Wayne Savings Bancshares Inc. (WAYN) - Description of business

Company Description
-----------------General Wayne Savings Bancshares, Inc. Wayne Savings Bancshares, Inc. (the "Company"), is a unitary holding company for Wayne Savings Community Bank (the "Bank"). The only significant asset of the Company is its investment in the Bank. A plan of conversion and reorganization was approved by the stockholders of the Company, the depositors of Wayne Savings Community Bank and the Office of Thrift Supervision ("OTS") in fiscal 2003, and the related stock offering was completed on January 8, 2003. As of that date 1,350,699 shares of common stock of the Company owned by the M.H.C. were retired and the Company sold 2,040,816 shares of common stock for $10.00 per share. After consideration of funding the employee stock ownership plan ("ESOP") with $1.6 million and related expenses of $1.9 million, net proceeds from the stock offering amounted to $17.1 million. An additional 1,847,820 shares were issued to existing shareholders based on an exchange rate of 1.5109 new shares of common stock for each existing share, resulting in 3,888,795 total new shares outstanding. At March 31, 2006, the Company had total assets of $403.7 million, total deposits of $332.6 million, and stockholders' equity of $35.5 million. On June 1, 2004, the Company acquired Stebbins Bancshares, Inc., and its national bank subsidiary, Stebbins National Bank of Creston, Ohio. The acquisition of Stebbins National Bank increased the Bank's branches to eleven full-service locations. The Company's principal office is located at 151 North Market Street, Wooster, Ohio, and its telephone number at that address is (330) 264-5767. Wayne Savings Community Bank The Bank is an Ohio-chartered stock savings and loan association headquartered in Wooster, Ohio. The Bank's deposits are insured by the Federal Deposit Insurance Corporation ("FDIC"). The Bank has been a member of the Federal Home Loan Bank ("FHLB") System since 1937. The Bank is a community-oriented savings institution offering traditional financial services to its local community. The Bank's primary lending and deposit gathering area includes Wayne, Holmes, Ashland, Medina and Stark counties, where it operates eleven full-service offices. This contiguous five-county area is located in northeast Ohio, and is an active manufacturing and agricultural market. The Bank's principal business activities consist of originating one- to four-family residential real estate loans, multi-family residential, commercial and non-residential real estate loans. The Bank also originates consumer loans, and to a lesser extent, construction loans. The Bank also invests in mortgage-backed securities and currently maintains a significant portion of its assets in liquid investments, such as United States Government securities, federal funds, and deposits in other financial institutions. During the most recent five fiscal years, the Company has rebalanced the loan portfolio by placing an increased emphasis on nonresidential real estate and commercial business loans. Nonresidential real estate loans and commercial loans have increased from $12.4 million, or 4.82% of the loan portfolio and $3.1 million, or 1.22% of the total loan portfolio at March 31, 2002 to $50.8 million, or 21.25%, and $21.6 million, or 9.02%, at March 31, 2006. Correspondingly, one- to four-family residential loans have decreased from $220.1 million, or 85.36% of the total loan portfolio at March 31, 2002 to $149.1 million, or 62.4%, at March 31, 2006. Nonresidential real estate loans and commercial loans generally carry higher yields and shorter terms than one- to four-family loans. The increased emphasis on nonresidential real estate and commercial business loans have diversified the loan portfolio, expanded the Company's product offerings and broadened the Company's customer base. The Bank's principal executive office is located at 151 North Market Street, Wooster, Ohio, and its telephone number at that address is (330) 264-5767.Market Area/Local Economy The Bank, headquartered in Wooster, Ohio, operates in Wayne, Ashland, Medina, Holmes and Stark Counties in northeast Ohio. Wooster, Ohio is located in Wayne County and is approximately midway between Cleveland and Columbus, Ohio. Wayne County is characterized by a diverse economic base, which is not dependent on any particular industry. It is one of the leading agricultural counties in the state. Since 1892, Wooster has been the headquarters of the Ohio Agricultural Research and Development Center, the agricultural research arm of The Ohio State University. In addition, Wayne County is also the home base of such nationally known companies like J.M. Smucker Company, Worthington Industries/The Gertsenslager Company, and the Wooster Brush Company. It is also the home of many industrial plants, including Packaging Corporation of America, International Paper Company, Morton Salt, and FritoLay, Inc. The City of Wooster has benefited from the commitment of the world renowned Cleveland Clinic as they have established new state of the art medical facilities. Wayne County is also known for its excellence in education. The College of Wooster was founded in 1866 and serves 1,800 students during the school season. Other quality educational opportunities are offered by the Agricultural Technical Institute of Ohio State University, and Wayne College, a branch of The University of Akron. Wayne Savings operates four full-service offices in Wooster, one stand-alone drive-thru facility and one full-service office in both Rittman and Creston. Ashland County, which is located due west of Wayne County, also has a diverse economic base. In addition to its agricultural segment, Ashland County has manufacturing plants producing rubber and plastics, machinery, transportation equipment, chemicals, apparel, and other items. Ashland is also the home of Ashland University. The City of Ashland is the county seat and the location of two of the Bank's branch offices. Medina County, located just north of Wayne County, is the center of a fertile agricultural region. Farming remains the largest industry in the county in terms of dollar value of goods produced. However, over 100 small manufacturing firms also operate in the county. The City of Medina is located in the center of the Cleveland-Akron-Lorain Standard Consolidated Statistical Marketing Area. Medina is located approximately 30 miles south of Cleveland and 15 miles west of Akron. Due to its proximity to Akron and Cleveland, a majority of Medina County's