SECURITIES AND EXCHANGE COMMISSIONWashington, D.C.   20549F O R M   1 0 - K[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934For the fiscal year ended December 31, 2010Commission file number:  000-51507WATERSTONE FINANCIAL, INC.(Exact name of registrant as specified in its charter)Federally Chartered Corporation
39-0691250(State or other jurisdiction of
(I.R.S.  Employer Identification No.)incorporation or organization)11200 W Plank Ct, Wauwatosa,  WI
53226(Address of principal executive offices)
(Zip Code)Registrant's telephone number, including area code:  (414) 761-1000Securities registered pursuant to Section 12(b) of the Act:Common Stock, $0.01 Par Value
The NASDAQ Stock Market, LLC(Title of class)
(Name of each exchange on which registered)Securities registered pursuant to Section 12(g) of the Act:NONE





Indicate by check mark whether the registrant is a well-known seasoned issuer (as defined in Rule 405 of the 1933 Act).





Yes
*

No
R





Indicate by check mark whether the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the 1934 Act.





Yes
*

No
R





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.





Yes
R

No
*





Indicate by check mark whether the registrant has submitted electronically and posted  on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files)




Yes
*

No
*





Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of registrant's knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  [ X ]





Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule12b-2 of the Exchange Act





Large accelerated filer
*

Accelerated filer
R

Non-accelerated filer
*

Smaller Reporting Company
*





Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 under the Exchange Act).





Yes
*

No
R





The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant, computed by reference to the last sale price on June 30, 2010, as reported by the NASDAQ Capital Market® was approximately $106.6 million.





As of February 28, 2011, 31,250,097 shares of the Registrant’s Common Stock were validly issued and outstanding.





DOCUMENTS INCORPORATED BY REFERENCEPart of Form 10-K Into WhichDocument

Portions of Document are IncorporatedProxy Statement for Annual Meeting of

Part IIIShareholders on May 17, 2011





WATERSTONE FINANCIAL, INC.FORM 10-K ANNUAL REPORT TO THE SECURITIES AND EXCHANGE COMMISSIONFOR THE YEAR ENDED DECEMBER 31, 2010











TABLE OF CONTENTSITEM


PAGEPART I1.
Business

3-401A.
Risk Factors

41-431B.
Unresolved Staff Comments

432.
Properties

443.
Legal Proceedings

45PART II5.
Market for Registrant's Common Equity, Related Stockholders Matters and

Issuer Purchases of Equity Securities

46-476.
Selected Financial Data

48-497.
Management's Discussion and Analysis of Financial

Condition and Results of Operations

50-677A.
Quantitative and Qualitative Disclosures About Market Risk

68-698.
Financial Statements and Supplementary Data

70-1159.
Changes in and Disagreements with Accountants

on Accounting and Financial Disclosure

1169A.
Controls and Procedures

116-1179B.
Other Information

118PART III10.
Directors and Executive Officers of the Registrant

11911.
Executive Compensation

12012.
Security Ownership of Certain Beneficial Owners and Management

and Related Stockholder Matters

12013.
Certain Relationships and Related Transactions, and Director Independence

12014.
Principal Accountant Fees and Services

120PART IV15.
Exhibits and Financial Statement Schedules

121Signatures

122








- 2 -
 Table of Contents


Part I





Waterstone Financial, Inc. and its subsidiaries, including WaterStone Bank, SSB, are referred to herein as the “Company,” “Waterstone Financial,” or “we.”





Item 1.   Business





Introduction





Waterstone Financial, Inc. was formed in October 2005 as the mid-tier stockholding company subsidiary of Lamplighter Financial, MHC, as part of the reorganization of WaterStone Bank into mutual holding company form.  WaterStone Bank was converted from a mutual to a stock savings bank as part of our reorganization.  In connection with the reorganization, the Company sold 30% of its common stock in a subscription offering, contributed 1.65% of its common stock to a charitable foundation, and issued the remaining 68.35% of its common stock to Lamplighter Financial, MHC.  As a result of the reorganization, the Company owns all of the stock of WaterStone Bank and Lamplighter Financial, MHC owned 68.35% of the common stock of the Company.  In this report, we refer to WaterStone Bank, both before and after the reorganization, as “WaterStone Bank” or the “Bank.”





On September 28, 2007, the Company completed its charter conversion to change the Company’s charter from a Wisconsin corporation to that of a federal corporation regulated exclusively by the Office of Thrift Supervision (the “OTS”).  Similarly, the Company’s mutual holding company parent, Lamplighter Financial, MHC (the “MHC”), also completed its charter conversion to change the MHC’s charter from a Wisconsin chartered mutual holding company to a federally chartered mutual holding company regulated exclusively by the OTS.  Shareholders were not required to exchange stock certificates in the name of Wauwatosa Holdings, Inc. for stock certificates in the name of Waterstone Financial, Inc.  All references to Waterstone Financial, Inc. include Wauwatosa Holdings, Inc.  WaterStone Bank continues to be a Wisconsin chartered savings bank.





The Company maintains a website at www.wsbonline.com.  We make available through that website, free of charge, copies of our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, amendments to those reports and proxy materials as soon as is reasonably practical after the Company electronically files those materials with, or furnishes them to, the Securities and Exchange Commission.  You may access those reports by following the links under “Investor Relations” at the Company’s website.





Cautionary Factors





This Form 10-K contains or incorporates by reference various forward-looking statements concerning the Company's prospects that are based on the current expectations and beliefs of management.  Forward-looking statements may also be made by the Company from time to time in other reports and documents as well as in oral presentations.  When used in written documents or oral statements, the words "anticipate," "believe," "estimate," "expect," "objective" and similar expressions and verbs in the future tense, are intended to identify forward-looking statements.  The statements contained herein and such future statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond the Company's control, that could cause the Company's actual results and performance to differ materially from what is expected.  In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Company:




·
adverse changes in real estate markets;·
adverse changes in the securities markets;·
general economic conditions, either nationally or in our market area, that are worse than expected;·
inflation and changes in interest rates that reduce our margins or reduce the fair value of financial instruments;·
changes in interest rates that reduce loan origination volumes and, ultimately, income from our mortgage banking operations;·
legislative or regulatory changes that adversely affect our business;·
our ability to maintain higher regulatory capital levels as imposed by federal and state regulators;·
our ability to maintain adequate levels of liquidity given regulatory limits on sources of funding and rates that can be paid for funding;·
our ability to enter new markets successfully and to take advantage of growth opportunities;·
significantly increased competition among depository and other financial institutions;·
changes in accounting policies and practices, as may be adopted by the bank regulatory agencies and the Financial Accounting Standards Board; and·
changes in consumer spending, borrowing and savings habits.  See also the factors regarding future operations discussed in "Management's Discussion and Analysis of Financial Condition and Results of Operations" and "Risk Factors" below.





- 3 -
 Table of Contents


BUSINESS OF WATERSTONE BANK





General





Our principal business consists of attracting deposits from the general public in the areas surrounding our eight banking offices and our nine automated teller machines (“ATM”), including stand-alone ATM facilities, located in Milwaukee, Washington and Waukesha counties, Wisconsin.





We invest those deposits, together with funds generated from operations, primarily in residential real estate mortgage loans. At December 31, 2010, residential real estate mortgage loans comprised 88.9% of our total loans receivable. On that same date, our residential mortgage loan portfolio was comprised of first mortgage loans secured by one-to four-family residences (43.3%), and over four-family residences (40.3%).  The remainder of our residential mortgage loans consisted of home equity loans and lines of credit (5.3%) secured by a junior position on one-to four-family residences. The remainder of our loans receivable consists of construction and land mortgages, commercial mortgages, commercial business loans and consumer loans.





Our revenues are derived principally from interest on loans and securities and mortgage banking activities. Our primary sources of funds are deposits, borrowings and principal and interest payments on loans and securities.







Business Strategy





Our business strategy is to operate as a well-capitalized and profitable community bank dedicated to providing a complete range of banking products and services available through multiple delivery channels. Our principal business activity historically has been the origination of residential mortgage loans, including over four-family properties. In 2006, we added a mortgage banking subsidiary and in 2007, we added additional business loan and deposit products and expanded our consumer loan product base.  There can be no assurances that we will successfully implement our business strategy.





Elements of our business strategy are as follows:




•
Improve Asset Quality.By all measures, our asset quality has deteriorated over the past five years.  We have taken a number of significant steps to improve our underwriting of loans and monitoring asset quality.  In 2006, we rewrote our underwriting policies, strengthened our underwriting and administration standards and implemented an officers’ loan committee for review and approval of all loans in excess of $500,000.  We hired senior loan officers experienced in systematically identifying, objectively evaluating and documenting good credit risks.  In 2007, we added an independent loan underwriting function for all residential loans and a loan review function to ensure that newly implemented controls and safeguards are uniformly implemented and applied.  We also expanded our collections staff and upgraded our information management systems to reduce the number of past-due loans that become chronically delinquent.   In 2008, we hired a Chief Credit Officer (CCO) and moved the credit analysis and loan review functions to a newly formed credit department headed by the CCO.  The CCO reports directly to the Chief Executive Officer.  Notwithstanding the forgoing, in the current distressed economic environment non-performing loans totaled $84.2 million, or 6.4% of total loans and real estate owned totaled $57.8 million at December 31, 2010.  During the year ended December 31, 2010, net charge-offs totaled $25.2 million.•
Capital Maintenance. Given the continuing weakness in our local and national economies, it is imperative that the Company maintain its current level of capital strength.  Continuing loan losses have eroded total shareholders’ equity by 14.7% since December 31, 2007.  The Company will continue reducing total assets during the year ending December 31, 2011 in order to maintain or increase the 9.5% equity to total assets ratio that existed as of December 31, 2010.  However, a declining asset base may adversely affect our ability to increase our interest income which may in turn result in less net interest income.•
Excess Liquidity.Until such time as we achieve our goal of improved asset quality, we will maintain higher than usual levels of balance sheet liquidity.  We have tripled our cash and cash equivalents balances from less than $25 million at December 31, 2008 to $75 million at December 31, 2010.  These higher levels of liquidity come at a cost to earnings but provide the ready cash that current economic conditions require.•
Mortgage Banking.We offer owner-occupied residential real estate mortgage loans through eight WaterStone bank offices and thirty-six Waterstone Mortgage Corporation offices in eight states.  Mortgage banking has historically been a volatile industry and continues to be so.  However, we are committed to and continue to invest in this product line.  Transaction volume will vary significantly and proportionally to movements in mortgage interest rates but we strive to maintain a standard net profit margin even as transaction volume varies.•
Continuing Emphasis on Residential Real Estate Lending.We offer long-term, fixed-rate loans and indexed, adjustable mortgage loans to our owner-occupied residential mortgage customers. We intend to continue our emphasis on the origination of residential real estate loans, especially over four-family loans. Current loans-to-one borrower limitations cap the amount of credit that we can extend to a single or affiliated group of borrowers at 15% of WaterStone Bank’s capital.•
Expansion of Product Offerings.Beginning in 2007, the Bank began offering variable rate, indexed residential mortgage loan and long-term fixed rate residential mortgage loans.  Expanded on-line banking and other forms of electronic banking have also provided the opportunity to add more commercial transaction accounts to our funding mix.





- 4 -
 Table of Contents





Competition





We face competition within our market area both in making real estate loans and attracting deposits. The Milwaukee-Waukesha-West Allis metropolitan statistical area has a high concentration of financial institutions including large commercial banks, community banks and credit unions. The FDIC has determined that our market area is a “high-rate” area with regard to deposit pricing as compared to the rest of the United States.  As of June 30, 2010, based on the FDIC’s annual Summary of Deposits Report, we had the seventh largest market share in our metropolitan statistical area representing 2.4% of all deposits.





