Item 1. Business
General
First Federal Bancshares of Arkansas, Inc. First Federal Bancshares of Arkansas, Inc. (the “Company”) is a Texas corporation organized in January 1996 by First Federal Bank of Arkansas, FA (“First Federal” or the “Bank”) for the purpose of becoming a unitary holding company of the Bank. The only significant assets of the Company are the capital stock of the Bank, the Company’s loan to the Employee Stock Ownership Plan (“ESOP”), and cash. The business and management of the Company consists of the business and management of the Bank. The Company does not presently own or lease any property, but instead uses the premises, equipment and furniture of the Bank. At the present time, the Company does not employ any persons other than officers of the Bank, and the Company utilizes the support staff of the Bank from time to time. Additional employees will be hired as appropriate to the extent the Company expands or changes its business in the future. At December 31, 2004, the Company had $751.7 million in total assets, $582.4 million in total deposits and $75.3 million in stockholders’ equity.
The Company’s executive office is located at the home office of the Bank at 1401 Highway 62-65 North, Harrison, Arkansas 72601, and its telephone number is (870) 741-7641.
First Federal Bank of Arkansas, FA. The Bank is a federally chartered stock savings and loan association formed in 1934. First Federal conducts business from its main office and fourteen full service branch offices, all of which are located in a six county area in Northcentral and Northwest Arkansas comprised of Benton, Marion, Washington, Carroll, Baxter and Boone counties. First Federal’s deposits are insured by the Savings Association Insurance Fund (“SAIF”), which is administered by the Federal Deposit Insurance Corporation (“FDIC”), to the maximum extent permitted by law.
The Bank is a community-oriented financial institution offering a wide range of retail and small business deposit accounts, including non-interest bearing and interest bearing checking, savings and money market accounts, certificates of deposit, and individual retirement accounts. Loan products offered by the Bank include residential real estate, consumer, construction, lines of credit, commercial real estate and commercial non-real estate. Other financial services include investment products offered through PrimeVest® Financial Services, Inc.; automated teller machines; 24-hour telephone banking; internet banking, including account access, bill payment and online loan applications; Bounce ProtectionTM overdraft service; debit cards; and safe deposit boxes.
The Bank is subject to examination and comprehensive regulation by the Office of Thrift Supervision (“OTS”), which is the Bank’s chartering authority and primary regulator. The Bank is also regulated by the FDIC, the administrator of the SAIF. The Bank is also subject to certain reserve requirements established by the Board of Governors of the Federal Reserve System (“FRB”) and is a member of the Federal Home Loan Bank (“FHLB”) of Dallas, which is one of the 12 regional banks comprising the FHLB System.
This Form 10-K and the Company’s Annual Report to Stockholders contain certain forward-looking statements and information relating to the Company that are based on the beliefs of management as well as assumptions made by and information currently available to management. In addition, in those and other portions of this document and the Company’s Annual Report to Stockholders, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “should” and similar expressions, or the negative thereof, as they relate to the Company or the Company’s management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future looking events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.
Employees
The Bank had 229 full-time employees and 38 part-time employees at December 31, 2004, compared to 237 full-time employees and 37 part-time employees at December 31, 2003. None of these employees is represented by a collective bargaining agent, and the Bank believes that it enjoys good relations with its personnel.
Available Information
The Company makes available free of charge its annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and all amendments to such reports filed pursuant to Sections 13(a) or 15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable on or through its website located at www.ffbh.com after filing with the United States Securities and Exchange Commission.
Competition
The Bank faces strong competition both in attracting deposits and making loans. Its most direct competition for deposits has historically come from other savings associations, community banks, credit unions and commercial banks, including many large financial institutions that have greater financial and marketing resources available to them. In addition, the Bank has faced additional significant competition for investors’ funds from short-term money market securities, mutual funds and other corporate and government securities. The ability of the Bank to attract and retain savings and certificates of deposit depends on its ability to generally provide a rate of return, liquidity and risk comparable to that offered by competing investment opportunities. The Bank’s ability to increase checking deposits depends on offering competitive checking accounts and promoting these products through effective channels. Additionally, the Bank must offer convenient hours, locations and online services to attract customers.
The Bank experiences strong competition for loans principally from savings associations, community banks, commercial banks and mortgage companies. In 2004, several new community banks and several well-established financial institutions have begun to establish branches in the Washington-Benton county area, providing for increased competition. The Bank competes for loans principally through the interest rates and loan fees it charges and the efficiency and quality of services it provides borrowers. Competition has increased as a result of the continuing reduction of restrictions on the interstate operations of financial institutions.
Lending Activities
General. At December 31, 2004, the Bank’s portfolio of net loans receivable amounted to $634.2 million or 84.4% of the Company’s total assets. The Bank has traditionally concentrated its lending activities on loans collateralized by real estate. Consistent with such approach, $596.6 million or 85.3% of the Bank’s total portfolio of loans receivable (“total loan portfolio”) consisted of loans collateralized by first mortgage loans at December 31, 2004.
In recent years, the Bank has placed an increased emphasis on commercial real estate lending, construction lending, and commercial lending in order to better utilize excess cash and to transition to more of a full-service community bank. The table below summarizes the changes in the composition of the loan portfolio between December 31, 2000, which is the earliest year presented in the loan composition table on page 4, and December 31, 2004 (dollars in millions):
(1) Gross of undisbursed loan funds, unearned discounts and net deferred loan fees and the allowance for loan losses.
Commercial real estate, construction and commercial lending are generally considered to involve a higher degree of risk than residential real estate lending due to the relatively larger loan amounts and the effect of general economic conditions on the successful operation of the related business and/or income producing properties. The Bank has attempted to reduce such risk by evaluating the credit history and past performance of the borrower, the quality of the borrowers’ management, the debt service ratio, the quality and characteristics of the income stream generated by the business or the property and appraisals supporting the property’s valuation as applicable. See “Asset Quality”.
Loan Composition. The following table sets forth certain data relating to the composition of the Bank’s loan portfolio by type of loan at the dates indicated.
Loan Maturity and Interest Rates. The following table sets forth certain information at December 31, 2004 regarding the dollar amount of loans maturing in the Bank’s loan portfolio based on their contractual terms to maturity. Demand loans and loans having no stated schedule of repayments and no stated maturity are reported as due in one year or less. All other loans are included in the period in which the final contractual repayment is due.
(1) Gross of undisbursed loan funds, unearned discounts and net deferred loan fees and the allowance for loan losses.
The following table sets forth the dollar amount of the Bank’s loans at December 31, 2004 due after one year from such date which have fixed interest rates or which have floating or adjustable interest rates.
Scheduled contractual maturities of loans do not necessarily reflect the actual term of the Bank’s loan portfolio. The average life of mortgage loans is substantially less than their average contractual terms because of loan prepayments and refinancing. The average life of mortgage loans tends to increase, however, when current mortgage loan rates substantially exceed rates on existing mortgage loans and, conversely, decrease when rates on existing mortgage loans substantially exceed current mortgage loan rates.
Origination, Purchase and Sale of Loans. The lending activities of the Bank are subject to the written, non-discriminatory underwriting standards and policies established by the Bank’s board of directors and management. Loan originations are obtained from a variety of sources, including realtor referrals, walk-in customers to the Bank’s branch locations, solicitation by loan officers, radio, television and newspaper advertising, and to a lesser extent, through the Bank’s Internet website. The Bank continually emphasizes its community ties and its practice of quick and efficient underwriting and loan approval processes, made possible in part through the use of automated underwriting software. The Bank believes it provides exceptional personalized service to its customers. The Bank requires hazard insurance, title insurance, and to the extent applicable, flood insurance on all secured real property.
Applications are initially received by loan officers or from the Bank’s secure website. Applications received over the Bank’s website are forwarded to loan officers. To a lesser extent, the Bank does utilize a commercial loan consultant/broker. This consultant has extensive experience in commercial lending and his fee is negotiated on a loan-by-loan basis by the executive committee of the Bank. All work performed by the consultant is reviewed by the Executive Vice President/Chief Lending Officer and the Senior Vice President/Commercial Lending Manager as well as the appropriate loan committee members as described herein. All loans are subject to review by members of the Bank’s loan committee. The loan committee is made up of loan officers of the Bank. Each loan committee member has a designated lending approval authority which is based upon the individual’s expertise in the various lending areas, which include residential loans, consumer loans, commercial real estate loans, and non-real estate commercial loans. Various members of the loan committee may approve loans based upon an aggregate approval authority by up to three members of the committee. Larger loans requiring more than three loan committee members also require the additional approval of the President/Chief Executive Officer, Executive Vice President/Chief Operating Officer, or the Executive Vice President/Chief Lending Officer. Residential loans of $1,000,000 or more, consumer loans of $500,000 or more, commercial real estate loans of $1,000,000 or more, and non-real estate loans of $500,000 or more require approval by the Bank’s board of directors. All loans are reviewed, subsequent to the loan being closed, by the board of directors.
During 2004, the Bank purchased participations in five commercial construction loans with a total commitment amount of $13.8 million as well as a $1.2 million participation in a commercial real estate loan. During 2003, the Bank purchased two commercial loan participations totaling $3.1 million. No loans were purchased during 2002. All participations purchased were current as of December 31, 2004.
To minimize interest rate risk, loans with fixed-rate terms of fifteen years or greater are typically sold to specific investors in the secondary mortgage market. The rights to service such loans are typically sold with the loans. This allows the Bank to provide its customers competitive long-term fixed-rate mortgage products which are very popular financing products for home buyers in today’s market, while not exposing the Bank to undue interest rate risk. These loans are originated subject to Fannie Mae and/or Freddie Mac underwriting guidelines and are typically underwritten and validated by a third party prior to loan closing. The Secondary Market Department of the Bank typically locks and confirms the purchase price of the loan on the day of the loan application which protects the Bank from market price movements and ensures that the Bank will receive a fair and reasonable price on the sale of the respective loan. Due to the loans being underwritten by a third party, the repurchase risk associated with these loans is substantially assumed by the underwriter. The Bank believes it has minimal risk of repurchase of these loans based upon the contracts with the specific investors. This risk typically involves potential early prepayments of the mortgage or an early default of a loan. In 2004, 2003, and 2002, the Bank was not required to repurchase any loans. In 2004, 2003, and 2002, the Bank’s secondary market loan sales amounted to $45.8 million, $123.5 million, and $65.5 million, respectively. The significant amount of loan sales in 2003 was primarily due to refinancing activity during a period of historically low interest rates. The Bank is not involved in loan hedging or other speculative mortgage loan origination activities.
In addition to sales of loans on the secondary market, the Bank periodically sells larger commercial loans or participations in such loans in order to comply with the Bank’s loans-to-one borrower limit. In such situations the loans are typically sold with servicing retained. During the years ended December 31, 2004, 2003, and 2002, such loans sold amounted to approximately $21.5 million, $6.6 million, and $1.8 million, respectively. At December 31, 2004, 2003, and 2002, the balances of loans sold with servicing retained were approximately $18.9 million, $8.4 million, and $2.0 million, respectively. Loan servicing fee income for the years ended December 31, 2004, 2003, and 2002, was approximately $159,000, $36,000, and $5,000, respectively.
Following is a table showing the Bank’s originations, sales, purchases, and repayments of loans during the periods indicated.
(1) Gross of undisbursed loan funds, unearned discounts and net loan fees and the allowance for loan losses.
Loans-to-One Borrower. A savings institution generally may not make loans-to-one borrower and related entities in an amount which exceeds 15% of its unimpaired capital and surplus, although loans in an amount equal to an additional 10% of unimpaired capital and surplus may be made to a borrower if the loans are fully secured by readily marketable securities. At December 31, 2004, the Bank’s limit on loans-to-one borrower was approximately $11.2 million. At December 31, 2004, the Bank’s largest loan or group of loans-to-one borrower, including persons or entities related to the borrower, amounted to $10.6 million. Such amount consists of four commercial real estate loans. The Bank’s ten largest loans or groups of loans-to-one borrower, including persons or entities related to the borrower, including unfunded commitments, totaled $84.9 million at December 31, 2004. None of these loans were 90 days or more past due at December 31, 2004.
One- to Four-Family Residential Real Estate Loans. The Bank has historically concentrated its lending activities on the origination of loans collateralized by first mortgage liens on existing one- to four-family residences. At December 31, 2004, $282.1 million or 40.4% of the Bank’s total loan portfolio consisted of one- to four-family residential real estate loans. Of the $282.1 million of such loans at December 31, 2004, $210.8 million or 74.7% had adjustable rates of interest (including $64.3 million of seven-year adjustable-rate loans) and $71.3 million or 25.3% had fixed rates of interest.
The Bank currently originates both fixed-rate and adjustable-rate one- to four-family residential mortgage loans. The Bank’s fixed-rate loans for portfolio are typically originated with maximum terms of fifteen years and are typically fully amortizing with monthly payments sufficient to repay the total amount of the loan with interest by the end of the loan term. The Bank does offer fixed-rate loans with terms exceeding fifteen years and such loans are typically sold in the secondary market. The Bank’s one- to four-family loans are typically originated under terms, conditions and documentation which permit them to be sold to U.S. Government-sponsored agencies such as Fannie Mae or Freddie Mac. However, as stated above, such loans with terms of less than fifteen years are generally originated for portfolio while substantially all of such loans with terms of fifteen years or longer are sold in the secondary market. The Bank’s fixed-rate loans typically include “due on sale” clauses.
The Bank’s adjustable-rate mortgage loans typically provide for an interest rate which adjusts every one-, three-, five- or seven-years in accordance with a designated index plus a margin. Such loans are typically based on a 15-, 20-, 25- or 30-year amortization schedule. The Bank generally does not offer below market rates, and the amount of any increase or decrease in the interest rate per one- or three-year period is generally limited to 2%, with a limit of 6% over the life of the loan. The Bank’s five-year adjustable-rate loans provide that any increase or decrease in the interest rate per period is limited to 3%, with a limit of 6% over the life of the loan. The Bank’s seven-year adjustable-rate loans provide that any increase or decrease in the interest rate per period is limited to 5% with a limit of 5% over the life of the loan. The Bank’s adjustable-rate loans are assumable (generally without release of the initial borrower), do not contain prepayment penalties and do not provide for negative amortization. The Bank’s adjustable-rate mortgage loans typically include “due on sale” clauses. Such loans may be converted to a fixed-rate loan at the discretion of the Bank. The Bank generally underwrites its one- and three-year adjustable-rate loans on the basis of the borrowers’ ability to pay at the rate after the first interest rate adjustment. Adjustable-rate loans decrease the risks associated with changes in interest rates but involve other risks, primarily because as interest rates rise, the payment by the borrower rises to the extent permitted by the terms of the loan, thereby increasing the potential for default. At the same time, the marketability of the underlying property may be adversely affected by higher interest rates.
The Bank’s residential mortgage loans generally do not exceed 80% of the appraised value of the secured property. However, pursuant to the underwriting guidelines adopted by the board of directors, the Bank may lend up to 97% of the appraised value of the property securing a one- to-four family residential loan with private mortgage insurance to protect the portion of the loan that exceeds 80% of the appraised value. The Bank may, on occasion, extend a loan up to 90% of the appraised value of the secured property without private mortgage insurance coverage. However, these exceptions are minimal and are only approved on loans with exceptional credit scores, sizeable asset reserves, or other compensating factors. At December 31, 2004, the Bank had $2.6 million of nonperforming, one- to four-family residential loans. See “Asset Quality”.
Multi-Family Residential Real Estate Loans. The Bank offers mortgage loans for the acquisition and refinancing of multi-family residential properties. At December 31, 2004, $9.5 million or 1.4% of the Bank’s total loan portfolio consisted of loans collateralized by existing multi-family residential real estate properties.
The Bank currently originates both fixed- and adjustable- rate multi-family loans. Fixed-rate loans are generally originated with amortization periods not to exceed 20 years, and typically have balloon periods of three, five or seven years. Adjustable-rate loans are typically amortized over terms up to 30 years, with interest rate adjustments every five to seven years. Loan-to-value ratios on the Bank’s multi-family real estate loans are currently limited to 80%. It is also the Bank’s general policy to obtain corporate or personal guarantees, as applicable, on its multi-family residential real estate loans from the principals of the borrower.
Multi-family real estate lending entails significant additional risks as compared with one- to four-family residential property lending. Such loans typically involve large loan balances to single borrowers or groups of related borrowers. The payment experience on such loans is typically dependent on the successful operation of the real estate project. The success of such projects is sensitive to changes in supply and demand conditions in the market for multi-family real estate as well as regional and economic conditions generally. At December 31, 2004, the Bank did not have any nonperforming multi-family real estate loans. See “Asset Quality”.
Commercial Real Estate Loans. The Bank originates mortgage loans for the acquisition and refinancing of commercial real estate properties. At December 31, 2004, $145.9 million or 20.9% of the Bank’s total loan portfolio consisted of loans collateralized by existing commercial real estate properties and developed as well as undeveloped land. In recent years, the Bank has placed an increased emphasis on commercial real estate lending in order to transition to a more full-service community bank as well as to take advantage of the high demand for this type of property in some of the markets we serve.
