Heritage Financial G (HBOS) - Description of business

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Item 1. Description of Business

General

     Since being formed in February 2002, Heritage Financial Group (the “Company”) has not engaged in any business other than through our wholly owned subsidiary, HeritageBank of the South (“the Bank”) and the management of its cash and investment portfolio. We neither own nor lease any business property, but we use the premises, equipment and furniture of the Bank. We employ only persons who are executive officers of the Bank as our executive officers, and we also use the support staff of the Bank. We currently do not separately compensate any employees, although, in the future, we may hire additional employees if we expand our business at the holding company level.

     The Company completed an initial public offering on June 29, 2005. It sold 3,372,375 shares of common stock in that offering for $10.00 per share. The Company’s employee stock ownership plan (the “ESOP”) purchased 440,700 shares with the proceeds of a loan from the Company. The Company received net proceeds of $32.4 million in the public offering, 50% of which was contributed to the Bank and $4.4 million of which was lent to the ESOP for its purchase of shares in the offering. The Company has issued 7,868,875 shares of common stock to Heritage, MHC (“MHC”), so that MHC owns 70% of its outstanding common stock.

     The Bank was originally chartered in 1955 as a federal credit union, serving the marine base in Albany, Georgia. Over the years, it evolved into a full-service, multi-branch community credit union in Dougherty, Lee, Mitchell and Worth counties. It was converted from a federal credit union charter to a federal mutual savings bank charter in July 2001. The objective of that charter conversion was to better serve customers and the local community though the broader lending ability of a savings bank and to expand our customer base beyond the limited field of membership permitted for credit unions. In February 2002, the Company was formed as part of the reorganization into the two-tier mutual holding company structure. On January 1, 2005, the Bank converted to a Georgia state-chartered stock savings bank.

     The principal business of the Bank consists of attracting retail and commercial deposits from the general public and investing those funds primarily in permanent loans secured by first mortgages on owner-occupied, one- to four-family residences, multi-family residences and commercial property and a variety of consumer and commercial business loans. Revenues from this business are derived principally from interest on loans and securities and fee income.

     The Bank offers a variety of deposit accounts having a wide range of interest rates and terms, which generally include savings accounts, money market deposit and term certificate accounts and checking accounts. It solicits deposits in our market areas and, to a lesser extent from financial institutions nationwide. It has not accepted brokered deposits.

Forward Looking Statements

     This document, including information incorporated by reference, contains forward-looking statements about the Company and its subsidiaries which we believe are within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, without limitation, statements with respect to anticipated future operating and financial performance, growth opportunities, interest rates, cost savings and funding advantages expected or anticipated to be realized by management. Words such as “may,” “could,” “should,” “would,” “believe,” “anticipate,” “estimate,” “expect,” “intend,” “plan” and similar expressions are intended to identify these forward-looking statements. Forward-looking statements by the Company and its management are based on beliefs, plans, objectives, goals, expectations, anticipations, estimates and the intentions of management and are not guarantees of future performance. The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise. The important factors we discuss below, as well as other factors discussed under the caption “Management’s Discussion and Analysis of Financial Condition and Results of Operations” and identified in our filings with the Securities & Exchange Commission “the SEC” and those presented elsewhere by our management from time to time, could cause actual results to differ materially from those indicated by the forward-looking statements made in this document:

	•		further developments in the Company’s ongoing review of and efforts to resolve any problem credit relationships described in this report, which could result in, among other things, further downgrades of aforementioned loans, additional provisions to the loan loss reserve and the incurrence of other material non-cash and cash charges;
	•		the strength of the United States economy in general and the strength of the local economies in which we conduct operations;
	•		the effects of, and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Federal Reserve Board;
	•		inflation, interest rate, market and monetary fluctuations;
	•		the timely development of and acceptance of our new products and services and the perceived overall value of these products and services by users, including the features, pricing and quality compared to competitors’ products and services;
	•		the willingness of users to substitute our products and services for products and services of our competitors;
	•		the impact of changes in financial services’ laws and regulations (including laws concerning taxes, banking, securities and insurance);
	•		the impact of technological changes;
	•		acquisitions;
	•		changes in consumer spending and saving habits; and
	•		our success at managing the risks involved in the foregoing.

