain at least 65% of its “portfolio assets” (total assets less (i) specified liquid assets up to 20% of total assets, (ii) intangibles, including goodwill, and (iii) the value of property used to conduct business) in certain “qualified thrift investments,” primarily residential mortgages and related investments, including certain mortgage-backed and related securities on a monthly average basis in 9 out of every 12 months. A savings association that fails the QTL test must either convert to a bank charter or operate under certain restrictions. As of June 30, 2006, the Bank’s assets invested in qualifying investments exceeded the percentage required to qualify the Bank under the QTL Test.

Limitation on Capital Distributions   OTS regulations impose limitations upon all capital distributions by savings institutions, such as cash dividends, payments to repurchase or otherwise acquire its shares, payments to stockholders of another institution in a cash-out merger and other distributions charged against capital. An institution, such as the Bank, that exceeds all capital requirements before and after a proposed capital distribution (“Tier 1 Association”) and has not been advised by the OTS that it is in need of more than normal supervision, could, after prior notice but without the approval of the OTS, make capital distributions during a calendar year equal to its net income year-to-date plus its net income for the prior two years that is still available for dividend

Loans to One Borrower Under federal law, savings associations are subject to the same limits as those applicable to national banks, which limit loans to one borrower to the greater of $500,000 or 15% of unimpaired capital and unimpaired surplus and an additional amount equal to 10% of unimpaired capital and unimpaired surplus if the loan is secured by readily marketable collateral (generally, financial instruments and bullion, but not real estate). As of June 30, 2006, the Bank’s loan to one borrower limit was $7.4 million.

Community Reinvestment Act and Fair Lending Laws   Savings associations share a responsibility under the Community Reinvestment Act (“CRA”) and related regulations of the OTS to help meet the credit needs of their communities, including low- and moderate-income neighborhoods. In addition, the Equal Credit Opportunity Act and the Fair Housing Act (together, the “Fair Lending Laws”) prohibit lenders from discriminating in their lending practices on the basis of characteristics specified in those statutes. An institution’s failure to comply with the provisions of CRA could, at a minimum, result in regulatory restrictions on its activities, and failure to comply with the Fair Lending Laws could result in enforcement actions by the OTS, as well as other federal regulatory agencies and the Department of Justice. The Bank received a satisfactory CRA rating under the current CRA regulations in its most recent federal examination by the OTS.

 

 

Transactions with Related Parties The Bank’s authority to engage in transactions with related parties or “affiliates” ( i.e. , any company that controls or is under common control with an institution, including the Company and its non-savings institution subsidiaries) or to make loans to certain insiders, is limited by Sections 23A and 23B of the Federal Reserve Act (“FRA”). Section 23A limits the aggregate amount of transactions with any individual affiliate to 10% of the capital and surplus of the savings institution and also limits the aggregate amount of transactions with all affiliates to 20% of the savings institution’s capital and surplus. Certain transactions with affiliates are required to be secured by collateral in an amount and of a type described in Section 23A and the purchase of low-quality assets from affiliates is prohibited. Section 23B provides that certain transactions with affiliates, including loans and asset purchases, must be on terms and under circumstances, including credit standards, that are substantially the same or at least as favorable to the institution as those prevailing at the time for comparable transactions with non-affiliated companies. In addition, savings institutions are prohibited from lending to any affiliate that is engaged in activities that are not permissible for bank holding companies and no savings institution may purchase the securities of any affiliate other than a subsidiary.

The Bank’s authority to extend credit to executive officers, directors and 10% stockholders, as well as entities controlled by such persons, is currently governed by Sections 22(g) and 22(h) of the FRA, and Regulation O thereunder. Among other things, these regulations generally requires such loans to be made on terms substantially the same as those offered to unaffiliated individuals and do not involve more than the normal risk of repayment. However, the regulation permits executive officers and directors to receive the same terms through benefit or compensation plans that are widely available to other employees, as long as the director or executive officer is not given preferential treatment compared to other participating employees. Regulation O also places individual and aggregate limits on the amount of loans the Bank may make to such persons based, in part, on the Bank’s capital position, and requires certain approval procedures to be followed. At June 30, 2006, the Bank was in compliance with the regulations.

Standards for Safety and Soundnes s The FDI Act requires each federal banking agency to prescribe for all insured depository institutions standards relating to, among other things, internal controls, information systems and audit systems, loan documentation, credit underwriting, interest rate risk exposure, asset growth, compensation, and such other operational and managerial standards as the agency deems appropriate. The federal banking agencies adopted Interagency Guidelines Prescribing Standards for Safety and Soundness (“Guidelines”) to implement the safety and soundness standards required under the FDI Act. 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; and 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, as required by the FDI Act. If an institution fails to meet these standards, the appropriate federal banking agency may require the institution to submit a compliance plan.