Many of the Bank’s commercial real estate loans are collateralized by properties such as office buildings, convenience stores, service stations, mini-storage facilities, motels, churches, small shopping malls, and strip centers. The Bank has experienced an increase in this type of lending over the last few years and underwrites commercial real estate loans specifically in relation to the type of property being collateralized. Cash flows and vacancy rates are primary considerations when underwriting loans collateralized by office buildings, mini-storage facilities and motels. Loans with borrowers that are corporations, limited liability companies, trusts, or other such legal entities are also typically
personally guaranteed by the principals of the respective entity. The financial strength of the individuals who are personally guaranteeing the loan is also a primary underwriting factor.
Commercial real estate loans include loans for the acquisition and development of land. This segment of the portfolio totaled $30.9 million, $7.0 million, $5.5 million, $2.7 million, and $1.4 million as of December 31, 2004, 2003, 2002, 2001, and 2000, respectively. The Bank has experienced a significant increase in this type of lending during 2004, primarily due to opportunities resulting from the growth and development of the Benton and Washington county areas discussed below. These loans are typically made to borrowers with whom the Bank has had previous favorable experience and whose personal financial position is strong. These loans include land purchased for development into single-family subdivision lots, condominium lots, and commercial lots. Generally, these loans are collateralized by properties in the Bank’s market areas.
The Bank’s policy requires real estate appraisals of all properties securing commercial real estate loans by licensed real estate appraisers pursuant to state licensing requirements. The Bank considers the quality and location of the real estate, the credit worthiness of the borrower, the cash flow of the project, and the quality of management involved with the property. The Bank’s commercial real estate loans are generally originated with amortizations not to exceed 20-25 years and typically have balloon periods of three-, five-, or seven-year terms. The Bank has originated some loans with variable rate terms based upon Wall Street Journal prime. To a lesser degree, the Bank has in the past offered a limited number of fixed rate commercial real estate loans with terms not to exceed 15 years subject to then current interest rate scenarios. As part of the criteria for underwriting multi-family and commercial real estate loans, the Bank generally estimates a cash flow analysis that includes a vacancy rate projection, expenses for taxes, insurance, maintenance and repair reserves as well as debt coverage ratios. This information is also estimated and obtained from commercial real estate appraisals.
Commercial real estate lending entails additional risks, as compared to the Bank’s one- to four-family residential property loans. Commercial real estate loans generally involve larger loan balances to single borrowers or groups of related borrowers. The payment experience on such loans is typically dependent on the successful operation of the real estate project. The success of such projects is sensitive to changes in supply and demand conditions in the market for commercial real estate, as well as regional and economic conditions generally. The Bank believes it has mitigated some of these additional risks by focusing its commercial real estate lending activities in the economically strong Washington/Benton County, Arkansas market. This region is the home of the world’s largest retailer, Wal-Mart, as well as the nation’s largest meat company, Tyson Foods, the trucking firm J. B. Hunt, and the University of Arkansas. Reports have ranked the region as one of the top performing economic areas in the country since 2003. Low unemployment rates, population growth, and job growth in this market add additional support to the Bank’s growth in the area of commercial real estate loans. At December 31, 2004, the Bank had one impaired commercial real estate loan relationship of $3.9 million for which an estimated $62,000 allowance for loan losses was recorded. At December 31, 2004, none of the loans in this relationship were over 90 days past due. See “Asset Quality”.
Construction Loans. The Bank originates one- to four-family residential, multi-family, and commercial real estate construction loans. However, the Bank’s primary emphasis has been residential construction lending. The Bank’s construction lending activities are typically limited to the Bank’s primary market areas. At December 31, 2004, construction loans amounted to $159.1 million or 22.8% of the Bank’s total loan portfolio, of which, $111.7 million consisted of one- to four-family residential construction loans, $25.5 million consisted of commercial real estate construction loans, and $21.9 million consisted of multi-family residential construction loans. As discussed above in the commercial real estate section, our market areas of Benton and Washington counties have experienced tremendous prosperity and growth and provided the Bank with increased lending opportunities, which can be demonstrated by the significant growth in construction lending. However, as stated previously, our primary focus in construction lending has been and remains residential construction lending. The Bank has been successful in marketing its lending products to the residential construction market, including involvement in homebuilders’ associations and maintaining established relationships with builders.
The Bank’s construction loans generally have fixed interest rates and are typically issued for terms of six- to twelve-months. However, the Bank is permitted to originate construction loans with terms up to two years under its loan policy. This practice is generally limited to larger projects that cannot be completed in the typical six- to twelve-month period. Construction loans are typically made with a maximum loan-to-value ratio of 80% on an as-completed basis.
The majority of the Bank’s construction loans are made to individual homeowners and local builders and developers for the purpose of constructing one- to four-family residences. To a lesser but growing extent, construction loans are also originated for multi-family and commercial properties. The Bank typically requires that permanent financing with the Bank or some other lender be in place prior to closing any non-speculative construction loan. Interest on construction/permanent loans is due upon completion of the construction phase of the loan. At such time, the loan automatically converts to a permanent loan at the interest rate established at the initial closing of the construction/permanent loan.
The Bank makes construction loans to local builders for the purpose of construction of speculative (or unsold) residential properties, and for the construction of pre-sold one- to four-family homes. These loans are subject to credit review, analysis of personal and, if applicable, corporate financial statements, and an appraisal of the property to be constructed. The Bank also reviews and inspects the project prior to the disbursement of funds (draws) during the construction term. Loan proceeds are disbursed after a satisfactory inspection of the project has been made based upon percentage of completion. Interest on these construction loans is due upon maturity. The Bank may extend the term of a construction loan upon payment of interest accrued if the property has not been sold by the maturity date. The Bank has not experienced any material credit or delinquency problems in this regard.
Construction lending is generally considered to involve a higher level of risk as compared to one- to four-family residential loans. This is due, in part, to the concentration of principal in a limited number of loans and borrowers, and the effects of general economic conditions on developers and builders. In addition, construction loans to a builder for construction of homes that are not pre-sold possess a greater potential risk to the Bank than construction loans to individuals on their personal residences or on houses that are pre-sold prior to the inception of the loan. In addition, the Bank analyzes each borrower involved in speculative building and limits the principal amount and number of unsold speculative homes at any one time with such borrower. At December 31, 2004, the Bank had nonperforming construction loans totaling $634,000. See “Asset Quality”.
Commercial Loans. The Bank also offers commercial loans which primarily consist of equipment and inventory loans which are typically cross-collateralized by commercial real estate. At December 31, 2004, such loans amounted to $27.5 million or 3.9% of the total loan portfolio. At December 31, 2004, the Bank had nonperforming commercial loans totaling $186,000. See “Asset Quality”.
The Bank’s commercial loans are typically originated with fixed interest rates and call provisions between one and five years. These loans are typically based on a maximum fifteen-year amortization schedule. To a lesser extent, the Bank does originate interest-only loans and variable-rate loans.
Consumer Loans. The Bank offers consumer loans in order to provide a full range of financial services to its customers while increasing the yield on its overall loan portfolio and decreasing its interest rate risk due to the relatively shorter term nature of consumer loans. The consumer loans offered by the Bank primarily include home equity and second mortgage loans, automobile loans, deposit account secured loans, and unsecured loans. Consumer loans amounted to $75.0 million or 10.7% of the total loan portfolio at December 31, 2004, of which $45.3 million, $19.1 million and $10.6 million consisted of home equity and second mortgage loans, automobile loans, and other consumer loans, respectively. The Bank intends to continue its emphasis on consumer loans in furtherance of its role as a community-oriented financial institution.
The Bank’s home equity and second mortgage loans are fixed-rate loans with fully-amortized terms of up to fifteen years, or variable-rate interest-only loans with terms up to three years. The variable-rate loans are typically tied to Wall Street Journal Prime, plus a margin commensurate with the risk as determined by the borrower’s credit score. Longer-term amortizing loans typically have a balloon feature in five, seven, or ten years. Although the Bank does not require that it hold the first mortgage on the secured property, the Bank does hold the first mortgage on a significant number of its home equity loans. The Bank generally limits the total loan-to-value on these mortgages to 90% of the value of the secured property.
The Bank’s automobile loans are typically originated for the purchase of new and used cars and trucks. Such loans are generally originated with a maximum term of five years. The Bank does offer extended terms on automobile loans to some customers based upon their creditworthiness.
Other consumer loans consist primarily of deposit account loans and unsecured loans. Loans secured by deposit accounts are originated for up to 95% of the account balance, with a hold placed on the account restricting the withdrawal of the account balance.
Consumer loans entail greater risk than do residential first mortgage loans, particularly in the case of consumer loans which are unsecured or secured by rapidly depreciating assets such as automobiles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. In addition, consumer loan collections are dependent on the borrower’s continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount which can be recovered on such loans. At December 31, 2004, the Bank had $723,000 of nonperforming consumer loans. See “Asset Quality”.
Asset Quality
When a borrower fails to make a required payment on a loan, the Bank attempts to cure the deficiency by contacting the borrower and seeking the payment. Depending upon the type of loan, late notices are sent and/or personal contacts are made. In most cases, deficiencies are cured promptly. While the Bank generally prefers to work with borrowers to resolve such problems, when a mortgage loan becomes 90 days delinquent, the Bank generally institutes foreclosure or other proceedings, as necessary, to minimize any potential loss.
Loans are placed on nonaccrual status when, in the judgment of management, the probability of collection of interest is deemed to be insufficient to warrant further accrual. When a loan is placed on nonaccrual status, previously accrued but unpaid interest is deducted from interest income. The Bank generally does not accrue interest on loans past due 90 days or more. Loans may be reinstated to accrual status when payments are made to bring the loan under 90 days past due and, in the opinion of management, collection of the remaining balance can be reasonably expected.
Real estate properties acquired through foreclosure are initially recorded at fair value less estimated selling costs. Valuations are periodically performed by management and the real estate is carried at the lower of carrying amount or fair value less cost to sell.
Delinquent Loans. The following table sets forth information concerning delinquent loans at December 31, 2004, in dollar amounts and as a percentage of the Bank’s total loan portfolio. The amounts presented represent the total outstanding principal balances of the related loans, rather than the actual payment amounts which are past due.
Interest income that would have been recorded under the original terms of the Bank’s nonaccruing loans for the year ended December 31, 2004 amounted to $243,000, and the interest recognized during this period amounted to $85,000.
The following table sets forth the amounts and categories of the Bank’s nonperforming assets at the dates indicated.
The increase in nonaccrual one- to four- family residential loans, construction loans, and consumer loans is due to a single relationship with a speculative homebuilder of approximately $1.7 million. We became aware in early January 2005 that this builder filed for bankruptcy protection and reviewed our collateral position on all of this builder’s loans and placed all of the borrower’s loans on nonaccrual status as of December 31, 2004. At December 31, 2004, a specific reserve of approximately $59,000 was recorded for these loans.
Restructured loans at December 31, 2004, consists of a commercial real estate relationship. This relationship was current as of December 31, 2004. We also reviewed our collateral position on all of this borrower’s loans and have recorded a specific reserve of approximately $62,000 at December 31, 2004.
Classified Assets. Federal regulations require that each insured savings association classify its assets on a regular basis. In addition, in connection with examinations of insured institutions, federal examiners have authority to identify problem assets and, if appropriate, classify them. There are three classifications for problem assets: “substandard,” “doubtful” and “loss.” Substandard assets have one or more defined weaknesses and are characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not corrected. Doubtful assets have the weaknesses of substandard assets with the additional characteristic that the weaknesses make collection or liquidation in full on the basis of currently existing facts, conditions and values questionable, and there is a high possibility of loss. An asset classified loss is considered uncollectible and of such little value that continuance as an asset of the institution is not warranted. At December 31, 2004, the Bank had $8.5 million of classified assets, $8.2 million of which were classified as substandard and $300,000 of which were classified as loss. In addition, at such date, the Bank had $3.2 million of assets designated as special mention. Special mention assets have potential weaknesses that deserve management’s close attention. If left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the asset or the institution’s credit position at some future date.
Allowance for Loan Losses. The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes it is likely that a loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as loss, doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based primarily on historical loss experience. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
The Bank reviews its non-homogeneous loans for impairment on a quarterly basis. The Bank considers commercial real estate, construction, multi-family, and commercial loans to be non-homogeneous loans. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures. Homogeneous loans are those that are considered to have common characteristics that provide for evaluation on an aggregate or pool basis. The Bank considers the characteristics of (1) one- to- four family residential first mortgage loans; (2) unsecured consumer loans; and (3) collateralized consumer loans to permit consideration of the appropriateness of the allowance for losses of each group of loans on a pool basis. The primary methodology used to determine the appropriateness of the allowance for losses includes segregating certain specific, poorly performing loans based on their performance characteristics from the pools of loans as to type, valuing these loans, and then applying a loss factor to the remaining pool balance based on several factors including past loss experience, inherent risks, and economic conditions in the primary market areas.
In estimating the amount of credit losses inherent in our loan portfolio, various judgments and assumptions are made. For example, when assessing the condition of the overall economic environment, assumptions are made regarding future market conditions and their impact on the loan portfolio. In the event the national or local economy were to sustain a prolonged downturn, the loss factors applied to our portfolios may need to be revised, which may significantly impact the measurement of the allowance for loan losses. For impaired loans that are collateral-dependent, the estimated fair value of the collateral may deviate significantly from the proceeds received when the collateral is sold.
Although we consider the allowance for loan losses of approximately $1.8 million adequate to cover losses inherent in our loan portfolio at December 31, 2004, no assurance can be given that we will not sustain loan losses that are significantly different from the amount recorded, or that subsequent evaluations of the loan portfolio, in light of factors then prevailing, would not result in a significant change in the allowance for loan losses.
The following table summarizes changes in the allowance for loan losses and other selected statistics for the periods indicated.
(1) Consumer loan charge-offs include overdraft charge-offs of $323,000, $182,000 and $214,000 for the years ended December 31, 2004, 2003, and 2002, respectively. Consumer loan recoveries include recoveries of overdraft charge-offs of $85,000, $50,000, and $53,000 for the years ended December 21, 2004, 2003, and 2002, respectively. Overdraft charge-offs and recoveries for the years ended December 31, 2001 and 2000 were not significant.
The following table presents the allocation of the Bank’s allowance for loan losses by the type of loan at each of the dates indicated.
(1) The allowance allocated to commercial real estate loans decreased between 2003 and 2002 primarily due to two factors. At December 31, 2002, there was a valuation allowance on an impaired loan that is not recorded in 2003 and the loss experience factor was revised downward in 2003 due to a more established history of low levels of charge-offs. The allowance increased in this category between 2003 and 2004 due primarily to loan growth.
Investment Activities
Investment Securities. The investment policy of the Bank, as established by the board of directors, is designed primarily to provide and maintain liquidity, to complement the Bank’s interest rate risk strategy and to generate a favorable return on investments. The Bank’s investment policy is currently implemented by the Bank’s President/Chief Executive Officer within the parameters set by the investment committee and the board of directors. The Bank is authorized to invest in obligations issued or fully guaranteed by the U.S. Government, certain federal agency obligations, certain time deposits, negotiable certificates of deposit issued by commercial banks and other insured financial institutions, municipal securities, investment grade corporate debt securities and other specified investments.
Investment securities that management has the positive intent and ability to hold to maturity are classified as held to maturity and are reported at amortized cost. Investment securities classified as available for sale are reported at fair value, with unrealized gains and losses excluded from earnings and reported net of tax in other comprehensive income. At December 31, 2004, the Bank held no investment securities classified as available for sale. At December 31, 2004, approximately $19.5 million of the Bank’s investment securities were pledged as collateral for certain deposits in excess of $100,000. In addition, certain U.S. Government and agency securities are pledged as collateral for Federal Home Loan Bank of Dallas (“FHLB”) advances under the FHLB’s blanket lien. At December 31, 2004, investments in the debt and/or equity securities of any one issuer, other than those issued by U.S. Government agencies, did not exceed more than 10% of the Company’s stockholders’ equity.
The following table sets forth the amount of investment securities held to maturity which contractually mature during each of the periods indicated and the weighted average yields for each range of maturities at December 31, 2004. Weighted average yields for municipal obligations have not been adjusted to a tax-equivalent basis. Expected maturities may differ from contractual maturities because issuers may have the right to call or prepay the obligation without prepayment penalties.
As of December 31, 2004, there were approximately $55.8 million of investment securities at an average interest rate of 4.65% with issuer call options, of which approximately $41.8 million at an average interest rate of 4.70% are callable within one year. In a rising interest rate environment, the Company believes that the issuers would not call these investment securities.
The following table sets forth the carrying value of the Company’s investment securities classified as held to maturity. The Company held no investment securities as available for sale at the dates indicated.
As a member of the FHLB of Dallas, the Bank is required to maintain an investment in FHLB stock. At December 31, 2004, the Bank’s investment in FHLB stock amounted to $4.9 million. No ready market exists for such stock and it has no quoted market value.
