First Niles Finl (FNFI) - Description of business

Symbol:	FNFI
SIC:	6035 - Savings Institution, Federally Chartered
Type:	OTCBB
State location:	OH
State of Inc:	DE
Phone:	330-652-2539
Fax:	330-652-0911
Full Time Employees:	11
Business Address:	55 North Main Street Niles, OH 44446 United States
Mailing Address:	55 NORTH MAIN STREET NILES OH 44446

General

First Niles Financial, Inc. (“First Niles” or the “Company”) is a unitary, non-diversified, Delaware holding company. First Niles has no significant operations outside those of its wholly-owned operating subsidiary, Home Federal Savings and Loan Association of Niles (“Home Federal” or the “Bank”). References in this Form 10-KSB to “we,” “us,” and “our” refer to First Niles and/or Home Federal as the context requires.

Our principal business consists of attracting retail deposits from the general public and investing those funds primarily in permanent and construction loans secured by first mortgages on one- to four-family residences. We also originate permanent and construction loans secured by first mortgages on commercial and multi-family real estate. To a much lesser extent, we originate consumer and commercial business loans. Competition from other financial institutions has, however, limited the volume of loans we have been able to originate and place in our portfolio. As a result, our excess funds are invested in short-term, lower-yielding investment and mortgage-backed and related securities. Additionally, we borrow funds from the Federal Home Loan Bank (“FHLB”) and reinvest the proceeds in investment securities at favorable interest rate spreads.

At December 31, 2005, we had $98.5 million of assets and stockholders’ equity of $16.4 million (or 16.6% of total assets). Our common stock is traded on The Nasdaq SmallCap Market under the symbol “FNFI.”

Home Federal is a federally chartered stock savings association headquartered in Niles, Ohio. Its deposits are insured up to applicable limits by the Federal Deposit Insurance Corporation (the “FDIC”) and are backed by the full faith and credit of the United States.

Our results of operations depend primarily on net interest income, which is determined by (i) the difference between rates of interest we earn on interest-earning assets, consisting primarily of mortgage loans, collateralized mortgage obligations and other investments, and the rates we pay on interest-bearing liabilities, consisting primarily of deposits and borrowings; and (ii) the relative amounts of our interest-earning assets and interest-bearing liabilities. The level of non-interest income, such as fees received from customer deposit account service charges and gains on sales of investments, and the level of non-interest expense, such as federal deposit insurance premiums, salaries and benefits, office occupancy costs, and data processing costs, also affect our results of operations. Finally, our results of operations may also be affected significantly by general economic and competitive conditions, particularly changes in market interest rates, government policies and actions of regulatory authorities, all of which are beyond our control.

Our offices are located at 55 North Main Street, Niles, Ohio 44446-5097 and our telephone number is (330) 652-2539.

Market Area

Our primary market area is Niles, Ohio. Our primary lending area consists generally of the area within a 30 mile radius of the City of Niles. We may grant loans outside of this 30 mile radius upon the approval of our Board of Directors, including granting some loans outside the State of Ohio.

Trumbull County, where Home Federal is located, consists primarily of suburban and rural communities with manufacturing and wholesale distribution activities serving as the basis of the local economy. Major employers in the area include General Motors Corp. and WCI Steel, Inc.

The level of competition in our market area is strong and dominated by commercial banks, with financial institutions of varying sizes and characteristics. In addition, our market area is projected to

experience a continuing decrease in population and no meaningful increase in households over the next several years. Niles and Trumbull County have per capita income and median household income lower than Ohio and the United States and in December 2005, Trumbull County also had an unemployment rate higher than both Ohio and the United States. These economic conditions and strong competition have resulted in reduced loan demand which, in turn, has resulted in a high concentration of investment securities and mortgage-backed and related securities in our portfolio compared to typical savings institutions. In the event current economic and market conditions persist or worsen, and loan demand remains weak, we cannot give any assurances that we will be able to maintain or increase our mortgage loan portfolio, which could adversely affect our operations and financial results.

Lending Activities

General. Our primary lending activity is the origination of permanent and construction loans secured by first mortgages on one- to four-family residential properties. We also make permanent and construction loans on multi-family and commercial properties, home equity lines of credit, and a limited number of other consumer and commercial business loans. Our mortgage loans carry either a fixed or an adjustable interest rate. Mortgage loans are generally long-term and amortize on a monthly basis with principal and interest due each month. At December 31, 2005, our net loan portfolio totaled $47.2 million, which constituted 47.9% of our total assets.

All loans that we originate are subject to ratification by the Board of Directors. Commercial real estate loans and multi-family loans are generally reviewed by the Board before we extend a lending commitment. Unless we are aware of factors that may lead to an environmental concern, we generally do not require any environmental study at the time a loan is made. If an environmental problem were discovered to exist after a loan has been originated and the loan has become delinquent, we may choose not to foreclose on the property if the potential environmental liability would render foreclosure imprudent.

Management is responsible for presenting to the Board information about the credit-worthiness of a borrower and the estimated value of the subject property. Information relating to credit-worthiness of a borrower generally consists of a summary of the borrower’s credit history, employment, employment stability, net worth and income. The estimated value of the property must be supported by an appraisal report prepared in accordance with our appraisal policy.