Capital Requirements The OTS capital regulations require savings institutions to meet three capital standards: a 1.5% tangible capital standard, a 4.0% leverage ratio if not assigned a composite CAMELS rating of “1” by the OTS (or core capital ratio) and an 8.0% risk-based capital standard. Core capital is defined as common stockholders’ equity (including retained earnings), certain non-cumulative perpetual preferred stock and related surplus, minority interests in equity accounts of consolidated subsidiaries less intangibles other than certain qualifying supervisory goodwill and certain mortgage servicing rights (“MSRs”). Tangible capital is defined as core capital less all intangible assets (including supervisory goodwill) plus a specified amount of MSRs. The OTS regulations also require that, in meeting the tangible, leverage and risk-based capital standards, institutions must deduct investments in and loans to subsidiaries engaged in activities not permissible for a national bank, and unrealized gains (losses) on certain available for sale securities.

The risk-based capital standard for savings institutions requires the maintenance of Tier 2 (core) and total capital (which is defined as core capital and supplementary capital) to risk-weighted assets of 4.0% and 8.0%, respectively. In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet assets, are multiplied by a risk-weight of 0% to 100%, as assigned by the OTS capital regulation based on the risks the OTS believes are inherent in the type of asset. The components of Tier 1 (core) capital are equivalent to those discussed earlier under the 3.0% leverage ratio standard. The components of supplementary capital currently include cumulative preferred stock, long-term perpetual preferred stock, mandatory convertible securities, subordinated debt and intermediate preferred stock and allowance for loan and lease losses. Allowance for loan and lease losses includable in supplementary capital is limited to a maximum of 1.25% of risk-weighted assets. Overall, the amount of supplementary capital included as part of total capital cannot exceed 100% of core capital. As of June 30, 2006, the Bank exceeded all minimum regulatory capital requirements as specified by the FDIC. For additional discussion, refer to Note 13 of the Company’s Audited Consolidated Financial Statements, included herein under Part II, Item 8, "Financial Statements and Supplementary Data."

Insurance of Deposit Accounts The FDIC has adopted a risk-based deposit insurance assessment system. The FDIC assigns an institution to one of three capital categories based on the institution’s financial information, as of the reporting period ending seven months before the assessment period, consisting of (1) well capitalized, (2) adequately capitalized or (3) undercapitalized, and one of three supervisory subcategories within each capital group. The supervisory subgroup to which an institution is assigned is based on a supervisory evaluation provided to the FDIC by the institution’s primary federal regulator and information which the FDIC determines to be relevant to the institution’s financial condition and the risk posed to the deposit insurance funds. An institution’s assessment rate depends on the capital category and supervisory category to which it is assigned. Under current rules the FDIC does not impose a deposit insurance assessment on institutions, such as the Bank, that are well-capitalized and in a supervisory subgroup A. On July, 11, 2006, the FDIC proposed rules that would change how it imposes deposit insurance assessments. Under the proposed rule, a depository institution would be subject to a minimum annual assessment rate of between 2 and 4 basis points based on the total deposits held by the institution. Accordingly, if the FDIC rule were in effect as proposed, at June 30, 2006, the Bank would pay an annual deposit insurance assessment to the FDIC of approximately $89,000 to $178,000.

Federal Reserve System   The Federal Reserve Board regulations require savings institutions to maintain non-interest-earning reserves against their transaction accounts, such as negotiable order of withdrawal and regular checking accounts. At June 30, 2006, the Bank 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.

Miscellaneous Business Activities The activities of savings institutions are governed by the Home Owners’ Loan Act, as amended (the “HOLA”) and, in certain respects, the Federal Deposit Insurance Act (the “FDI Act”). The federal banking statutes, as amended, (1) restrict the solicitation of brokered deposits by savings institutions that are troubled or not well-capitalized, (2) prohibit the acquisition of any corporate debt security that is not rated in one of the four highest rating categories, (3) restrict the aggregate amount of loans secured by non-residential real estate property to 400% of capital, (4) permit savings and loan holding companies to acquire up to 5% of the voting shares of non-subsidiary savings institutions or savings and loan holding companies without prior approval, and (5) permit bank holding companies to acquire healthy savings institutions.