Sources of Funds
General. Deposits are the primary source of the Bank’s funds for lending and other investment purposes. In addition to deposits, the Bank derives funds from loan principal repayments and prepayments and interest payments, maturities and calls of investment securities and advances from the FHLB of Dallas. Loan repayments are a relatively stable source of funds, while deposit inflows and outflows are significantly influenced by general interest rates and money market conditions. Borrowings are used when funds from deposit sources are insufficient to meet funding needs. They may also be used on a longer term basis for general business purposes. FHLB advances are the primary source of borrowings.
Deposits. The Bank’s deposit products include a broad selection of deposit instruments, including negotiable order of withdrawal (“NOW”) accounts, demand deposit accounts (“DDA”), money market accounts, regular savings accounts and term certificate accounts. Deposit account terms vary, with the principal differences being the minimum balance required, the time period the funds must remain on deposit, early withdrawal penalties and the interest rate.
The Bank considers its primary market area to be Northcentral and Northwest Arkansas. The Bank utilizes traditional marketing methods to attract new customers and savings deposits. In the second quarter of 2004, the Bank began a direct mail campaign to solicit checking accounts. This program was instrumental in attaining 14.2% growth in checking account balances in 2004. The Bank will continue to focus much of its marketing resources on cross-selling checking accounts and developing new checking account relationships with the Bank. The Bank does not advertise for deposits outside of its primary market area and management believes that an insignificant number of deposit accounts were held by non-residents of Arkansas at December 31, 2004. Services of deposit brokers have been used on a limited basis with less than 1% of certificates of deposit at December 31, 2004 obtained through a broker.
The Bank has been competitive in the types of accounts and in interest rates it has offered on its deposit products but does not necessarily seek to match the highest rates paid by competing institutions. Although market demand generally dictates which deposit maturities and rates will be accepted by the public, the Bank intends to continue to offer longer-term deposits to the extent possible and consistent with its asset and liability management goals.
The following table shows the distribution of, and certain other information relating to, the Bank’s deposits by type of deposit, as of the dates indicated.
The following table presents the average balance of each type of deposit and the average rate paid on each type of deposit and/or total deposits for the periods indicated.
The following table presents, by various interest rate categories, the amount of certificates of deposit at December 31, 2004 and 2003 and the amounts at December 31, 2004 which mature during the periods indicated.
The following table sets forth maturities of the Bank’s certificates of deposit of $100,000 or more at December 31, 2004 by time remaining to maturity.
Borrowed funds. The Bank utilizes FHLB advances in its normal operating and investing activities. The Bank pledges as collateral for FHLB advances its FHLB stock and FHLB demand deposit account and has entered into a blanket collateral agreement with the FHLB. Eligible collateral under the blanket lien includes First Mortgage Collateral (as defined), multi-family residential mortgages meeting the requirements for eligibility as First Mortgage Collateral, U.S. Government and Agency Securities (as defined by the FHLB), privately issued mortgage-backed securities that qualify as eligible collateral under applicable regulations, FHLB Term Deposit Accounts, and other non-securitized real estate related collateral.
Advances at December 31, 2004, have maturity dates and weighted average rates as follows:
The following table sets forth information with respect to the Company’s FHLB advances at and during the periods indicated.
Subsidiaries
The Bank is permitted to invest up to 2% of its assets in the capital stock of, or secured or unsecured loans to, subsidiary corporations, with an additional investment of 1% of assets when such additional investment is utilized primarily for community development purposes. The Bank’s only subsidiary, First Harrison Service Corporation (the “Service Corporation”), was formed in 1971. At December 31, 2004, the Service Corporation was inactive.
REGULATION
Set forth below is a brief description of those laws and regulations which, together with the descriptions of laws and regulations contained elsewhere herein, are deemed material to an investor’s understanding of the extent to which the Company and the Bank are regulated. The description of the laws and regulations hereunder, as well as descriptions of laws and regulations contained elsewhere herein, does not purport to be complete and is qualified in its entirety by reference to applicable laws and regulations.
The Company
General. The Company, as a savings and loan holding company within the meaning of the Home Owners’ Loan Act (“HOLA”), has registered with the OTS and is subject to OTS regulations, examinations, supervision and reporting requirements. As a subsidiary of a savings and loan holding company, the Bank is subject to certain restrictions in its dealings with the Company and affiliates thereof.
Holding Company Acquisitions. Federal law generally prohibits a savings and loan holding company, without prior OTS approval, from acquiring the ownership or control of any other savings institution or savings and loan holding company, or all, or substantially all, of the assets or more than 5% of the voting shares thereof which is not a subsidiary. These provisions also prohibit, among other things, any director or officer of a savings and loan holding company, or any individual who owns or controls more than 25% of the voting shares of such holding company, from acquiring control of any savings institution not a subsidiary of such savings and loan holding company, unless the acquisition is approved by the OTS.
Holding Company Activities. There are generally no restrictions on the activities of a savings and loan holding company which controlled only one subsidiary savings association on or before May 4, 1999 (a “grandfathered holding company”). However, if the Director of the OTS determines that there is reasonable cause to believe that the continuation by a savings and loan holding company of an activity constitutes a serious risk to the financial safety, soundness or stability of its subsidiary savings association, the Director may impose such restrictions as it deems necessary to address such risk, including limiting (i) payment of dividends by the savings association; (ii) transactions between the savings association and its affiliates; and (iii) any activities of the savings association that might create a serious risk that the liabilities of the holding company and its affiliates may be imposed on the savings association. Notwithstanding the above rules as to permissible business activities of unitary savings and loan holding companies, if the savings association subsidiary of such a holding company fails to meet the qualified thrift lender (QTL) test, then such unitary holding company also shall become subject to the activities restrictions applicable to multiple savings and loan holding companies and, unless the savings association requalifies as a QTL within one year thereafter, shall register as, and become subject to the restrictions applicable to, a bank holding company.
If a savings and loan holding company acquires control of a second savings association and holds it as a separate institution, the holding company becomes a multiple savings and loan holding company. As a general rule, multiple savings and loan holding companies are subject to restrictions on their activities that are not imposed on a grandfathered holding company. They are restricted to activities traditionally permitted to multiple savings and loan holding companies and to financial holding companies under provisions of the Bank Holding Company Act. Multiple savings and loan holding companies may:
• furnish or perform management services for a savings association subsidiary of a savings and loan holding company;
• hold, manage or liquidate assets owned or acquired from a savings association subsidiary of a savings and loan holding company;
• hold or manage properties used or occupied by a savings association subsidiary of a savings and loan holding company;
• engage in activities determined by the Federal Reserve to be closely related to banking and a proper incident thereto; and
• engage in services and activities previously determined by the Federal Home Loan Bank Board by regulation to be permissible for a multiple savings and loan holding company as of March 5, 1987.
The activities financial holding companies may engage in include:
• lending, exchanging, transferring or investing for others, or safeguarding money or securities;
• insuring, guaranteeing or indemnifying others, issuing annuities, and acting as principal, agent or broker for purposes of the foregoing;
• providing financial, investment or economic advisory services, including advising an investment company;
• issuing or selling interests in pooled assets that a bank could hold directly;
• underwriting, dealing in or making a market in securities; and
• merchant banking activities.
Every savings institution subsidiary of a savings and loan holding company is required to give the OTS at least 30 days’ advance notice of any proposed dividends to be made on its guaranteed, permanent or other non-withdrawable stock, or else such dividend will be invalid.
Restrictions on Transactions with Affiliates. Transactions between a savings institution and its “affiliates” are subject to quantitative and qualitative restrictions under Sections 23A and 23B of the Federal Reserve Act and OTS regulations. Affiliates of a savings institution generally include, among other entities, the savings institution’s holding company and companies that are controlled by or under common control with the savings institution. Generally, Section 23A (i) limits the extent to which the savings association or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such association’s capital stock and surplus, and contain an aggregate limit on all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus. Section 23B applies to “covered transactions” as well as certain other transactions and requires that all transactions be on terms substantially the same, or at least favorable, to the association or subsidiary as those provided to a non-affiliate. The term “covered transaction” includes the making of loans to, purchase of assets from, issuance of a guarantee to an affiliate and similar transactions. Section 23B transactions also apply to the provision of services and the sale of assets by a savings association to an affiliate. In addition to the restrictions imposed by Sections 23A and 23B, Section 11 of the HOLA prohibits a savings association from (i) making a loan or other extension of credit to an affiliate, except for any affiliate which engages only in certain activities which are permissible for bank holding companies, or (ii) purchasing or investing in any stocks, bonds, debentures, notes or similar obligations of any affiliate, except for affiliates which are subsidiaries of the savings association.
In addition, Sections 22(g) and (h) of the Federal Reserve Act place restrictions on loans to executive officers, directors and principal stockholders. Under Section 22(h), loans to a director, an executive officer and to a greater than 10% stockholder of a savings institution (“a principal stockholder”), and certain affiliated interests of either, may not exceed, together with all other outstanding loans to such person and affiliated interests, the savings institution’s loans to one borrower limit (generally equal to 15% of the institution’s unimpaired capital and surplus). Section 22(h) also requires that loans to directors, executive officers and principal stockholders be made on terms substantially the same as offered in comparable transactions to other persons unless the loans are made pursuant to a benefit or compensation program that (i) is widely available to employees of the institution and (ii) does not give preference to any director, executive officer or principal stockholder, or certain affiliated interests of either, over other employees of the savings institution. Section 22(h) also requires prior board approval for certain loans. In addition, the aggregate amount of extensions of credit by a savings institution to all insiders cannot exceed the institution’s unimpaired capital and surplus. Furthermore, Section 22(g) places additional restrictions on loans to executive officers. At December 31, 2004, the Bank was in compliance with the above restrictions.
Sarbanes-Oxley Act of 2002. On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley Act of 2002, which generally establishes a comprehensive framework to modernize and reform the oversight of public company auditing, improve the quality and transparency of financial reporting by those companies and strengthen the independence of auditors. Certain of the legislation’s more significant reforms are noted below.
The legislation creates a public company accounting oversight board which is empowered to set auditing, quality control and ethics standards, to inspect registered public accounting firms, to conduct investigations and to take disciplinary actions, subject to SEC oversight and review. The board will be funded by mandatory fees paid by all public companies. The legislation also improves the Financial Accounting Standards Board, giving it full financial independence from the accounting industry.
The legislation strengthens auditor independence from corporate management by, among other things, limiting the scope of consulting services that auditors can offer their public company audit clients.
The legislation heightens the responsibility of public company directors and senior managers for the quality of the financial reporting and disclosure made by their companies. Among other things, the legislation provides for a strong public company audit committee that will be directly responsible for the appointment, compensation and oversight of the work of the public company auditors.
The legislation contains a number of provisions to deter wrongdoing. CEOs and CFOs will have to certify that company financial statements fairly present the company’s financial condition. If a misleading financial statement later resulted in a restatement, the CEO and CFO must forfeit and return to the company any bonus, stock or stock option compensation received in the twelve months following the misleading financial report. The legislation also prohibits any company officer or director from attempting to mislead or coerce an auditor. Among other reforms, the legislation empowers the SEC to bar certain persons from serving as officers or directors of a public company; prohibits insider trades during pension fund “blackout periods;” directs the SEC to adopt rules requiring attorneys to report securities law violations; and requires that civil penalties imposed by the SEC go into a disgorgement fund to benefit harmed investors.
The legislation imposes a range of corporate disclosure requirements. Among other things, the legislation requires public companies to report all off-balance-sheet transactions and conflicts, as well as to present any pro forma disclosures in a way that is not misleading and in accordance with requirements to be established by the SEC. The legislation also accelerated the required reporting of insider transactions, which now generally must be reported by the end of the second business day following a covered transaction; requires that annual reports filed with the SEC include a statement by management asserting that it is responsible for creating and maintaining adequate internal controls and assessing the effectiveness of those controls; and requires companies to disclose whether or not they have adopted an ethics code for senior financial officers, and, if not, why not, and whether the audit committee includes at least one “financial expert,” as defined by the SEC. The legislation also requires the SEC, based on certain enumerated factors, to regularly and systematically review corporate filings.
The legislation contains provisions which generally seek to limit and expose to public view possible conflicts of interest affecting securities analysts.
Finally, the legislation imposes a range of criminal penalties for fraud and other wrongful acts, as well as extends the period during which certain types of lawsuits can be brought against a company or its insiders.
The Bank
General. The OTS has extensive authority over the operations of federally chartered savings institutions. As part of this authority, savings institutions are required to file periodic reports with the OTS and are subject to periodic examinations by the OTS and the FDIC. The last regulatory examination of the Bank by the OTS was completed in February 2004. The Bank was not required to make any material changes to its operations as a result of such examination. The investment and lending authority of savings institutions are prescribed by federal laws and regulations, and such institutions are prohibited from engaging in any activities not permitted by such laws and regulations.
The OTS’ enforcement authority over all savings institutions and their holding companies includes, among other things, the ability to assess civil money penalties, to issue cease and desist or removal orders and to initiate injunctive actions. In general, these enforcement actions may be initiated for violations of laws and regulations and unsafe or unsound practices. Other actions or inactions may provide the basis for enforcement action, including misleading or untimely reports filed with the OTS.
Insurance of Accounts. The deposits of the Bank are insured to the maximum extent permitted by the SAIF, which is administered by the FDIC, and are backed by the full faith and credit of the U.S. Government. As insurer, the FDIC is authorized to conduct examinations of, and to require reporting by, FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious threat to the FDIC. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action.
Currently, FDIC deposit insurance rates generally range from zero basis points to 27 basis points, depending on the assessment risk classification assigned to the depository institution. The FDIC also assesses depository institutions the Financing Corporation (“FICO”) debt service assessment which became applicable to all insured institutions as of January 1, 1997, in accordance with the Deposit Insurance Funds Act of 1996. SAIF and Bank Insurance Fund (“BIF”)
members both paid quarterly FICO debt service assessments ranging from 1.46 basis points to 1.54 basis points in 2004. The current assessment rate is 1.44 basis points and is adjusted quarterly.
The FDIC may terminate the deposit insurance of any insured depository institution, including the Bank, if it determines after a hearing that the institution has engaged or is engaging in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations, or has violated any applicable law, regulation, order or any condition imposed by an agreement with the FDIC. It also may suspend deposit insurance temporarily during the hearing process for the permanent termination of insurance, if the institution has no tangible capital. If insurance of accounts is terminated, the accounts at the institution at the time of the termination, less subsequent withdrawals, shall continue to be insured for a period of six months to two years, as determined by the FDIC. Management is aware of no existing circumstances which would result in termination of the Bank’s deposit insurance.
Regulatory Capital Requirements. Federally insured savings institutions are required to maintain minimum levels of regulatory capital. The OTS has established capital standards applicable to all savings institutions. These standards generally must be as stringent as the comparable capital requirements imposed on national banks. The OTS also is authorized to impose capital requirements in excess of these standards on individual institutions on a case-by-case basis.
Current OTS capital standards require savings institutions to satisfy three different capital requirements. Under these standards, savings institutions must maintain “tangible” capital equal to at least 1.5% of adjusted total assets, “core” capital equal to at least 4.0% of adjusted total assets and “total” capital (a combination of core and “supplementary” capital) equal to at least 8.0% of “risk-weighted” assets. For purposes of the regulation, core capital generally consists of common stockholders’ equity (including retained earnings), noncumulative perpetual preferred stock and related surplus, minority interests in the equity accounts of fully consolidated subsidiaries, certain nonwithdrawable accounts and pledged deposits and “qualifying supervisory goodwill.” Tangible capital is given the same definition as core capital but does not include qualifying supervisory goodwill and is reduced by the amount of all the savings institution’s intangible assets, with only a limited exception for purchased mortgage servicing rights. Both core and tangible capital are further reduced by an amount equal to a savings institution’s debt and equity investments in subsidiaries engaged in activities not permissible to national banks (other than subsidiaries engaged in activities undertaken as agent for customers or in mortgage banking activities and subsidiary depository institutions or their holding companies). These adjustments do not materially affect the Bank’s regulatory capital. At December 31, 2004, the Bank exceeded its tangible, core and risk-based capital requirements.
In determining compliance with the risk-based capital requirement, a savings institution is allowed to include both core capital and supplementary capital in its total capital, provided that the amount of supplementary capital included does not exceed the savings institution’s core capital. Supplementary capital generally consists of hybrid capital instruments; perpetual preferred stock which is not eligible to be included as core capital; subordinated debt and intermediate-term preferred stock; and general allowances for loan losses up to a maximum of 1.25% of risk-weighted assets. In determining the required amount of risk-based capital, total assets, including certain off-balance sheet items, are multiplied by a risk weight based on the risks inherent in the type of assets. The risk weights assigned by the OTS for principal categories of assets are (i) 0% for cash and securities issued by the U.S. Government or unconditionally backed by the full faith and credit of the U.S. Government; (ii) 20% for securities (other than equity securities) issued by U.S. Government-sponsored agencies and mortgage-backed securities issued by, or fully guaranteed as to principal and interest by, the FNMA or the FHLMC, except for those classes with residual characteristics or stripped mortgage-related securities; (iii) 50% for prudently underwritten permanent one- to four-family first lien mortgage loans not more than 90 days delinquent and having a loan-to-value ratio of not more than 90% at origination unless insured to such ratio by an insurer approved by the FNMA or the FHLMC, qualifying residential bridge loans made directly for the construction of one- to four-family residences and qualifying multi-family residential loans; and (iv) 100% for all other loans and investments, including consumer loans, commercial loans, and one- to four-family residential real estate loans more than 90 days delinquent, and for repossessed assets.