At December 31, 2005, the maximum amount we could have loaned to any one borrower and the borrower’s related entities was approximately $2.4 million. At December 31, 2005, our largest lending relationship to a single borrower or group of related borrowers consisted of four loans aggregating $2.2 million. These loans were secured by a condominium rehabilitation project in Ft. Myers, Florida, and three single family rental units located in suburban Cleveland, Ohio.

Our second largest lending relationship at December 31, 2005 consisted of three purchased participation loans totaling $1.6 million. These three loans were secured by an apartment complex, a combination warehouse, office and retail complex and a hotel, all located in the Columbus, Ohio area.

Our next largest lending relationship consisted of six loans totaling $1.4 million. Of the six loans, three were for the construction or development of residential housing, including condominiums, one was for the construction of a commercial office building and two were secured by a commercial building presently used as a restaurant. All six of these loans were located within our primary lending area.

Our fourth largest lending relationship at December 31, 2005 totaled $1.1 million and consisted of 21 loans secured by residential rental properties and a single family residence. All of the properties securing these loans are within our primary lending area.

Our fifth largest lending relationship consisted of three loans totaling $985,000 secured by two commercial office buildings and a single family residence. The properties securing these loans are outside our primary lending area, but within Northeast Ohio.

Each of the above lending relationships was current and performing in accordance with its terms at December 31, 2005.

We had fourteen other lending relationships which exceeded $400,000 at December 31, 2005. As of that date, all of these lending relationships were current and performing generally in accordance with their loan terms. One relationship, though performing in accordance with its loan terms at December 31, 2005, was on nonaccrual status. (See “Asset Quality — Non-Performing Assets”).

Loan Portfolio Composition. The following table sets forth information concerning the composition of our loan portfolio in dollar amounts and in percentages as of the dates indicated. The dollar amounts and percentages were calculated before deductions for loans in process, deferred fees and discounts and allowances for losses.


	December 31,
	2005			2004
	Amount		Percent			Amount		Percent
	(Dollars in Thousands)
Real Estate Loans:
One- to four-family	$	34,614		69.68	%		$	30,868	68.64	%
Commercial		6,411		12.90				6,641	14.77
Multi-family		3,543		7.13				1,423	3.16
Construction or development		2,258		4.54				3,772	8.39

Total real estate loans		46,826		94.25				42,704	94.96

Other Loans:
Consumer Loans:
Home equity line of credit		2,236		4.50				1,750	3.89
Other		396		.80				349	.78

Total consumer loans		2,632		5.30				2,099	4.67
Commercial business loans		224		.45				167	.37

Total other loans		2,856		5.75				2,266	5.04

Total loans		49,682		100.00				44,970	100.00	%

Less:
Loans in process		1,623						1,180
Deferred fees and discounts		136						81
Allowance for losses		743						743

		2,502						2,004

Total loans receivable, net	$	47,180					$	42,966

The following table shows the composition of our loan portfolio by fixed- and adjustable-rate at the dates indicated.


	December 31,
	2005			2004
	Amount		Percent			Amount		Percent
	(Dollars in Thousands)
Fixed-Rate Loans:
Real estate:
One- to four-family	$	28,948		58.27			$	23,963	53.29	%
Commercial		2,848		5.73				2,684	5.97
Multi-family		348		0.70				452	1.00
Construction or development		1,790		3.60				3,097	6.89

Total real estate loans		33,934		68.30				30,196	67.15

Consumer:
Home Equity		—		—				—	—
Consumer		376		.76				349	.78
Commercial business		224		.45				167	.37

		600		1.21				516	1.15

Total fixed-rate loans		34,534		69.51				30,712	68.30

Adjustable-Rate Loans:
Real estate:
One- to four-family		5,666		11.41				6,905	15.35
Commercial		3,563		7.17				3,957	8.80
Multi-family		3,195		6.43				971	2.16
Construction or development		468		.94				675	1.50

Total real estate loans		12,892		25.95				12,508	27.81

Consumer:
Home Equity		2,256		4.54				1,750	3.89
Other		—		—				—	—
Total adjustable-rate loans		15,148		30.49				14,258	31.70
Total loans		49,682		100.00	%			44,970	100.00	%

Less:
Loans in process		1,623						1,180
Deferred fees and discounts		136						81
Allowance for loan losses		743						743

		2,502						2,004

Total loans receivable, net	$	47,180					$	42,966

The above table is not necessarily consistent with Note C to our Audited Consolidated Financial Statements due to differences in certain categories of loans and inclusion of loans in process balances in the above table but not in Note C.

The following schedule illustrates the contractual maturity of our real estate construction and commercial business loan portfolios at December 31, 2005, before net items. Loans that have adjustable or renegotiable interest rates are shown as maturing in the period during which the contract is due. The schedule does not reflect the effects of possible prepayments or enforcement of due-on-sale clauses.