labor force is employed in these two cities. The Bank operates one full-service office in Medina County, which is located in the Village of Lodi. Holmes County, located directly south of Wayne County, has a mostly rural economy. The local economy depends mostly upon agriculture, light manufacturing, fabrics, and wood products. Because of the scenic beauty and a large Amish settlement, revenues from tourism are becoming increasingly significant. The county is also noted for its many fine cheese-making operations. A large number of Holmes County residents are employed in Wayne County. The City of Millersburg is the county seat and the location of one of the Bank's branch offices. Stark County, located directly east of Wayne County, is characterized by a diverse economy and over 1,500 different products are manufactured in the county. Stark County also has a strong agricultural base, and ranks fourth in Ohio in the production of dairy products. The major employers in North Canton are the Hoover Company, Diebold Incorporated (a major manufacturer of bank security products and automated teller machines) and the Timken Company (a world-wide manufacturer of tapered roller bearings and specialty steels). Maytag Corp., the parent of the Hoover Company, was acquired by Whirlpool Corp. The future of the Hoover Company in North Canton is uncertain. Timken has also had plants close, resulting injob losses in the North Canton region of approximately 30%. The Bank does not have a material concentration of loans in the North Canton market area. Jackson Township is the home to the Belden Village Shopping Center, while Plain Township is a residential and agricultural area with a few widely scattered light industries. North Canton is the location of one of the Bank's branches.Lending Activities General. Historically, the principal lending activity of the Company has been the origination of fixed and adjustable rate mortgage ("ARM") loans collateralized by one- to four-family residential properties located in its market area. The Company originates ARM loans for retention in its portfolio, and fixed rate loans that are eligible for resale in the secondary mortgage market. The Company also originates loans collateralized by non-residential and multi-family residential real estate, as well as commercial business loans. The Company also originates consumer loans to broaden services offered to customers. The Company has sought to make its interest-earning assets more interest rate sensitive by originating adjustable rate loans, such as ARM loans, home equity loans, and medium-term consumer loans. The Company also purchases mortgage-backed securities generally with estimated remaining average lives of 5 years or less. At March 31, 2006, approximately $70.9 million, or 24.4%, of the Company's total loans and mortgage-backed securities consisted of loans or securities with adjustable interest rates. The Company continues to actively originate fixed rate mortgage loans, generally with 15 to 30 year terms to maturity, collateralized by one- to our-family residential properties. One- to four-family fixed rate residential mortgage loans generally are originated and underwritten according to standards that allow the Company to resell such loans in the secondary mortgage market for purposes of managing interest rate risk and liquidity. Since November 2005, the Company has decided to retain all one- to four-family, fixed rate residential mortgage loan originations with terms of 15 and 30 years in an attempt to stabilize this sector of the loan portfolio. The Company retains servicing on its sold mortgage loans and realizes monthly service fee income. The Company also originates interim construction loans on one- to four-family residential properties. The Company has continued developing the commercial business loan program. The purpose of this program is to increase the Company's interest rate sensitive assets, increase interest income and diversify both the loan portfolio and the Company's customer base. The Company has three experienced commercial lenders to help in this effort. The Company targets small local businesses with loan amounts in the $50,000 - $1.0 million range with a majority of loans under $500,000. Commercial loans increased to $21.6 million at March 31, 2006 as compared to $14.1 million at March 31, 2005 and $3.1 million at March 31, 2002. Further, the Company has placed an increased emphasis on nonresidential real estate loan products over the last five years. Nonresidential real estate and land loans increased from $12.4 million, or 4.8%, of the total loan portfolio at March 31, 2002 to $50.8 million, or 21.2%, of the total loan portfolio at March 31, 2006. Analysis of Loan Portfolio. Set forth below are selected data relating to the composition of the Company's loan portfolio, including loans held for sale, by type of loan as of the dates indicated. At March 31, -------------------------------------------------------------------------------------------- 2006 2005 2004 2003 2002 --------------- ---------------- ---------------- ------------------ --------------- Mortgage loans: $ % $ % $ % $ % $ % -------- ------ -------- ------ -------- ------ -------- -------- -------- ------ (Dollars in thousands) One- to four-family residential(1).................. $149,134 62.40% $157,658 72.60% $171,736 81.97% $200,764 86.41% $220,145 85.36% Residential construction loans.... 4,675 1.96 4,053 1.87 2,914 1.39 3,548 1.53 8,728 3.38 Multi-family residential.......... 7,930 3.32 7,872 3.63 6,800 3.25 8,512 3.66 7,368 2.86 Non-residential real estate/land(2).................. 50,778 21.25 29,187 13.44 18,439 8.80 12,067 5.19 12,423 4.82 -------- ------ -------- ------ -------- ------ -------- -------- -------- ------ Total mortgage loans......... 212,517 88.93 198,770 91.54 199,889 95.41 224,891 96.79 248,664 96.42 Other loans: Consumer loans(3)................. 4,901 2.05 4,306 1.98 3,156 1.51 3,892 1.67 6,096 2.36 Commercial business loans......... 21,550 9.02 14,075 6.48 6,471 3.08 3,571 1.54 3,134 1.22 -------- ------ -------- ------ -------- ------ -------- -------- -------- ------ Total other loans............ 26,451 11.07 18,381 8.46 9,627 4.59 7,463 3.21 9,230 3.58 -------- ------ -------- ------ -------- ------ -------- -------- -------- ------ Total loans before net items...... 238,968 100.00% 217,151 100.00% 209,516 100.00% 232,354 100.00% 257,894 100.00% ====== ====== ====== ======== ====== Less: Loans in process.................. 1,729 1,638 2,579 2,244 4,616 Deferred loan origination fees.... 443 512 679 1,059 1,376 Allowance for loan losses......... 