Qualified Thrift Lender Test. All savings institutions are required to meet a QTL test to avoid certain restrictions on their operations. A savings institution that does not meet the QTL test must either convert to a bank charter or comply with the following restrictions on its operations: (i) the institution may not engage in any new activity or make any new investment, directly or indirectly, unless such activity or investment is permissible for a national bank; (ii) the branching powers of the institution shall be restricted to those of a national bank; and (iii) payment of dividends by the institution shall be subject to the rules regarding payment of dividends by a national bank. Upon the expiration of three years from the date the savings institution ceases to be a QTL, it must cease any activity and not retain any investment not permissible for a national bank.
Currently, the QTL test requires either (i) that a savings association qualifies as a domestic building and loan association as defined in Section 7701 (a)(19) of the Internal Revenue Code of 1986, as amended, (“Code”) or (ii) that 65% of an institution’s “portfolio assets” (as defined) consist of certain housing and consumer-related assets on a monthly average basis in nine out of every 12 months. Assets that qualify without limit for inclusion as part of the 65% requirement are loans made to purchase, refinance, construct, improve or repair domestic residential housing and manufactured housing; home equity loans; educational loans; small business loans; loans made through credit cards or credit card accounts; mortgage-backed securities (where the mortgages are secured by domestic residential housing or manufactured housing); stock issued by the FHLB of Dallas; and direct or indirect obligations of the FDIC. In addition, the following assets, among others, may be included in meeting the test subject to an overall limit of 20% of the savings institution’s portfolio assets: 50% of residential mortgage loans originated and sold within 90 days of origination; investments in a service corporation that derives at least 80% of its gross revenues from activities related to domestic or manufactured residential housing; 200% of the amount of loans and investments in “starter homes”; 200% of the amount of certain loans in “credit-needy” areas; loans for the purchase, construction, development, or improvements of “community service facilities” not in credit-needy areas; loans for personal, family, or household purchases (other than those in the includable without limit category); and stock issued by the FHLMC or the FNMA. Portfolio assets consist of total assets minus the sum of (i) goodwill and other intangible assets, (ii) property used by the savings institution to conduct its business, and (iii) liquid assets up to 20% of the institution’s total assets. At December 31, 2004, the qualified thrift investments of the Bank were approximately 81.2% of its portfolio assets.
Federal Home Loan Bank System. The Bank is a member of the FHLB of Dallas, which is one of 12 regional FHLBs that administers the home financing credit function of savings institutions. Each FHLB serves as a reserve or central bank for its members within its assigned region. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policies and procedures established by the board of directors of the FHLB. At December 31, 2004, the Bank had $89.8 million of outstanding FHLB advances.
As a member, the Bank is required to purchase and maintain stock in the FHLB of Dallas in an amount equal to the sum of 0.15% of total assets as of the previous December 31 and 4.25% of outstanding advances. At December 31, 2004, the Bank had $4.9 million in FHLB stock, which was in compliance with this requirement. No ready market exists for such stock and it has no quoted market value.
The FHLBs are required to provide funds for the resolution of troubled savings institutions and to contribute to affordable housing programs through direct loans or interest subsidies on advances targeted for community investment and low- and moderate-income housing projects. These contributions have adversely affected the level of FHLB dividends paid in the past and could continue to do so in the future. These contributions also could have an adverse effect on the value of FHLB stock in the future.
Federal Reserve System. The FRB requires all depository institutions to maintain reserves against their transaction accounts and non-personal time deposits. As of December 31, 2004, no reserves were required to be maintained on the first $7.0 million of transaction accounts, reserves of 3% were required to be maintained against the next $40.6 million of net transaction accounts (with such dollar amounts subject to adjustment by the FRB), and a reserve of 10% (which is subject to adjustment by the FRB to a level between 8% and 14%) against all remaining net transaction accounts. Because required reserves must be maintained in the form of vault cash or a noninterest-bearing account at a Federal Reserve Bank, the effect of this reserve requirement is to reduce an institution’s earning assets.
TAXATION
Federal Taxation
General. The Company and Bank are subject to the generally applicable corporate tax provisions of the Code, and the Bank is subject to certain additional provisions of the Code which apply to thrift and other types of financial institutions. The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters material to the taxation of the Company and the Bank and is not a comprehensive discussion of the tax rules applicable to the Company and Bank.
Year. The Bank files a federal income tax return on the basis of a fiscal year ending on December 31. The Company filed a consolidated federal income tax return with both the Bank and the Service Corporation.
Bad Debt Reserves. Prior to the enactment of the Small Business Jobs Protection Act (the “Act”), which was signed into law on August 21, 1996, certain thrift institutions, such as the Bank, were allowed deductions for bad debts under methods more favorable than those granted to other taxpayers. Qualified thrift institutions could compute deductions for bad debts using either the specific charge-off method of Section 166 of the Code or the reserve method of Section 593 of the Code.
Under Section 593, a thrift institution annually could elect to deduct bad debts under either (i) the “percentage of taxable income” method applicable only to thrift institutions, or (ii) the “experience” method that also was available to small banks. Under the percentage of taxable income method, a thrift institution generally was allowed a deduction for an addition to its bad debt reserve equal to 8% of its taxable income (determined without regard to this deduction and with additional adjustments). Under the experience method, a thrift institution was generally allowed a deduction for an addition to its bad debt reserve equal to the greater of (i) an amount based on its actual average experience for losses in the current and five preceding taxable years, or (ii) an amount necessary to restore the reserve to its balance as of the close of the base year. A thrift institution could elect annually to compute its allowable addition to bad debt reserves for qualifying loans either under the experience method or the percentage of taxable income method.
Section 1616(a) of the Act repealed the Section 593 reserve method of accounting for bad debts by thrift institutions, effective for taxable years beginning after 1995. Thrift institutions that are treated as “small banks” are allowed to utilize the experience method applicable to such institutions, while thrift institutions that are treated as “large banks” are required to use only the specific charge-off method. The percentage of taxable income method of accounting for bad debts is no longer available for any financial institution.
A thrift institution required to change its method of computing reserves for bad debts will treat such change as a change in the method of accounting, initiated by the taxpayer and having been made with the consent of the Secretary of the Treasury. Section 481(a) of the Code requires certain amounts to be recaptured with respect to such change. Generally, the amounts to be recaptured will be determined solely with respect to the “applicable excess reserves” of the taxpayer. The amount of the applicable excess reserves will be taken into account ratably over a period of six taxable years, beginning with the first taxable year after 1995, subject to the residential loan requirement described below. In the case of a thrift institution that is treated as a large bank, the amount of the institution’s applicable excess reserves generally is the excess of (i) the balance of its reserve for losses on qualifying real property loans (generally loans secured by improved real estate) and its reserve for losses on nonqualifying loans (all other types of loans) as of the close of its last taxable year beginning before January 1, 1996, over (ii) the balances of such reserves as of the close of its last taxable year beginning before January 1, 1988 (i.e., the “pre-1988 reserves”). In the case of a thrift institution that is treated as a small bank, the amount of the institution’s applicable excess reserves generally is the excess of (i) the balance of its reserve for losses on qualifying real property loans and its reserve for losses on nonqualifying loans as of the close of its last taxable year beginning before January 1, 1996, over (ii) the greater of the balance of (a) its pre-1988 reserves or, (b) what the thrift’s reserves would have been at the close of its last year beginning before January 1, 1996, had the thrift always used the experience method.
For taxable years that begin after December 31, 1995, and before January 1, 1998, if a thrift meets the residential loan requirement for a tax year, the recapture of the applicable excess reserves otherwise required to be taken into account as a Code Section 481(a) adjustment for the year will be suspended. A thrift meets the residential loan requirement if, for the tax year, the principal amount of residential loans made by the thrift during the year is not less than its base amount. The “base amount” generally is the average of the principal amounts of the residential loans made by the thrift during the six most recent tax years beginning before January 1, 1996. A residential loan is a loan as described in Section 7701(a) (19)
(C) (v) (generally a loan secured by residential or church property and certain mobile homes), but only to the extent that the loan is made to the owner of the property. The Bank’s applicable excess reserves were fully recaptured ratably over a period of six taxable years, beginning with taxable year 1998 and concluding with taxable year 2003.
The balance of the pre-1988 reserves is subject to the provisions of Section 593(e), as modified by the Act, which requires recapture in the case of certain excessive distributions to shareholders. The pre-1988 reserves may not be utilized for payment of cash dividends or other distributions to a shareholder (including distributions in dissolution or liquidation) or for any other purpose (except to absorb bad debt losses). Distribution of a cash dividend by a thrift institution to a shareholder is treated as made: first, out of the institution’s post-1951 accumulated earnings and profits; second, out of the pre-1988 reserves; and third, out of such other accounts as may be proper. To the extent a distribution by the Bank to the Company is deemed paid out of its pre-1988 reserves under these rules, the pre-1988 reserves would be reduced and the Bank’s gross income for tax purposes would be increased by the amount which, when reduced by the income tax, if any, attributable to the inclusion of such amount in its gross income, equals the amount deemed paid out of the pre-1988 reserves. As of December 31, 2004, the Bank’s pre-1988 reserves for tax purposes totaled approximately $4.2 million.
Minimum Tax. The Code imposes an alternative minimum tax at a rate of 20%. The alternative minimum tax generally applies to a base of regular taxable income plus certain tax preferences (“alternative minimum taxable income” or “AMTI”) and is payable to the extent such AMTI is in excess of an exemption amount. Items of tax preference that constitute AMTI include (a) tax-exempt interest on newly issued (generally, issued on or after August 8, 1986) private activity bonds other than certain qualified bonds and (b) 75% of the excess (if any) of (i) adjusted current earnings as defined in the Code, over (ii) AMTI (determined without regard to this preference and prior to reduction by net operating losses).
Net Operating Loss Carryovers. A financial institution may, for federal income tax purposes, carry back net operating losses (“NOLs”) to the preceding two taxable years and forward to the succeeding 20 taxable years. This provision applies to losses incurred in taxable years beginning after 1997. The Job Creation and Worker Assistance Act of 2002 temporarily increased the general NOL carryback period from two years to five years for NOLs arising in taxable years ending in 2001 and 2002. At December 31, 2004, the Bank had no NOL carryforwards for federal income tax purposes.
Capital Gains and Corporate Dividends-Received Deduction. Corporate net capital gains are taxed at a maximum rate of 35%. The corporate dividends-received deduction is 80% in the case of dividends received from a “20-percent-owned corporation”, i.e., a corporation having at least twenty percent (but generally less than 80 percent) of its stock owned by the recipient corporation and corporations which own less than 20% of the stock of a corporation distributing a dividend may deduct only 70% of dividends received or accrued on their behalf. However, a corporation may deduct 100% of dividends from a member of the same affiliated group of corporations.
Other Matters. Federal legislation is introduced from time to time that would limit the ability of individuals to deduct interest paid on mortgage loans. Individuals are currently not permitted to deduct interest on consumer loans. Significant increases in tax rates or further restrictions on the deductibility of mortgage interest could adversely affect the Bank.
The Bank’s federal income tax returns for the tax years ended December 31, 2001 forward are open under the statute of limitations and are subject to review by the IRS.
State Taxation
The Bank is subject to the Arkansas corporation income tax, which is a progressive rate up to a maximum of 6.7% of all taxable earnings.
The Company is incorporated under Texas law and, accordingly, is subject to Texas franchise tax in an amount equal to 4.5% of net income allocated to Texas pursuant to apportionments of gross receipts based upon where the Company conducts business.
Item 2.
Item 2. Properties.
At December 31, 2004, the Bank conducted its business from its executive office in Harrison, Arkansas, and fourteen full service offices, all of which are located in Northcentral and Northwest Arkansas.
The following table sets forth information with respect to the offices and other properties of the Bank at December 31, 2004.
(1) Such property is subject to a five-year lease expiring August 1, 2008, with three five-year renewal options.
(2) Such property is subject to a five-year lease expiring November 1, 2007.
Item 3.
Item 3. Legal Proceedings.
Neither the Company nor the Bank is involved in any pending legal proceedings other than nonmaterial legal proceedings occurring in the ordinary course of business.
Item 4.
Item 4. Submission of Matters to Vote of Security Holders.
No matters were submitted to a vote of security holders during the fourth quarter of 2004.
PART II.
Item 5.
Item 5. Market for Registrant’s Common Equity, Related Stockholder Matters, and Issuer Purchases of Equity Securities.
Shares of the Company’s common stock are traded under the symbol “FFBH” on the Nasdaq National Market System. At February 22, 2005, the Company had 5,079,408 shares of common stock outstanding and had approximately 1,985 beneficial holders of common stock.
The following table sets forth the dividends declared and the reported high and low end of day closing prices of a share of the Company’s common stock as reported by Nasdaq for the periods indicated. Such table has been adjusted for the two-for-one stock split paid on December 31, 2003.
The Company is in its 16th announced repurchase program, which was approved by the board of directors on May 26, 2004, and publicly announced on June 8, 2004. Total shares approved to be purchased in this program are 260,257, of which 211,266 have been purchased as of December 31, 2004. All treasury stock purchases are made under publicly announced repurchase programs.
Item 6.
Item 6. Selected Financial Data.
SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA
The selected consolidated financial and other data of the Company set forth below and on the following page is not complete and should be read in conjunction with, and is qualified in its entirety by, the more detailed information, including the Consolidated Financial Statements and related Notes, appearing elsewhere herein.
(1) Per share amounts have been restated for the two-for-one stock split that was paid on December 31, 2003.
(1)
Ratios are based on average daily balances.
(2)
Interest rate spread represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of average interest-bearing liabilities, and net interest margin represents net interest income as a percent of average interest-earning assets.
(3)
Noninterest expense to net interest income plus noninterest income.
(4)
Asset quality ratios are end of period ratios.
(5)
Nonperforming assets consist of nonperforming loans and real estate owned (“REO”). Nonperforming loans consist of nonaccrual loans and restructured loans while REO consists of real estate acquired in settlement of loans.
(6)
Capital ratios are end of period ratios for First Federal Bank.
(7)
Dividend payout ratio is the total dividends declared divided by net income.
Item 7.
Item 7. Management’s Discussion and Analysis of Financial Condition and Results of Operations.
GENERAL
Management’s discussion and analysis of financial condition and results of operations is intended to assist a reader in understanding the consolidated financial condition and results of operations of the Company for the periods presented. The information contained in this section should be read in conjunction with the Consolidated Financial Statements and the accompanying Notes to Consolidated Financial Statements and the other sections contained herein.
The Bank is a federally chartered stock savings and loan association formed in 1934. First Federal conducts business from its main office and fourteen full-service branch offices, all of which are located in a six county area in Northcentral and Northwest Arkansas comprised of Benton, Marion, Washington, Carroll, Baxter and Boone counties. The Bank will continue to focus its growth and expansion efforts in this six county area, especially in Benton and Washington counties, one of the fastest growing areas of the state. The Bank is a community-oriented financial institution offering a wide range of retail and commercial deposit accounts, including non-interest bearing and interest bearing checking, savings and money market accounts, certificates of deposit, and individual retirement accounts. Loan products offered by the Bank include residential real estate, consumer, construction, lines of credit, commercial real estate and commercial business loans. Other financial services include investment products offered through PrimeVest Financial Services, Inc.; automated teller machines; 24-hour telephone banking; internet banking, including account access, bill payment and online loan applications; Bounce ProtectionTM overdraft service; debit cards; and safe deposit boxes.
First Federal’s lending focus has traditionally been on permanent residential real estate. This continues to hold true, although in recent years an increased emphasis has been placed on commercial real estate lending and construction lending. Most of our lending growth is expected to occur in the Washington and Benton county areas, which are the headquarters of the state’s two largest employers, Wal-Mart and Tyson Foods. These employers attract suppliers who establish offices in the area and create jobs, which fosters demand for housing and office space. As of November 2004, unemployment in the Fayetteville/Springdale/Rogers metro area was 2.7%, compared to the Arkansas rate of 5.5% and the U.S. rate of 5.4%.
Certificates of deposit and savings accounts continue to comprise the majority of our deposit accounts. However, in recent years, increased emphasis has been placed on growth in checking accounts This emphasis will continue with plans to attract checking accounts through the utilization of targeted direct mail throughout our market area. Checking accounts offer low interest deposits, fee income potential, and the opportunity to cross-sell other financial services.
The Company’s results of operations depend primarily on its net interest income, which is the difference between interest income on interest-earning assets, such as loans and investments, and interest expense on interest-bearing liabilities, such as deposits and borrowings. The Company’s results of operations are also affected by the provision for loan losses, the level of its noninterest income and expenses, and income tax expense.
Noninterest income is generated primarily through deposit account fee income, profit on sale of loans, mortgage and installment lending fee income, and bank owned life insurance income.
Noninterest expense consists primarily of employee compensation and benefits, office occupancy expense, data processing expense, and other operating expense.