     The Company disclaims any obligation to update or revise any forward-looking statements based on the occurrence of future events, the receipt of new information, or otherwise.

Market Area

     We intend to continue to be a community-oriented financial institution offering a variety of financial services to meet the needs of the communities we serve. We are headquartered in Albany, Georgia and primarily serve Dougherty, Lee and Worth counties in Georgia. Our geographic market area for loans and deposits is principally Dougherty and Lee counties, though we have a presence in Worth County, and, to a lesser extent, the rest of southwest Georgia. We occasionally make loans beyond our market area to meet customer’s needs and develop business. We have a 15% deposit market share and a 35% mortgage market share in the Albany Metropolitan Statistical Area, ranking us first among all insured depository institutions in the area. As of June 30, 2005, we had a 19.2% market share of insured deposits in Dougherty County, 2.1% market share of insured deposits in Lee County and 9.3% market share of insured deposits in Worth County, ranking us first, ninth and fourth, respectively, in those counties, among all insured depository institutions.

     The local economy is historically based on manufacturing, but it has become more service-oriented in the last two decades. Median household income and per capita income for our market area are below the state and national averages, reflecting the urban nature of the market and limited availability of high paying white collar and technical jobs. As of December 2005, our market area reported an unemployment rate of 5.7%, as compared to the national average of 4.9%. Major employers in our market area include the United States Marine Corps Logistics Base, Phoebe Putney Memorial Hospital, Procter & Gamble, Calltech Communications, Albany State University, Palmyra Medical Centers and Miller Brewing Company.

     One of the major employers in this area over the past several years, Merck & Co., recently announced its plans to close its Albany, Georgia plant by the end of 2006. The effect that the closing of this plant will have on the local economy and the potential loss of bank customers resulting from the closing of the plant cannot be determined at this time.

Market Area Expansion

     On March 14, 2006, the Company and the Bank entered into an agreement with Ameris Bancorp (“Ameris”) and two of its banking subsidiaries. Under the agreement, the Company and the Bank will enter into a series of transactions with Ameris resulting in the Bank being able to lawfully operate a new branch in the state of Florida. The opening of the branch is subject to the receipt of regulatory approval and the completion of the transactions with Ameris. As part of the agreement, the Bank will make a $1 million payment to Ameris. The Bank is conducting a search to determine where in Florida it will locate the new branch.

Competition

     We face strong competition in originating commercial, real estate and other loans and in attracting deposits. Competition in originating real estate loans comes primarily from other savings institutions, commercial banks, credit unions and mortgage bankers. Other savings institutions, commercial banks, credit unions and finance companies provide vigorous competition in consumer lending. Commercial business competition is primarily from local commercial banks.

     We attract our deposits through our branch office system and the Internet. Competition for those deposits is principally from other savings institutions, commercial banks and credit unions located in the same community, as well as mutual funds and other alternative investments. We compete for these deposits by offering superior service and a variety of deposit accounts at competitive rates.

Internet Website

     the Company maintains a website at www.eheritagebank.com. The information contained on that website is not included as part of, or incorporated by reference into, this Annual Report on Form 10-KSB. The Company currently makes available on or through its website its Annual Report on Form 10-KSB, Quarterly Reports on Form 10-QSB and Current Reports on Form 8-K or amendments to these reports. These materials are also available free of charge on the Securities and Exchange Commission’s website at www.sec.gov.