Our competition for loans and deposits comes principally from commercial banks, savings institutions, mortgage banking firms and credit unions. We face additional competition for deposits from money market funds, brokerage firms, and mutual funds. Our primary focus is to build and develop profitable consumer and commercial customer relationships while maintaining our role as a community bank.





Market Area





The Bank’s market area is broadly defined as the Milwaukee, Wisconsin metropolitan market which is geographically located in the southeast corner of the state.  More specifically, our primary market area is Milwaukee and Waukesha counties and the five surrounding counties of Ozaukee, Washington, Jefferson, Walworth and Racine.  The Bank has four branch offices in Milwaukee County, three branch offices in Waukesha County and one branch office in Washington County.  At June 30, 2010, 44.2% of deposits in the state of Wisconsin were located in the seven County metropolitan Milwaukee market.





Our primary market area for deposits includes the communities in which we maintain our banking office locations. Our primary lending market area is broader than our primary deposit market area and includes all of the primary market area noted above but extends further west to the Madison, Wisconsin market and further north to the Appleton and Green Bay, Wisconsin markets.  In addition, our mortgage banking operation has twelve offices in Wisconsin, five offices in Minnesota, four offices in each of Florida and Illinois, three offices in Idaho and one office in each of Arizona, Colorado, Maryland and Tennessee.





Lending Activities





The scope of the discussion included under “Lending Activities” is limited to lending operations related to loans originated for investment.  A discussion of the lending activities related to loans originated for sale is included under “Mortgage Banking Activities.”





Historically, our principal lending activity has been originating mortgage loans for the purchase or refinancing of residential real estate. Generally, we retain the loans that we originate which we refer to as loans originated for investment. One- to four-family residential mortgage loans represented $584.0 million, or 43.3%, of our total loan portfolio at December 31, 2010.  Over four-family residential mortgage loans represented $542.6 million, or 40.3%, of our total loan portfolio at December 31, 2010.  We also offer construction and land loans, commercial real estate loans, home equity lines of credit and commercial loans. At December 31, 2010, construction and land loans, commercial real estate loans, home equity loans and commercial business loans totaled $56.8 million, $51.7 million, $72.0 million and $40.4 million, respectively.







- 5 -
 Table of Contents




Loan Portfolio Composition.The following table sets forth the composition of our loan portfolio in dollar amounts and as a percentage of the total portfolio at the dates indicated.







At December 31,2010


2009


2008


2007


2006Amount

Percent


Amount

Percent


Amount

Percent


Amount

Percent


Amount

Percent(Dollars in Thousands)Mortgage loans:Residential real estate:One- to four-family
$
584,014


43.34
%

$
681,578


46.31
%

$
790,486


48.70
%

$
672,362


45.64
%


638,089


44.17
%Over four-family

542,602


40.26
%


536,731


36.47
%


512,746


31.59
%


477,766


32.45
%


492,693


34.10
%Home equity

71,952


5.34
%


85,964


5.84
%


89,648


5.52
%


85,954


5.84
%


91,536


6.34
%Construction and land

56,794


4.21
%


69,814


4.74
%


131,840


8.12
%


156,289


10.61
%


168,605


11.67
%Commercial

51,733


3.84
%


48,948


3.33
%


55,193


3.40
%


51,983


3.53
%


51,062


3.53
%Commercial business

40,442


3.00
%


48,094


3.27
%


43,006


2.65
%


28,222


1.92
%


2,657


0.18
%Consumer

154


0.01
%


619


0.04
%


365


0.02
%


286


0.01
%


141


0.01
%Total loans
$
1,347,691


100.00
%

$
1,471,748


100.00
%


1,623,284


100.00
%


1,472,862


100.00
%


1,444,783


100.00
%Undisbursed loan proceeds

(39,265
)





(49,818
)





(61,192
)





(67,549
)





(67,390
)Net deferred loan fees and premiums

(1,989
)





(1,920
)





(2,334
)





(3,265
)





(4,486
)Allowance for loan losses

(29,175
)





(28,494
)





(25,167
)





(12,839
)





(7,195
)Loans, net
$
1,277,262





$
1,391,516





$
1,534,591





$
1,389,209





$
1,365,712














- 6 -
 Table of Contents










Loan Portfolio Maturities and Yields.The following table summarizes the final maturities of our loan portfolio at December 31, 2010.  Demand loans, loans having no stated repayment schedule or maturity, and overdraft loans are reported as being due in one year or less.  Maturities are based upon the final contractual payment dates and do not reflect the impact of prepayments and scheduled monthly payments that will occur.








One- to four-family


Over four-family


Home Equity


Construction and LandWeighted





Weighted





Weighted





WeightedMaturity Date

Amount


Average Rate


Amount


Average Rate


Amount


Average Rate


Amount


Average Rate(Dollars in Thousands)Jan 1, 2011 –  Dec 31, 2011

$
53,877



6.38
%

$
65,796



6.06
%

$
31,900



3.87
%

$
39,766



5.42
%Jan 1, 2012 –  Dec 31, 2012


46,895



6.39
%


60,969



6.28
%


6,993



4.54
%


1,273



5.57
%Jan 1, 2013 –  Dec 31, 2013


28,541



6.48
%


82,257



6.08
%


11,439



4.40
%


141



7.54
%Jan 1, 2014 –  Dec 31, 2014


1,560



6.45
%


11,379



5.80
%


6,108



3.89
%


451



3.75
%Jan 1, 2015 –  Dec 31, 2015


1,328



6.11
%


9,938



6.20
%


8,437



3.72
%


2,511



3.79
%Jan 1, 2016 and thereafter


451,813



5.93
%


312,263



5.97
%


7,075



5.20
%


12,652



5.76
%Total

$
584,014



6.04
%

$
542,602



6.03
%

$
71,952



4.13
%

$
56,794



5.42
%Commercial Real Estate


Commercial Business


Consumer


TotalWeighted






Weighted






Weighted






WeightedMaturity Date

Amount


Average Rate


Amount


Average Rate


Amount


Average Rate


Amount


Average Rate(Dollars in Thousands)Jan 1, 2011 –  Dec 31, 2011

$
7,721



6.74
%

$
24,510



4.68
%

$
107



6.94
%

$
223,677



5.58
%Jan 1, 2012 –  Dec 31, 2012


6,538



6.18
%


4,985



6.84
%


13



8.44
%


127,666



6.24
%Jan 1, 2013 –  Dec 31, 2013


10,074



6.14
%


6,542



6.71
%


19



5.97
%


139,013



6.06
%Jan 1, 2014 –  Dec 31, 2014


851



6.19
%


2,744



6.24
%


15



6.77
%


23,108



5.37
%Jan 1, 2015 –  Dec 31, 2015


6,778



6.48
%


953



6.10
%


-



-



29,945



5.35
%Jan 1, 2016 and thereafter


19,771



6.14
%


708



6.87
%


-



-



804,282



5.94
%Total

$
51,733



6.28
%

$
40,442



5.45
%

$
154



6.92
%

$
1,347,691



5.90
%









- 7 -
 Table of Contents


The following table sets forth the scheduled repayments of fixed and adjustable rate loans at December 31, 2010 that are contractually due after December 31, 2011.









Due After December 31, 2011Fixed


Variable


Total(In Thousands)Mortgage loansReal estate loans:One- to four-family

$
15,977


$
514,160


$
530,137Over four-family


69,522



407,284



476,806Home equity


2336



37,716



40,052Construction and land


3,989



13,039



17,028Commercial


17,795



26,217



44,012Commercial


14,390



1,542



15,932Consumer


47



-



47Total loans

$
124,056


$
999,958


$
1,124,014












One- to Four-Family Residential Mortgage Loans.  WaterStone Bank’s primary lending activity is originating residential mortgage loans secured by properties located in Milwaukee and surrounding counties.  One- to four-family residential mortgage loans totaled $584.0 million, or 43.3% of total loans at December 31, 2010.  One- to four-family residential mortgage loans originated for investment during the year ended December 31, 2010 totaled $11.4 million, or 10.2% of all loans originated.  Our one- to four-family residential mortgage loans have fixed and adjustable rates.  Our variable-rate mortgage loans generally provide for maximum rate adjustments of 100 basis points per adjustment, with a lifetime maximum adjustment of either 300 or 600 basis points, regardless of the initial rate.  Our variable-rate mortgage loans typically amortize over terms of up to 30 years.  Portfolio one- to four-family loans at December 31, 2010 are variable rate loans but are not necessarily indexed.  They are adjustable semi-annually at our discretion with the limits noted above.  The Company does not and has never offered residential mortgage loans specifically designed for borrowers with sub-prime credit scores, including Alt-A and negative amortization loans.  Further, prior to 2007, we did not offer indexed, variable-rate loans other than home equity lines of credit and we have never offered “teaser rate” first mortgage products.




Variable rate mortgage loans can decrease the interest rate risk associated with changes in market interest rates by periodically repricing, but involve other risks because, as interest rates increase, the underlying payments by the borrower increase, thus increasing the potential for default by the borrower.  At the same time, the marketability of the underlying collateral may be adversely affected by higher interest rates.  Upward adjustment of the contractual interest rate is also limited by the maximum periodic and lifetime interest rate adjustments permitted by our loan documents and, therefore, the effectiveness of variable rate mortgage loans in decreasing the risk associated with changes in interest rates may be limited during periods of rapidly rising interest rates.  Moreover, during periods of rapidly declining interest rates the interest income received from the adjustable rate loans can be significantly reduced, thereby adversely affecting interest income.




All residential mortgage loans that we originate include "due-on-sale" clauses, which give us the right to declare a loan immediately due and payable in the event that, among other things, the borrower sells or otherwise disposes of the real property subject to the mortgage and the loan is not repaid.  We also require homeowner's insurance and where circumstances warrant, flood insurance on properties securing real estate loans.  The average single family first mortgage loan balance was $195,000 and the highest outstanding balance was $4.0 million on December 31, 2010.  The average two- to four-family first mortgage loan balance was $136,000 on December 31, 2010 and the highest outstanding balance was $1.1 million.






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 Table of Contents




Over Four-familyReal Estate Loans.Over four-family loans totaled $542.6 million, or 40.3% of total loans at December 31, 2010.  Over four-family loans originated during the year ended December 31, 2010 totaled $69.6 million or 62.2% of all loans originated for investment.  These loans are generally secured by properties located in our primary market area.  Our over four-family real estate underwriting policies generally provide that such real estate loans may be made in amounts of up to 80% of the appraised value of the property provided the loan complies with our current loans-to-one borrower limit.  Over four-family real estate loans are offered with interest rates that are fixed for periods of up to five years or are variable and either adjust based on a market index or at our discretion.  Contractual maturities do not exceed 10 years while principal and interest payments are typically based on a 30-year amortization period.  In reaching a decision on whether to make an over four-family real estate loan, we consider gross revenues and the net operating income of the property, the borrower's expertise and credit history, business cash flow, and the appraised value of the underlying property.  In addition, we will also consider the terms and conditions of the leases and the credit quality of the tenants.  We generally require that the properties securing these real estate loans have debt service coverage ratios (the ratio of earnings before interest, taxes, depreciation and amortization divided by interest expense and current maturities of long term debt) of at least 1.15 times.  Generally, over four-family loans made to corporations, partnerships and other business entities require personal guarantees by the principals and by the owners of 20% or more of the borrower.