Like most banks, First Federal Bank’s two greatest challenges are managing interest rate risk and asset quality. The Bank’s current interest rate risk position as measured by our regulator, the Office of Thrift Supervision (“OTS”), is at a minimal level as defined by Thrift Bulletin 13a. The level of interest rate risk is impacted by the movement of interest rates and the timing and magnitude of assets repricing compared to liabilities repricing. The Bank attempts to reduce the impact of changes in interest rates on its net interest income by managing the repricing gap as described in the “Asset and Liability Management” section. We strive to maintain the asset quality of our loan portfolio at acceptable levels through sound underwriting procedures, including the use of credit scoring; an independent large loan review function; active collection procedures for delinquent loans; and, in the event of repossession, prompt and efficient liquidation of real estate, automobiles and other forms of collateral. Both the board of directors and senior management place a high priority on managing interest rate risk and asset quality.
CRITICAL ACCOUNTING POLICIES
Various elements of our accounting policies, by their nature, are inherently subject to estimation techniques, valuation assumptions and other subjective assessments. In particular, the methodology for the determination of our allowance for loan losses, due to the judgments, estimates and assumptions inherent in that policy, is critical to preparation of our financial statements. This policy and the judgments, estimates and assumptions are described in greater detail in subsequent sections of Management’s Discussion and Analysis and in the Notes to the Consolidated Financial Statements included herein. In particular, Note 1 to the Consolidated Financial Statements - “Summary of Significant Accounting Policies” describes generally our accounting policies. We believe that the judgments, estimates and assumptions used in the preparation of our Consolidated Financial Statements are appropriate given the factual circumstances at the time. However, given the sensitivity of our Consolidated Financial Statements to this critical accounting policy, the use of other judgments, estimates and assumptions could result in material differences in our results of operations or financial condition.
In estimating the amount of credit losses inherent in our loan portfolio, various judgments and assumptions are made. For example, when assessing the condition of the overall economic environment, assumptions are made regarding future market conditions and their impact on the loan portfolio. In the event the national economy were to sustain a prolonged downturn, the loss factors applied to our portfolios may need to be revised, which may significantly impact the measurement of the allowance for loan losses. For impaired loans that are collateral-dependent, the estimated fair value of the collateral may deviate significantly from the proceeds received when the collateral is sold.
CHANGES IN FINANCIAL CONDITION
Changes in financial condition between December 31, 2004 and 2003 are presented in the following table (dollars in thousands). Material changes between periods will be discussed in the sections which follow the table.
Loans Receivable. Changes in loan composition between December 31, 2004 and 2003 are presented in the following table (dollars in thousands).
The Bank continued to experience increased demand for commercial real estate loans, construction loans, and commercial loans. Generally, the Bank’s construction loans were for the purpose of constructing single-family residential properties. The interest rate environment and robust economy of our market area provided increased demand and opportunity for our other loan products as well. In recent years, the Bank has placed an increased emphasis on commercial real estate lending, construction lending, and commercial lending to diversify its loan portfolio, take advantage of market opportunities in these types of loans, and help the Bank transition to a more full-service community bank, as well as to provide opportunities to cross-sell its other banking products.
Allowance for Loan Losses. Changes in the composition of the allowance for loan losses between December 31, 2004 and 2003 are presented in the following table (in thousands).
The increase in the general loan loss allowance was primarily due to loan portfolio growth as well as an increase in charge-off experience related to overdrafts on demand deposit accounts. The increase in the specific allowance for loan losses was due to a valuation allowance recorded at December 31, 2004, related to a single commercial loan relationship that was not required at December 31, 2003.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as conditions change and more information becomes available.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as loss, doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based primarily on historical loss experience. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
The Bank reviews its non-homogeneous loans for impairment on a quarterly basis. The Bank considers commercial real estate, construction, multi-family, and commercial loans to be non-homogeneous loans. A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the shortfall in relation to the principal and interest owed. Impairment is measured on a loan-by-loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures. Homogeneous loans are those that are considered to have common characteristics that provide for evaluation on an aggregate or pool basis. The Bank considers the characteristics of (1) one- to- four family residential first mortgage loans; (2) unsecured consumer loans; and (3) collateralized consumer loans to permit consideration of the appropriateness of the allowance for losses of each group of loans on a pool basis. The primary methodology used to determine the appropriateness of the allowance for losses includes segregating certain specific, poorly performing loans based on their performance characteristics from the pools of loans as to type, valuing these loans, and then applying a loss factor to the remaining pool balance based on several factors, including past loss experience, inherent risks, and economic conditions in the primary market areas.
In estimating the amount of credit losses inherent in our loan portfolio, various judgments and assumptions are made. For example, when assessing the condition of the overall economic environment, assumptions are made regarding future market conditions and their impact on the loan portfolio. In the event the national economy were to sustain a prolonged downturn, the loss factors applied to our portfolios may need to be revised, which may significantly impact the measurement of the allowance for loan losses. For impaired loans that are collateral-dependent, the estimated fair value of the collateral may deviate significantly from the proceeds received when the collateral is sold.
Although we consider the allowance for loan losses of $1.8 million appropriate and adequate to cover losses inherent in our loan portfolio at December 31, 2004, no assurance can be given that we will not sustain loan losses that are significantly different from the amount recorded, or that subsequent evaluations of the loan portfolio, in light of factors then prevailing, would not result in a significant change in the allowance for loan losses.
Investment Securities. Changes in the composition of investment securities held to maturity between December 31, 2004 and 2003 are presented in the following table (dollars in thousands).
During 2004, investment securities totaling approximately $88 million were purchased and $112 million matured or were called. The majority of these purchases and maturities were shorter-term certificates of deposit and U.S. Government and agency obligations. The decreases in certificates of deposit and U.S. Government and agency obligations were due to calls and maturities in excess of purchases.
Office Properties and Equipment. The increase in office properties and equipment of $1.1million was due primarily to the purchase of land for future branch expansion.
Deposits. Changes in the composition of deposits between December 31, 2004 and 2003 are presented in the following table (dollars in thousands).
The Bank experienced a change in the mix of deposits due to the low interest rate environment during the year. Certificates of deposit and money market accounts decreased while demand and NOW deposit accounts increased. During the second quarter of 2004, the Bank launched a new marketing program aimed at increasing checking accounts. As part of this program, the Bank changed its checking account offerings to make them more attractive to potential customers as well as offering “thank you” gifts with account openings and referrals. The promotion and marketing of checking accounts will continue to be emphasized since they are a very attractive source of funds for the Bank as they offer low-interest deposits, fee income potential, and the opportunity to cross-sell other financial services. Checking account growth was 14.2% during 2004 with the average balance of checking accounts during 2004 of $104.7 million with an average cost of 0.27%. Deposit fee income increased 27.0% during 2004 primarily through an increase in clearing and honoring checks for customers who did not have sufficient funds in their checking account.
FHLB Advances. The Bank experienced $50.2 million or 126.9% growth in FHLB of Dallas advances during the year. The advances were used to fund loan growth in 2004. The balance of advances at December 31, 2004 of $89.8 million consisted of $51.6 million of fixed rate advances with an average cost of 3.77% and $38.2 million of floating rate advances with an average cost of 2.49%.
Stockholders’ Equity. Stockholders’ equity increased approximately $200,000 from December 31, 2003 to December 31, 2004. The increase in stockholders’ equity was primarily due to net income of $7.8 million, the reissuance of 210,918 shares of treasury stock totaling $2.0 million resulting from the exercise of stock options, and the release of ESOP shares totaling $1.7 million, offset by the purchase of treasury stock totaling $9.5 million and payment of dividends totaling $2.2 million during 2004. See the Consolidated Statements of Stockholders’ Equity for the years ended December 31, 2004, 2003 and 2002 for more detail.
Average Balance Sheets
The following table sets forth certain information relating to the Company’s average balance sheets and reflects the average yield on assets and average cost of liabilities for the periods indicated and the yields earned and rates paid at December 31, 2004. Such yields and costs are derived by dividing income or expense by the average balance of assets or liabilities, respectively, for the periods presented and outstanding balances at December 31, 2004. Average balances are based on daily balances during the periods.
(1) Includes nonaccrual loans.
(2) Includes FHLB of Dallas stock.
Rate/Volume Analysis
The table below sets forth certain information regarding changes in interest income and interest expense of the Company for the periods indicated. For each category of interest-earning assets and interest-bearing liabilities, information is provided on changes attributable to (i) changes in volume (changes in average volume multiplied by prior rate); (ii) changes in rate (change in rate multiplied by prior average volume); (iii) changes in rate-volume (changes in rate multiplied by the change in average volume); and (iv) the net change.
CHANGES IN RESULTS OF OPERATIONS
The table below presents a comparison of results of operations for the years ended December 31, 2004, 2003, and 2002 (dollars in thousands). Specific changes in captions will be discussed below the table.
Net Interest Income. Net interest income is determined by the Company’s interest rate spread (i.e., the difference between the yields earned on its interest-earning assets and the rates paid on its interest-bearing liabilities) and the relative amounts of interest-earning assets and interest-bearing liabilities. The Company’s net interest income increased in both comparison periods due to increases in interest rate spread and interest rate margin. In the 2003 vs. 2002 period, the average rates paid on interest-bearing liabilities declined by 98 basis points compared to the decline in the average yield on earning assets of 88 basis points. This resulted in a 10 basis point improvement in the interest rate spread from 2002 to 2003. In the 2004 vs. 2003 period the increases in the interest rate spread and interest rate margin were primarily the result of the shift in composition of interest-earning assets. Interest-earning cash balances and proceeds from maturing and called investment securities were used to fund loan growth resulting in a higher yield being earned on the funds.
Interest Income and Interest Expense
Dollar and percentage changes in interest income and interest expense for the comparison periods are presented in the rate/volume analysis table which appears on page 37.
Interest Income. The increase in the 2004 vs. 2003 period was primarily due to an increase in the average balance of loans and an increase in the average yield earned on investment securities, offset by decreases in the average balances of investment securities and other interest-earning assets and decreases in the average yields earned on loans and other interest-earning assets. The decrease in the average yield earned on loans was primarily due to an overall decline in rates during the periods and customers’ refinancing to lower rates. The decrease in the average balances of investment securities held to maturity and other interest-earning assets was due to proceeds from called or matured investments and interest-earning cash balances being used to fund loan growth. The average balance of loans increased primarily due to construction and commercial real estate loan growth in 2004.
The decrease in the 2003 vs. 2002 period was primarily due to a decrease in the average yield earned on loans, investment securities, and other interest-earning assets and a decrease in the average balance of investment securities, offset by an increase in the average balance of loans. The decrease in the average yield earned on loans, investment securities, and other interest-earning assets was primarily due to the declining level of interest rates in 2003. The decrease in the average balance of investment securities held to maturity was primarily the result of maturing FHLB CDs. The average balance of loans increased primarily due to construction loan growth in 2003.
Interest Expense. The decrease in interest expense in the 2004 vs. 2003 period was primarily due to decreases in the average rates paid on deposit accounts and FHLB advances, offset by increases in the average balances of deposits and FHLB advances. The decrease in the average interest rate paid on deposits was primarily the result of maturing certificates and variable interest-bearing deposits being repriced to lower interest rates. The increase in FHLB advances was due to the use of FHLB advances to fund loan growth.
The decrease in interest expense in the 2003 vs. 2002 period was primarily due to a decrease in the average rate paid on deposit accounts and FHLB advances. The decrease in the average interest rate paid on deposits was primarily the result of maturing certificates and variable interest-bearing deposits being reinvested at lower interest rates.
Provision for Loan Losses. The provision for loan losses is determined by management as the amount to bring the allowance for loan losses to a level that is considered adequate to absorb probable losses inherent in the loan portfolio. Such provision and the adequacy of the allowance for loan losses is evaluated quarterly by management of the Bank based on the Bank’s past loan loss experience, known and inherent risks in the portfolio, adverse situations that may affect the borrower’s ability to repay, the estimated value of any underlying collateral and current economic conditions.
Factors influencing management’s decision to increase the provision in the 2004 vs. 2003 period include an increase in the loan portfolio, particularly commercial real estate and construction loans, as well as an increase in nonaccrual and restructured loans.
In 2003, the primary factor contributing to the decrease in the provision from 2002 was a decline in charge-offs, which were $308,000 less than in 2002.
Noninterest Income. Deposit fee income increased as a result of the Bank’s continued promotion of Bounce ProtectionTM overdraft service as well as an increase in the number of checking accounts and a change in the insufficient funds fee structure. The number of checking accounts increased approximately 8.0% from December 31, 2003 to December 31, 2004 and increased 7.4% from December 31, 2002 to December 31, 2003. The Bank plans to continue to aggressively promote
checking accounts in 2005 through direct mail campaigns to further expand its checking accounts and increase deposit fee income.
Gain on sale of loans changed in relation to increases or decreases in originations of loans for sale during the comparison periods. The activity in loans held for sale is summarized below (in thousands):
Sales of loans peaked in 2003 due to record low interest rates in 2003 and the resulting refinancing activity.
Other noninterest income decreased during the 2004 vs. 2003 period and increased in the 2003 vs. 2002 period primarily due to an adjustment of the carrying value of donated real estate from its cost to its estimated fair value. The gain on contribution was recognized during the year ended December 31, 2003. A corresponding expense in the amount of $500,000, the fair value of the donated real estate, was also recorded during the year ended December 31, 2003, and is included in the balance of contributions expense.
Noninterest Expense
Salaries and Employee Benefits. The changes in the composition of this line item are presented below (in thousands):
(1) Employee Stock Ownership Plan
(2) Management Recognition and Retention Plan
2004 vs. 2003
The increase in salaries was due to normal salary and merit increases and an increase in bonuses paid to loan officers related to loan quality and production. Payroll taxes increased due to the increase in salaries. The increase in employee stock ownership plan expense was due to an increase in the Company’s average stock price from $15.89 in 2003 to $20.58 in 2004.
2003 vs. 2002
The increase in salaries was due to an increase in personnel and normal salary and merit increases. Payroll taxes and insurance increased due to the increase in salaries. The increase in employee stock ownership plan expense was due to an increase in the Company’s average stock price from $12.21 in 2002 to $15.89 in 2003. The defined benefit plan expense increased due to an increase in the Bank’s required contribution to the multiemployer pension plan as a result of decreased yields on plan assets.
Net occupancy expense. The changes in the composition of this line item are presented below (in thousands):
2004 vs. 2003
The increases in depreciation, utilities, and taxes and insurance are related to the new corporate headquarters being open a full year in 2004 compared to seven months in 2003. The increase in building repairs and maintenance can be partially attributed to expenses related to the new corporate office, but also relates to remodeling and refurbishing of other branch locations. The decrease in furniture, fixtures, and equipment expense was due to furnishings purchased in 2003 for the new building with unit costs below the Company’s capitalization level.
2003 vs. 2002
The increase in net occupancy expense was primarily due to an increase in depreciation expense on buildings and equipment. This increase in depreciation was due to completion of the new corporate headquarters in Harrison in June 2003. Furniture, fixtures, and equipment expense also increased for the same reason and represents furnishings for the new building with unit costs below the Company’s capitalization level.
Data processing expense. Data processing expense increased in both comparison periods due primarily to an upgrade of the Bank’s wide area network, increased ATM volume, and growth in electronic banking services.
Advertising and public relations. Advertising and public relations increased for the year ended December 31, 2004 compared to the same period in 2003 primarily due to costs associated with the new checking account marketing program, including direct mail, “thank you” gifts, marketing brochures, posters and billboards.
Contributions. Contributions decreased between the 2004 and 2003 periods and increased between the 2003 and 2002 periods mainly due to the contribution of real estate during the year ended December 31, 2003, discussed above in the noninterest income narrative. The $526,000 balance of contributions expense for the year ended December 31, 2003, includes the fair value of the donated real estate of $500,000.
Other expenses. The changes in the composition of this line item are presented below (in thousands):
2004 vs. 2003
Other expenses decreased slightly overall for the year ended December 31, 2004 compared to the year ended December 31, 2003. Consultant and management fees decreased in 2004 primarily due to fees paid to a consulting firm in 2003 related to preparation for internal control assertion and attestation under the requirements of Section 404 of the Sarbanes-Oxley Act of
2002. Fees paid to a third party vendor related to the Bounce ProtectionTM program also decreased during the year ended December 31, 2004 due to the end of the contractual payment period during the year. Offsetting these decreases were fees paid to a consultant in 2004 related to our new checking account marketing program. The increase in professional fees was primarily due to increased fees paid to our audit firm related to the requirements of Sarbanes-Oxley.
2003 vs. 2002
Other expenses in this period increased primarily due to consultant and management fees. These fees increased due to fees paid to a consulting firm related to preparation for compliance with Section 404 of the Sarbanes-Oxley Act of 2002, which will require management to report on its assessment of the effectiveness of internal control and our independent auditors to attest to such assertion. Fees paid to a third party vendor related to the Bounce ProtectionTM program also increased due to increased overdraft activity during 2003. Other components of the increase in consultant and management fees include fees paid to a consultant for the deposit reclassification program and fees paid to a consultant for work performed in the area of human resources. The deposit reclassification program allows the Bank to reduce its reserve requirement, thereby freeing up funds to be invested in interest-earning assets.
Income Taxes.