	Real Estate Construction or Development			Commercial Business			Total
	Amount		Weighted Average Rate			Amount		Weighted Average Rate		Amount	Weighted Average Rate
	(Dollars in Thousands)
Due During Periods Ending December 31,
2006 ⁽¹⁾	$	1,790		6.35	%		$	5	8.00	%	$	1,795	6.35	%
2007 to 2010		468		7.38				79	6.95			547	7.32
After 2010		—		—				140	7.26			140	7.26

Totals	$	2,258		6.56			$	224	7.17		$	2,482	6.62

(1) Includes demand loans, non-accrual loans, loans having no stated maturity and overdraft loans.

All of the loans in the above table due after December 31, 2006 have fixed interest rates, except for two adjustable rate loans totaling $468,000.

One- to Four-Family Residential Real Estate Lending . Residential loan originations are generated by our marketing efforts, present and walk-in customers, and referrals from real estate brokers and builders. We have focused our lending efforts primarily on the origination of loans secured by first mortgages on owner-occupied, one- to four-family residences in our market area. At December 31, 2005, one- to four-family residential mortgage loans totaled $34.6 million, or 69.7% of our gross loan portfolio.

We originate one- to four-family mortgage loans on either a fixed or adjustable basis, as consumer demand dictates. The pricing strategy for fixed-rate mortgage loans focuses on setting interest rates that are competitive with other local financial institutions. Adjustable-rate mortgage loans are generally offered with either one-year or three-year repricing periods. Due to their wide availability and market rate sensitivity, we generally use the one-year and three-year U.S. Treasury Security Constants plus a stated margin over such indices for pricing of adjustable-rate mortgage loans. During the year ended December 31, 2005, we originated $2.1 million of one- to four-family adjustable-rate mortgage loans and $6.7 million of one- to four-family, fixed-rate mortgage loans. We have not sold any mortgage loans. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management; Market Risk Analysis” in our Annual Report to Stockholders.

Fixed-rate loans secured by one- to four-family residences have maximum maturities of 30 years, and are fully amortizing, with payments due monthly. However, these loans normally remain outstanding for a substantially shorter period of time because of refinancing and other prepayments. Additionally, some of these loans may have balloon payments which substantially shorten their effective maturities, typically to the 10 to 15 year range. A significant change in the current level of interest rates could alter the average life of a residential loan in our portfolio considerably. Our one- to four-family loans are not assumable, do not contain prepayment penalties and do not permit negative amortization of principal. Our real estate loans generally contain a “due on sale” clause allowing us to declare the unpaid principal balance due and payable upon the sale of the security property.

Our one- to four-family residential adjustable-rate mortgage loans are fully amortizing with contractual maturities of up to 30 years, and payments due monthly. Our adjustable-rate mortgage loans provide for specified minimum and maximum interest rates. As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as our cost of funds. Our adjustable-rate mortgage loans are generally not convertible into fixed-rate loans.

Adjustable-rate mortgage loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower’s payment rises, and thus, increases the potential for default. We have not experienced significant delinquencies concerning these loans. See “- Asset Quality — Non-Performing Assets” and “-Asset Quality — Classified Assets.”

We generally underwrite our one- to four-family loans based on the applicant’s employment, credit history, and appraised value of the subject property. Presently, we lend up to 90% of the lesser of the appraised value or purchase price for one- to four-family loans. Properties securing our one- to four-family loans are appraised by independent fee appraisers approved and qualified by our Board of Directors. We generally require our borrowers to obtain title insurance and fire, property and flood insurance, if necessary, in an amount not less than the value of the security property.

Commercial and Multi-family Real Estate Lending . We are engaged in commercial and multi-family real estate lending. These loans are secured primarily by small retail establishments, small office buildings, warehouses, and other non-residential and multi-family residential properties located in our market area. We also purchase participation interests in loans originated by other financial institutions. At December 31, 2005, commercial real estate loans totaled $6.4 million, or 12.9% of our gross loan portfolio, and multi-family real estate loans totaled $3.5 million, or 7.1% of our gross loan portfolio.

Our loans secured by commercial and multi-family real estate are originated with either a fixed or adjustable interest rate. The interest rate on adjustable-rate loans is based on a variety of indices, which are generally determined upon negotiation with the borrower. Loan-to-value ratios on our commercial and multi-family loans typically do not exceed 80% of the appraised value of the property securing the loan. These loans typically require monthly payments and have maximum maturities of 30 years. While maximum maturities may extend to 30 years, loans frequently have shorter maturities that generally range from 10 to 15 years.

We grant loans secured by commercial and multi-family real estate based on the income producing potential of the property and the financial strength of the borrower. The net operating income, which is the income derived from the operation of the property less all operating expenses, must be sufficient to cover the payments related to the outstanding debt. We generally require personal guarantees of the borrowers in addition to the security property as collateral for such loans. Appraisals on properties securing commercial and multi-family real estate loans are performed by independent fee appraisers approved by our Board of Directors. See “- Loan Originations, Purchases and Repayments.”