An over four-family borrower's financial information is monitored on an ongoing basis by requiring periodic financial statement updates, payment history reviews and periodic face-to-face meetings with the borrower.  We generally require borrowers with aggregate outstanding balances exceeding $1.0 million to provide updated financial statements and federal tax returns annually.  These requirements also apply to all guarantors on these loans.  We also require borrowers with rental investment property to provide an annual report of income and expenses for the property, including a tenant list and copies of leases, as applicable.  The average outstanding over four-family mortgage loan balance was $629,000 on December 31, 2010 with the largest outstanding balance at $9.7 million.  At December 31, 2010, our largest exposure to one borrower or to a related group of borrowers was $20.7 million, and consisted of six separate loans on residential properties with over four units.  The largest loan in the group is a loan with a December 31, 2010 outstanding balance of $6.5 million secured by a 112 unit apartment building.




Loans secured by over four-family real estate generally involve larger principal amounts and greater risk than owner-occupied, one- to four-family residential mortgage loans.  Because payments on loans secured by over four-family propertiesoften depend on the successful operation or management of the properties, repayment of such loans may be affected by adverse conditions in the real estate market or the economy.




Home Equity Loans. We also offer home equity loans and home equity lines of credit, both of which are secured by owner-occupied and non-owner occupied one- to four-family residences.  At December 31, 2010, outstanding home equity loans and equity lines of credit totaled $72.0 million, or 5.3% of total loans outstanding.  At December 31, 2010, the unadvanced portion of home equity lines of credit totaled $25.8 million.  Home equity loans and lines originated during the year ended December 31, 2010 totaled $5.5 million, or 4.9% of all loans originated for investment.  The underwriting standards utilized for home equity loans and home equity lines of credit include a determination of the applicant's credit history, an assessment of the applicant's ability to meet existing obligations and payments on the proposed loan, and the value of the collateral securing the loan.  Home equity loans are offered with adjustable rates of interest and with terms up to 10 years.  The loan-to-value ratio for our home equity loans and our lines of credit is generally limited to 90% when combined with the first security lien, if applicable.  Our home equity lines of credit have ten-year terms and adjustable rates of interest which are indexed to the prime rate, as reported in The Wall Street Journal.  Interest rates on home equity lines of credit are generally limited to a maximum rate of 18%.  The average outstanding home equity loan balance was $38,000 at December 31, 2010 with the largest outstanding balance at $750,000.






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 Table of Contents




Residential Construction and Land Loans.  We originate construction loans to individuals and contractors for the construction and acquisition of single and multi-family residences.  At December 31, 2010, construction mortgage loans totaled $56.8 million, or 4.2%, of total loans.  Construction and land loans originated during the year ended December 31, 2010 totaled $8.4 million, or 7.5% of all loans originated for investment.  At December 31, 2010, the unadvanced portion of these construction loans totaled $2.8 million.




Our construction mortgage loans generally provide for the payment of interest only during the construction phase, which is typically up to nine months although our policy is to consider construction periods as long as 12 months or more.  At the end of the construction phase, the construction loan converts to a longer term mortgage loan.  Construction loans can be made with a maximum loan-to-value ratio of 90%, provided that the borrower obtains private mortgage insurance if the loan balance exceeds 80% of the lesser of the appraised value or sales price of the secured property.  The average outstanding construction loan balance totaled $871,000 on December 31, 2010 and ranged from $120,000 to $3.9 million.The average outstanding land loan balance was $358,000 on December 31, 2010 with the largest outstanding balance at $10.0 million.




Before making a commitment to fund a residential construction loan, we require an appraisal of the property by an independent licensed appraiser.  We also review and inspect each property before disbursement of funds during the term of the construction loan.  Loan proceeds are disbursed after inspection based on the percentage of completion method.




Construction financing is generally considered to involve a higher degree of credit risk than longer-term financing on improved, owner-occupied real estate.  Risk of loss on a construction loan depends largely upon the accuracy of the initial estimate of the value of the property at completion of construction compared to the estimated cost (including interest) of construction and other assumptions.  If the estimate of construction cost is inaccurate, we may be required to advance funds beyond the amount originally committed in order to protect the value of the property.  Additionally, if the estimate of value is inaccurate, we may be confronted with a project, when completed, with a value that is insufficient to ensure full repayment of the loan.




Commercial Real Estate Loans.Commercial real estate loans totaled $51.7 million at December 31, 2010, or 3.8% of total loans, and are made up of loans secured by office and retail buildings, churches, restaurants, other retail properties and mixed use properties.  Commercial real estate loans originated during the year ended December 31, 2010 totaled $5.8 million, or 5.2% of all loans originated for investment.  These loans are generally secured by property located in our primary market area.  Our commercial real estate underwriting policies provide that such real estate loans may be made in amounts of up to 80% of the appraised value of the property.  Commercial real estate loans are offered with interest rates that are fixed up to five years or are variable and either adjust based on a market index or at our discretion.  Contractual maturities do not exceed 10 years while principal and interest payments are typically based on a 30-year amortization period.   In reaching a decision on whether to make a commercial real estate loan, we consider gross revenues and the net operating income of the property, the borrower's expertise and credit history, business cash flow, and the appraised value of the underlying property.  In addition, we will also consider the terms and conditions of the leases and the credit quality of the tenants.  We generally require that the properties securing these real estate loans have debt service coverage ratios (the ratio of earnings before interest, taxes, depreciation and amortization divided by interest expense and current maturities of long term debt) of at least 1.15 times.  Environmental surveys are required for commercial real estate loans when environmental risks are identified.  Generally, commercial real estate loans made to corporations, partnerships and other business entities require personal guarantees by the principals and by the owners of 20% or more of the borrower.




A commercial borrower's financial information is monitored on an ongoing basis by requiring periodic financial statement updates, payment history reviews and periodic face-to-face meetings with the borrower.  We generally require borrowers with aggregate outstanding balances exceeding $1.0 million to provide annually updated financial statements and federal tax returns.  These requirements also apply to all guarantors on these loans.  We also require borrowers to provide an annual report of income and expenses for the property, including a tenant list and copies of leases, as applicable.  The average commercial real estate loan in our portfolio at December 31, 2010 was $450,000 with the largest outstanding balance at $3.7 million.






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Commercial Loans.Commercial loans totaled $40.4 million at December 31, 2010, or 3.0% of total loans, and are made up of loans secured by accounts receivable, inventory, equipment and real estate.  Commercial loans originated during the year ended December 31, 2010 totaled $11.2 million, or 10.0% of all loans originated.  These loans are generally made to borrowers that are located in our primary market area.  Working capital lines of credit are granted for the purpose of carrying inventory and accounts receivable or purchasing equipment.  These lines require that certain working capital ratios must be maintained and are monitored on a monthly or quarterly basis.  Working capital lines of credit are short-term loans of 12 months or less with variable interest rates.  At December 31, 2010, the unadvanced portion of working capital lines of credit totaled $10.6 million.  Outstanding balances fluctuate up to the maximum commitment amount based on fluctuations in the balance of the underlying collateral.  Personal property loans secured by equipment are considered commercial business loans and are generally made for terms of up to 84 months and for up to 80% of the value of the underlying collateral.  Interest rates on equipment loans may be either fixed or variable.  Commercial business loans are generally variable rate loans with initial fixed rate periods of up to five years.  These loans generally amortize over 15 to 25 years.  Small Business Administration participation is available to qualifying borrowers on all types of commercial business loans.




A commercial borrower's financial information is monitored on an ongoing basis by requiring periodic financial statement updates, usually quarterly, payment history reviews and periodic face-to-face meetings with the borrower.  The average outstanding commercial loan at December 31, 2010 was $179,000 with the largest outstanding balance at $2.6 million.




The following table shows loan origination, principal repayment activity, transfers to real estate owned, charge-offs and sales during the periods indicated.







Year Ended December 31,2010


2009


2008(In Thousands)Total loans at beginning of year

$
1,516,800



1,636,277



1,495,970Mortgage loans originated for investment:ResidentialOne- to four-family


11,390



25,660



205,526Over four-family


69,602



66,657



122,113Home equity


5,528



8,491



20,672Construction and land


8,355



7,914



51,367Commercial


5,813



7,352



14,876Total mortgage loans originated for investment


100,688



116,074



414,554Consumer loans originated for investment


76



180



280Commercial loans originated for investment


11,204



12,640



21,934Total loans originated for investment


111,968



128,894



436,768Other loans – net activityPrincipal repayments


(169,093
)


(202,998
)


(228,099
)Transfers to real estate owned


(41,781
)


(54,072
)


(32,946
)Loan principal charge-off


(25,151
)


(23,360
)


(25,301
)Net activity in loans held for investment


(124,057
)


(151,536
)


150,422Loans originated for sale


1,084,362



739,151



255,891Loans sold


(1,031,492
)


(707,092
)


(266,006
)Net activity in loans held for sale


52,870



32,059



(10,115
)Total loans receivable and held for sale at end of period

$
1,445,613



1,516,800



1,636,277


_____________


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Origination and Servicing of Loans.  All loans originated by us are underwritten pursuant to internally developed policies and procedures.  While we generally underwrite owner-occupied residential mortgage loans to Freddie Mac and Fannie Mae standards, due to several unique characteristics, our loans originated prior to 2008 do not conform to the secondary market standards.  The unique features of these loans include: interest payments in advance of the month in which they are earned, discretionary rate adjustments that are not tied to an independent index and pre-payment penalties.




Exclusive of our mortgage banking operations, we generally retain in our portfolio a significant majority of the loans that we originate.  At December 31, 2010, WaterStone Bank was servicing $6.3 million in loan participations originated by the Bank and subsequently sold to unrelated third parties.  Loan servicing includes collecting and remitting loan payments, accounting for principal and interest, contacting delinquent mortgagors, supervising foreclosures and property dispositions in the event of unremedied defaults, making certain insurance and tax payments on behalf of the borrowers and generally administering the loans.




Loan Approval Procedures and Authority.  WaterStone Bank’s lending activities follow written, non-discriminatory, underwriting standards and loan origination procedures established by WaterStone Bank’s board of directors.  The loan approval process is intended to assess the borrower's ability to repay the loan, the viability of the loan and the adequacy of the value of the property that will secure the loan, if applicable.  To assess the borrower's ability to repay, we review the employment and credit history and information on the historical and projected income and expenses of borrowers.




Loan officers are authorized to approve and close any loan that qualifies under WaterStone Bank underwriting guidelines within the following lending limits:





o
A secured one- to four-family mortgage loan up to $500,000 for a borrower with total outstanding loans from the Bank of less than $1,000,000 that is independently underwritten can be approved by select loan officers.


o
A loan up to $500,000 for a borrower with total outstanding loans from the Bank of less than $500,000 can be approved by select commercial loan officers.


o
Any secured mortgage loan ranging from $500,001 to $2,999,999 or any new loan to a borrower with outstanding loans from the Bank exceeding $1,000,000 must be approved by the Officer Loan Committee.


o
Any loan for $3,000,000 or more must be approved by the Officer Loan Committee and the board of directors prior to closing.  Any new loan to a borrower with outstanding loans from the Bank exceeding $10,000,000 must be approved by the board of directors prior to closing.





Asset Quality





When a loan becomes more than 30 days delinquent, WaterStone Bank sends a letter advising the borrower of the delinquency.  The borrower is given 30 days to pay the delinquent payments or to contact WaterStone Bank to make arrangements to bring the loan current over a longer period of time.  If the borrower fails to bring the loan current within 90 days from the original due date or to make arrangements to cure the delinquency over a longer period of time, the matter is referred to legal counsel and foreclosure or other collection proceedings are considered.  We may consider forbearance in select cases where a temporary loss of income might result, if a reasonable plan is presented by the borrower to cure the delinquency in a reasonable period of time after his or her income resumes.