Holding Company Regulation The Company is a non-diversified savings and loan holding company within the meaning of the HOLA. As such, the Company is registered with the OTS and is subject to OTS regulations, examinations, supervision and reporting requirements. In addition, the OTS has enforcement authority over the Company and its non-savings institution subsidiaries. Among other things, this authority permits the OTS to restrict or prohibit activities that are determined to be a serious risk to the subsidiary savings institution. The Bank must notify the OTS 30 days before declaring any dividend to the Company.

 

As a unitary savings and loan holding company, the Company generally will not be restricted under existing laws as to the types of business activities in which it may engage, provided that the Bank continues to be a QTL. Upon any non-supervisory acquisition by the Company of another savings association or savings bank that meets the QTL test and is deemed to be a savings institution by the OTS, the Company would become a multiple savings and loan holding company (if the acquired institution is held as a separate subsidiary) and would be subject to extensive limitations on the types of business activities in which it could engage. The HOLA limits the activities of a multiple savings and loan holding company and its non-insured institution subsidiaries primarily 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 OTS, and activities authorized by OTS regulation. The OTS is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (i) the approval of interstate supervisory acquisitions by savings and loan holding companies, and (ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions.

The HOLA prohibits a savings and loan holding company, directly or indirectly, or through one or more subsidiaries, from acquiring another savings institution or holding company thereof, without prior written approval of the OTS. It also prohibits the acquisition or retention of, with certain exceptions, more than 5% of a non-subsidiary savings institution, a non-subsidiary holding company, or a non-subsidiary company engaged in activities other than those permitted by the HOLA; or acquiring or retaining control of an institution that is not federally insured. In evaluating applications by holding companies to acquire savings institutions, the OTS must consider the financial and managerial resources, future prospects of the company and institution involved, the effect of the acquisition on the risk to the insurance fund, the convenience and needs of the community and competitive factors.

Federal law generally provides that no “person,” acting directly or indirectly or through or in concert with one or more other persons, may acquire “control,” as that term is defined in OTS regulations, of a federally-insured savings institution without giving at least 60 days written notice to the OTS and providing the OTS an opportunity to disapprove of the proposed acquisition. Such acquisitions of control may be disapproved if it is determined, among other things, that (i) the acquisition would substantially lessen competition; (ii) the financial condition of the acquiring person might jeopardize the financial stability of the savings institution or prejudice the interests of its depositors; or (iii) the competency, experience or integrity of the acquiring person or the proposed management personnel indicates that it would not be in the interest of the depositors or the public to permit the acquisition of control by such person.

Sarbanes-Oxley Act of 2002   The Sarbanes-Oxley Act of 2002 was enacted in response to public concerns regarding corporate accountability in connection with recent accounting scandals. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies, and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws. The Sarbanes-Oxley Act generally applies to all companies that file or are required to file periodic reports with the SEC, under the Securities Exchange Act of 1934.

The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules requiring the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules, and mandates further studies of certain issues by the SEC. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.

The USA Patriot Act The USA Patriot Act gave 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. Certain provisions of the Act impose affirmative obligations on a broad range of financial institutions, including thrifts, like First Federal. These obligations include enhanced anti-money laundering programs, customer identification programs and regulations relating to private banking accounts or correspondence accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States).

The federal banking agencies have implemented regulations pursuant to the USA Patriot Act. These regulations require financial institutions to adopt the policies and procedures contemplated by the USA Patriot Act. The Bank believes it is in compliance with the requests of the law.

Federal Securities Law   Shares of the Company’s common stock are registered with the SEC under Section 12(b) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”). The Company is also subject to the proxy rules, tender offer rules, insider trading restrictions, annual and periodic reporting, and other requirements of the Exchange Act.

Federal and State Taxation

Federal Taxation The Company is subject to those rules of federal income taxation generally applicable to Companies under the Internal Revenue Code of 1986, as amended (the "IRC"). The Company, the Bank, and the Bank’s wholly owned subsidiaries file a consolidated federal income tax return The consolidated entity pays taxes at the federal statutory rate of 35% of its taxable income, as defined in the IRC. Refer to Notes 1 and 10 of the Company’s Audited Consolidated Financial Statements, included herein under Part II, Item, 8, "Financial Statements and Supplemental Data," for additional discussion. As of June 30, 2006, the Company had no material disputes outstanding with the Internal Revenue Service.