Loans secured by commercial and multi-family real estate properties are generally larger and involve a greater degree of credit risk than one- to four-family residential mortgage loans because they typically involve large balances to single borrowers or groups of related borrowers. Because payments on loans secured by commercial and multi-family real estate properties are often dependent on the successful operation or management of the properties, repayment of such loans may be subject to adverse conditions in the real estate market or the economy. If the cash flow from the project is reduced, the borrower’s ability to repay the loan may be impaired. For example, cash flow from the project is reduced if leases are not obtained or renewed. See “- Asset Quality — Nonperforming Loans.”

Construction and Development Lending . We originate residential and commercial construction loans to individuals as well as loans secured by building lots or raw land held for development. Presently, all of these loans are secured by property located within our market area. We also purchase participation interests in construction loans originated by other lenders. At December 31, 2005, we had $2.3 million in construction and development loans outstanding, representing 4.5% of our gross loan portfolio. At

December 31, 2005, our largest construction lending relationship consisted of a $800,000 loan secured by a commercial office building, currently in the process of construction and located within our primary lending area. Approximately $784,000 of this relationship was unfunded at December 31, 2005.

Construction loans to individuals for their residences generally are structured to be converted to permanent loans at the end of the construction phase, which typically runs six months. These construction loans have rates and terms that match the one- to four-family loans then offered by Home Federal, except that during the construction phase the borrower pays only interest on the loan. Residential construction loans are generally underwritten pursuant to the same guidelines used for originating permanent residential loans.

Loans secured by building lots or raw land held for development are generally granted with terms of up to five years and are available at a fixed interest rate. Payments on loans secured by building lots are due monthly and are amortized on a 20-year basis, resulting in a balloon payment at maturity. Payments on raw land held for development are due monthly and are interest only. Loans secured by building lots or raw land for development are granted based on both the financial strength of the borrower and the value of the underlying property. At December 31, 2005, we had no loans secured by building lots and raw land.

We obtain construction loans principally through continued business from builders who have previously borrowed from Home Federal, as well as referrals from existing and walk-in customers. The application process includes submission of accurate plans, specifications and costs of the project to be constructed. We use these items as a basis for determining the appraised value of the subject property. We base loan amounts on the lesser of current appraised value and/or the cost of construction (land plus building). We also conduct periodic inspections of construction projects we finance.

There are uncertainties inherent in estimating construction costs and the market for the project upon completion. Accordingly, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, the related loan-to-value ratios and the likelihood of success of the project. Construction loans to borrowers other than owner-occupants also involve many of the same risks discussed above regarding commercial real estate loans and tend to be more sensitive to general economic conditions than many other types of loans.

Other Lending . We also originate consumer loans and a nominal amount of commercial business loans. Our consumer loan portfolio consists of home equity lines of credit and other personal loans secured by first or second mortgages on residential real estate, and loans secured by deposits.

The largest component of our consumer lending is home equity lines of credit, which we began offering during 2001. At December 31, 2005, our home equity line of credit portfolio totaled $2.2 million, or 4.5% of our gross loan portfolio. We are currently offering this product with a ten-year draw period followed by a ten-year repayment period. The minimum monthly payment during the draw period is interest only. The payments during the repayment period will fully amortize the outstanding debt after ten years. At December 31, 2005, we had $2.0 million of unused credit available under our home equity line of credit program.

Our underwriting standards for home equity lines of credit generally include a determination of the applicant’s payment history on other debts and their ability to meet existing obligations and payments on the proposed loan. Although creditworthiness of the applicant is of primary consideration, our underwriting process also includes an evaluation of the value of the security property in relation to the proposed line of credit. An individual home equity line of credit, along with any other debt secured by the subject property, may not exceed 89.9% of the appraised value of the property. We generally use county real estate tax appraisals to determine the appraised value of the property.

Loan Originations, Purchases and Repayments

We originate loans through our marketing efforts, existing and walk-in customers and referrals from real estate brokers and builders. While we originate both adjustable-rate and fixed-rate loans, our ability to originate loans is dependent upon the relative customer demand for loans in our market. Demand is affected by local competition and the interest rate environment.

During the last several years, our dollar volume of fixed-rate, one- to four-family loans has exceeded the dollar volume of the same type of adjustable-rate loans. Although our primary business is the origination of one- to four-family mortgage loans, competition from other financial institutions continues to limit the volume of loans we have been able to originate and place in our portfolio. As a result, we will from time to time purchase mortgage loans and investment and mortgage-backed and related securities to supplement our portfolios. We do not sell loans nor do we originate loans according to secondary market guidelines.

In periods of economic uncertainty, the ability of financial institutions, including Home Federal, to originate large dollar volumes of real estate loans may be substantially reduced or restricted, with a resulting decrease in interest income.

The following table shows our loan origination, purchase and repayment activities for the periods indicated.