Selected Consolidated Financial Information

		At December 31,
		2005		2004		2003		2002		2001
		(In thousands)
Selected Financial Condition Data:
Total assets		$	363,797			$	343,468			$	335,668			$	310,902			$	293,218
Loans, net			250,493				235,275				240,794				227,490				229,448
Securities available for sale, at fair value:
U.S. government and agency securities			14,044				11,528				8,960				4,983				6,581
Corporate debt securities			3,786				4,364				2,965				3,617				—
Mortgage-backed securities			31,098				26,478				24,481				16,922				15,121
State, county and municipal			6,869				8,874				7,210				7,118				6,792
Equity and other investments			9,069				8,044				7,896				2,994				—
Federal Home Loan Bank stock, at cost			2,927				2,957				2,000				1,750				1,282
Deposits			238,640				248,543				255,321				237,294				215,786
Federal Home Loan Bank advances and other borrowings			50,000				51,000				40,000				35,000				42,890
Total equity			68,983				39,134				36,987				34,288				33,072

		For the Year Ended December 31,
		2005			2004			2003			2002			2001
		(In thousands)
Selected Operations Data:
Total interest income		$	19,243			$	17,780			$	18,720			$	19,591			$	20,842
Total interest expense			5,935				4,898				5,853				6,756				9,200
Net interest income			13,308				12,882				12,867				12,835				11,642
Provision for loan losses			1,014				200				650				2,750				4,362
Net interest income after provision for loan losses			12,294				12,682				12,217				10,085				7,280
Fees and service charges			3,836				3,932				2,969				2,603				2,555
Gain (loss) on sales of investment securities			(5	)			139				403				1,649				(11	)
Other noninterest income			1,504				1,384				1,589				1,003				907
Total noninterest income			5,335				5,455				4,961				5,255				3,451
Total noninterest expense			13,584				13,054				13,849				12,932				12,169
Income (loss) before taxes and extraordinary items			4,045				5,083				3,329				2,407				(1,438	)
Income tax provision (benefit)			1,095				1,550				1,053				839				(1)(1,164	)
Net income (loss)		$	2,950			$	3,533			$	2,276			$	1,568			$	(274	)

		Year Ended December 31,
		2005		2004		2003		2002		2001
Selected Financial Ratios and Other Data:
Performance Ratios:
Return on assets (ratio of net income to average total assets)			0.83	%			1.04	%			0.70	%			0.52	%			(0.10	)%
Return on equity (ratio of net income to average equity)			5.18	%			9.28	%			6.39	%			4.66	%			(0.82	)% (1)
Return on assets, net of tax			0.83	%			1.04	%			0.70	%			0.52	%			(0.35	)% (1)
Return on equity, net of tax			5.18	%			9.28	%			6.39	%			4.66	%			(2.94	)%
Dividend payout ratio			16.13	%			—				—				—				—
Interest Rate Spread Information:
Average during period			3.86	%			4.08	%			4.14	%			4.57	%			4.45	%
End of period			3.97	%			3.92	%			4.24	%			4.60	%			4.19	%
Net interest margin(2)			4.15	%			4.24	%			4.31	%			4.71	%			4.35	%
Operating expense to average total assets			3.81	%			3.84	%			4.28	%			4.28	%			4.33	%
Average interest-earning assets to average interest-bearing liabilities			115.95	%			110.10	%			108.63	%			109.00	%			104.55	%
Efficiency ratio(3)			72.86	%			71.19	%			77.68	%			71.49	%			80.63	%
Asset Quality Ratios:
Nonperforming assets to total assets at end of period			0.25	%			0.22	%			0.26	%			0.44	%			1.51	%
Nonperforming loans to total loans			0.33	%			0.24	%			0.19	%			0.37	%			1.22	%
Allowance for loan losses to nonperforming loans			473.18	%			525.71	%			754.96	%			402.00	%			82.81	%
Allowance for loans losses to net loans			1.44	%			1.24	%			1.43	%			1.48	%			1.01	%
Net charge offs to average loans outstanding			0.15	%			0.30	%			0.24	%			0.71	%			1.94	%
Capital Ratios:
Equity to total assets at end of period			18.96	%			11.39	%			11.02	%			11.03	%			11.28	%
Average equity to average assets			15.98	%			11.21	%			11.02	%			11.15	%			11.86	%
Other Data:
Number of full-service offices			6				6				7				8				8