All loans are reviewed on a regular basis, and such loans are placed on non-accrual status when they become more than 90 or more days delinquent.  When loans are placed on non-accrual status, unpaid accrued interest is reversed, and further income is recognized only to the extent received.





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Non-Performing Assets.Non-performing assets consist of non-accrual loans and other real estate owned.  Loans are generally placed on non-accrual status when contractually past due 90 days or more as to interest or principal payments.  Additionally, whenever management becomes aware of facts or circumstances that may adversely impact the collectibility of principal or interest on loans, management may place such loans on non-accrual status immediately, rather than waiting until the loan becomes 90 days past due. At that time, previously accrued and uncollected interest on such loans is reversed and additional income is recorded only to the extent that payments are received and the collection of principal is reasonably assured.  Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time, and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.




The table below sets forth the amounts and categories of our non-accrual loans and real estate owned at the dates indicated.






At December 31,2010


2009


2008


2007


2006(Dollars in Thousands)Non-accrual loans:ResidentialOne- to four-family

$
56,759



45,988



42,182



32,587



12,044Over four-family


20,587



16,683



35,787



38,218



8,384Home equity


712



1,159



2,015



1,332



439Construction and land


3,013



6,269



18,271



3,855



7,664Commercial real estate


1,577



2,773



9,325



4,358



357Commercial


1,530



2,441



150



-



-Consumer


-



-



-



-



-Total non-accrual loans


84,178



75,313



107,730



80,350



28,888Real estate ownedOne- to four-family


28,142



27,016



16,720



4,988



404Over four-family


14,903



8,824



6,057



755



-Construction and land


9,926



10,458



1,094



2,619



116Commercial real estate


4,781



4,631



782



181



-Total real estate owned


57,752



50,929



24,653



8,543



520Total non-performing assets

$
141,930



126,242



132,383



88,893



29,408Total performing troubled debt restructurings

$
33,592



42,730



2,409



2,228



-Total non-accrual loans to total loans, net


6.44
%


5.30
%


6.91
%


5.73
%


2.10
%Total non-accrual loans and performing troubleddebt restructurings to total loans receivable


9.01
%


8.31
%


7.06
%


5.89
%


2.10
%Total non-accrual loans to total assets


4.65
%


4.03
%


5.71
%


4.70
%


1.75
%Total non-performing assets  to total assets


7.85
%


6.76
%


7.02
%


5.20
%


1.78
%


______________________________






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Total non-accrual loans increased by $8.9 million to $84.2 million as of December 31, 2010 compared to $75.3 million as of December 31, 2009.  The ratio of non-accrual loans to total loans was 6.44% at December 31, 2010 compared to 5.30% at December 31, 2009.  The $8.9 million increase in non-accrual loans during the year ended December 31, 2010 reflects from $87.3 million in loans that were placed into non-accrual status during the period, partially offset by the following: $41.8 million in transfers to real estate owned (net of charge-offs), $24.4 million in charge-offs, $7.9 million in loans that returned to accrual status and $3.6 million in loans that were paid in full.





Of the $84.2 million in total non-accrual loans as of December 31, 2010, $68.6 million have been reviewed to assess whether a specific valuation allowance is necessary.  A specific valuation allowance is established for an amount equal to the impairment when the carrying value of the loan exceeds the present value of expected future cash flows, discounted at the loan’s original effective interest rate, or the fair value of the underlying collateral.  The fair value of the underlying collateral is estimated based upon updated appraisals.  Depending on the length of time since the last appraisal, the Company may apply an adjustment factor to align such value with current market conditions.  Based upon these specific reviews, a total of $18.6 million in charge-offs have been recorded with respect to these loans.  In addition, specific reserves totaling $7.4 million have been recorded as of December 31, 2010.  The remaining $15.6 million of non-accrual loans were reviewed on an aggregate basis, due to their size (less than $500,000), and $3.5 million in general valuation allowance was deemed necessary as of December 31, 2010.   The $3.5 million in general valuation allowance is based upon a migration analysis performed with respect to similar non-accrual loans in prior periods.





During the year ended December 31, 2010, $6.7 million of interest income would have been recognized on non-accrual loans if such loans had continued to perform in accordance with their contractual terms.  Interest income of $2.6 million was recognized during 2010 on non-accrual loans using the cash basis of accounting.  The remaining $4.1 million in interest income on non-accrual loans was contractually due and payable during 2010 but was not reported as interest income.




Total real estate owned increased by $6.9 million to $57.8 million at December 31, 2010, compared to $50.9 million at December 31, 2009.  During the year ended December 31, 2010, $41.8 million was transferred from loans to real estate owned upon completion of foreclosure.  Declines in property values evidenced by updated appraisals, responses to list prices on properties held for sale and/or deterioration in the condition of properties resulted in write-downs totaling $2.1 million during the year ended December 31, 2010.  During the same period, proceeds from the sale of real estate owned totaled $33.5 million which resulted in a net gain of $1.4 million.  The net gain on sale of real estate owned properties represented 4.3% of the recorded value of the properties as of the date of sale.  We owned 284 properties as of December 31, 2010, compared to 226 properties at December 31, 2009.  Of the $57.8 million in real estate owned properties as of December 31, 2010, $47.8 million consist of one– to four-family, over four-family and commercial real estate properties.  Of these properties, $32.8 million, or 56.8%, represent properties that are generating rental revenue.  Foreclosed properties are recorded at the lower of carrying value or fair value with charge-offs, if any, charged to the allowance for loan losses upon transfer to real estate owned.  The fair value is primarily based upon updated appraisals in addition to an analysis of current real estate market conditions.





During 2010 and 2009, as a result of continuing efforts to mitigate the risk of loan losses, the Company has increased activity with respect to loans modified in a troubled debt restructuring.  Troubled debt restructurings involve granting concessions to a borrower experiencing financial difficulty in connection with the modification of the terms of the loan, such as changes in payment schedule or interest rate, in an effort to avoid foreclosure.   As of December 31, 2010, $36.5 million in loans had been modified in troubled debt restructurings, and $2.9 million of these loans are included in the non-accrual loan total.  The remaining $33.6 million, while meeting the internal requirements for modification in a troubled debt restructuring, were current with respect to payments under their original loan terms at the time of the restructuring and thus, continue to be included with accruing loans.  Provided these loans perform in accordance with the modified terms, they will continue to be accounted for on an accrual basis.  Typical restructured terms include six to twelve months of principal forbearance and a reduction in interest rate.  Of the $36.5 million in restructured loans as of December 31, 2010, $24.0 million were one- to four-family loans.  An additional $8.7 million were over four-family loans.  All loans that have been modified in a troubled debt restructuring are considered to be impaired.  As such, an analysis has been performed with respect to all of these loans to determine the need for a valuation reserve.  When a borrower is expected to perform in accordance with the restructured terms and ultimately return to and perform under market terms, a valuation allowance is established for an amount equal to the impairment when the carrying amount of the loan exceeds the present value of the expected future cash flows.  When there is doubt as to the borrower’s ability to perform under the restructured terms or ultimately return to and perform under market terms, a valuation allowance is established equal to the impairment when the carrying amount exceeds fair value of the underlying collateral.  As a result of the impairment analysis, a $1.4 million valuation allowance has been established as of December 31, 2010 with respect to the $36.5 million in troubled debt restructurings.




There were no accruing loans past due 90 days or more during the years ended December 31, 2010, 2009 and 2008.






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Allowance for Loan Losses





We establish valuation allowances on loans that are deemed to be impaired. A loan is considered impaired when, based on current information and events, it is probable that we will not be able to collect all amounts due according to the contractual terms of the loan agreement. A valuation allowance is established for an amount equal to the impairment when the carrying amount of the loan exceeds the present value of the expected future cash flows, discounted at the loan’s original effective interest rate or the fair value of the underlying collateral.




We also establish valuation allowances based on an evaluation of the various risk components that are inherent in the loan portfolio. The risk components that are evaluated include past loan loss experience; the level of non-performing and classified assets; current economic conditions; volume, growth, and composition of the loan portfolio; adverse situations that may affect the borrower’s ability to repay; the estimated value of any underlying collateral; regulatory guidance; and other relevant factors. The allowance is increased by provisions charged to earnings and recoveries of previously charged-off loans and reduced by charge-offs. The adequacy of the allowance for loan losses is reviewed and approved quarterly by the WaterStone Bank board of directors. The allowance reflects management’s best estimate of the amount needed to provide for the probable loss on impaired loans and other inherent losses in the loan portfolio, and is based on a risk model developed and implemented by management and approved by the WaterStone Bank board of directors.




Actual results could differ from this estimate, and future additions to the allowance may be necessary based on unforeseen changes in loan quality and economic conditions. In addition, the Federal Deposit Insurance Corporation and the Wisconsin Department of Financial Institutions, as an integral part of their examination process, periodically review WaterStone Bank’s allowance for loan losses. Such regulators have the authority to require WaterStone Bank to recognize additions to the allowance based on their judgments of information available to them at the time of their review or examination.




Any loan that is 90 or more days delinquent is placed on non-accrual and classified as a non-performing asset. A loan is classified as impaired when it is probable that we will be unable to collect all amounts due in accordance with the terms of the loan agreement.  Non-performing assets are then evaluated and accounted for in accordance with generally accepted accounting principles.








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The following table sets forth activity in our allowance for loan losses for the periods indicated.




At or for the YearEnded December 31,2010


2009


2008


2007


2006(Dollars in Thousands)Balance at beginning of period

$
28,494



25,167



12,839



7,195



5,250Provision for loan losses


25,832



26,687



37,629



11,697



2,201Charge-offs:Mortgage loansOne- to four-family (1)


16,906



13,602



8,397



1,397



524Over four-family


3,439



3,304



10,056



634



-Home equity (1)


619



861



394



120



-Construction and land


2,319



3,957



5,088



3,982



-Commercial real estate


575



910



1,838



27



5Consumer


13



9



4



3



7Commercial


1,470



1,000



-



-



-Total charge-offs


25,341



23,643



25,777



6,163



536Recoveries:Mortgage loansOne- to four-family


127



181



313



68



144Over four-family


55



23



31



-



30Home equity


3



1



1



1



-Construction and land


2



77



125



-



-Commercial real estate


1



-



-



40



100Consumer


1



1



6



1



6Commercial


1



-



-



-



-Total recoveries


190



283



476



110



280Net charge-offs


25,151



23,360



25,301



6,053



256Allowance at end of year

$
29,175



28,494



25,167



12,839



7,195Ratios:Allowance for loan losses to non-performing loans at end of period


34.66
%


37.83
%


23.36
%


15.98
%


24.91
%Allowance for loan losses to netloans outstanding at end of period


2.23
%


2.01
%


1.61
%


0.92
%


0.52
%Net charge-offs to average loansoutstanding (annualized)


1.75
%


1.54
%


1.67
%


0.44
%


0.02
%Current year provision for loan lossesto net charge-offs


102.71
%


114.24
%


148.73
%


193.24
%


859.77
%Net charge-offs to beginning of theyear allowance


88.27
%


92.82
%


197.06
%


84.13
%


4.88
%


_____________


(1) Prior to the year ended December 31, 2007, one- to four-family loans include home equity loans and home equity lines of credit as a separate breakdown is not available for these years.