	Year Ended December 31,
	2005			2004
	(In Thousands)
Originations by type:
Adjustable rate:
Real estate - one- to four-family	$	2,065			$	1,397
- commercial		477				480
- multi-family		1,990				300
Non-real estate - home equity		1,105				919
- other consumer		—				—
- commercial business		—				—

Total adjustable-rate		5,637				3,096

Fixed rate:
Real estate - one- to four-family		6,654				8,515
- commercial		697				1,063
- multi-family		676				—
- land and development		—				—
Non-real estate - home equity		159				380
- other consumer		—				—
- commercial business		100				109
Total fixed-rate		8,286				10,067

Total loans originated		13,923				13,163

Purchases:
Real estate - one- to four-family		—				—
- commercial		—				—
- multi-family		—				—
- land and development		—				—

Total loans purchased		—				—
Mortgage-backed and related securities		—				—
Total purchased		—				—

Repayments:
Principal repayments		13,895				18,811
Total reductions		13,895				18,811

Increase (decrease) in other items, net		(77	)			(39	)
Net increase (decrease)	$	(49	)		$	(5,687	)

Asset Quality

When a borrower fails to make a payment on a loan on or before the default date, we consider the loan 30 days past due. At that time, we generally send out a delinquent notice to the borrower. One of our officers reviews each delinquent account and, at his or her discretion, we attempt to cure the delinquency by contacting the borrower. If the loan becomes 60 days delinquent, our legal counsel will generally send a personal letter to the borrower requesting payment of the delinquent amount in full, or the establishment of an acceptable repayment plan to bring the loan current within 90 days. If the account becomes 90 days delinquent, and an acceptable repayment plan has not been agreed upon, the collection officer will generally refer the account to legal counsel, with instructions to prepare a notice of intent to foreclose. The notice of intent to foreclose allows the borrower up to 30 days to bring the account current. During this 30 day period, an officer may accept a written repayment plan from the borrower which would bring the account current within 90 days. Once the loan becomes 120 days delinquent, and an acceptable repayment plan has not been agreed upon, the collection officer, after receiving consent from our Board of Directors, will turn over the account to our legal counsel with instructions to initiate foreclosure.

Delinquent Loans. The following table sets forth our loan delinquencies by type, number, amount and percentage of type at December 31, 2005.


	Loans Delinquent For:
	30-89 Days		90 Days and Over			Total Delinquent Loans
	Number	Amount		Percent of Loan Category			Number		Amount		Percent of Loan Category		Number	Amount	Percent of Loan Category
	(Dollars in Thousands)
Real Estate:
One- to four-family	1	$	55		0.16	%		8		$	527	1.52	%	9	$	582	1.68	%
Commercial
Multi-family	—		—					—			—	—		—		—	—
Construction or development	—		—		—			—			—	—		—		—	—
Consumer:
Home Equity	—		—		—			—			—	—		—		—	—
Other	—		—		—			2			72	2.74		2		72	2.74
Commercial	—		—		—			—			—	—		—		—	—

Total	1	$	55					10		$	599			11	$	654

Non-Performing Assets. The table below sets forth the amounts and categories of our non-performing assets. Loans are placed on non-accrual status when the collection of principal and/or interest becomes doubtful. For all years presented, we have had no troubled debt restructurings which involve forgiving a portion of interest or principal on any loans or making loans at a rate materially less than that of market rates.


	December 31,
	2005			2004
	(Dollars in Thousands)
Non-accruing loans:
One- to four-family	$	527			$	283
Commercial real estate		306				342
Construction or development		—				—
Land		—				—

Total		833				625

Accruing loans delinquent more than 90 days:
One- to four-family		—				95
Multi-family		—				—
Commercial real estate		—				1
Construction or development		—				—
Consumer:
Home Equity		—				—
Other		72				70
Commercial business		—				—

Total		72				166

Real Estate Owned		35				51

Total non-performing assets	$	940			$	842

Total as a percentage of gross loans receivable		1.89	%			1.87	%

For the year ended December 31, 2005, we would have received $59,000 in additional gross interest income if the non-accruing loans had been current in accordance with their original terms.

Other Loans of Concern. At December 31, 2005, there were no problem loans that are not included in the table above.

Classified Assets. Federal regulations provide for the classification of loans and other assets, such as debt and equity securities considered by the Office of Thrift Supervision to be of lesser quality, as “substandard,” “doubtful” or “loss.” 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 insured 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 they cannot be counted as assets without the establishment of a specific loan loss reserve.

When an insured institution classifies problem assets as either substandard or doubtful, it may establish general allowances for loan losses in an amount deemed prudent by management. General allowances represent loss allowances which have been established to recognize the inherent risk associated with lending activities, but 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 that portion of the asset so classified or to charge off that particular amount. A thrift 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 and the FDIC, either of which may order the establishment of additional general or specific loss allowances.

In connection with the filing of our periodic reports with the Office of Thrift Supervision and in accordance with our classification of loans policy, we regularly review the problem loans in our portfolio to determine whether any loans require classification in accordance with applicable regulations. On the basis of management’s review of our loans, at December 31, 2005, we had classified $835,000 of our loans as substandard, representing 5.1% of stockholders’ equity and 0.8% of total assets. No assets were classified as doubtful or as loss.