1,484 1,374 815 678 730 -------- -------- -------- -------- -------- Total loans receivable, net.. $235,312 $213,627 $205,443 $228,373 $251,172 ======== ======== ======== ======== ======== Mortgage-backed securities, net(4) $ 55,731 $ 60,352 $ 88,428 $ 76,002 $ 17,326 ======== ======== ======== ======== ======== (1) Includes equity loans collateralized by second mortgages in the aggregate amount of $20.9 million, $20.3 million, $20.3 million, $21.2 million, and $18.9 million as of March 31, 2006, 2005, 2004, 2003 and 2002, respectively. Such loans have been underwritten on substantially the same basis as the Company's first mortgage loans. (2) Includes land loans of $674,000, $1.4 million, $575,000, $813,000 and $736,000 as of March 31, 2006, 2005, 2004, 2003 and 2002, respectively. (3) Includes second mortgage loans of $783,000, $1.4 million, $535,000, $859,000 and $1.2 million as of March 31, 2006, 2005, 2004, 2003 and 2002, respectively. (4) Includes mortgage-backed securities designated as available for sale. Loan and Mortgage-Backed Securities Maturity and Repricing Schedule. The following table sets forth certain information as of March 31, 2006, regarding the dollar amount of loans and mortgage-backed securities maturing in the Company's portfolio based on their contractual terms to maturity. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. Adjustable and floating rate loans and mortgage-backed securities are included in the period in which interest rates are next scheduled to adjust rather than in which they mature, and fixed rate loans and mortgage-backed securities are included in the period in which the final contractual repayment is due. Fixed rate mortgage-backed securities are assumed to mature in the period in which the final contractual payment is due on the underlying mortgage. One Three Five Ten Beyond Within Through Through Through Through Twenty One Year Three Years Five Years Ten Years Twenty Years Years Total ----------- ----------- ----------- ----------- ------------ ----------- ----------- (In Thousands) Mortgage loans: One- to four-family residential: Adjustable ....................... $ 30,781 $ 9,647 $ 1,947 $ 195 $ -- $ -- $ 42,570 Fixed ............................ 2,783 956 1,078 11,291 32,125 58,331 106,564 Construction:(1) Adjustable ....................... -- -- -- -- -- -- -- Fixed ............................ 473 -- -- -- 509 1,964 2,946 Multi-family residential, nonresidential and land: Adjustable ....................... 3,962 11,128 10,438 6,634 -- -- 32,162 Fixed ............................ 2,161 8,711 3,505 3,448 8,721 -- 26,546 Other Loans: Commercial business loans .......... 17,883 1,276 1,511 172 587 121 21,550 Consumer ........................... 1,271 1,336 1,987 303 4 -- 4,901 ----------- ----------- ----------- ----------- ----------- ----------- ----------- Total loans .......................... $ 59,314 $ 33,054 $ 20,466 $ 22,043 $ 41,946 $ 60,416 $ 237,239 =========== =========== =========== =========== =========== =========== =========== Mortgage-backed securities(2) ........ $ 9,018 $ 2,615 $ 1,527 $ 13,242 $ 19,675 $ 10,155 $ 56,232 =========== =========== =========== =========== =========== =========== =========== ----------------------------- (1) Amounts shown are net of loans in process of $1.7 million in construction loans. (2) Includes mortgage-backed securities available for sale. Does not include premiums of $514,000, discounts of $287,000 and unrealized losses of $728,000. The following table sets forth at March 31, 2006, the dollar amount of all fixed rate and adjustable rate loans and mortgage-backed securities maturing or repricing after March 31, 2007. Fixed Adjustable (In Thousands) Mortgage loans: One- to four-family residential ...................... $103,781 $ 11,789 Construction (1) ..................................... 2,473 -- Multi-family residential, non-residential and land (1) 24,385 28,200 Consumer ............................................. 3,630 -- Commercial business .................................. 2,436 1,231 -------- -------- Total loans ................................... $136,705 $ 41,220 ======== ========Mortgage-backed securities(2) .......................... $ 45,164 $ 2,050 ======== ========----------------- (1) Net of loans in process of $1.7 million in residential construction loans. (2) Includes mortgage-backed securities available for sale, which totaled $53.9 million as of March 31, 2006. Does not include premiums of $514,000, discounts of $287,000 and unrealized losses of $728,000. One- to Four-Family Residential Real Estate Loans. The Company's primary lending activity consists of the origination of one- to four-family, owner-occupied, residential mortgage loans on properties located in the Company's market area. The Company generally does not originate one- to four-family residential loans secured by properties outside of its market area. At March 31, 2006, the Company had $149.1 million, or 62.4%, of its total loan portfolio invested in one- to four-family residential mortgage loans. The Company's fixed rate loans generally are originated and underwritten according to standards that permit resale in the secondary mortgage market. Whether the Company can or will sell fixed rate loans into the secondary market, however, depends on a number of factors including the Company's portfolio mix, gap and liquidity positions, and market conditions. Moreover, the Company is more likely to retain fixed rate loans if its one-year gap is positive. The Company's fixed rate mortgage loans are amortized on a monthly basis with principal and interest due each month. One- to four-family residential real estate loans often remain outstanding for significantly shorter periods than their contractual terms because borrowers may refinance or prepay loans at their option. The Company's one- to four-family residential portfolio has declined $8.5 million, or 5.4%, from March 31, 2005 to March 31, 2006. This reduction was due mainly to the low interest rate environment which prompted many mortgage customers to refinance their loans, coupled with management's intent to increase the commercial loan portfolio. The Company's secondary market activities have been limited to sales of $6.1 million, $6.0 million, $6.2 million, $4.0 million and $27.4 million, for the fiscal years ended March 31, 2006, 2005, 2004, 2003 and 2002, respectively. Such sales generally constituted current period originations. In the third quarter of fiscal 2006, the Company's