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 Table of Contents


Allocation of Allowance for Loan Losses.The following table sets forth the allowance for loan losses allocated by loan category, the total loan balances by category, and the percent of loans in each category to total loans at the dates indicated.  The allowance for loan losses allocated to each category is not necessarily indicative of future losses in any particular category and does not restrict the use of the allowance to absorb losses in other categories.








At December 31,2010


2009


2008Allowance for Loan Losses


% of Loans in Category to Total Loans


% of Allowance in Category to Total Allowance


Allowance for Loan Losses


% of Loans in Category to Total Loans


% of Allowance in Category to Total Allowance


Allowance for Loan Losses


% of Loans in Category to Total Loans


% of Allowance in Category to Total Allowance(Dollars in Thousands)Real Estate:ResidentialOne- to four-family

$
16,150



43.34
%


55.36
%

$
17,875



46.31
%


62.73
%

$
14,218



48.70
%


56.49
%Over four-family


6,877



40.26
%


23.57
%


5,208



36.47
%


18.28
%


6,844



31.59
%


27.20
%Home equity


1,196



5.34
%


4.10
%


1,642



5.84
%


5.76
%


1,027



5.52
%


4.08
%Construction and land


3,252



4.21
%


11.14
%


2,635



4.74
%


9.25
%


2,137



8.12
%


8.49
%Commercial Real Estate


671



3.84
%


2.30
%


720



3.33
%


2.53
%


445



3.40
%


1.77
%Commercial


1,001



3.00
%


3.43
%


371



3.27
%


1.30
%


457



2.65
%


1.82
%Consumer


28



0.01
%


0.10
%


43



0.04
%


0.15
%


39



0.02
%


0.15
%Total allowance for loan losses

$
29,175



100.00
%


100.00
%

$
28,494



100.00
%


100.00
%

$
25,167



100.00
%


100.00
%







At December 31,2007


2006Allowance for Loan Losses


% of Loans in Category to Total Loans


% of Allowance in Category to Total Allowance


Allowance for Loan Losses


% of Loans in Category to Total Loans


% of Allowance in Category to Total Allowance(Dollars In Thousands)Real Estate:Residential(1)One- to four-family

$
5,433



45.64
%


42.32
%

$
4,200



44.17
%


58.37
%Over four-family


4,369



32.45
%


34.03
%


2,034



34.10
%


28.27
%Home equity(1)


536



5.84
%


4.17
%


-



6.34
%


-Construction and land


2,087



10.61
%


16.26
%


167



11.67
%


2.32
%Commercial Real Estate


280



3.53
%


2.18
%


764



3.53
%


10.62
%Commercial


99



1.92
%


0.77
%


-



0.18
%


-Consumer


35



0.01
%


0.27
%


30



0.01
%


0.42
%Total allowance for loan losses

$
12,839



100.00
%


100.00
%


7,195



100.00
%


100.00
%




(1)  Prior to the year ended December 31, 2007, one- to four-family loans include home equity loans and home equity lines of credit, as a separate breakdown for the allowance for loan losses is not available for those years.


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All impaired loans meeting the criteria established by management are evaluated individually, based primarily on the value of the collateral securing each loan and the ability of the borrowers to repay according to the terms of the loans.  Specific loss allowances are established as required by this analysis.  At least once each quarter, management evaluates the adequacy of the balance of the allowance for loan losses based on several factors some of which are not loan specific, but are reflective of the inherent losses in the loan portfolio.  This process includes, but is not limited to, a periodic review of loan collectibility in light of historical experience, the nature and volume of loan activity, conditions that may affect the ability of the borrower to repay, underlying value of collateral and economic conditions in our immediate market area.  All loans for which a specific loss review is not required are segregated by loan type and a loss allowance is established by using loss experience data and management's judgment concerning other matters it considers significant including trends in non-performing loan balances, impaired loan balances, classified asset balances and the current economic environment.  The allowance is allocated to each category of loans based on the results of the above analysis.




The above analysis process is both quantitative and subjective, as it requires us to make estimates that are susceptible to revisions as more information becomes available.  Although we believe that we have established the allowance at levels appropriate to absorb probable and estimable losses, additions may be necessary if future economic conditions differ substantially from the current environment.




At December 31, 2010, the allowance for loan losses was $29.2 million, compared to $28.5 million at December 31, 2009.  As of December 31, 2010, the allowance for loan losses to total loans receivable was 2.23% and was equal to 34.66% of non-performing loans, compared to 2.01% and 37.83%, respectively, at December 31, 2009.The $681,000 increase in the allowance for loan loss during the year ended December 31, 2010 is attributable to a $2.1 million increase in the general valuation allowance, partially offset by a $1.4 million decrease in specific loan loss reserves related to impaired loans.  The increase in the general valuation allowance resulted from an increase in non-performing loans and loans that, while still performing, have been identified as having higher risk characteristics.  The increase in the amount and number of loans identified as exhibiting elevated levels of risk with respect to loss outweighed the decline in overall delinquent loans.  Loans with elevated risk profiles include loans internally classified as special mention and watch.  These loans resulted in a $3.3 million increase to the general valuation allowance during the year.  This was partially offset by a $1.2 million reduction to the general valuation allowance due primarily to a $113.6 million decrease in the balance of loans outstanding.  The $1.4 million decrease in specific loan loss reserves was primarily the result of a decrease in number and amount of impaired loans with significant collateral shortfalls.  Weakness in the residential real estate market has continued for the past three years and the risk of loss on loans secured by residential real estate remains at an elevated level.





Net charge-offs totaled $25.2 million, or 1.75% of average loans for the year ended December 31, 2010, compared to $23.4 million, or 1.54% of average loans  for the year ended December 31, 2009.  Of the $25.2 million in net charge-offs during the year ended December 31, 2010, $16.8 million related to loans secured by one- to four-family residential loans.  The majority of charge-offs in this category relate to two borrower types, borrowers with single family residential jumbo loans and small real estate investors.  Lending relationships with borrowers that had residential jumbo loans accounted for $10.2 million of net charge-offs in one-to four-family loans for the year ended December 31, 2010.  An additional $5.4 million of charge-offs relate to lending relationships with small real estate investors, whose collateral consists of non-owner occupied two- to four-family properties.  Net charge-offs related to land and construction loans totaled $2.3 million during the year ended December 31, 2010.  Of this total, $2.2 million related to a single loan made to a borrower to finance the purchases of raw land for eventual residential condominium development.





The $25.8 million loan loss provision for the year ended December 31, 2010 reflects the Company’s conclusion as to the need for the ending allowance to be $29.2 million following the net charge-offs recorded during the period and a review of the Bank’s loan portfolio and general economic conditions.





Our revised underwriting policies and procedures emphasize the fact that credit decisions must rely on both the credit quality of the borrower and the estimated value of the underlying collateral.  Credit quality is assured only when the estimated value of the collateral is objectively determined and is not subject to significant fluctuation.  The quantified deterioration of the credit quality of our loan portfolio as described above is the direct result of borrowers who were not financially strong enough to make regular interest and principal payments or maintain their properties when the economic environment no longer allowed them the option of converting estimated real estate value increases into short-term cash flow.






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Mortgage Banking Activity


In addition to the lending activities previously discussed, the Company also originates residential mortgage loans for the purpose of sale on the secondary market.  The Company originated $1.08 billion in mortgage loans held for sale during the year ended December 31, 2010 as compared to $739.2 million during the year ended December 31, 2009.  Proceeds from sales to third parties during the year ended December 31, 2010 totaled $1.07 billion as compared to $716.6 million during the year ended December 31, 2009.  These sales generated approximately $35.5 million and $10.0 million in mortgage banking income for the periods ended December 31, 2010 and 2009, respectively.
 
 The increase in mortgage banking income was the combined result of increased volume, increased sales margins, expansion of the branch network and the addition of mandatory loan delivery terms.  The increase in the volume of originations and sales of mortgage loans resulted from an increase in demand for fixed-rate loans due in large part to historically low interest rates on these products.  In addition to the increase in demand, the increase in volume was also driven by an expansion of our mortgage banking operations from 21 to 30 branch locations outside of the Bank branch network.  During the year ended December 31, 2010, branches were added in Illinois, Maryland, North Carolina, Colorado, Florida and Minnesota.
 
 In addition to the increase in mortgage banking income due to an increase in volume, the average margin earned on loans sold increased during the year ended December 31, 2010 as compared to 2009.  The increase in average sales margin was driven by the following factors: a change in product mix towards government guaranteed loans which yield a higher margin than conventional loans, a change in product mix towards real estate purchase loans which yield a higher margin than loans originated for the purpose of a refinancing and change in the geographic composition of origination activity towards higher yielding geographic markets.
 
 Margins also increased during the current year due to an increase in the use of mandatory delivery to investors.  Prior to 2010, the Company originated loans held for sale on a “best efforts” delivery basis.  Under the "best efforts" delivery method, the buyer of the loan, or investor, assumed all interest rate risk.  Just prior to the end of 2009, the Company began to originate loans for sale on a “mandatory” delivery basis.  Under the "mandatory" delivery method, the investor committed to buy only those loans that were originated within a specified range of yield to the buyer.  Higher fees are paid by the investor to the originator for “mandatory” delivery as compared to “best efforts” delivery in exchange for the assumption of interest rate risk.






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Investment Activities





Wauwatosa Investments, Inc. is WaterStone Bank’s investment subsidiary located in Las Vegas, Nevada.  Wauwatosa Investments, Inc. manages the Bank’s investment portfolio.  The Bank’s Treasurer and its Treasury Officer are responsible for implementing our Investment Policy and monitoring the investment activities of Wauwatosa Investments, Inc.  The Investment Policy is reviewed annually by management and changes to the policy are recommended to and subject to the approval of our board of directors.  Authority to make investments under the approved Investment Policy guidelines is delegated by the board to designated employees.  While general investment strategies are developed and authorized by management, the execution of specific actions rests with the Treasurer and Treasury Officer who may act jointly or severally.  In addition, the President of Wauwatosa Investments, Inc. has execution authority for securities transactions.  The Treasurer and Treasury Officer are responsible for ensuring that the guidelines and requirements included in the Investment Policy are followed and that all securities are considered prudent for investment.  The Treasurer, the Treasury Officer and the President of Wauwatosa Investments, Inc. are authorized to execute investment transactions (purchases and sales) without the prior approval of the board and within the scope of the established Investment Policy.




Our Investment Policy requires that all securities transactions be conducted in a safe and sound manner.  Investment decisions are based upon a thorough analysis of each security instrument to determine its quality, inherent risks, fit within our overall asset/liability management objectives, effect on our risk-based capital measurement and prospects for yield and/or appreciation.




Consistent with our overall business and asset/liability management strategy, which focuses on sustaining adequate levels of core earnings, our investment portfolio is comprised primarily of securities that are classified as available for sale.  At December 31, 2010 and 2009, we owned one structured note that has been classified as held to maturity.  During the year ended December 31, 2010, municipal securities with a total book value of $14.0 million were sold at a gain of $11,000.  During the same period, collateralized mortgage obligations with a total book value of $6.7 million were sold at a gain of $44,000.  Two available for sale municipal securities with a total book value of $503,000 were sold in 2009 at a gain of $12,000.  There were no sales with respect to the available for sale investment portfolio during the year ended December 31, 2008.  Impairment losses of $1.1 million and $2.0 million were recognized as an other than temporary impairment during 2009 and 2008, respectively.  There were no impairment losses recognized as other than temporary impairment during the year ended December 31, 2010.  A cumulative effect adjustment of $1.1 million was made in 2009 effective January 1, 2009 in connection with the early adoption of new guidance impacting ASC Topic 820, Fair Value Measurements and Disclosures, which partially reversed the impairment loss recognized during the year ended December 31, 2008.