Allowance for Loan Losses . The allowance for loan losses is established through a provision for loan losses which is based on management’s evaluation of past loss experience, current trends in the level of delinquent and specific problem loans, loan concentration to single borrowers, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral, and current and anticipated economic conditions in our market area. A significant portion of our loan portfolio is concentrated in one- to four-family mortgage loans which concentration, historically, has not led to any significant loan losses. Management prepares quarterly analyses of loans classified as substandard and non-performing and evaluates these loans in conjunction with its determination of the appropriate provision for loan losses to be recorded for the period. Management also analyzes borrowers with significant outstanding balances to reevaluate credit risk, the quality of the loan and factors that may affect the borrowers’ ability to pay. Accordingly, the allowance represents management’s estimate of losses inherent in our loan portfolio as of a specified date.

Although management believes that it uses the best information available to determine the allowance, unforeseen market conditions could result in adjustments and net earnings could be significantly affected if circumstances differ substantially from the assumptions used in making the final determination. Future additions to our allowance will be the result of periodic loan, property and collateral reviews and thus, cannot be predicted in advance. At December 31, 2005, our total allowance for loan losses represented coverage of 82.0% of non-performing loans. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations-Results of Operations — Provision for Loan Losses” and Notes A and C of the Notes to Consolidated Financial Statements contained in our Annual Report to Stockholders filed as Exhibit 13 to this Annual Report on Form 10-KSB.

The following table sets forth an analysis of our allowance for loan losses.


	At and For the Years Ended December 31,
	2005			2004
	(Dollars in Thousands)
Balance at beginning of period	$	743			$	759

Charge-offs: One- to four-family		—				16
Total charge-offs		—				16

Recoveries:		—				—
Net (charge-offs) recoveries		—				(16	)
Additions charged to operations		—				—

Balance at end of period	$	743			$	743

Ratio of net charge-offs (recoveries) during the period to average loans outstanding during the period		—	%			0.04	%

Ratio of net charge-offs (recoveries) during the period to average non-performing loans		—	%			1.70	%

The distribution of our allowance for loan losses at the dates indicated is summarized as follows:


	December 31,
	2005			2004
	Amount of Loan Loss Allowance		Loan Amounts by Category		Percent of Loans in Each Category to Total Loans		Amount of Loan Loss Allowance	Loan Amounts by Category		Percent of Loans in Each Category to Total Loans
	(Dollars in Thousands)
One- to four-family	$	235		$	34,614	69.68	%	$	209		$	30,868	68.64	%
Multi-family, commercial, real estate, construction or development		376			12,212	24.57			378			11,836	26.32
Consumer and commercial business		14			2,856	5.75			12			2,266	5.04
Unallocated		118			—	—			144			—	—

Total	$	743		$	49,682	100.00	%	$	743		$	44,970	100.00	%

Investment Activities

We must maintain sufficient levels of investments that qualify as liquid assets to meet the safety and soundness requirement under Office of Thrift Supervision regulations. Our liquidity may increase or decrease depending upon the availability of funds and comparative yields on investments in relation to the

return on loans. Historically, we have maintained liquid assets at levels believed adequate to meet the requirements of normal operations, including potential deposit outflows. We regularly review and update cash flow projections to assure that we maintain adequate liquidity.

Federally chartered savings institutions have the authority to invest in various types of liquid assets, including U.S. Treasury obligations, securities of various federal agencies, certain certificates of deposit of insured banks and savings institutions, certain bankers’ acceptances, repurchase agreements and federal funds. Subject to various restrictions, federally chartered savings institutions may also invest in investment grade commercial paper and corporate debt securities and mutual funds whose assets conform to the investments that a federally chartered savings institution is otherwise authorized to make directly. See “Regulation - Federal Regulation of Savings Associations” for a discussion of additional restrictions on our investment activities.

President Stephens, Vice President Safarek and Compliance Officer Csontos have the basic responsibility for the management of our investment portfolio, subject to the direction and guidance of the Board of Directors. These officers consider various factors when making decisions, including the marketability, maturity and tax consequences of the proposed investment. The maturity structure of investments is affected by various market conditions, including the current and anticipated slope of the yield curve, the level of interest rates, the trend of new deposit inflows and the anticipated demand for funds via deposit withdrawals and loans.

The general objectives of our investment portfolio are to: (i) provide and maintain liquidity within the guidelines prescribed by Office of Thrift Supervision regulations; (ii) provide liquidity when loan demand is high and to assist in maintaining earnings when loan demand is low; and (iii) maximize earnings while satisfactorily managing risk, including credit risk, reinvestment risk, liquidity risk and interest rate risk. See “Management’s Discussion and Analysis of Financial Condition and Results of Operations - Asset and Liability Management; Market Risk Analysis” in our Annual Report to Stockholders.

Our investment securities consist primarily of U.S. agency securities. The U.S. agency securities consist of different callable securities, issued by either the Federal Home Loan Bank system, Fannie Mae or Freddie Mac. These securities have original maturities ranging from 30 months to 15 years and original call periods ranging from one month to three years.

Our mortgage-backed and related securities portfolio consists of securities issued under government-sponsored agency programs. We hold entirely collateralized mortgage obligations. Collateralized mortgage obligations are special types of pass-through debt securities in which the principal and interest payments on the underlying mortgages or mortgage-backed securities are used to create classes of securities with different maturities and, in some cases, amortization schedules, as well as a residual interest, with each class possessing different risk characteristics.