2004 vs. 2003
The increase in income tax expense was primarily due to an increase in taxable income and, to a lesser extent, an increase in the effective tax rate. The increase in the effective tax rate from 30.9% in 2003 to 32.1% in 2004 was attributable to the tax benefit of the contribution of the real estate made in 2003.
2003 vs. 2002
The decrease in income tax expense was primarily due to a decrease in taxable income and, to a lesser extent, a decrease in the effective tax rate. The decrease in the effective tax rate from 34.0% in 2002 to 30.9% in 2003 was attributable to the tax benefit of the contribution of real estate and an increase in nontaxable interest income.
OFF-BALANCE SHEET ARRANGEMENTS
The Company, in the normal course of business, makes commitments to buy or sell assets or to incur or fund liabilities. Commitments include, but are not limited to:
• the origination, purchase, or sale of loans;
• the fulfillment of commitments under letters-of-credit, extensions of credit on home equity lines of credit, construction loans, and predetermined overdraft protection limits; and
• the commitment to fund withdrawals of certificates of deposit at maturity.
At December 31, 2004, the Bank’s off-balance sheet arrangements principally included lending commitments, which are described below. At December 31, 2004, the Company had no interests in non-consolidated special purpose entities. At December 31, 2004, commitments included:
• total approved loan origination commitments outstanding amounting to $20.6 million, including $1.9 million of loans committed to sell;
• rate lock agreements with customers of $6.4 million, all of which have been locked with an investor;
• funded mortgage loans committed to sell of $1.6 million;
• unadvanced portion of construction loans of $62.7 million;
• unused lines of credit of $22.4 million;
• outstanding standby letters of credit of $1.6 million;
• total predetermined overdraft protection limits of $10.4 million; and
• certificates of deposit scheduled to mature in one year or less totaling $137.1 million.
Total unfunded commitments to originate loans for sale and the related commitments to sell of $6.4 million meet the definition of a derivative financial instrument. The related asset and liability are considered immaterial at December 31, 2004.
Historically, a very small percentage of predetermined overdraft limits have been used. At December 31, 2004, overdrafts of accounts with Bounce ProtectionTM represented usage of 2.3% of the limit. We expect this trend to continue in the future.
Based on historical experience, management believes that a significant portion of maturing deposits will remain with the Bank. We anticipate that we will continue to have sufficient funds, through repayments, deposits and borrowings, to meet our current commitments.
CONTRACTUAL OBLIGATIONS
We are contractually obligated to make future minimum payments as follows (in thousands):
LIQUIDITY AND CAPITAL RESOURCES
The Bank’s liquidity, represented by cash and cash equivalents and eligible investment securities, is a product of its operating, investing and financing activities. The Bank’s primary sources of funds are deposits, borrowings, collections on outstanding loans, maturities and calls of investment securities and other short-term investments and funds provided from operations. While scheduled loan amortization and maturing investment securities and short-term investments are relatively predictable sources of funds, deposit flows and loan prepayments are greatly influenced by general interest rates, economic conditions and competition. The Bank manages the pricing of its deposits to maintain a steady deposit balance. In addition, the Bank invests excess funds in overnight deposits and other short-term interest-earning assets which provide liquidity to meet lending requirements. The Bank has generally been able to generate enough cash through the retail deposit market, its traditional funding source, to offset the cash utilized in investing activities. As an additional source of funds, the Bank has borrowed from the FHLB of Dallas. During 2004, the use of FHLB advances increased due to increased demand for the Bank’s loan products. At December 31, 2004, available borrowing capacity with the FHLB was approximately $169 million.
Liquidity management is both a daily and long-term function of business management. Excess liquidity is generally invested in short-term investments such as overnight deposits and certificates of deposit. On a longer-term basis, the Bank maintains a strategy of investing in various lending products. The Bank uses its sources of funds primarily to meet its ongoing commitments, to pay maturing savings certificates and savings withdrawals, to repay maturing FHLB of Dallas advances, and to fund loan commitments.
As of December 31, 2004, the Bank’s regulatory capital was in excess of all applicable regulatory requirements. At December 31, 2004, the Bank’s tangible, core and risk-based capital ratios amounted to 9.74%, 9.74% and 13.75%, respectively, compared to regulatory requirements of 1.5%, 4.0% and 8.0%, respectively.
IMPACT OF INFLATION AND CHANGING PRICES
The financial statements and related financial data presented herein have been prepared in accordance with generally accepted accounting principles, which require the measurement of financial position and operating results in terms of historical dollars, without considering changes in relative purchasing power over time due to inflation.
Unlike most industrial companies, virtually all of the Bank’s assets and liabilities are monetary in nature. As a result, interest rates generally have a more significant impact on a financial institution’s performance than does the effect of inflation.
IMPACT OF NEW ACCOUNTING STANDARDS
See Note 1 to the Consolidated Financial Statements.
FORWARD-LOOKING STATEMENTS
The Company’s Annual Report on Form 10-K contains certain forward-looking statements and information relating to the Company that are based on the beliefs of management as well as assumptions made by and information currently available to management. In addition, in this document, the words “anticipate,” “believe,” “estimate,” “expect,” “intend,” “should” and similar expressions, or the negative thereof, as they relate to the Company or the Company’s management, are intended to identify forward-looking statements. Such statements reflect the current views of the Company with respect to future looking events and are subject to certain risks, uncertainties and assumptions. Should one or more of these risks or uncertainties materialize or should underlying assumptions prove incorrect, actual results may vary materially from those described herein as anticipated, believed, estimated, expected or intended. The Company does not intend to update these forward-looking statements.
Item 7A.
Item 7A. Quantitative and Qualitative Disclosure about Market Risk.
ASSET AND LIABILITY MANAGEMENT
The ability to maximize net interest income is largely dependent upon the achievement of a positive interest rate spread that can be sustained during fluctuations in prevailing interest rates. Interest rate sensitivity is a measure of the difference between amounts of interest-earning assets and interest-bearing liabilities that either reprice or mature within a given period of time. The difference, or the interest rate repricing “gap”, provides an indication of the extent to which an institution’s interest rate spread will be affected by changes in interest rates. A gap is considered positive when the amount of interest-rate sensitive assets exceeds the amount of interest-rate sensitive liabilities, and is considered negative when the amount of interest-rate sensitive liabilities exceeds the amount of interest-rate sensitive assets. Generally, during a period of rising interest rates, a negative gap within shorter maturities would adversely affect net interest income, while a positive gap within shorter maturities would result in an increase in net interest income, and during a period of falling interest rates, a negative gap within shorter maturities would result in an increase in net interest income while a positive gap within shorter maturities would have the opposite effect. As of December 31, 2004, the Bank estimates that the ratio of its one-year gap to total assets was a negative 18.3% and its ratio of interest-earning assets to interest-bearing liabilities maturing or repricing within one year was 67.2%.
The Bank focuses its residential lending activities on the origination of one-, three-, five- and seven-year adjustable-rate residential mortgage loans (“ARMs”). Although adjustable-rate loans involve certain risks, including increased payments and the potential for default in an increasing interest rate environment, such loans decrease the risks associated with changes in interest rates. As of December 31, 2004, $210.8 million or 74.7% of the Bank’s portfolio of one- to four-family residential mortgage loans consisted of ARMs, including $64.3 million in seven-year ARMs.
The Company’s investment portfolio amounted to $56.7 million or 7.5% of the Company’s total assets at December 31, 2004. Of such amount, $3.1 million or 5.5% is contractually due within one year and $200,000 or .4% is contractually due after one year to five years. However, actual maturities can be shorter than contractual maturities due to the ability of borrowers to call or prepay such obligations without call or prepayment penalties. As of December 31, 2004, there was approximately $55.8 million of investment securities at an average interest rate of 4.65% with call options held by the issuer, of which approximately $41.8 million, at an average interest rate of 4.70%, are callable within one year. To the extent that these higher yielding securities are called, the Company may reinvest such funds at prevailing interest rates which may have a downward impact on the Company’s interest rate spread.
Deposits are the Bank’s primary funding source and the Bank prices its deposit accounts based upon competitive factors and the availability of prudent lending and investment opportunities. The Bank seeks to lengthen the maturities of its deposits by offering longer term certificates of deposit when market conditions have created opportunities to attract such deposits. However, the Bank does not solicit high-rate jumbo certificates of deposit and does not pursue an aggressive growth strategy which would force the Bank to focus exclusively on competitors’ rates rather than deposit affordability. At December 31, 2004 the Bank had $335.0 million in certificates of deposit of which $137.1 million mature in one year or less. At December 31, 2004, the Bank had $89.8 million of FHLB advances of which $31.2 million is due in one year or less.
Net Portfolio Value
The value of the Bank’s loan and investment portfolio will change as interest rates change. As a result of the Bank’s interest rate repricing gap, rising interest rates will generally decrease the Bank’s net portfolio value (“NPV”), while falling interest rates will generally increase the value of that portfolio. NPV is the difference between incoming and outgoing discounted cash flows from assets, liabilities, and off-balance sheet contracts. The following tables set forth, quantitatively, as of December 31, 2004 and 2003, the OTS estimate of the projected changes in NPV in the event of a 100, 200 and 300 basis point instantaneous and permanent increase and a 100 basis point instantaneous and permanent decrease in market interest rates. Due to the current low prevailing interest rate environment the changes in NPV are not estimated for a decrease in interest rates of 200 or 300 basis points.
Computations of prospective effects of hypothetical interest rate changes are calculated by the OTS from data provided by the Bank and are based on numerous assumptions, including relative levels of market interest rates, loan repayments, and deposit runoffs, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions the Bank may undertake in response to changes in interest rates.
Management cannot predict future interest rates or their effect on the Bank’s NPV. Certain shortcomings are inherent in the method of analysis presented in the computation of NPV. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in differing degrees to changes in market interest rates. Additionally, certain assets, such as adjustable-rate loans, have features that restrict changes in interest rates during the initial term and over the remaining life of the asset. In addition, the proportion of adjustable-rate loans in the Bank’s portfolio could decrease in future periods due to refinancing activity if market rates decrease. Further, in the event of a change in interest rates, prepayment and early withdrawal levels could deviate significantly from those assumed in the table. Finally, the ability of many borrowers to service their adjustable-rate debt may decrease in the event of an interest rate increase.
Item 8.
Item 8. Financial Statements and Supplementary Data.
MANAGEMENT REPORT ON INTERNAL CONTROL
Financial Statements
The management of First Federal Bancshares of Arkansas, Inc. and its subsidiary, First Federal Bank of Arkansas, FA (the “Bank”), (collectively referred to as the “Company”) is responsible for the preparation, integrity, and fair presentation of its published financial statements and all other information presented in this annual report on Form 10-K. The financial statements have been prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) and, as such, include amounts based on informed judgments and estimates made by management.
Internal Control
Management is responsible for establishing and maintaining adequate internal control over financial reporting for financial presentations in conformity with both GAAP and the Office of Thrift Supervision Instructions for Schedules SC, SO, and the Reconciliation of Equity Capital included on Schedule SI of the Thrift Financial Reports (“TFR Instructions”). Pursuant to the rules and regulations of the Securities and Exchange Commission, internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management and other personnel, to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with GAAP and includes those policies and procedures that:
Pertain to the maintenance of records that in reasonable detail accurately and fairly reflect the transactions and dispositions of the assets of the Company;
Provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with GAAP, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the Company; and
Provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use or disposition of the company’s assets that could have a material effect on the financial statements.
Management has evaluated the effectiveness of its internal control over financial reporting for financial presentations in conformity with both GAAP and the TFR Instructions as of December 31, 2004 based on the control criteria established in a report entitled Internal Control-Integrated Framework, issued by the Committee of Sponsoring Organizations of the Treadway Commission. Based on such evaluation, we have concluded that the Company’s internal control over financial reporting is effective as of December 31, 2004.
Compliance With Laws and Regulations
Management is also responsible for ensuring compliance with the federal laws and regulations concerning loans to insiders and the federal and state laws and regulations concerning dividend restrictions, both of which are designated by the Federal Deposit Insurance Corporation (“FDIC”) as safety and soundness laws and regulations. Management assessed its compliance with the designated safety and soundness laws and regulations and has maintained records of its determinations and assessments as required by the FDIC. Based on this assessment, management believes that the Bank has complied, in all material respects, with the designated safety and soundness laws and regulations for the year ended December 31, 2004.
The independent registered public accounting firm of Deloitte & Touche LLP, as auditors of the Company’s consolidated financial statements, has issued an attestation report on management’s assessment of the Company’s internal control over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
First Federal Bancshares of Arkansas, Inc.
Harrison, Arkansas
We have audited the accompanying consolidated statements of financial condition of First Federal Bancshares of Arkansas, Inc. and its subsidiary (the “Company”) as of December 31, 2004 and 2003, and the related statements of income, stockholders’ equity, and cash flows for each of the three years in the period ended December 31, 2004. These financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, such financial statements present fairly, in all material respects, the financial position of First Federal Bancshares of Arkansas, Inc. and its subsidiary as of December 31, 2004 and 2003, and the results of their operations and their cash flows for each of the three years in the period ended December 31, 2004, in conformity with accounting principles generally accepted in the United States of America.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the effectiveness of the Company’s internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission and our report dated February 28, 2005 expressed an unqualified opinion on management’s assessment of the effectiveness of the Company’s internal control over financial reporting and an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.
REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
To the Board of Directors and Stockholders of
First Federal Bancshares of Arkansas, Inc.
Harrison, Arkansas
We have audited management’s assessment, included in the accompanying Management Report on Internal Control, that First Federal Bancshares of Arkansas, Inc. and its subsidiary (the “Company”) maintained effective internal control over financial reporting as of December 31, 2004, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Because management’s assessment and our audit were conducted to meet the reporting requirements of Section 112 of the Federal Deposit Insurance Corporation Improvement Act (FDICIA), management’s assessment and our audit of the Company’s internal control over financial reporting included controls over the preparation of the schedules equivalent to the basic financial statements in accordance with the Office of Thrift Supervision Instructions for Thrift Financial Reports for Schedules SC, SO, and the Reconciliation of Equity Capital included on Schedule SI. The Company’s management is responsible for maintaining effective internal control over financial reporting and for its assessment of the effectiveness of internal control over financial reporting. Our responsibility is to express an opinion on management’s assessment and an opinion on the effectiveness of the Company’s internal control over financial reporting based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether effective internal control over financial reporting was maintained in all material respects. Our audit included obtaining an understanding of internal control over financial reporting, evaluating management’s assessment, testing, and evaluating the design and operating effectiveness of internal control, and performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinions.
A company’s internal control over financial reporting is a process designed by, or under the supervision of, the company’s principal executive and principal financial officers, or persons performing similar functions, and effected by the company’s board of directors, management, and other personnel to provide reasonable assurance regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. A company’s internal control over financial reporting includes those policies and procedures that (1) pertain to the maintenance of records that, in reasonable detail, accurately and fairly reflect the transactions and dispositions of the assets of the company; (2) provide reasonable assurance that transactions are recorded as necessary to permit preparation of financial statements in accordance with generally accepted accounting principles, and that receipts and expenditures of the company are being made only in accordance with authorizations of management and directors of the company; and (3) provide reasonable assurance regarding prevention or timely detection of unauthorized acquisition, use, or disposition of the company’s assets that could have a material effect on the financial statements.
Because of the inherent limitations of internal control over financial reporting, including the possibility of collusion or improper management override of controls, material misstatements due to error or fraud may not be prevented or detected on a timely basis. Also, projections of any evaluation of the effectiveness of the internal control over financial reporting to future periods are subject to the risk that the controls may become inadequate because of changes in conditions, or that the degree of compliance with the policies or procedures may deteriorate.
In our opinion, management’s assessment that the Company maintained effective internal control over financial reporting as of December 31, 2004, is fairly stated, in all material respects, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission. Also, in our opinion, the Company maintained, in all material respects, effective internal control over financial reporting as of December 31, 2004, based on the criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission.
We have not examined, and accordingly, we do not express an opinion or any other form of assurance on management’s statement referring to compliance with laws and regulations.
We have also audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States) the consolidated financial statements as of and for the year ended December 31, 2004 of the Company, and our report dated February 28, 2005 expressed an unqualified opinion on those financial statements.
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.
CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2004 AND 2003
(In thousands, except share data)
See notes to consolidated financial statements.
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC
CONSOLIDATED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2004, 2003, 2002
(In thousands, except earnings per share)
See notes to consolidated financial statements.
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS’ EQUITY YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002 (In thousands, except share data)
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2004, 2003 AND 2002
(In thousands)
(Continued)
(Concluded)
See notes to consolidated financial statements.
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002
1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Nature of Operations and Principles of Consolidation-First Federal Bancshares of Arkansas, Inc. (the “Company”) is a unitary holding company which owns all of the stock of First Federal Bank of Arkansas, FA (the “Bank”). The Bank provides a broad line of financial products to individuals and small to medium-sized businesses. The consolidated financial statements also include the accounts of the Bank’s wholly-owned subsidiary, First Harrison Service Corporation (“FHSC”), which is inactive. All material intercompany transactions have been eliminated in consolidation.