Available for Sale Portfolio




Government Sponsored Enterprise Bonds.  At December 31, 2010, our Government sponsored enterprise bond portfolio totaled $57.7 million, all of which were issued by government sponsored enterprises such as Federal National Mortgage Associated (Fannie Mae), Federal Home Loan Mortgage Corporation (Freddie Mac) and the Federal Home Loan Bank (FHLB) and were classified as available for sale.  The weighted average yield on these securities was 1.76% and the weighted average remaining average life was 3.1 years at December 31, 2010.  While these securities generally provide lower yields than other investments in our securities investment portfolio, we maintain these investments, to the extent appropriate, for liquidity purposes and prepayment protection.  The estimated fair value of our government sponsored enterprise bond portfolio at December 31, 2010 was $371,000 more than the amortized cost of $57.3 million.  A total of $44.8 million of government enterprise bonds are pledged as collateral for borrowings at December 31, 2010.








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Mortgage-backed Securities and Collateralized Mortgage Obligations.  We purchase mortgage-backed securities and collateralized mortgage obligations guaranteed by Fannie Mae, Freddie Mac and Ginnie Mae and collateralized mortgage obligations issued by investment banks.  We invest in mortgage-backed securities and collateralized mortgage obligations to achieve positive interest rate spreads with minimal administrative expense, and to lower our credit risk.  We regularly monitor the credit quality of this portfolio.




Mortgage-backed securities and collateralized mortgage obligations are created by the pooling of mortgages and the issuance of a security with an interest rate which is less than the interest rate on the underlying mortgages.  These securities typically represent a participation interest in a pool of single-family or multi-family mortgages, although we focus our investments on mortgage related securities backed by one- to four-family mortgages.  The issuers of such securities pool and resell the participation interests in the form of securities to investors such as WaterStone Bank, and in the case of government agency sponsored issues, guarantee the payment of principal and interest to investors.  Mortgage-backed securities and collateralized mortgage obligations generally yield less than the loans that underlie such securities because of the cost of payment guarantees, if any, and credit enhancements.  These fixed-rate securities are usually more liquid than individual mortgage loans.




At December 31, 2010, mortgage-backed securities and collateralized mortgage obligations totaled $109.1 million.  Of this total, $79.9 million are backed by government sponsored enterprises and $3.7 million are backed by U.S. Government agencies.  The remaining $25.4 million were issued by investment banks.  At December 31, 2010, the estimated fair value of the securities issued by investment banks was $752,000 less than the amortized cost of $26.2 million.




The mortgage-backed securities and collateralized mortgage obligations portfolio had a weighted average yield of 4.54% and a weighted average remaining life of 2.9 years at December 31, 2010.  The estimated fair value of our mortgage-backed securities and collateralized mortgage obligations portfolio at December 31, 2010 was $2.0 million more than the amortized cost of $107.1 million.  Mortgage-backed securities and collateralized mortgage obligations valued at $55.2 million are pledged as collateral for borrowings at December 31, 2010. Investments in mortgage-backed securities and collateralized mortgage obligations involve a risk that actual prepayments may differ from estimated prepayments over the life of the security, which may require adjustments to the amortization of any premium or accretion of any discount relating to such instruments, thereby changing the net yield on such securities.  There is also reinvestment risk associated with the cash flows from such securities or if such securities are redeemed by the issuer.  In addition, the market value of such securities may be adversely affected in a rising interest rate environment, particularly since all of our mortgage-backed securities and collateralized mortgage obligations have a fixed rate of interest.




All collateralized mortgage obligations issued by investment banks were rated AAA by Moody’s at the date of purchase.  As of December 31, 2010, all securities continue to be rated as investment grade, except that two collateralized mortgage obligations issued by investment banks with other than temporary impairment have been downgraded to CCC by S&P and to either Caa1 or Caa2 by Moody’s.  The estimated fair value of these securities was $20.3 million at December 31, 2010.




With respect to the first of the two aforementioned downgraded securities, during the year ended December 31, 2008, we recognized a $2.0 million loss on impairment.  As of December 31, 2008, this security had an amortized cost of $4.7 million, reflecting the impairment loss recognized in the income statement and a fair value of $4.2 million.  As of January 1, 2009, a cumulative effect adjustment was made to retained earnings for $1.1 million to reflect the difference between credit loss and the estimated fair value of the security when the other than temporary loss was identified.  During the year ended December 31, 2009, the Company recognized an additional other than temporary impairment loss totaling $135,000 with respect to this security.  Also, during the year ended December 31, 2009, the second of the two aforementioned downgraded collateralized mortgage obligations was found to have an other than temporary impairment totaling $997,000.  These two securities had a fair value of $20.3 million and an amortized cost of $21.2 million as of December 31, 2010.  At the same date, unrealized losses on these collateralized mortgage obligations include other-than-temporary impairment recognized in other comprehensive income (before taxes) of $881,000.  No other collateralized mortgage obligations have been found to have other than temporary impairment as of December 31, 2010.








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Municipal Obligations.  These securities consist of obligations issued by states, counties and municipalities or their agencies and include general obligation bonds, industrial development revenue bonds and other revenue bonds.  Our Investment Policy requires that such non-Wisconsin state agency or municipal obligations be rated AA or better by a nationally recognized rating agency.  A security that is downgraded below investment grade will require additional analysis of creditworthiness and a determination will be made to hold or dispose of the investment.  At December 31, 2010, our state agency and municipal obligations portfolio totaled $31.1 million, all of which was classified as available for sale.  The weighted average yield on this portfolio was 4.79% at December 31, 2010, with a weighted average remaining life of 8.5 years.  The estimated value of our municipal obligations bond portfolio at December 31, 2010 was $684,000 less than the amortized cost of $31.8 million.  The estimated market value of the municipal obligations portfolio has been negatively impacted in the current economic environment by both the financial difficulties being encountered by the companies that insure the bonds and by the credit quality of the municipalities.  At December 31, 2010 one municipal school district bond in the State of California was rated Baa1 by Moody’s.  The estimated value of this security was $159,000 less than the amortized cost of $431,000 as of December 31, 2010.  Based upon an assessment performed as of December 31, 2010, we have determined that no securities in this category are other than temporarily impaired.




Other Debt Securities.As of December 31, 2010, we held a trust preferred security with a fair value of $5.3 million and amortized cost of $5.0 million.  This security, which yields 10.0% is callable beginning in the second quarter of 2013 with final maturity in 2068.    Based upon an assessment performed as of December 31, 2010, the Company has determined that this security is not other than temporarily impaired.




Held to Maturity Portfolio.As of December 31, 2010, we held one structured corporate note that has been designated as held to maturity since its purchase in 2007.  The corporate note has an amortized cost of $2.6 million and an estimated fair value of $2.5 million.  The final maturity of this security is 2022, however, it is callable quarterly.  The corporate note has a yield of 7.5%.  We have determined that the security is not other-than-temporarily impaired at December 31, 2010.




Investment Securities Portfolio.




The following table sets forth the carrying values of our available for sale securities portfolio at the dates indicated.






At December 31,2010


2009


2008Amortized





Amortized





AmortizedCost


Fair Value


Cost


Fair Value


Cost


Fair Value(In Thousands)Securities available for sale:Government sponsored enterprise bonds

$
57,327


$
57,698


$
40,400


$
40,589


$
11,007


$
11,342Mortgage-backed securities


107,068



109,054



119,838



116,835



139,862



131,542Municipal obligations


31,804



31,120



43,599



43,241



32,697



31,362Corporate notes


-



-



-



-



992



941Other debt securities


5,000



5,294



5,250



4,750



5,250



4,700Total securities available for sale

$
201,199


$
203,166


$
209,087


$
205,415


$
189,808


$
179,887







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Portfolio Maturities and Yields.The composition and maturities of the securities portfolio at December 31, 2010 are summarized in the following table.  Maturities are based on the final contractual payment dates and do not reflect the impact of prepayments or early redemptions that may occur.  Municipal obligation yields have not been adjusted to a tax-equivalent basis.  Certain mortgage related securities have interest rates that are adjustable and will reprice annually within the various maturity ranges.  These repricing schedules are not reflected in the table below.









One Year or Less


More than One Year through Five Years


More than Five Years through Ten Years


More than Ten Years


Total SecuritiesWeighted




Weighted




Weighted




Weighted




WeightedCarrying

Average


Carrying

Average


Carrying

Average


Carrying

Average


Carrying

AverageValue

Yield


Value

Yield


Value

Yield


Value

Yield


Value

Yield(Dollars in Thousands)Securities available for sale:Government sponsored enterprise bonds

$
3,025


4.91
%

$
54,673


1.59
%

$
-


-


$
-


-


$
57,698


1.76
%Mortgage-backed securities


8,359


5.33
%


99,487


4.46
%


-


-



1,208


5.54
%


109,054


4.54
%Municipal obligations


-


-



12,916


3.58
%


8,570


5.07
%


9,634


5.96
%


31,120


4.79
%Other debt securities


-


-



-


-



-


-



5,294


10.00
%


5,294


10.00
%Total securities available for sale

$
11,384


5.22
%

$
167,076


3.45
%

$
8,570


5.07
%

$
16,136


7.11
%

$
203,166


3.92
%Securities held to maturity:Corporate notes


-


-



-


-



-


-


$
2,648


7.50
%

$
2,648


7.50
%












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Sources of Funds




General.Deposits have traditionally been our primary source of funds for use in lending and investment activities. We also rely on advances from the Federal Home Loan Bank of Chicago and borrowings from other commercial banks in the form of repurchase agreements collateralized by investment securities.  In addition to deposits and borrowings, we derive funds from scheduled loan payments, investment maturities, loan prepayments, retained earnings and income on earning assets.  While scheduled loan payments and income on earning assets are relatively stable sources of funds, deposit inflows and outflows can vary widely and are influenced by prevailing market interest rates, economic conditions and competition from other financial institutions.




Deposits.A majority of our depositors are persons who work or reside in Milwaukee and Waukesha Counties and, to a lesser extent, other southeastern Wisconsin communities.  We offer a selection of deposit instruments, including checking, savings, money market deposit accounts, and fixed-term certificates of deposit.  Deposit account terms vary, with the principal differences being the minimum balance required, the amount of time the funds must remain on deposit and the interest rate.  Certificates of deposit comprised 85.1% of total deposits at December 31, 2010, and had a weighted average cost of 1.74% on that date.  Our reliance on certificates of deposit has resulted in a higher cost of funds than would otherwise be the case if demand deposits, savings and money market accounts made up a larger part of our deposit base.  Development of our branch network and expansion of our commercial products and services are expected to result in decreased reliance on higher cost certificates of deposit in the long-term by aggressively seeking lower cost savings, checking and money market accounts.




Interest rates paid, maturity terms, service fees and withdrawal penalties are established on a periodic basis.  Deposit rates and terms are based primarily on current operating strategies and market rates, liquidity requirements, rates paid by competitors and growth goals.  Effective March 1, 2010, maximum deposit rates that the Bank may offer are limited by the FDIC.  To attract and retain deposits, we rely upon personalized customer service, long-standing relationships and competitive interest rates.