management temporarily halted sales of loans to stabilize balances in this segment of the loan portfolio. There were no loans identified as available for sale as of March 31, 2006, 2005, 2004, 2003, or 2002. The Company currently offers one- to four-family residential mortgage loans with terms typically ranging from 15 to 30 years, and with adjustable or fixed interest rates. Originations of fixed rate mortgage loans versus ARM loans are monitored on an ongoing basis and are affected significantly by the level of market interest rates, customer preference, the Company's interest rate gap position, and loan products offered by the Company's competitors. Despite the Company's emphasis on ARM loans, the low interest rate environment over the last few years has resulted in customer preference for fixed rate mortgage loans. As a result, during the year ended March 31, 2006, the Company's ARM portfolio decreased by $3.5 million, or 7.6%. The Company offers one ARM loan product. The Treasury ARM loan adjusts annually with interest rate adjustment limitations of 2% per year and with a cap of 3% or 5% on total rate increases or decreases over the life of the loan. The index on the Treasury ARM loan is the weekly average yield on U.S. Treasury securities, adjusted to a constant maturity of one year plus a margin. However, these loans are underwritten at the fully-indexed interest rate. One- to four-family residential ARM loans totaled $42.6 million, or 17.8%, of the Company's total loan portfolio at March 31, 2006. The primary purpose of offering ARM loans is to make the Company's loan portfolio more interest rate sensitive. However, as the interest income earned on ARM loans varies with prevailing interest rates, such loans do not offer the Company predictable cash flows as would long-term, fixed rate loans. ARM loans carry increased credit risk associated with potentially higher monthly payments by borrowers as general market interest rates increase. It is possible, therefore, that during periods of rising interest rates, the risk of default on ARM loans may increase due to the upward adjustment of interest costs to the borrower. Management believes that the Company's credit risk associated with its ARM loans is reduced because the Company has either a 3% or 5% cap on interest rate increases during the life of its ARM loans. The Company also offers home equity loans and equity lines of credit collateralized by a second mortgage on the borrower's principal residence. In underwriting these home equity loans, the Company requires that the maximum loan-to-value ratios, including the principal balances of both the first and second mortgage loans, not exceed 85%. The home equity loan portfolio consists of adjustable rate loans which use the prime rate as published in The Wall Street Journal as interest rate indices. Home equity loans include fixed term adjustable rate loans, as well as lines of credit. As of March 31, 2006, the Company's equity loan portfolio totaled $20.9 million, or 13.6%, of its one- to four-family mortgage loan portfolio. The Company's one- to four-family residential first mortgage loans customarily include due-on-sale clauses, which are provisions giving the Company the right to declare a loan immediately due and payable in the event, among other things, that the borrower sells or otherwise disposes of the underlying real property serving as security for the loan. Due-on-sale clauses are an important means of adjusting the rates on the Company's fixed rate mortgage loan portfolio. Regulations limit the amount that a savings association may lend relative to the appraised value of the real estate securing the loan, as determined by an appraisal at the time of loan origination. The Company's lending policies limit the maximum loan-to-value ratio on both fixed rate and ARM loans without private mortgage insurance to 80% of the lesser of the appraised value or the purchase price of the property to serve as collateral for the loan. However, the Company makes one- to four-family real estate loans with loan-to-value ratios in excess of 80%. For 15 year fixed rate ARM loans with loan-to-value ratios of 80.01% to 85%, 85.01% to 90%, 90.01% to 95%, and 95.01% to 97%, the Company requires the first 6%, 12%, 25% and 30%, respectively, of the loan to be covered by private mortgage insurance. For 30 year fixed rate loans with loan-to-value ratios of 80.01% to 85%, 85.01% to 90%, and 90.01% to 97%, the Company requires the first 12%, 25%, and 30%, respectively, of the loan to be covered by private mortgage insurance. The Company requires fire and casualty insurance, as well as title insurance regarding good title, on all properties securing real estate loans made by the Company and flood insurance, where applicable. Multi-Family Residential Real Estate Loans. Loans secured by multi-family real estate constituted approximately $7.9 million, or 3.3%, of the Company's total loan portfolio at March 31, 2006. The Company's multi-family real estate loans are secured by multi-family residences, such as apartment buildings. At March 31, 2006, most of the Company's multi-family loans were secured by properties located within the Company's market area. At March 31, 2006, the Company's multi-family real estate loans had an average balance of $496,000, and the largest multi-family real estate loan had a principal balance of $3.2 million. Multi-family real estate loans currently are offered with adjustable interest rates or short term balloon maturities, although in the past the Company originated fixed rate long-term multi-family real estate loans. The terms of each multi-family loan are negotiated on a case by case basis, although such loans typically haveadjustable interest rates tied to a market index, and amortize over 15 to 25 years. The Company currently does not emphasize multi-family real estate construction loans. Loans secured by multi-family 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. Non-Residential Real Estate and Land Loans. Loans secured by non-residential real estate constituted approximately $50.1 million, or 21.0%, of the Company's total loan portfolio at March 31, 2006. The Company's non-residential real estate loans are secured by improved property such as offices, s facilities, and other non-residential buildings. At March 31, 2006, most of the Company's non-residential real estate loans were secured by properties located within the Company's market area. At March 31, 2006, the Company's non-residential loans had an average balance of $241,000 and the largest non-residential