Our policy is to purchase only collateralized mortgage obligations that are in the first or second repayment tranche (investment class) and are AAA rated. We expect the life of our collateralized mortgage obligations to be typically under five years at the time of purchase, although the contractual life may exceed 20 years. Premiums associated with collateralized mortgage obligations purchased are not significant; therefore, the risk of significant yield adjustments because of accelerated prepayments is limited. Yield adjustments are encountered as interest rates rise or decline, which in turn slows or increases prepayment rates and affects the average life of the collateralized mortgage obligations. The purpose of our collateralized mortgage obligation investment strategy is to: (i) assist in maintaining Home Federal’s qualified thrift lender status (see “Regulation - Qualified Thrift Lender”); (ii) generate high cash flow so as to lessen liquidity and reinvestment risk; (iii) preserve asset quality; and (iv) generate additional interest income.

At December 31, 2005, we held collateralized mortgage obligations with a fair market value of $11.3 million, all of which were secured by underlying collateral issued under government agency-sponsored programs.

Substantially all of our collateralized mortgage obligations are currently classified as available for sale. We anticipate classifying as available for sale all new purchases of collateralized mortgage obligations. At December 31, 2005, $10.2 million of our collateralized mortgage obligations qualified as high risk mortgage securities under Office of Thrift Supervision regulations. These securities qualified as high-risk mortgage-related securities because of the current low interest rate environment. The low rate environment increases the likelihood that the underlying mortgages will prepay, which causes the estimated life of the securities, and therefore their market value, to become uncertain. At the time of purchase none of these securities qualified as high risk.

While mortgage-backed and related securities, such as collateralized mortgage obligations, carry reduced credit risk as compared to conventional loans, mortgage-backed and related securities remain subject to the risk that a fluctuating interest rate environment, along with other factors such as the geographic distribution of the underlying mortgage loans, may alter the prepayment rate of such mortgage loans and thus, affect both the prepayment speed, and value, of such securities.

The following table sets forth the composition of our investment and mortgage-backed and related securities portfolio at the dates indicated. Our investment securities portfolio at December 31, 2005, contained neither tax-exempt securities nor securities of any issuer with an aggregate book value in excess of 10% of our retained earnings, excluding those issued by the U.S. Government or its agencies.


	December 31,
	2005			2004
	Book Value		% of Total			Book Value		% of Total
	(Dollars in Thousands)
Investment securities:
Freddie Mac stock	$	1,438		4.25	%		$	1,842	5.60	%
U.S. agency securities		31,189		92.20				29,899	90.89
Federal Home Loan Bank stock		1,199		3.55				1,141	3.47
Other		—		—				15	0.04

Total investment securities and Federal Home Loan Bank stock	$	33,826		100.00	%		$	32,897	100.00	%

Mortgage-backed and related securities:
Collateralized mortgage obligations	$	11,326		100.00	%		$	16,031	100.00	%

Unamortized discounts, net		—		—				—	—

Total mortgage-backed and related securities	$	11,326		100.00	%		$	16,031	100.00	%

Other interest-earning investments:
Money market mutual fund	$	525		16.92	%		$	1,582	31.00	%
Interest-bearing deposits with banks		537		17.30				2,521	49.40
Federal funds sold		2,041		65.78				1,000	19.60

Total	$	3,103		100.00	%		$	5,103	100.00	%

The following table sets forth the contractual maturities of our investment and mortgage-backed and related securities at December 31, 2005.


	1 Year or Less		After 1 to 3 Years			After 3 to 5 Years		After 5 to 10 Years		After 10 to 20 Years			Over 20 Years			December 31, 2005 Balance Outstanding
	(In Thousands)
U.S. agency securities	$	—		$	3,991		$	15,372		$	9,869			$	1,957		$	—		$	31,189

Collateralized mortgage obligations		—			25			—			—				3,721			7,580			11,326

Total	$	—		$	4,016		$	15,372		$	9,869			$	5,678		$	7,580		$	42,515

Weighted average yield		—			3.50	%		4.29	%		4.51	%			4.65	%		4.41	%		4.31	%

Sources of Funds

General. Our sources of funds are deposits and borrowings, payment of principal and interest on loans, interest earned on or maturation of other investment securities and short-term investments, and funds provided from operations.

Deposits . We offer a variety of deposit accounts having a wide range of interest rates and terms. Our deposits consist of passbook and statement savings accounts, money market deposit accounts, NOW accounts and certificate of deposit accounts currently ranging in terms from six months to five years. We only solicit deposits from our market area and do not use brokers to obtain deposits. We primarily rely on competitive pricing policies, advertising and customer service to attract and retain these deposits. The flow of deposits is influenced significantly by general economic conditions, changes in market interest rates and competition.