The flow of deposits is influenced significantly by general economic conditions, changes in money market and other prevailing interest rates and competition.  The variety of deposit accounts that we offer allows us to be competitive in obtaining funds and responding to changes in consumer demand.  Based on historical experience, management believes our deposits are relatively stable.  It is unclear whether future levels of deposits will reflect our historical experience particularly in view of new FDIC limits on the rates we may offer on deposits.  The ability to attract and maintain money market accounts and certificates of deposit, and the rates paid on these deposits, has been and will continue to be significantly affected by market conditions.  At December 31, 2010 and December 31, 2009, $974.4 million and $1.01 billion, or 85.1% and 86.8%, respectively, of our deposit accounts were certificates of deposit, of which $347.5 million and $920.1 million, respectively, had maturities of one year or less.  The percentage of our deposit accounts that are certificates of deposit is greater than most of our competitors.




Deposits obtained from brokers totaled $14.4 million and $63.6 million at December 31, 2010 and 2009, respectively.  Brokered deposits have historically been utilized when their relative cost compares favorably to the cost of retail deposits generated directly by the Bank.  Brokered deposits have also been historically utilized in order to obtain significant additional deposit fundingover a period of weeks rather than months.  A consent order issued by state and federal regulators effective December 18, 2009 prohibits the Bank from accepting new or renewing existing brokered deposits.




Total deposits decreased by $19.4 million, or 1.7%, from December 31, 2009 to December 31, 2010.  This net decrease was the result of a $37.1 million, or 3.7%, decrease in certificates of deposit, which was partially offset by an $11.4 million, or 12.4%, increase in money market and savings accounts and a $6.3 million, or 10.3%, increase in demand deposits.  The $37.1 million decrease in certificates of deposit consisted of a $49.1 million decrease in non-local brokered deposits, partially offset by a $12.1 million increase in local certificates.  Brokered deposits totaling $14.4 million will mature during the year ended December 31, 2011 and cannot be renewed as long as the Bank remains under the terms of the current consent order.




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 Table of Contents


The following table sets forth the distribution of total deposit accounts, by account type, at the dates indicated.






At December 31,2010


2009


2008Weighted






Weighted






WeightedAverage






Average






AverageBalance

Percent

Rate


Balance

Percent

Rate


Balance

Percent

Rate(Dollars in Thousands)Deposit type:Demand deposits

$
30,030


2.62
%

0.00
%

$
24,255


2.08
%

0.00
%

$
20,664


1.73
%

0.00
%NOW accounts


37,705


3.29
%

0.08
%


37,165


3.19
%

0.08
%


32,770


2.74
%

0.13
%Regular savings


44,540


3.89
%

0.22
%


45,219


3.88
%

0.48
%


27,029


2.26
%

0.47
%Money market andsavings deposits


58,863


5.14
%

0.48
%


46,809


4.02
%

0.46
%


73,901


6.18
%

0.22
%Total transaction accounts


171,138


14.94
%

0.24
%


153,448


13.17
%

0.18
%


154,364


12.91
%

0.21
%Certificates of deposit


974,391


85.06
%

1.74
%


1,011,442


86.83
%

2.52
%


1,041,533


87.09
%

3.85
%Total deposits

$
1,145,529


100.00
%

1.51
%

$
1,164,890


100.00
%

2.21
%

$
1,195,897


100.00
%

3.38
%







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 Table of Contents







At December 31, 2010, the aggregate balance of certificates of deposit of $100,000 or more was approximately $271.7 million.  The following table sets forth the maturity of those certificates at December 31, 2010.









(In Thousands)Due in:Three months or less

$
33,095Over three months through six months


32,308Over six months through 12 months


33,929Over 12 months


172,362Total

$
271,694







Borrowings.Our borrowings at December 31, 2010 consist of advances from the Federal Home Loan Bank of Chicago, repurchase agreements collateralized by investment securities and two bank lines of credit totaling $70.0 million that were used to finance loans held for sale.  The following table sets forth information concerning balances and interest rates on borrowings at the dates and for the periods indicated.








At or For the Year EndedDecember 31,2010


2009


2008Borrowings:

(Dollars in Thousands)Balance outstanding at end of period

$
456,959


$
507,900


$
487,000Weighted average interest rate at the end of period


3.94
%


3.85
%


3.99
%Maximum amount of borrowings outstanding at anymonth end during the period


506,902



512,000



519,296Average balance outstanding during the period


481,808



511,384



494,655Weighted average interest rate during the period


4.03
%


3.90
%


4.11
%











Legal Proceedings





The Company and its subsidiaries are not involved in any legal proceedings where the outcome, if adverse to us, would have a material and adverse affect on our financial condition or results of operations.





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Subsidiary Activities





Waterstone Financial currently has one wholly-owned subsidiary, WaterStone Bank, which in turn has three wholly-owned subsidiaries.  Wauwatosa Investments, Inc., which holds and manages our investment portfolio, is located and incorporated in the state of Nevada.  Waterstone Mortgage Corporation is a mortgage banking business incorporated in Wisconsin. Main Street Real Estate Holdings, LLC, is an inactive Wisconsin limited liability corporation and previously owned Bank office facilities and held Bank office facility leases.





Wauwatosa Investments, Inc.Established in 1998, Wauwatosa Investments, Inc. operates in Nevada as WaterStone Bank’s investment subsidiary.  This wholly-owned subsidiary owns and manages the majority of the consolidated investment portfolio.  It has its own board of directors currently comprised of its President, the WaterStone Bank Chief Financial Officer, Treasury Officer and the Chairman of the Company’s board of directors.





Waterstone Mortgage Corporation.Acquired in February 2006, Waterstone Mortgage Corporation is a mortgage banking business with twelve offices in Wisconsin, five offices in Minnesota, four offices in each of Florida and Illinois, three in Idaho, two in Florida and one office in each of Arizona, Colorado, Maryland and Tennessee.  Waterstone Mortgage Corporation was the largest mortgage broker in the Milwaukee area based on 2010 dollar volume of retail first and second mortgages originated.  It has its own board of directors currently comprised of its President, its CFO, the WaterStone Bank CEO, CFO, Senior Vice President and General Counsel and the Vice President Residential Lending.





Main Street Real Estate Holdings, LLC.  Established in 2002, Main Street Real Estate Holdings, LLC was established to acquire and hold Bank office and retail facilities both owned and leased.  Main Street Real Estate Holdings, LLC is currently inactive.





Personnel





As of December 31, 2010, we had 595 full-time equivalent employees.  Our employees are not represented by any collective bargaining group.  Management believes that we have good relations with our employees.




Supervision and Regulation





The following discussion is only a summary of the primary laws and regulations affecting the powers and operations of WaterStone Bank, Waterstone Financial, and Lamplighter Financial, MHC.  It is not intended to be a comprehensive description of all laws and regulations applicable to these entities and is qualified in its entirety by reference to the applicable laws and regulations.






- 27 -
 Table of Contents






Regulation of WaterStone Bank





WaterStone Bank is a stock savings bank organized under the laws of the State of Wisconsin.  The lending, investment, and other business operations of WaterStone Bank are governed by Wisconsin law and regulations, as well as applicable federal law and regulations, and WaterStone Bank is prohibited from engaging in any operations not authorized by such laws and regulations.  WaterStone Bank is subject to extensive regulation by the Wisconsin Department of Financial Institutions, Division of Banking (“WDFI”) and by the Federal Deposit Insurance Corporation (“FDIC”), as its deposit insurer and primary federal regulator.  WaterStone Bank’s deposit accounts are insured up to applicable limits by the FDIC under its Deposit Insurance Fund (“DIF”).  A summary of the primary laws and regulations that govern the operations of WaterStone Bank are set forth below.





Intrastate and Interstate Merger and Branching Activities





Wisconsin Law and Regulation.Any Wisconsin savings bank meeting certain requirements may, upon approval of the WDFI, establish one or more branch offices in the state of Wisconsin or the states of Illinois, Indiana, Iowa, Kentucky, Michigan, Minnesota, Missouri, and Ohio.  In addition, upon WDFI approval, a Wisconsin savings bank may establish a branch office in any other state as the result of a merger or consolidation.





Federal Law and Regulation.  The Interstate Banking Act (the "IBA") permits the federal banking agencies to, under certain circumstances, approve acquisition transactions between banks located in different states, regardless of whether an acquisition would be prohibited under state law.  The IBA authorizes de novobranching into another state if the host state enacts a law expressly permitting out of state banks to establish such branches within its borders.  Additionally, the IBA authorizes branching by merger, subject to certain state law limitations.





Loans and Investments





Wisconsin Law and Regulations.Under Wisconsin law and regulation, WaterStone Bank is authorized to make, invest in, sell, purchase, participate or otherwise deal in mortgage loans or interests in mortgage loans without geographic restriction, including loans made on the security of residential and commercial property.  Wisconsin savings banks also may lend funds on a secured or unsecured basis for business, commercial or agricultural purposes, provided the total of all such loans does not exceed 20% of WaterStone Bank’s total assets, unless the WDFI authorizes a greater amount. Loans are subject to certain other limitations, including percentage restrictions based on WaterStone Bank’s total assets.




Wisconsin savings banks may invest funds in certain types of debt and equity securities, including obligations of federal, state and local governments and agencies. Subject to prior approval of the WDFI, compliance with capital requirements and certain other restrictions, Wisconsin savings banks may invest in residential housing development projects.   Wisconsin savings banks may also invest in service corporations or subsidiaries with the prior approval of the WDFI, subject to certain restrictions.





Wisconsin savings banks may make loans and extensions of credit, both direct and indirect, to one borrower in amounts up to 15% of WaterStone Bank’s capital plus an additional 10% for loans fully secured by readily marketable collateral.  In addition, and notwithstanding the 15% of capital and additional 10% of capital limitations set forth above, Wisconsin savings banks may make loans to one borrower, or a related group of borrowers, for any purpose in an amount not to exceed $500,000, or to develop domestic residential housing units in an amount not to exceed the lesser of $30 million or 30% of WaterStone Bank’s capital, subject to certain conditions. At December 31, 2010, WaterStone Bank did not have any loans which exceeded the “loans-to-one borrower” limitations.








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Finally, under Wisconsin law, WaterStone Bank must qualify for and maintain a level of qualified thrift investments equal to 60% of its assets as prescribed in Section 7701(a)(19) of the Internal Revenue Code of 1986, as amended. A Wisconsin savings bank that fails to meet this qualified thrift lender test becomes subject to certain operating restrictions otherwise applicable only to commercial banks. At December 31, 2009, WaterStone Bank maintained 98.7% of its assets in qualified thrift investments and therefore met the qualified thrift lender requirement.





Federal Law and Regulation.   FDIC regulations also govern the equity investments of WaterStone Bank, and, notwithstanding Wisconsin law and regulations, FDIC regulations prohibit WaterStone Bank from making certain equity investments and generally limit WaterStone Bank’s equity investments to those that are permissible for national banks and their subsidiaries.   Under FDIC regulations, WaterStone Bank must obtain prior FDIC approval before directly, or indirectly through a majority-owned subsidiary, engaging “as principal” in any activity that is not permissible for a national bank unless certain exceptions apply.  The activity regulations provide that state banks that meet applicable minimum capital requirements would be permitted to engage in certain activities that are not permissible for national banks, including guaranteeing obligations of others, activities which the Board of Governors of the Federal Reserve System (FRB) has found to be closely related to banking, and certain real estate and securities activities conducted through subsidiaries. The FDIC will not approve an activity that it determines presents a significant risk to the FDIC insurance fund.  The activities of WaterStone Bank and its subsidiaries are permissible under applicable federal regulations.





Loans to, and other transactions with, affiliates of WaterStone Bank, such as Waterstone Financial and Lamplighter Financial, MHC, are restricted by the Federal Reserve Act and regulations issued by the FRB thereunder. See “Transactions with Affiliates and Insiders” below.