real estate loan had a principal balance of $2.3 million. The terms of each non-residential real estate loan are negotiated on a case by case basis. Non-residential real estate loans are currently offered with adjustable interest rates or short term balloon maturities, although in the past the Company has originated fixed rate long term non-residential real estate loans. Non-residential real estate loans originated by the Company generally amortize over 15 to 25 years. The Company currently does not emphasize non-residential real estate construction loans. Nonresidential real estate loans have significantly increased from $12.4 million or 4.82% of the total loan portfolio at March 31, 2002 to $50.8 million or 21.25% of the total loan portfolio at March 31, 2006. The Company intends to further diversify its loan portfolio and its increased emphasis on nonresidential real estate lending. Loans secured by non-residential real estate generally involve a greater degree of 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 non-residential real estate is typically dependent upon the successful operation of the related real estate project. If the cash flow from the project is reduced, the borrower's ability to repay the loan may be impaired. The Company also originates a limited number of land loans secured by individual improved and unimproved lots for future residential construction. Land loans are generally offered with a fixed rate and with terms of up to 5 years. Land loans totaled $674,000 at March 31, 2006. Residential Construction Loans. To a lesser extent, the Company originates loans to finance the construction of one- to four-family residential property. At March 31, 2006, the Company had $4.7 million, or 2.0%, of its total loan portfolio invested in interim construction loans. The Company makes construction loans to private individuals and to builders. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. Construction loans are typically structured as permanent one- to four-family loans originated by the Company with a 12-month construction phase. Accordingly, upon completion of the construction phase, there is no change in interest rate or term to maturity of the original construction loan, nor is a new permanent loan originated. Commercial Business Loans. Commercial business loans totaled $21.6 million, or 9.0% of the Company's total loan portfolio at March 31, 2006. This represents net growth of $7.5 million which equatesto a 53.1% increase as percentage of total loans compared to $14.1 million at March 31, 2005. The Company has three experienced commercial lenders and is developing an additional commercial lender internally. The Company has plans to continue commercial lending growth as market conditions permit. Commercial loans carry a higher degree of risk than one-to-four-residential loans. Such lending typically involves large loan balances concentrated in a single borrower or groups of related borrowers for rental or business properties. In addition, the payment experience on loans secured by income-producing properties is typically dependent on the success of the operation of the related project and thus is typically affected by adverse conditions in the real estate market and in the economy. The Company makes loans generally in the $100,000 to $1,000,000 range with the majority of them being under $500,000. Commercial loans are generally underwritten based on the borrower's ability to pay and assets such as buildings, land and equipment are taken as additional loan collateral. Each loan is evaluated for a level of risk and assigned a rating from "1" (the highest rating) to "7" (the lowest rating). All loans originated to date have been rated 4 or higher. Consumer Loans. Ohio savings associations are authorized to invest in secured and unsecured consumer loans in an aggregate amount which, when combined with investments in commercial paper and corporate debt securities, does not exceed 20% of an association's assets. In addition, an Ohio association is permitted to invest up to 5% of its assets in loans for educational purposes. As of March 31, 2006, consumer loans totaled $4.9 million, or 2.1%, of the Company's total loan portfolio. The principal types of consumer loans offered by the Company are second mortgage loans, fixed rate auto and truck loans, education loans, credit card loans, unsecured personal loans, and loans secured by deposit accounts. Consumer loans are offered primarily on a fixed rate basis with maturities generally of less than ten years. The Company's second mortgage consumer loans are secured by the borrower's principal residence with a maximum loan-to-value ratio, including the principal balances of both the first and second mortgage loans, of 80% or less. Such loans are offered on a fixed rate basis with terms of up to ten years. At March 31, 2006, second mortgage loans totaled $783,000, or .5%, of one- to four-family mortgages. The underwriting standards employed by the Company for consumer loans include a determination of the applicant's credit history and an assessment of the applicant's ability to meet existing obligations and payments on the proposed loan. The quality and stability of the applicant's monthly income are determined by analyzing the gross monthly income from primary employment, and additionally from any verifiable secondary income. Creditworthiness of the applicant is of primary consideration. However, where applicable, the underwriting process also includes a comparison of the value of the collateral in relation to the proposed loan amount. Consumer loans entail greater credit risk than residential mortgage loans, particularly in the case of consumer loans that are unsecured or secured by assets that depreciate rapidly, such as automobiles, mobile homes, boats, and recreational vehicles. In such cases, repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment for the outstanding loan and the remaining deficiency often does not warrant further substantial collection efforts against the borrower. In particular, amounts realizable on the sale of repossessed automobiles may be significantly reduced based upon the condition of the automobiles and the lack of demand for used automobiles. The Company adds a general provision on a regular basis to its consumer loan loss allowance, based on, among other factors, general economic conditions and prior loss experience. See "--Delinquencies and Classified Assets--Non-Performing and Impaired Assets," and "--Classification of Assets" for information regarding the Company's loan loss