(1)		The Bank was a federal credit union prior to June 2001 and was exempt from federal and state income tax. Had the Bank been subject to federal and state income taxes for the full fiscal year ended December 31, 2001, income tax expense (benefit), assuming an effective tax rate of 32.0%, would have been $(460,000) and net income (loss) would have been $(978,000).
(2)		Net interest income divided by average interest-earning assets.
(3)		Total noninterest expense as a percentage of net interest income plus non-interest income.

Lending Activities

     The following table presents information concerning the composition of the Bank’s loan portfolio in dollar amounts and in percentages (before deductions for allowances for losses) as of the dates indicated.

		December 31,
		2005			2004			2003			2002			2001
		Amount			Percent			Amount			Percent			Amount			Percent			Amount			Percent			Amount			Percent
		(Dollars in Thousands)
Real Estate
One- to four-family		$	74,121				29.17	%		$	74,324				31.20	%		$	77,342				31.66	%		$	61,389				26.59	%		$	74,910				32.32	%
Multi-family			15,918				6.26				17,049				7.16				17,013				6.96				17,483				7.57				11,850				5.11
Commercial			37,985				14.95				38,581				16.19				42,112				17.24				44,908				19.45				25,187				10.87
Construction and development			16,505				6.50				8,248				3.46				11,382				4.66				11,489				4.98				11,861				5.12
Total real estate loans			144,529				56.88				138,202				58.01				147,849				60.52				135,269				58.58				123,808				53.41
Other loans
Consumer loans:
Student			1,110				0.44				1,190				0.50				1,307				0.54				1,721				0.75				1,899				0.82
Automobile			50,137				19.73				47,455				19.92				44,280				18.13				51,057				22.11				59,699				25.76
Home equity			15,591				6.14				13,837				5.81				12,807				5.24				12,420				5.38				11,739				5.06
Other			9,058				3.56				9,212				3.87				9,534				3.90				10,932				4.73				20,913				9.02
Total consumer loans			75,896				29.87				71,694				30.09				67,928				27.81				76,130				32.96				94,250				40.66
Commercial business loans			33,686				13.26				28,346				11.90				28,520				11.67				19,504				8.45				13,736				5.93
Total other loans			109,582				43.12				100,040				41.99				96,448				39.48				95,634				41.42				107,986				46.59
Total loans			254,111				100.00	%			238,240				100.00	%			244,297				100.00	%			230,903				100.00	%			231,794				100.00	%
Less allowance for loan losses			3,618								2,965								3,503								3,413								2,346
		$	250,493							$	235,275							$	240,794							$	227,490							$	229,448

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

		December 31,
		2005			2004			2003
		Amount			Percent			Amount			Percent			Amount			Percent
		(Dollars in Thousands)
Fixed Rate Loans:
Real Estate
One- to four-family		$	69,928				27.52	%		$	71,373				29.96	%		$	74,784				30.61	%
Multi-family			15,113				5.95				16,385				6.88				15,885				6.50
Commercial			26,293				10.35				33,562				14.09				34,888				14.28
Construction and development			8,299				3.27				3,687				1.55				4,293				1.76
Total real estate loans			119,633				47.08				125,007				52.48				129,850				53.15
Consumer			55,970				22.02				53,908				22.63				51,827				21.21
Commercial business			12,098				4.76				9,073				3.81				6,497				2.66
Total fixed-rate loans			187,701				73.86				187,988				78.90				188,174				77.02
Adjustable Rate Loans:
Real Estate
One- to four-family			4,193				1.65				2,951				1.24				2,558				1.05
Multi-family			805				0.32				664				0.28				1,128				0.46
Commercial			11,692				4.60				5,018				2.11				7,223				2.96
Construction and development			8,206				3.23				4,562				1.91				7,089				2.90
Total real estate loans			24,896				9.80				13,195				5.54				17,998				7.37
Consumer			19,926				7.84				17,785				7.47				16,101				6.59
Commercial business			21,588				8.50				19,272				8.09				22,024				9.02
Total adjustable rate loans			66,410				26.14				50,252				21.10				56,123				22.98
Total loans			254,111				100.00	%			238,240				100.00	%			244,297				100.00	%
Less allowance for loan losses			3,618								2,965								3,503
Total loans, net		$	250,493							$	235,275							$	240,794