The variety of deposit accounts we offer has allowed us to be competitive in obtaining funds and to respond with flexibility to changes in consumer demand. We have become more susceptible to short-term fluctuations in deposit flows, as customers have become more interest rate conscious. We endeavor to manage the pricing of our deposits in keeping with our asset/liability management, liquidity and profitability objectives. Based on our experience, we believe that our savings and checking accounts are relatively stable sources of funds. Our ability to attract and maintain certificates of deposit and the rates paid on these deposits, however, has been and will continue to be significantly affected by market conditions.

The following table sets forth the deposit flows at Home Federal during the periods indicated.


	Years Ended December 31,
	2005			2004
	(Dollars in Thousands)
Opening balance	$	61,458			$	61,936
Deposits		46,591				50,774
Withdrawals		(48,302	)			(52,191	)
Interest credited		1,055				939

Ending balance	$	60,802			$	61,458

Net increase (decrease)	$	(656	)		$	(478	)

Percent increase (decrease)		(1.08	)%			(0.77	)%

The following table sets forth the dollar amount of savings deposits in the various types of deposit programs we offered for the periods indicated.


	December 31,
	2005			2004
	Amount		Percent of Total			Amount		Percent of Total
	(Dollars in Thousands)
Transactions and Savings Deposits:
Passbook and statement savings accounts (.75%) ⁽¹⁾	$	17,773		29.23	%		$	18,978	30.88	%
NOW accounts (.50%) ⁽¹⁾		4,542		7.47				4,533	7.38
Money market accounts (1.00%) ⁽¹⁾		3,711		6.11				3,732	6.07
Demand accounts (0.00%)(1)		21		0.03				—	—

Total non-certificates		26,047		42.84				27,243	44.33

Certificates:
1.51 - 3.00%		12,183		20.03				15,982	26.00
3.01 - 4.50%		20,799		34.21				14,563	23.70
4.51 - 6.00%		1,773		2.92				3,670	.97

Total certificates		34,755		57.16				34,215	55.67

Total deposits	$	60,802		100.00	%		$	61,458	100.00	%

(1) Interest rates stated apply to December 31, 2005.

The following table shows rate and maturity information for our certificates of deposit as of December 31, 2005.


	1.51- 3.00%			3.01- 4.50%			4.51- 6.00%		Total		Percent
	(Dollars in Thousands)
Certificate accounts maturing in quarter ending:

March 31, 2006	$	3,894			$	1,000		$	—		$	4,894		14.08	%
June 30, 2006		3,676				3,836			32			7,544		21.70
September 30, 2006		2,353				4,621			—			6,974		20.07
December 31, 2006		1,208				2,981			—			4,189		12.05
March 31, 2007		513				1,475			749			2,737		7.88
June 30, 2007		225				3,570			—			3,795		10.92
September 30, 2007		43				934			992			1,969		5.66
December 31, 2007		201				678			—			879		2.53
March 31, 2008		70				316			—			386		1.11
June 30, 2008		—				918			—			918		2.64
September 30, 2008		—				388			—			388		1.12
December 31, 2008		—				82			—			82		0.24
Thereafter		—				—			—			—		—

Total	$	12,183			$	20,799		$	1,773		$	34,755		100.00	%

Percent of total		35.06	%			59.84	%		5.10	%		100.00	%

The following table indicates the amount of our certificates of deposit and other deposits by time remaining until maturity as of December 31, 2005.


	Maturity
	3 Months or Less		Over 3 to 6 Months		Over 6 to 12 Months	Over 12 Months		Total
	(In Thousands)
Certificates of deposit less than $100,000	$	3,411		$	3,620	$	4,839		$	7,146	$	19,016
Certificates of deposit of $100,000 or more		1,483			3,923		6,325			4,008		15,739
Total certificates of deposit	$	4,894		$	7,543	$	11,164		$	11,154	$	34,755

Borrowings . Although deposits are our primary source of funds, we utilize borrowings when they are a less costly source of funds or can be invested at a positive interest rate spread or when we desire additional capacity to fund loan demand. At December 31, 2005, we had borrowings totaling $20.5 million. The average balance of our borrowings during this period was $21.9 million. Our current borrowings consist of twelve different Federal Home Loan Bank advances. Ten advances have a fixed interest rate initial term, followed by a period where the advance converts to a variable rate, at the option of the Federal Home Loan Bank. The fixed initial terms range from three months to five years. Each advance is subject to a prepayment penalty if paid prior to its maturity date, except for when prior to maturity an advance is converted to a variable rate. The advances can be prepaid without penalty at the

time of conversion from a fixed to a variable rate, and quarterly thereafter. After the fixed interest rate period expires, each advance converts to a variable rate equivalent to the three-month London Interbank Offered Rate. Ten of the advances have an initial maturity of 10 years. We also have a fixed rate advance with an original maturity of three years and a variable rate advance priced 265 basis points below the prime rate with an original maturity of two years. The weighted average interest rate of our twelve FHLB advances is 4.59% at December 31, 2005. See Note H of the Notes to Consolidated Financial Statements in our Annual Report to Shareholders.

Subsidiary and Other Activities

As a federally chartered savings association, Home Federal is permitted by Office of Thrift Supervision regulations to invest up to 2% of i