experience and reserve policy. Mortgage-Backed Securities. The Company also invests in mortgage-backed securities generally issued or guaranteed by the United States Government or agencies thereof. Investments in mortgage-backed securities are made either directly or by exchanging mortgage loans in the Company's portfolio for such securities. These securities consist primarily of adjustable rate mortgage-backed securities issued or guaranteed by the Federal National Mortgage Association ("FNMA"), Federal Home Loan Mortgage Corporation ("FHLMC"), and the Government National Mortgage Association ("GNMA"). Total mortgage-backed securities, including those designated as available for sale, decreased from $60.4 million at March 31, 2005 to $55.7 million at March 31, 2006 primarily due to repayments. The Company's objectives in investing in mortgage-backed securities vary from time to time depending upon market interest rates, local mortgage loan demand, and the Company's level of liquidity. Mortgage-backed securities are more liquid than whole loans and can be readily sold in response to market conditions and changes in interest rates. Mortgage-backed securities purchased by the Company also have lower credit risk because principal and interest are either insured or guaranteed by the United States Government or agencies thereof. Loan Originations, Solicitation, Processing, and Commitments. Loan originations are derived from a number of sources such as real estate broker referrals, existing customers, borrowers, builders, attorneys and walk-in customers. The Company has also entered into a number of participation loans with high quality lead lenders. The participations are outside the Company's normal lending area and diversify the loan portfolio. Upon receiving a loan application, the Company obtains a credit report and employment verification to verify specific information relating to the applicant's employment, income, and credit standing. In the case of a real estate loan, an appraiser approved by the Company appraises the real estate intended to secure the proposed loan. An underwriter in the Company's loan department checks the loan application file for accuracy and completeness, and verifies the information provided. One- to four-family and multi-family residential, and commercial real estate loans, for up to $150,000, may be approved by the manager of the mortgage loan department, loans between $150,000 and $300,000 must be approved by the Chief Executive Officer and loans in excess of $300,000 must be approved by the Board of Directors. The Loan Committee meets once a week to review and verify that loan officer approvals of loans are made within the scope of management's authority. All approvals subsequently are ratified monthly by the full Board of Directors. Fire and casualty insurance is required at the time the loan is made and throughout the term of the loan. After the loan is approved, a loan commitment letter is promptly issued to the borrower. At March 31, 2006, the Company had commitments to originate $1.6 million of loans. 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. The borrower must provide proof of fire and casualty insurance on the property serving as collateral, which insurance must be maintained during the full term of the loan. A title search of the property is required on all loans secured by real property. Origination, Purchase and Sale of Loans and Mortgage-Backed Securities. The table below shows the Company's loan origination, purchase and sales activity for the periods indicated. At March 31, ----------------------------------- 2006 2005 2004 --------- --------- --------- (In Thousands) Total loans receivable, net at beginning of year ...... $ 213,627 $ 205,443 $ 228,373 Loans originated: One- to four-family residential(1) ................. 19,929 20,312 53,116 Multi-family residential(2) ........................ 128 18 421 Non-residential real estate/land ................... 30,989 11,237 1,147 Consumer loans ..................................... 3,613 1,932 1,318 Commercial loans ................................... 8,456 22,696 15,859 --------- --------- --------- Total loans originated .......................... 63,115 56,195 71,861 Loans sold: Whole loans ........................................ (6,065) (6,726) (6,198) --------- --------- --------- Total loans sold ................................ (6,065) (6,726) (6,198) Mortgage loans transferred to REO ..................... (412) (268) (279) Loan repayments ....................................... (34,980) (52,517) (89,107) Other loan activity, net(3) ........................... 27 11,500 793 --------- --------- --------- Total loans receivable, net at end of year ...... $ 235,312 $ 213,627 $ 205,443 ========= ========= ========= Mortgage-backed securities at beginning of year ....... $ 60,352 $ 88,428 $ 76,002 Mortgage-backed securities purchased .................. 22,361 8,018 55,526 Principal repayments and other activity ............... (26,982) (36,094) (43,100) --------- --------- --------- Mortgage-backed securities at end of year ....... $ 55,731 $ 60,352 $ 88,428 ========= ========= ========= ------------------- (1) Includes loans to finance the construction of one- to four-family residential properties, and loans originated for sale in the secondary market. (2) Includes loans to finance the sale of real estate acquired through foreclosure. (3) For fiscal 2005, includes other activity related to the Stebbins acquisition. Loan Origination Fees and Other Income. In addition to interest earned on loans, the Company generally receives loan origination fees. The Company accounts for loan origination fees in accordance with Statement of Financial Accounting Standards ("SFAS") No. 91 "Accounting for Non-refundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases." To the extent that loans are originated or acquired for the Company's portfolio, SFAS No. 91 requires that the Company defer loan origination fees and costs and amortize such amounts as an adjustment of yield over the life of the loan by use of the level yield method. SFAS No. 91 reduces the amount of revenue recognized by many financial institutions at the time such loans are originated or acquired. Fees deferred under SFAS No. 91 are recognized into income immediately upon prepayment or the sale of the related loan. At March 31, 2006, the Company had $443,000 of deferred loan origination fees. Loan origination fees are volatile sources of income. Such fees vary with the volume and type of loans and commitments made and