     The following schedule illustrates the contractual maturity of the Bank’s loan portfolio at December 31, 2005. Mortgages 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
										Multi-Family and
		One-to-Four Family			Commercial			Construction			Consumer			Commercial Business			Total
						Weighted							Weighted							Weighted							Weighted							Weighted							Weighted
Due During Years Ending						Average							Average							Average							Average							Average							Average
December 31, (1)		Amount			Rate			Amount			Rate			Amount			Rate			Amount			Rate			Amount			Rate			Amount			Rate
		(Dollars in Thousands)
Anytime		$	419				6.62	%		$	1,983				6.34	%		$	652				6.06	%		$	664				14.61	%		$	125				7.65	%		$	3,843				7.79	%
2006			6,941				7.18				14,006				7.03				11,114				7.47				4,143				8.60				14,891				7.65				51,095				7.45
2007			3,982				6.47				14,093				6.33				1,099				6.23				6,256				8.96				1,071				6.98				26,501				6.99
2008 and 2009			10,748				6.74				22,504				6.52				2,664				6.85				22,143				7.24				12,419				6.93				70,478				6.86
2010 and 2011			4,811				7.06				900				6.56				209				8.17				27,170				6.65				3,428				7.56				36,518				6.80
2012 to 2026			30,717				6.22				417				6.98				767				7.78				15,520				8.05				1,752				7.25				49,173				6.87
2027 and following			16,503				5.62				—				—				—				—				—				—				—				—				16,503				5.62
Total		$	74,121							$	53,903							$	16,505							$	75,896							$	33,686							$	254,111

(1)		The total amount of loans due after December 31, 2006 which have predetermined interest rates is $165 million, while the total amount of loans due after such dates which have floating or adjustable interest rates is $34 million.
(2)		Includes demand loans, loans having no stated maturity and overdraft loans.

      Lending authority. The Bank has established lending limits for its officers. Loans up to $200,000 may be approved by senior loan officers. The President of the Bank and the Chief Operating Officer of the Bank may each approve loans up to $300,000. The commercial manager may make and approve loans up to $500,000. The Chief Executive Officer of the Bank may make or approve loans up to $1,000,000, and the Senior Credit Officer may approve loans up to $1,000,000. The Chief Executive Officer and the Senior Credit Officer may jointly approve loans up to $2.5 million and the Executive Loan Committee may approve loans up to $3.0 million. Loans over these amounts or outside our general underwriting guidelines must be approved by the board of directors.

     Effective January 1, 2005, we became subject to the lending limit established under Georgia law for loans to one borrower and the borrower’s related entities. See “How We Are Regulated — the Bank — Georgia Regulation.” Based on our capital level at December 31, 2005, the maximum amount under Georgia law that we could loan to any one borrower and the borrower’s related entities was $11.5 million for fully secured loans (including loans secured by real estate for which we have an independent appraisal) and $6.9 million for all other loans. Internally, we have set limits of $7.5 million for fully secured loans and $4.5 million for all other loans to any one borrower and the borrower’s related entities.