Use of Estimates-The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates and such differences could be significant. The allowance for loan losses is a material estimate that is particularly susceptible to significant change in the near term.
Cash and Cash Equivalents-For the purpose of presentation in the consolidated statements of cash flows, cash and cash equivalents includes cash on hand and amounts due from depository institutions, which includes interest-bearing amounts available upon demand.
Investment Securities-The Company classifies investment securities into one of two categories: held to maturity or available for sale. The Company does not engage in trading activities. Debt securities that the Company has the positive intent and ability to hold to maturity are classified as held to maturity and recorded at cost, adjusted for the amortization of premiums and the accretion of discounts.
Investment securities that the Company intends to hold for indefinite periods of time are classified as available for sale and are recorded at fair value. Unrealized holding gains and losses are excluded from earnings and reported net of tax in other comprehensive income. Investment securities in the available for sale portfolio may be used as part of the Company’s asset and liability management practices and may be sold in response to changes in interest rate risk, prepayment risk, or other economic factors. At December 31, 2004 and 2003, the Company did not own any investment securities classified as available for sale.
Premiums are amortized into interest income using the interest method to the earlier of maturity or call date. Discounts are accreted into interest income using the interest method over the period to maturity. The specific identification method of accounting is used to compute gains or losses on the sales of investment securities.
Declines in the fair value of held to maturity and available for sale securities below their cost that are deemed to be other than temporary are reflected in earnings as realized losses. In estimating other than temporary impairment losses, management considers independent price quotations and the financial condition of the issuer.
Loans Receivable-The Bank originates and maintains loans receivable which are substantially concentrated in its lending territory (primarily Northwest and Northcentral Arkansas). The majority of the Bank’s loans are residential mortgage loans, commercial real estate loans, commercial loans, and construction loans for residential property. The Bank’s policy calls for collateral or other forms of repayment assurance to be received from the borrower at the time of loan origination. Such collateral or other form of repayment assurance is subject to changes in economic value due to various factors beyond the control of the Bank.
Loans receivable that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are stated at unpaid principal balances adjusted for any charge-offs, the allowance for loan losses, and any deferred loan fees or costs. Deferred loan fees or costs and discounts on first mortgage loans are amortized or accreted to income using the level-yield method over the remaining period to contractual maturity.
Mortgage loans originated and committed for sale in the secondary market are carried at the lower of cost or estimated market value in the aggregate. Such loans are generally carried at cost due to the short period of time between funding and sale, generally two to three weeks.
The accrual of interest on impaired loans is discontinued when, in management’s opinion, the borrower may be unable to meet payments as they become due or when the loan becomes 90 days past due, whichever occurs first. When interest accrual is discontinued, all unpaid accrued interest is reversed against interest income. The interest on these loans is accounted for on the cash basis until qualifying for return to accrual. Loans are returned to accrual status when payments are made to bring the loan under 90 days past due and, in the opinion of management, collection of the remaining balance can be reasonably expected.
Allowance for Loan Losses-The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to earnings. Loan losses are charged against the allowance when management believes it is likely that a loan balance is uncollectible. Subsequent recoveries, if any, are credited to the allowance.
The allowance for loan losses is evaluated on a regular basis by management and is based upon management’s periodic review of the collectibility of the loans in light of historical experience, the nature and volume of the loan portfolio, adverse situations that may affect the borrower’s ability to repay, estimated value of any underlying collateral and prevailing economic conditions. This evaluation is inherently subjective as it requires estimates that are susceptible to significant revision as more information becomes available or conditions change.
The allowance consists of specific, general and unallocated components. The specific component relates to loans that are classified as loss, doubtful, substandard or special mention. For such loans that are also classified as impaired, an allowance is established when the discounted cash flows (or collateral value or observable market price) of the impaired loan is lower than the carrying value of that loan. The general component covers non-classified loans and is based primarily on historical loss experience. An unallocated component is maintained to cover uncertainties that could affect management’s estimate of probable losses. The unallocated component of the allowance reflects the margin of imprecision inherent in the underlying assumptions used in the methodologies for estimating specific and general losses in the portfolio.
A loan is considered impaired when, based on current information and events, it is probable that the Bank will be unable to collect the scheduled payments of principal or interest when due according to the contractual terms of the loan agreement. Factors considered by management in determining impairment include payment status, collateral value, and the probability of collecting scheduled principal and interest payments when due. Loans that experience insignificant payment delays and payment shortfalls generally are not classified as impaired. Management determines the significance of payment delays and payment shortfalls on a case-by-case basis, taking into consideration all of the circumstances surrounding the loan and the borrower, including the length of the delay, the reasons for the delay, the borrower’s prior payment record, and the amount of the short fall in relation to the principal and interest owed. Impairment is measured on a loan by loan basis by either the present value of expected future cash flows discounted at the loan’s effective interest rate, the loan’s obtainable market price, or the fair value of the collateral if the loan is collateral dependent.
Large groups of smaller balance homogeneous loans are collectively evaluated for impairment. Accordingly, the Bank does not separately identify individual consumer and residential loans for impairment disclosures. Homogeneous loans are those that are considered to have common characteristics that provide for evaluation on an aggregate or pool basis. The Bank considers the characteristics of (1) one- to four-family residential first mortgage loans; (2) unsecured consumer loans; and (3) collateralized consumer loans to permit consideration of the appropriateness of the allowance for losses of each group of loans on a pool basis. The primary methodology used to determine the appropriateness of the allowance for losses includes segregating certain specific, poorly performing loans based on their performance characteristics from the pools of loans as to type, valuing these loans, and then applying a loss factor to the remaining pool balance based on several factors including past loss experience, inherent risks, and economic conditions in the primary market areas.
Rate Lock Commitments-On March 13, 2002, the Financial Accounting Standards Board (“FASB”) determined that loan commitments related to the origination or acquisition of mortgage loans that will be held for sale must be accounted for as derivative instruments, effective for fiscal quarters beginning after April 10, 2002. Accordingly, the Company adopted such accounting on July 1, 2002.
The Bank enters into commitments to originate loans whereby the interest rate on the loan is determined prior to funding (rate lock commitments). Rate lock commitments on mortgage loans that are intended to be sold are considered to be derivatives. Accordingly, such commitments, along with any related fees received from potential borrowers, are recorded at fair value in derivative assets or liabilities, with changes in fair value recorded in the net gain or loss on sale of mortgage loans. Fair value is based on fees currently charged to enter into similar agreements, and for fixed-rate commitments also considers the difference between current levels of interest rates and the committed rates. Prior to July 1, 2002, such commitments were recorded to the extent of fees received. Fees received were subsequently included in the net gain or loss on sale of mortgage loans.
The cumulative effect of adopting SFAS No. 133, Accounting for Derivative Instruments and Hedging Activities, for rate lock commitments as of July 1, 2002 was not material, nor was its effect material at December 31, 2004 or 2003.
Real Estate Acquired in Settlement of Loans-Real estate acquired in settlement of loans is initially recorded at estimated fair value less estimated costs to sell, establishing a new cost basis. Subsequent to foreclosure, valuations are periodically performed by management and the assets are carried at the lower of carrying amount or fair value less costs to sell. Revenue and expenses from operations and changes in the valuation allowance are included in other noninterest expenses.
Office Properties and Equipment-Land is carried at cost. Buildings and equipment are stated at cost less accumulated depreciation and amortization. The Company computes depreciation using the straight-line method over the estimated useful lives of the individual assets which range from 3 to 40 years.
Income Taxes- Deferred income tax assets and liabilities are determined using the liability (or balance sheet) method. Under this method, the net deferred tax asset or liability is determined based on the tax effects of the temporary differences between the book and tax bases of the various statement of financial condition assets and liabilities and gives current recognition to changes in tax rates and laws.
Interest Rate Risk-The Bank’s asset base is exposed to risk including the risk resulting from changes in interest rates and changes in the timing of cash flows. The Bank monitors the effect of such risks by considering the mismatch of the maturities of its assets and liabilities in the current interest rate environment and the sensitivity of assets and liabilities to changes in interest rates. The Bank’s management has considered the effect of significant increases and decreases in interest rates and believes such changes, if they occurred, would be manageable and would not affect the ability of the Bank to hold its assets as planned. However, the Bank is exposed to significant market risk in the event of significant and prolonged interest rate changes.
Employee Stock Ownership Plan-Compensation expense for the Employee Stock Ownership Plan (“ESOP”) is determined based on the average fair value of shares committed to be released during the period and is recognized as the shares are committed to be released. For the purpose of earnings per share, ESOP shares are included in weighted-average common shares outstanding as the shares are committed to be released.
Stock Compensation Plans-Statement of Financial Accounting Standards No. 123, Accounting for Stock-Based Compensation (“SFAS 123”), provides that entities may adopt a fair value based method of accounting for employee stock compensation plans, whereby compensation cost is measured at the grant date based on the value of the award and is recognized over the service period, which is usually the vesting period. However, it also provides that an entity may measure compensation cost for those plans using the intrinsic value based method of accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25, Accounting for Stock Issued to Employees, whereby compensation cost is the excess, if any, of the quoted market price of the stock at the grant date (or other measurement date) over the amount an employee must pay to acquire the stock. The Company applies the provisions of APB Opinion No. 25 in accounting for its stock option plan. No compensation cost has been recognized for options granted to employees as all options granted had an exercise price equal to the market price of the underlying stock on the grant date. Had compensation cost for these plans been determined based on the fair value at the grant dates for awards under those plans consistent with the methods of SFAS 123, the effect on the Company’s pro forma net income and pro forma earnings per share would not have been significant.
Earnings Per Common Share-Basic earnings per share represents income available to common stockholders divided by the weighted-average number of common shares outstanding during the period. Diluted earnings per share reflects additional common shares that would have been outstanding if dilutive potential common shares had
been issued, as well as any adjustment to income that would result from the assumed issuance. Potential common shares that may be issued by the Company relate solely to outstanding stock options, and are determined using the treasury stock method.
Stock Split-On November 25, 2003, the Board of Directors of the Company declared a two-for-one stock split payable December 31, 2003, to the stockholders of record on December 17, 2003. Stockholders’ equity, including shares, has been retroactively restated to reflect the stock split as of the earliest date presented in this report. All per share amounts and weighted average shares outstanding have been restated to reflect the stock split.
Recent Accounting Pronouncements-In December 2004, the FASB issued SFAS No. 123(R), Share-Based Payment, which establishes accounting standards for all transactions in which an entity exchanges its equity instruments for goods and services. SFAS No. 123(R) focuses primarily on accounting for transactions with employees, and carries forward without change prior guidance for share-based payments for transactions with non-employees. SFAS No. 123(R) eliminates the intrinsic value measurement objective in APB Opinion 25 and generally requires measurement of the cost of employee services received in exchange for an award of equity instruments based on the fair value of the award on the date of the grant. The standard requires grant date fair value to be estimated using either an option-pricing model adjusted for the unique characteristics of the award or an observable market price, if such a price exists. Such cost must be recognized over the period during which an employee is required to provide service in exchange for the award - the requisite service period (which is usually the vesting period). We will be required to apply SFAS No. 123(R) to all awards granted, modified or settled in our first reporting period after June 15, 2005. As of the required effective date, all public entities will apply this Statement using a modified version of prospective application. Under that transition method, compensation cost is recognized on or after the required effective date for the portion of outstanding awards for which the requisite service has not yet been rendered, based on the grant-date fair value of those awards calculated under Statement 123 for either recognition or pro forma disclosures. For periods before the required effective date, entities may elect to apply a modified version of retrospective application under which financial statements for prior periods are adjusted on a basis consistent with the pro forma disclosures required for those periods by Statement 123. We will adopt SFAS No. 123(R) in the third quarter of 2005 using the modified prospective application. Based on our current activities, we estimate that the adoption of this Statement will not have a material effect on the financial statements of the Company.
In December 2004, the FASB issued SFAS No. 153, Exchanges of Nonmonetary Assets an amendment of APB No. 29. This Statement amends Opinion 29 to eliminate the exception for nonmonetary exchanges of similar productive assets and replaces it with a general exception for exchanges of nonmonetary assets that do not have commercial substance. The Statement specifies that a nonmonetary exchange has commercial substance if the future cash flows of the entity are expected to change significantly as a result of the exchange. This Statement is effective for nonmonetary asset exchanges occurring in fiscal periods beginning after June 15, 2005. Earlier application is permitted for nonmonetary asset exchanges occurring in fiscal periods beginning after the date this Statement is issued. Retroactive application is not permitted. Based on our current activities, we estimate that the adoption of this Statement will not have a material effect on the financial statements of the Company.
Reclassifications-Certain amounts in the 2003 and 2002 consolidated financial statements have been reclassified to conform to the classifications adopted for reporting in 2004.
2. RESTRICTIONS ON CASH AND AMOUNTS DUE FROM BANKS
The Bank is required to maintain average balances on hand or with the Federal Reserve Bank. At December 31, 2004 and 2003, these reserve balances amounted to $571,000 and $520,000, respectively.
3. INVESTMENT SECURITIES
Investment securities consisted of the following at December 31 (in thousands):
The following table shows gross unrealized losses and fair value aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, at December 31, 2004:
The Company has pledged investment securities held to maturity with carrying values of approximately $19.5 million and $15.5 million at December 31, 2004 and 2003, respectively, as collateral for certain deposits in excess of $100,000.
The scheduled maturities of debt securities at December 31, 2004, by contractual maturity are shown below (in thousands). Expected maturities may differ from contractual maturities because borrowers may have the right to call or prepay obligations with or without call or prepayment penalties.
As of December 31, 2004 and 2003, investments with carrying values of approximately $55.8 million and $70.0 million, respectively, have call options held by the issuer, of which approximately $41.8 million and $55.4 million, respectively, are callable within one year.
4. LOANS RECEIVABLE
Loans receivable consisted of the following at December 31 (in thousands):
At December 31, 2004 and 2003, loans receivable included loans committed to be sold with net book values of $1.6 million and $1.7 million, respectively.
Mortgage loans serviced for others are not included in the accompanying consolidated statements of financial condition. The unpaid principal balances of such loans at December 31, 2004 and 2003 were $18.9 million and $8.4 million, respectively. Servicing loans for others generally consists of collecting mortgage payments, maintaining escrow accounts, disbursing payments to investors, and foreclosure processing. Servicing income for the years ended December 31, 2004, 2003, and 2002 was $159,000, $36,000 and $5,000, respectively.
The following is a summary of information pertaining to impaired and non-accrual loans:
Interest income recorded during the years ended December 31, 2004, 2003 and 2002 for nonaccrual loans was $85,000, $112,000, and $413,000, respectively. Under the original terms, these loans would have reported approximately $243,000, $274,000, and $525,000, of interest income for the years ended December 31, 2004, 2003, and 2002, respectively.
5. ACCRUED INTEREST RECEIVABLE
Accrued interest receivable consisted of the following at December 31 (in thousands):
6. ALLOWANCES FOR LOAN AND REAL ESTATE LOSSES
A summary of the activity in the allowances for loan and real estate losses is as follows for the years ended December 31 (in thousands):
7. OFFICE PROPERTIES AND EQUIPMENT
Office properties and equipment consisted of the following at December 31 (in thousands):
Depreciation expense for the years ended December 31, 2004, 2003, and 2002, amounted to approximately $1,185,000, $1,167,000, and, $819,000, respectively.
8. DEPOSITS
Deposits are summarized as follows at December 31 (in thousands):
Overdrafts of demand deposit accounts of $574,000 and $240,000 at December 31, 2004 and 2003, respectively, have been reclassified for financial reporting and are reflected in net loans receivable on the consolidated statements of financial condition.
The aggregate amount of time deposits in denominations of $100 thousand or more was approximately $87 million and $80 million at December 31, 2004 and 2003, respectively.
At December 31, 2004, scheduled maturities of certificates of deposit are as follows (in thousands):
Interest expense on deposits consisted of the following (in thousands):
Eligible deposits of the Bank are insured up to $100 thousand by the Savings Association Insurance Fund (“SAIF”) of the Federal Deposit Insurance Corporation (“FDIC”).
9. FEDERAL HOME LOAN BANK STOCK AND ADVANCES
The Bank is a member of the Federal Home Loan Bank System. As a member of this system, it is required to maintain an investment in capital stock of the Federal Home Loan Bank (“FHLB”) in an amount equal to the sum of 0.15% of total assets as of the previous December 31 and 4.25% of outstanding advances. No ready market exists for such stock and it has no quoted market value. The carrying value of the stock is its cost.