purchased, principal repayments, and competitive conditions in the mortgage markets, which in turn respond to the demand for and availability of money. The Company receives other fees, service charges, and other income that consist primarily of deposit transaction account service charges, late charges, credit card fees, and income from REO operations. The Company recognized fees and service charges of $1.3 million, $1.3 million and $1.5 million, for the fiscal years ended March 31, 2006, 2005 and 2004, respectively. Loans to One Borrower. Savings associations are subject to the same limits as those applicable to national banks, which under current regulations restrict loans to one borrower to an amount equal to 15% of unimpaired capital and unimpaired surplus on an unsecured basis, 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). At March 31, 2006, the Company's largest concentration of loans to one borrower totaled $3.2 million. All of the loans in this concentration were current at March 31, 2006. The Company had no loans at March 31, 2006, which exceeded the loans to one borrower regulations.Delinquencies and Classified Assets Delinquencies. The Company's collection procedures provide that when a loan is 15 days past due, a computer-generated late charge notice is sent to the borrower requesting payment, plus a late charge. This notice is followed with a letter again requesting payment when the payment becomes 20 days past due. If delinquency continues, at 30 days another collection letter is sent and personal contact efforts are attempted, either in person or by telephone, to strengthen the collection process and obtain reasons for the delinquency. Also, plans to arrange a repayment plan are made. If a loan becomes 60 days past due, the loan becomes subject to possible legal action if suitable arrangements to repay have not been made. In addition, the borrower is given information which provides access to consumer counseling services, to the extent required by HUD regulations. When a loan continues in a delinquent status for 90 days or more, and a repayment schedule has not been made or kept by the borrower, a notice of intent to foreclose is sent to the borrower, giving 30 days to cure the delinquency. If not cured, foreclosure proceedings are initiated. Non-Performing and Impaired Assets. Loans are reviewed on a regular basis and are placed on a non-accrual status when, in the opinion of management, the collection of additional interest is doubtful. Mortgage loans are placed on non-accrual status generally when either principal or interest is 90 days or more past due and management considers the interest uncollectible. Interest accrued and unpaid at the time a loan is placed on non-accrual status is charged against interest income. Under the provisions of SFAS No. 114, "Accounting by Creditors for Impairment of a Loan," a loan is defined as impaired when, based on current information and events, it is probable that a creditor will be unable to collect all amounts due under the contractual terms of the loan agreement. In applying the provisions of SFAS No. 114, the Bank considers investment in one- to four-family residential loans and consumer installment loans to be homogeneous and therefore excluded from separate identification for impairment. With respect to the Bank's investment in multi-family commercial and nonresidential loans, and the evaluation of impairment thereof, such loans are collateral dependent and, as a result, are carried as a practical expedient at the lower of cost or fair value. At March 31, 2006, the Company had non-performing loans of $772,000 and a ratio of non-performing and impaired loans to loans receivable of .33%. At March 31, 2005, the Company had non-performing loans of $906,000 and a ratio of non-performing and impaired loans to loans receivable of 0.42%. For both fiscal 2006 and 2005, the nonperforming loans consisted mainly of one- to four-family residential mortgage loans. The Company generally does not recognize losses on one- to four-family residential mortgage loans primarily because the loan will generally be a maximum 85% LTV ratio on these mortgages without further insurance. In the opinion of management, all non-performing loans are adequately collateralized as of March 31, 2006 and no significant unreserved loss is anticipated. Real estate acquired by the Company as a result of foreclosure or by deed in lieu of foreclosure ("REO") is deemed REO until such time as it is sold. When REO is acquired, it is recorded at the lower of the unpaid principal balance of the related loan or its fair value, less estimated selling expenses. Valuations are periodically performed by management, and any subsequent decline in fair value is charged to operations. The following table sets forth information regarding our non-accrual and impaired loans and real estate acquired by foreclosure at the dates indicated. For all the dates indicated, we did not have any material loans which had been restructured pursuant to SFAS No. 15. At March 31, ---------------------------------------------- 2006 2005 2004 2003 2002 ------ ------ ------ ------ ------ (Dollars In Thousands) Non-accrual loans: Mortgage loans: One- to four-family residential ............. $ 725 $ 895 $ 714 $ 664 $ 616 All other mortgage loans .................... -- -- 24 430 1,070 Non-mortgage loans: Commercial business loans ................... 47 -- -- 1,380 1,416 Consumer .................................... -- 11 9 6 25 ------ ------ ------ ------ ------ Total non-accrual loans ......................... 772 906 747 2,480 3,127 Accruing loans 90 days or more delinquent ....... -- -- -- 15 38 ------ ------ ------ ------ ------ Total non-performing loans ...................... 772 906 747 2,495 3,165 Loans deemed impaired (1) ....................... -- -- -- -- 645 ------ ------ ------ ------ ------ Total non-performing and impaired loans ......... 772 906 747 2,495 3,810 Total real estate owned (2) ..................... 156 35 100 -- 19 ------ ------ ------ ------ ------ Total non-performing and impaired assets ........ $ 928 $ 941 $ 847 $2,495 $3,829 ====== ====== ====== ====== ====== Total non-performing and impaired loans to net loans receivable .............................. 0.33% 0.42% 0.36% 1.09% 1.52% ====== ====== ====== ====== ====== Total non-performing and impaired loans to total assets ....................................... 0.19% 0.22% 0.20% 0.66% 1.14% ====== ====== ====== ====== ====== Total non-performing and impaired assets to total assets ....................................... 