      Major loan customers . Our five largest lending relationships are with commercial borrowers and total $23.6 million in the aggregate, or 9.3% of our $254.1 million loan portfolio at December 31, 2005. The largest relationship consists of $5.2 million in loans to a retail pharmacy business, primarily secured by real estate. The next four largest relationships at December 31, 2005, were $4.7 million secured by various residential rental properties, $4.6 million secured by an aviation business, $4.6 million secured by various real estate ventures, and $4.5 million secured by various residential and commercial rental properties. At December 31, 2005, we had 11 other lending relationships that exceeded $2.0 million, for a total of $28.2 million, or 11.1% of our total loan portfolio. All of these loans were current as of December 31, 2005.

      One- to Four-Family Residential Real Estate Lending . We originate loans secured by first mortgages on one- to four-family residences in our lending area, and on occasion, outside our lending area for customers whose primary residences are within our lending area. The majority of these loans are originated for funding by another lender. During 2002 and 2003, this type of lending increased because of increased demand for refinancing and our decision, in 2003, to originate more fixed-rate residential loans for our portfolio. In 2004, this loan demand decreased, primarily due to a decrease in refinancing activity, and we reduced the amount of mortgage loans originated for our portfolio, though we continued to originate loans for funding by another lender. In 2005, we ceased originating 15 and 30 year one- to four-family residential loans for our own portfolio. At December 31, 2005, we had $74.1 million, or 29.2% of our loan portfolio in one- to four-family residential loans. Of these, $70.0 million were fixed-rate loans and $4.1 million were adjustable rate loans.

     We generally underwrite our one- to four-family owner-occupied loans based on the applicant’s employment and credit history and the 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 residential loans. For loans with a loan-to-value ratio in excess of 80%, we generally require private mortgage insurance in order to reduce our exposure below 80%. Properties securing our one- to four-family loans are appraised by independent fee appraisers approved by the board of directors. We require our borrowers to obtain title insurance and hazard insurance, and flood insurance, if necessary.

     We currently originate one- to four-family mortgage loans on either a fixed- or adjustable-rate basis, as consumer demand dictates. Our pricing strategy for mortgage loans includes setting interest rates that are competitive with other local financial institutions and consistent with our internal needs. Fixed-rate loans have a five year term, with a balloon payment and a 15- to 30-year amortization calculation.

     Adjustable-rate mortgage, or ARM, loans are generally offered with annual repricing with a maximum annual rate change of 1% and maximum overall rate change of 4%. We use a variety of indices to reprice our ARM loans. Our ARM loans generally provide for specified minimum and maximum interest rates, with a lifetime cap and floor, and a periodic adjustment of the interest rate over the rate in effect on the date of origination. As a consequence of using caps, the interest rates on these loans may not be as rate sensitive as is our cost of funds. Our ARM loans are written using generally accepted underwriting guidelines. ARM loans generally pose different credit risks than fixed-rate loans, primarily because as interest rates rise, the borrower’s payment rises, increasing the potential for default. The majority of these loans were originated during 2002 and 2003, as rates were decreasing. Rates have increased in 2005 and 2004, but we have not experienced significant delinquencies.

     We no longer originate one- to four-family loans that are assumable. However, our portfolio does contain one- to four-family loans that are assumable, subject to our approval, and may contain prepayment penalties. Due mainly, however, to the generally large loan size, these loans may not be readily saleable to Freddie Mac or Fannie Mae, but are saleable to other private investors. Our real estate loans contain a “due on sale” clause allowing us to declare the unpaid principal balance due and payable upon the sale of the collateral.

     We generally underwrite our non- owner-occupied, one- to four-family loans primarily based on a 1.25% debt service coverage, though we also consider the applicant’s creditworthiness and the appraised value of the property. Presently, we lend up to 85% of the lesser of the appraised value or purchase price for the residence. These loans are offered with a fixed rate or an adjustable rate using the prime rate as the index. These loans have terms of up to 15 years and are not assumable. We generally obtain title opinions from our counsel regarding these properties.