The Bank pledges eligible collateral for its FHLB advances as defined in its blanket lien agreement with the FHLB as well as its FHLB demand deposit account and FHLB stock. Eligible collateral under the blanket lien includes First Mortgage Collateral (as defined), multi-family residential mortgages meeting the requirements for eligibility as First Mortgage Collateral, U.S. Government and Agency Securities (as defined), privately issued mortgage-backed securities that qualify as eligible collateral under applicable regulations, Federal Home Loan Bank Term Deposit Accounts, and other non-securitized real estate related collateral. Advances at December 31, 2004 and 2003, consisted of the following (in thousands):
10. INCOME TAXES
The provisions (benefits) for income taxes are summarized as follows (in thousands):
The reasons for the differences between the statutory federal income tax rates and the effective tax rates are summarized as follows (in thousands):
The Company’s net deferred tax liability account was comprised of the following at December 31 (in thousands):
Specifically exempted from deferred tax recognition requirements are bad debt reserves for tax purposes of U.S. savings and loans in the institution’s base year, as defined. Base year reserves totaled approximately $4.2 million. Consequently, a deferred tax liability of approximately $1.6 million related to such reserves was not provided for in the consolidated statements of financial condition at December 31, 2004 and 2003. Payment of dividends to shareholders out of retained earnings deemed to have been made out of earnings previously set aside as bad debt reserves may create taxable income to the Bank. No provision has been made for income tax on such a distribution as the Bank does not anticipate making such distributions.
11. BENEFIT PLANS
Stock Option Plan-The Stock Option Plan (“SOP”) provides for a committee of the Company’s Board of Directors to award incentive stock options, non-qualified or compensatory stock options and stock appreciation rights representing up to 1,030,750 shares of Company stock. One-fifth of the options granted vested immediately upon grant, with the balance vesting in equal amounts on the four subsequent anniversary dates of the grant. Options granted vest immediately in the event of retirement, disability, or death. Stock options granted expire in ten years unless grantee terminates employment, in which case the award expires five years after termination date or ten years after grant date, whichever comes first.
Under the SOP, options have been granted to directors and key employees to purchase common stock of the Company. The exercise price in each case equals the fair market value of the Company’s stock at the date of grant. Options granted are summarized as follows:
A summary of the status of the Company’s SOP as of December 31, 2004, 2003, and 2002, and changes during the years ending on those dates are presented below:
Management Recognition and Retention Plan-The Management Recognition and Retention Plan (“MRR Plan”) provides for a committee of the Company’s Board of Directors to award restricted stock to key officers as well as non-employee directors. The MRR Plan authorizes the Company to grant up to 412,300 shares of the Company stock, of which 401,688 shares have been granted through December 31, 2004. Compensation expense has been recognized over the vesting period based on the fair market value of the shares on the grant date. Shares granted will be deemed vested in the event of disability or death. Approximately $27,000 and $45,000 in compensation expense was recognized during the years ended December 31, 2004 and 2003, respectively. No compensation expense was recognized during the year ended December 31, 2002.
Employee Stock Ownership Plan-The Company established an Employee Stock Ownership Plan on May 3, 1996. During 1996, the ESOP borrowed $4.1 million from the Company to purchase shares of Company stock. The loan is collateralized by the shares that were purchased with the proceeds of the loan. As the loan is repaid, ESOP shares will be allocated to participants of the ESOP and are available for release to the participants subject to the vesting provisions of the ESOP.
Forfeitures of nonvested benefits will be reallocated among remaining participating employees in the same proportion as contributions. During each of the years ended December 31, 2004, 2003, and 2002, 83,208 shares were released by the ESOP to participant accounts. At December 31, 2004, there were 600,091 shares allocated to participant accounts and 104,009 unallocated shares. The fair value of the unallocated shares amounted to approximately $2.3 million at December 31, 2004.
During the years ended December 31, 2004, 2003, and 2002, ESOP expense was approximately $1.7 million, $1.2 million, and $924,000, respectively.
Other Postretirement Benefits-The Bank is a participant in a multi-employer retirement plan and therefore separate information is not available. The plan is noncontributory and covers substantially all employees. The plan provides a retirement benefit and a death benefit. Retirement benefits are payable in monthly installments for life and must begin not later than the first day of the month coincident with or the next month following the seventieth birthday or the participant may elect a lump-sum distribution. Death benefits are paid in a lump-sum distribution, the amount of which depends on years of service. Net pension expense was approximately $358,000, $480,000 and $108,000 for the years ended December 31, 2004, 2003, and 2002 respectively.
12. EARNINGS PER SHARE
13. OFF-BALANCE SHEET ARRANGEMENTS AND COMMITMENTS
The Bank is a party to financial instruments with off-balance sheet risk in the normal course of business to meet the financing needs of its customers. These financial instruments include commitments to extend credit and standby letters of credit. Those instruments involve, to varying degrees, elements of credit risk in excess of the amount recognized in the consolidated statements of financial condition.
The Bank does not use financial instruments with off-balance sheet risk as part of its asset/liability management program or for trading purposes. The Bank’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual amounts of those instruments. The Bank uses the same credit policies in making commitments and conditional obligations as it does for on-balance sheet instruments.
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses. The Bank evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Bank upon extension of credit, is based on management’s credit evaluation of the counterparty. Such collateral consists primarily of residential properties. Standby letters of credit are conditional commitments issued by the Bank to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers.
The funding period for construction loans is generally six- to twelve-months and commitments to originate mortgage loans are generally outstanding for 60 days or less.
The Company, in the normal course of business, makes commitments to buy or sell assets or to incur or fund liabilities. Commitments include, but are not limited to:
• the origination, purchase or sale of loans;
• the fulfillment of commitments under letters-of-credit, extensions of credit on home equity lines of credit, construction loans, and under predetermined overdraft protection limits; and
• the commitment to fund withdrawals of certificates of deposit at maturity.
At December 31, 2004, the Bank’s off-balance sheet arrangements principally included lending commitments, which are described below. At December 31, 2004, the Company had no interests in non-consolidated special purpose entities.
At December 31, 2004, commitments included:
• total approved loan origination commitments outstanding amounting to $20.6 million, including $1.9 million of loans committed to sell;
• rate lock agreements with customers of $6.4 million, all of which have been locked with an investor;
• funded mortgage loans committed to sell of $1.6 million;
• unadvanced portion of construction loans of $62.7 million;
• unused lines of credit of $22.4 million;
• outstanding standby letters of credit of $1.6 million;
• total predetermined overdraft protection limits of $10.4 million; and
• certificates of deposit scheduled to mature in one year or less totaling $137.1 million.
Total unfunded commitments to originate loans for sale and the related commitments to sell of $6.4 million meet the definition of a derivative financial instrument. The related asset and liability are considered immaterial at December 31, 2004.
Historically, a very small percentage of predetermined overdraft limits have been used. At December 31, 2004, overdrafts of accounts with Bounce Protectionä represented usage of 2.3% of the limit.
Based on historical experience, management believes that a significant portion of maturing deposits will remain with the Bank. Management anticipates that the Bank will continue to have sufficient funds, through repayments, deposits and borrowings, to meet our current commitments.
14. FAIR VALUE OF FINANCIAL INSTRUMENTS
The estimated fair value amounts have been determined by the Company using available market information and appropriate valuation methodologies. However, considerable judgment is required to interpret market data to develop the estimates of fair value. Accordingly, the estimates presented herein are not necessarily indicative of the amounts the Company could realize in a current market exchange. The use of different market assumptions and/or estimation methodologies may have a material effect on the estimated fair value amounts. The estimated fair values of financial instruments are as follows (in thousands):
For cash and cash equivalents, Federal Home Loan Bank stock, cash surrender value of life insurance and accrued interest receivable, the carrying value is a reasonable estimate of fair value, primarily because of the short-term nature of the instruments or, as to Federal Home Loan Bank stock, the ability to sell the stock back to the Federal Home Loan Bank at cost. The fair value of investment securities is based on quoted market prices, dealer quotes and prices obtained from independent pricing services. The fair value of variable rate loans is based on repricing dates. Fixed-rate loans were valued using discounted cash flows. The discount rates used to determine the present value of these loans were based on interest rates currently being charged by the Bank on comparable loans as to credit risk and term.
The fair value of demand deposit accounts, NOW accounts, savings accounts and money market deposits is the amount payable on demand at the reporting date. The fair value of fixed-maturity certificates of deposit and Federal Home Loan Bank advances is estimated using the rates currently offered for deposits of similar terms and advances of similar remaining maturities at the reporting date. For advance payments by borrowers, for taxes and insurance and for accrued interest payable the carrying value is a reasonable estimate of fair value, primarily because of the short-term nature of the instruments.
The fair value estimates presented herein are based on pertinent information available to management as of December 31, 2004 and 2003. Although management is not aware of any factors that would significantly affect the estimated fair value amounts, such amounts have not been comprehensively revalued for purposes of these financial statements since the reporting date and, therefore, current estimates of fair value may differ significantly from the amounts presented herein.
15. CONTINGENCIES
The Company is a defendant in certain claims and legal actions arising in the ordinary course of business. In the opinion of management, after consultation with legal counsel, the ultimate disposition of these matters is not expected to have a material adverse effect on the consolidated financial statements of the Company.
16. RETAINED EARNINGS-SUBSTANTIALLY RESTRICTED
Upon conversion, the Company established a special liquidation account for the benefit of eligible account holders and the supplemental eligible account holders in an amount equal to the net worth of the Bank as of the date of its latest statement of financial condition contained in the final offering circular used in connection with the conversion. The liquidation account will be maintained for the benefit of eligible account holders and supplemental eligible account holders who continue to maintain their accounts in the Bank after conversion. In the event of a complete liquidation (and only in such event), each eligible and supplemental eligible account holder will be entitled to receive a liquidation distribution from the liquidation account in an amount proportionate to the current adjusted qualifying balances for accounts then held.
The Company may not declare or pay cash dividends on its shares of common stock if the effect thereof would cause the Company’s stockholders’ equity to be reduced below applicable regulatory capital maintenance requirements for insured institutions or below the special liquidation account referred to above.
17. REGULATORY MATTERS
The Bank is subject to various regulatory capital requirements administered by the Office of Thrift Supervision (“OTS”). Failure to meet minimum capital requirements can initiate certain mandatory-and possible additional discretionary-actions by regulators that, if undertaken, could have a direct and material effect on the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance sheet items as calculated under regulatory accounting practices. The Bank’s capital amounts and classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the following table) of tangible capital (as defined) to tangible assets (as defined) and core capital (as defined) to adjusted tangible assets (as defined), and of total risk-based capital (as defined) to risk-weighted assets (as defined). Management believes, as of December 31, 2004, that the Bank meets all capital adequacy requirements to which it is subject.
At December 31, 2004 and 2003, the most recent notification from the OTS categorized the Bank as well capitalized under the regulatory framework for prompt corrective action. To be categorized as well capitalized the Bank must maintain minimum core (Tier I leverage), Tier I risk-based, and total risk-based ratios as set forth in the table. There are no conditions or events since that notification that management believes have changed the Bank’s category.
The Bank’s actual capital amounts (in thousands) and ratios are also presented in the table:
18. RELATED PARTY TRANSACTIONS
In the normal course of business, the Bank has made loans to its directors, officers, and their related business interests. In the opinion of management, related party loans are made on substantially the same terms, including interest rates and collateral, as those prevailing at the time for comparable transactions with unrelated persons and do not involve more than the normal risk of collectibility. The aggregate dollar amount of loans outstanding to directors, officers, and their related business interests was approximately $2.6 and $2.5 million at December 31, 2004 and 2003, respectively.
Deposits from related parties held by the Bank at December 31, 2004 and 2003 amounted to $2.8 million and $3.9 million, respectively.
19. PARENT COMPANY ONLY FINANCIAL INFORMATION
The following condensed statements of financial condition, as of December 31, 2004 and 2003, and condensed statements of income and of cash flows for each of the three years in the period ended December 31, 2004, for First Federal Bancshares of Arkansas, Inc. should be read in conjunction with the consolidated financial statements and the notes herein.
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.
(Parent Company Only)
CONDENSED STATEMENTS OF FINANCIAL CONDITION
DECEMBER 31, 2004 AND 2003
(In thousands)
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.
(Parent Company Only)
CONDENSED STATEMENTS OF INCOME
YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002
(In thousands)
FIRST FEDERAL BANCSHARES OF ARKANSAS, INC.
(Parent Company Only)
CONDENSED STATEMENTS OF CASH FLOWS
YEARS ENDED DECEMBER 31, 2004, 2003, AND 2002
(In thousands)
******
SELECTED QUARTERLY OPERATING RESULTS
(IN THOUSANDS, EXCEPT SHARE AND PER SHARE DATA)
(1) Basic and diluted earnings per share, as well as basic and diluted shares outstanding, have been restated for the effect of the two-for-one stock split paid on December 31, 2003. Basic and diluted shares outstanding are summarized below.
Item 9.
Item 9. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure.
Not Applicable.
Item 9A.
Item 9A. Controls and Procedures.
Our management evaluated, with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of the design and operation of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934) as of the end of the period covered by this report. Based on such evaluation, our Chief Executive Officer and Chief Financial Officer have concluded that our disclosure controls and procedures are designed to ensure that information required to be disclosed by us in the reports that we file or submit under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and regulations and are operating in an effective manner.
Management’s annual report on internal control over financial reporting and the attestation report of the Company’s independent registered public accounting firm are included in Item 8 under the headings “Management Report on Internal Control” and “Report of Independent Registered Public Accounting Firm,” respectively, and are incorporated herein by reference.
No change in the Company’s internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) occurred during the fiscal quarter ended December 31, 2004 that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
Item 9B.
Item 9B. Other Information.
Not Applicable.
PART III.
Item 10.
Item 10. Directors and Executive Officers of the Registrant.
The information regarding directors and executive officers is incorporated herein by reference from the section entitled “Information with Respect to Nominee for Director, Continuing Directors and Executive Officers” in our definitive Proxy Statement (“2005 Proxy Statement”) to be filed pursuant to Regulation 14A of the Securities Exchange Act of 1934, as amended, for our Annual Meeting of Stockholders to be held on April 27, 2005. The 2005 Proxy Statement will be filed within 120 days after the end of our fiscal year ended December 31, 2004.
The information regarding compliance with Section 16(a) of the Securities and Exchange Act of 1934 is incorporated herein by reference from the section entitled “Section 16(a) Beneficial Ownership Reporting Compliance” of our 2005 Proxy Statement.
The information regarding audit committee financial experts is incorporated by reference herein from the subsection entitled “Committees and Meetings of the Board of the Company and the Bank” in the section entitled “Information with Respect to Nominee for Director, Continuing Directors and Executive Officers” in our 2005 Proxy Statement.
The information regarding the code of ethics applicable to our principal executive officer, principal financial officer and principal accounting officer is incorporated herein by reference from the subsection entitled-”Code of Ethics for Executive Officers and Financial Professionals” in the section entitled “Information with Respect to Nominee for Director, Continuing Directors and Executive Officers” in our 2005 Proxy Statement.
Item 11.
Item 11. Executive Compensation.
Information regarding executive compensation is incorporated herein by reference from the sections entitled “Executive Compensation” and “Performance Graph” in our 2005 Proxy Statement.
Item 12.
Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.
Information regarding security ownership of certain beneficial owners and management is incorporated herein by reference from the section entitled “Beneficial Ownership of Common Stock By Certain Beneficial Owners and Management and Related Stockholder Matters” and information regarding securities authorized for issuance under equity compensation plans is incorporated herein by reference from the subsection entitled “Equity-Based Compensation Plans” in our 2005 Proxy Statement.
Item 13.
Item 13. Certain Relationships and Related Transactions.
Information regarding certain relationships and related transactions is incorporated herein by reference from the section entitled “Transactions with Certain Related Persons” in our 2005 Proxy Statement.
Item 14.
Item 14. Principal Accountant Fees and Services.
The information regarding principal auditor fees and services is incorporated herein by reference from the section entitled “Relationship with Independent Auditors” in our 2005 Proxy Statement.
PART IV.
Item 15.
Item 15. Exhibits and Financial Statement Schedules.
(a) Documents Filed as Part of this Report
(1) Financial statements have been included in Item 8.
(2) All schedules for which provision is made in the applicable accounting regulation of the SEC are omitted because of the absence of conditions under which they are required or because the required information is included in the financial statements and related notes thereto.
(b) Exhibit Index.
2.1*
Plan of Conversion
3.1*
Articles of Incorporation of First Federal Bancshares of Arkansas, Inc.
3.2*
Bylaws of First Federal Bancshares of Arkansas, Inc.
4.0**
Stock Certificate of First Federal Bancshares of Arkansas, Inc.
10.6*
Employment Agreement between the Company, the Bank and Larry J. Brandt
10.7***
Employment Agreement between the Company, the Bank and Tommy W. Richardson
10.8***
Employment Agreement between the Company, the Bank and Sherri R. Billings
21.0
Subsidiaries of the Registrant - Reference is made to
“Item 1 Business - Subsidiaries” for the required information
31.1
Certification of Chief Executive Officer pursuant to Rule 13a-14(a) of Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
31.2
Certification of Chief Financial Officer pursuant to Rule 13a-14(a) of Exchange Act, as adopted pursuant to Section 302 of the Sarbanes-Oxley Act of 2002
32.1
Section 906 Certification of the CEO
32.2
Section 906 Certification of the CFO
(*) Incorporated herein by reference from the Company’s Registration Statement on Form S-1 (File No. 333-612) filed with the SEC.
(**) Incorporated herein by reference from the Company’s Registration Statement on Form 8-A filed with the SEC.
(***) Incorporated herein by reference from the Company’s Annual Report on Form 10-K for the fiscal year ended December 31, 2002 filed with the SEC.
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
Pursuant to the requirements of the Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.