0.23% 0.23% 0.23% 0.66% 1.14% ====== ====== ====== ====== ====== -------------------------------- (1) Includes loans deemed impaired that are currently performing. (2) Represents the net book value of property acquired by the Company through foreclosure or deed in lieu of foreclosure. These properties are recorded at the lower of the loan's unpaid principal balance or fair value less estimated selling expenses. During the year ended March 31, 2006, 2005 and 2004, gross interest income of $44,000, $40,000 and $37,000 would have been recorded on loans currently accounted for on a non-accrual basis if the loans had been current throughout the period. Interest income recognized on non-accrual loans totaled $44,000, $45,000 and $23,000 for the years ended March 31, 2006, 2005 and 2004, respectively. The Company did not record interest income on impaired loans for fiscal 2006 or 2005. The Company recognized interest income on impaired loans using the cash method of accounting of approximately $249,000 for the year ended March 31, 2004. The following table sets forth information with respect to loans past due 60-89 days and 90 days or more in our portfolio at the dates indicated. At March 31, ------------------------------------------ 2006 2005 2004 2003 2002 ------ ------ ------ ------ ------ (In Thousands)Loans past due 60-89 days .......... $ 626 $1,084 $ 669 $ 723 $ 431 Loans past due 90 days or more ..... 772 906 747 2,495 3,165 ------ ------ ------ ------ ------ Total past due 60 days or more .. $1,398 $1,990 $1,416 $3,218 $3,596 ====== ====== ====== ====== ====== Classification of Assets. Federal regulations provide for the classification of loans and other assets such as debt and equity securities considered by the OTS to be of lesser quality as "substandard," "doubtful," or "loss" assets. An asset is considered "substandard" if it is inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those characterized by the "distinct possibility" that the savings institution will sustain "some loss" if the deficiencies are not corrected. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard," with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified as "loss" are those considered "uncollectible" and of such little value that theirClassification of Assets. (continued)continuance as assets without the establishment of a specific loss reserve is not warranted. Assets that do not expose the savings institution to risk sufficient to warrant classification in one of the aforementioned categories, but which possess some weaknesses, are required to be designated "special mention" by management. When a savings institution classifies problem assets as either substandard or doubtful, it is required to establish general allowances for loan losses in an amount deemed prudent by management. General allowances represent loss allowances that have been established to recognize the inherent risk associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When a savings institution classifies problem assets as "loss," it is required either to establish a specific allowance for losses equal to 100% of the amount of the assets so classified, or to charge off such amount. A savings institution's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the OTS, which can order the establishment of additional general or specific loss allowances. The Company regularly reviews the problem loans in its portfolio to determine whether any loans require classification in accordance with applicable regulations. The following table sets forth the aggregate amount of the Company's classified assets at the dates indicated. At March 31, ------------------------------------------ 2006 2005 2004 2003 2002 ------ ------ ------ ------ ------ (Dollars in Thousands) Substandard assets(1) ........ $1,119 $2,767 $ 839 $2,481 $3,303 Doubtful assets .............. -- -- -- -- -- Loss assets .................. -- -- -- -- 105 ------ ------ ------ ------ ------ Total classified assets ... $1,119 $2,767 $ 839 $2,481 $3,408 ====== ====== ====== ====== ====== ---------------- (1) Includes REO. Allowance for Loan Losses. In determining the amount of the allowance for loan losses at any point in time, management and the Board of Directors apply a systematic process focusing on the risk of loss in the loan portfolio. First, delinquent non-residential, multi-family and commercial loans are evaluated individually for potential impairment in their carrying value. Second, management applies historic loss experience to the individual loan types in the portfolio. In addition to the historic loss percentage, management employs an additional risk percentage tailored to the perception of overall risk in the economy. However, the analysis of the allowance for loan losses requires an element of judgment and is subject to the possibility that the allowance may need to be increased, with the corresponding reduction in earnings. During the fiscal years ended March 31, 2006, 2005 and 2004, the Company added $211,000, $430,000 and $173,000, respectively, to the provision for loan losses. The Company's allowance for loan losses totaled $1.5 million, $1.4 million and $815,000 at March 31, 2006, 2005 and 2004, respectively. Management decreased the provision for loan losses by $219,000 in fiscal 2006 mainly due to the Company's decrease in non-accrual loans and classified assets, coupled with the absence of the additional provisioning related to the Stebbin's acquisition in fiscal 2005. These positive factors were partially offset by provisioning related to the Company's portfolio growth in fiscal 2006. While management believes that the Company's current allowance for loan losses is adequate, there can be no assurance that the allowance for loan losses will be adequate to cover losses that may in fact be realized in the future or that additional provisions for loan losses will not be required. To the best of management's knowledge, all known losses as of March 31, 2006 have been recorded. Analysis of the Allowance For Loan Losses. The following table sets forth the analysis of the allowance for loan losses for the periods indicated. At or for the Year Ended March 31, ----------------------------------------------------------------- 2006 2005 2004 2003 2002 --------- --------- --------- --------- --------- (In Thousands) Loans receivable, net ........................ $ 235,312 $ 213,627 $ 205,443 $ 228,373 $ 251,172 ========= ========= ========= ========= ========= Average loans receivable, net ................ 222,944 212,785 214,174 242,120 253,058