      Commercial and Multi-Family Real Estate Lending . We offer a variety of multi-family and commercial real estate loans. These loans are secured primarily by multi-family dwellings, and a limited amount of small retail establishments, hotels, motels, warehouses and small office buildings located in our market areas. At December 31, 2005, multi-family and commercial real estate loans totaled $15.9 million and $38.0 million or 6.26% and 14.95%, respectively, of our gross loan portfolio.

     Our loans secured by multi-family and commercial real estate are originated with either a fixed or adjustable interest rate over a three-or five-year term with a balloon payment based on a 15 year amortization. The interest rate on adjustable-rate loans is based on a variety of indices, generally determined through negotiation with the borrower. Loan-to-value ratios on our multi-family and commercial real estate loans typically do not exceed 80% of the appraised value of the property securing the loan.

     Loans secured by multi-family and commercial real estate are underwritten 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 and an assignment of rents or leases in order to be assured that the cash flow from the project will be used to repay the debt. Appraisals on properties securing multi-family and commercial real estate loans are performed by independent state certified or licensed fee appraisers approved by the board of directors, with a second independent appraisal review performed if the loan exceeds $500,000.

     We generally do not maintain a tax or insurance escrow account for loans secured by multi-family and commercial real estate. In order to monitor the adequacy of cash flows on income-producing properties, the borrower is generally required to provide periodic financial information.

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

      Construction and Development Lending . Our construction loan portfolio consists of loans for the construction of one- to four-family residences, multi-family residences and commercial properties. Construction lending generally affords us an opportunity to receive interest at rates higher than those obtainable from residential lending and to receive higher origination and other loan fees. In addition, construction loans are generally made with adjustable rates of interest for six to nine month terms, with interest-only payments due during the construction period. At December 31, 2005, we had $16.5 million in construction loans outstanding, representing 6.5% of our gross loan portfolio and consisting of $4.7 million in construction loans for one- to four-family residences and commercial properties being constructed and $11.8 million in acquisition and development loans to builders for the development of lots for future residential and commercial construction.

     Construction loans also involve additional risks because funds are advanced upon the security of the project under construction, which is of uncertain value prior to the completion of construction. Moreover, because of the uncertainties inherent in estimating construction costs, delays arising from labor problems, material shortages, and other unpredictable contingencies, it is relatively difficult to evaluate accurately the total loan funds required to complete a project, and the related loan-to-value ratios. We fund our construction loans based on percentage of completion as determined by physical property inspections. Acquisition and development loans are required to be paid down as lots are sold, though on an accelerated basis so that we are repaid before all the lots are sold. See also the discussion under the headings “- Classified Assets” and “- Loan Delinquencies and Defaults” below.

      Commercial Business Lending . At December 31, 2005, commercial business loans totaled $33.7 million or 13.3% of our gross loan portfolio. Our commercial business lending activities encompass loans with a variety of purposes and security, including loans to finance accounts receivable, inventory and equipment. Our commercial business lending policy includes credit file documentation and analysis of the borrower’s background, capacity to repay the loan, the adequacy of the borrower’s capital and collateral as well as an evaluation of other conditions affecting the borrower. Analysis of the borrower’s past, present and future cash flows is also an important aspect of our credit analysis. We generally obtain personal guarantees on our commercial business loans. Nonetheless, these loans are believed to carry higher credit risk than more traditional single family loans.

     Unlike residential mortgage loans, commercial business loans are typically made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business and, therefore, are of higher risk. Commercial business loans are generally secured by business assets, such as accounts receivable, equipment and inventory. This collateral may depreciate over time, may be difficult to appraise and may fluctuate in value based on the success of the business. As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself (which, in turn, is often dependent in part upon general economic conditions).

     Our management recognizes the generally increased risks associated with our commercial business lending. Our commercial lending policy emphasizes complete credit file documentation and analysis of the borrower’s character, capacity to repay the loan, the adequacy of the borrower’s capital and collateral as well as an evaluation of the industry conditions affecting the borrower. Review o