Iowa Taxation   The Bank currently files an Iowa franchise tax return. The state of Iowa imposes a tax on the Iowa franchise taxable income of savings institutions at the rate of 5%. Iowa franchise taxable income is generally similar to federal taxable income except that interest from state and municipal obligations is taxable, and no deduction is allowed for state franchise taxes. The Company and the Bank’s wholly-owned subsidiaries currently file a combined Iowa Corporation income tax return on a fiscal year basis. The state corporation income tax ranges from 6% to 12% depending upon Iowa corporation taxable income. Interest from federal securities is not taxable for purposes of the Iowa corporation income tax.

Delaware Taxation   Delaware franchise taxes are imposed on the Company. This tax is based on computations involving the Company’s number of authorized shares outstanding or assumed par value of its capital. The tax is not based on the company’s earnings.

Nebraska Taxation   Nebraska franchise taxes are imposed on the Bank. The tax is calculated based on the dollar amount of deposits located in the branches in Nebraska. The amount of tax paid to the state of Nebraska on an annual basis is not significant.  

ITEM 1A         RISK FACTORS

 

The Company’s earnings are significantly affected by general business and economic conditions, including credit risk and interest rate risk.

 

The Company’s business and earnings are sensitive to general business and economic conditions in the United States and, in particular, the states where it has significant operations. These conditions include short-term and long-term interest rates, inflation, monetary supply, fluctuations in both debt and equity capital markets, the strength of the U.S. and local economies, consumer spending, borrowing and saving habits, and fluctuations in the housing market. For example, an economic downturn, increase in unemployment or higher interest rates could decrease the demand for loans and other products and services and/or result in a deterioration in credit quality and/or loan performance and collectability. Nonpayment of loans, if it occurs, could have an adverse effect on the Company’s financial condition and results of operations. Higher interest rates also could increase the Company’s cost to borrow funds and increase the rate the Company pays on deposits.

 

The banking and financial services industry is highly competitive, which could adversely affect the Company’s financial condition and results of operations.

 

The Company operates in a highly competitive environment in the products and services the Company offers and the markets in which the Company serves. The competition among financial services providers to attract and retain customers is intense. Customer loyalty can be easily influenced by a competitor’s new products, especially offerings that provide cost savings to the customer. Some of Company’s competitors may be better able to provide a wider range of products and services over a greater geographic area.

 

The Company believes the banking and financial services industry will become even more competitive as a result of legislative, regulatory and technological changes and the continued consolidation of the industry. Technology has lowered barriers to entry and made it possible for non-banks to offer products and services traditionally provided by banks, such as automatic funds transfer and automatic payment systems. Also, investment banks and insurance companies are competing in more banking businesses such as syndicated lending and consumer banking. Many of the Company’s competitors are subject to fewer regulatory constraints and have lower cost structures. The Company expects the consolidation of the banking and financial services industry to result in larger, better-capitalized companies offering a wide array of financial services and products.

 

Federal and state agency regulation could increase the Company’s cost structures, or have other negative effects on the Corporation.

 

The Company and the Bank are heavily regulated at the federal and state levels. This regulation is designed primarily to protect consumers, depositors and the banking system as a whole, not stockholders. Congress and state legislatures and federal and state 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 including limiting the types of financial services and products the Company may offer, increasing the ability of non-banks to offer competing financial services and products and/or increasing the Company’s cost structures. Also, the Company’s failure to comply with laws, regulations or policies could result in sanctions by regulatory agencies and damage to its reputation.

 

The Company is dependent on senior management, and the loss of service of any of the Company’s senior executive officers could cause the Company’s business to suffer.

 

The Company’s continued success depends to a significant extent upon the continued services of its senior management. The loss of services of any of The Company’s senior executive officers could cause The Company’s business to suffer. In addition, The Company’s success depends in part upon senior management’s ability to implement The Company’s business strategy.

 

The Company’s stock price can be volatile.

 

The Company’s stock price can fluctuate widely in response to a variety of factors including actual or anticipated variations in the Company’s quarterly results; new technology or services by the Company’s competitors; unanticipated losses or gains due to unexpected events, including losses or gains on securities held for investment purposes; significant acquisitions or business combinations, strategic partnerships, joint ventures or capital commitments by or involving the Company’s or its competitors; changes in accounting policies; failure to integrate the Company’s acquisitions or realize anticipated benefits from the Company’s acquisitions; or changes in government regulations.

 

General market fluctuations, industry factors and general economic and political conditions, such as economic slowdowns or recessions, interest rate changes, credit loss trends or currency fluctuations, also could cause the Company’s stock price to decrease regardless of its operating results.

 

 

ITEM 1B         UNRESOLVED STAFF COMMENTS

At this time the Company does not have any unresolved comments from the Securities and Exchange Commission.