Lending Standards





Wisconsin Law and Regulation.Wisconsin law and regulations issued by the WDFI impose on Wisconsin savings banks certain fairness in lending requirements and prohibit savings banks from discriminating against a loan applicant based upon the applicant’s physical condition, developmental disability, sex, marital status, race, color, creed, national origin, religion or ancestry.





Federal Law and Regulation.  The federal banking agencies adopted uniform regulations prescribing standards for extensions of credit that are secured by liens on interests in real estate or made for the purpose of financing the construction of a building or other improvements to real estate.  Under the joint regulations adopted by the federal banking agencies, all insured depository institutions, such as WaterStone Bank, must adopt and maintain written policies that establish appropriate limits and standards for extensions of credit that are secured by liens or interests in real estate or are made for the purpose of financing permanent improvements to real estate. These policies must establish loan portfolio diversification standards, prudent underwriting standards (including loan-to-value limits) that are clear and measurable, loan administration procedures, and documentation, approval and reporting requirements. The real estate lending policies must reflect consideration of the Interagency Guidelines for Real Estate Lending Policies that have been adopted by the federal bank regulators.





The Interagency Guidelines, among other things, require a depository institution to establish internal loan-to-value limits for real estate loans that are not in excess of the following supervisory limits:




·
for loans secured by raw land, the supervisory loan-to-value limit is 65% of the value of the collateral;




·
for land development loans (i.e., loans for the purpose of improving unimproved property prior to the erection of structures), the supervisory limit is 75%;




·
for loans for the construction of commercial, over four-family or other non-residential property, the supervisory limit is 80%;




·
for loans for the construction of one- to four-family properties, the supervisory limit is 85%; and




·
for loans secured by other improved property (e.g., farmland, completed commercial property and other income-producing property, including non-owner occupied, one- to four-family property), the limit is 85%.





Although no supervisory loan-to-value limit has been established for owner-occupied, one- to four-family and home equity loans, the Interagency Guidelines state that for any such loan with a loan-to-value ratio that equals or exceeds 90% at origination, an institution should require appropriate credit enhancement in the form of either mortgage insurance or readily marketable collateral.






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Deposits





Wisconsin Law and Regulation.Under Wisconsin law, WaterStone Bank is permitted to establish deposit accounts and accept deposits.  WaterStone Bank’s board of directors, or its designee, determines the rate and amount of interest to be paid on or credited to deposit accounts subject to FDIC limitations.





Deposit Insurance





Wisconsin Law and Regulation.Under Wisconsin law, WaterStone Bank is required to obtain and maintain insurance on its deposits from a deposit insurance corporation.  The deposits of WaterStone Bank are insured up to the applicable limits by the FDIC.





Federal Law and Regulation.  WaterStone Bank is a member of the DIF, which is administered by the FDIC.  The Bank’s deposit accounts are insured by the FDIC, generally up to a maximum of $250,000.  In addition, noninterest-bearing transaction accounts are fully insured regardless of the dollar amount until December 31, 2012.




The FDIC imposes an assessment against all depository institutions.    On February 27, 2009 the FDIC issued a final rule that alters the way the FDIC calculates federal deposit insurance assessment rates beginning in the second quarter of 2009 and thereafter. Under the rule, the FDIC first establishes an institution’s initial base assessment rate.  This initial base assessment rate ranges, depending on the risk category of the institution, form 12 to 45 basis points.  The FDIC then adjusts the initial base assessment (higher or lower) to obtain the total base assessment rate.  The adjustments to the initial base assessment rate are based upon an institution’s levels of unsecured debt, secured liabilities, and brokered deposits.  The total base assessment rate ranges from 7 to 77.5 basis points of the institution’s deposits.




On February 7, 2011, the FDIC approved a final rule that changes the FDIC insurance premium assessment base from domestic deposits to average assets minus average tangible equity.  The rule lowers overall assessment rates in order to generate the same approximate amount of revenue under the new larger base as was raised under the old base.  The assessment rates in total would be between 2.5 and 9 basis points on the broader base for banks in the lowest risk category, and 30 to 45 basis points for banks in the highest risk category.  These changes will go into effect beginning with the second quarter of 2011 and will be payable at the end of September 2011.




The FDIC issued an interim rule that provided for a special assessment to be collected on September 30, 2009, based on June 30, 2009, Call Report data. The special assessment increased the Bank’s FDIC premium expense by $876,000 in 2009.  On November 12, 2009, the FDIC issued a rule requiring all depository institutions to prepay their estimated assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012.  Under the rule, this prepayment was due on December 31, 2009.  The assessment rate for the fourth quarter of 2009 and for 2010 was based on each institution’s total base assessment rate for the third quarter of 2009, modified to assume that the assessment rate in effect on September 30, 2009 had been in effect for the entire third quarter, and the assessment rate for 2011 and 2012 would be equal to the modified third quarter assessment rate plus an additional 3 basis points.  In addition, each institution’s base assessment rate for each period was calculated using its third quarter assessment base, adjusted quarterly for an estimated 5% annual growth rate in the assessment base through the end of 2012.  WaterStone Bank received a waiver from the FDIC relative to the 2010, 2011 and 2012 prepayment.





Insurance of deposits may be terminated by the FDIC upon a finding that an institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC. We do not know of any practice, condition or violation that might lead to termination of deposit insurance.







In addition to the FDIC assessments, the Financing Corporation (FICO) is authorized to impose and collect, with the approval of the Federal Deposit Insurance Corporation, assessments for anticipated payments, issuance costs and custodial fees on bonds issued by the FICO in the 1980s to recapitalize the former Federal Savings and Loan Insurance Corporation. The bonds issued by the FICO are due to mature in 2017 through 2019. For the quarter ended December 31, 2010, the annualized FICO assessment was equal to 1.04 basis points for each $100 in domestic deposits maintained at an institution.




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Capitalization





Wisconsin Law and Regulation.  Wisconsin savings banks are required to maintain a minimum capital to assets ratio of 6% and must maintain total capital necessary to ensure the continuation of insurance of deposit accounts by the FDIC. If the WDFI determines that the financial condition, history, management or earning prospects of a savings bank are not adequate, the WDFI may require a higher minimum capital level for the savings bank.   If a Wisconsin savings bank's capital ratio falls below the required level, the WDFI may direct the savings bank to adhere to a specific written plan established by the WDFI to correct the savings bank's capital deficiency, as well as a number of other restrictions on the savings bank's operations, including a prohibition on the declaration of dividends. At December 31, 2010 and 2009, WaterStone Bank’s capital to assets ratio, as calculated under Wisconsin law, was 9.12% and 8.86%, respectively.





Federal Law and Regulation.  Under FDIC regulations, federally insured state-chartered banks that are not members of the Federal Reserve System ("state non-member banks"), such as WaterStone Bank, are required to comply with minimum capital requirements.  For an institution determined by the FDIC to not be anticipating or experiencing significant growth and to be, in general, a strong banking organization, rated composite 1 under the Uniform Financial Institutions Ranking System established by the Federal Financial Institutions Examination Council, the minimum Tier I leverage capital to total assets ratio is 3%.  For all other institutions, the minimum leverage capital ratio is not less than 4%.  Tier I leverage capital is the sum of common shareholders' equity, non-cumulative perpetual preferred stock (including any related surplus) and minority investments in certain subsidiaries, less intangible assets (except for certain servicing rights and credit card relationships) and certain other specified items.





The FDIC regulations require state non-member banks to maintain certain levels of regulatory capital in relation to regulatory risk-weighted assets.  The ratio of regulatory capital to regulatory risk-weighted assets is referred to as a bank's "risk-based capital ratio."  Risk-based capital ratios are determined by allocating assets and specified off-balance sheet items (including recourse obligations, direct credit substitutes and residual interests) to four risk-weighted categories ranging from 0% to 100%, with higher levels of capital being required for the categories perceived as representing greater risk.  For example, under the FDIC's risk-weighting system, cash and securities backed by the full faith and credit of the U.S. government are given a 0% risk weight, loans secured by one-to-four family residential properties generally have a 50%risk weight, and commercial loans have a risk weighting of 100%.





State non-member banks, such as WaterStone Bank, must maintain a minimum ratio of total capital to risk-weighted assets of at least 8%, of which at least one-half must be Tier I capital.  Total capital consists of Tier I capital plus Tier 2 or supplementary capital items, which include allowances for loan losses in an amount of up to 1.25% of risk-weighted assets, cumulative preferred stock and certain other capital instruments, and a portion of the net unrealized gain on equity securities.  The includable amount of Tier 2 capital cannot exceed the amount of the institution's Tier I capital.  Banks that engage in specified levels of trading activities are subject to adjustments in their risk based capital calculation to ensure the maintenance of sufficient capital to support market risk.





The FDIC, along with the other federal banking agencies, has adopted a regulation providing that the agencies will take into account the exposure of a bank's capital and economic value to changes in interest rate risk in assessing a bank's capital adequacy.  The FDIC also has authority to establish individual minimum capital requirements in appropriate cases upon a determination that an institution's capital level is, or is likely to become, inadequate in light of the particular circumstances.  As such, in connection with a consent order effective December 18, 2009, federal and state regulators require that WaterStone Bank maintain a minimum Tier I capital ratio of 8.50% and a minimum total risk-based capital ratio of 12.00%.  WaterStone Bank was in compliance with the higher regulatory minimums at December 31, 2010 with a Tier I capital ratio of 8.83% and a total risk-based capital ratio of 14.13%.





Unlike bank holding companies, savings and loan holding companies are not currently subject to specific regulatory capital requirements.  The Dodd-Frank Act, however, requires the Federal Reserve Board to promulgate consolidated capital requirements for depository institution holding companies that are no less stringent, both quantitatively and in terms of components of capital, than those applicable to institutions themselves.  That will eliminate the inclusion of certain instruments from tier 1 capital, such as trust preferred securities, that are currently includable for bank holding companies.  Instruments issued by mutual holding companies by May 9, 2010, are grandfathered.  There is a five year transition period from the July 21, 2010 date of enactment of the Dodd-Frank Act before the capital requirements will apply to savings and loan holding companies.





The Dodd-Frank Act also extends the “source of strength” doctrine to savings and loan holding companies.  The regulatory agencies must promulgate regulations implementing the “source of strength” policy that requires holding companies act as a source of strength to their subsidiary depository institutions by providing capital, liquidity and other support in times of financial stress.




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Safety and Soundness Standards





Each federal banking agency, including the FDIC, has adopted guidelines establishing general standards relating to internal controls, information and internal audit systems, loan documentation, credit underwriting, interest rate exposure, asset growth, asset quality, earnings and compensation, fees and benefits. In general, the guidelines require, among other things, appropriate systems and practices to identify and manage the risks and exposures specified in the guidelines. The guidelines prohibit excessive compensation as an unsafe and unsound practice and describe compensation as excessive when the amounts paid are unreasonable or disproportionate to the services performed by an executive officer, employee, director, or principal shareholder.





Prompt Corrective Regulatory Action





The Federal Deposit Insurance Corporation Improvement Act requires, among other things, that federal bank regulatory authorities take “prompt corrective action” with respect to institutions that do not meet minimum capital requirements. For these purposes, the statute establishes five capital categories: well capitalized, adequately capitalized, undercapitalized, significantly undercapitalized, and critically undercapitalized.  Under the regulations, a bank shall be deemed to be (i) “well capitalized” if it has total risk-based capital of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a Tier I leverage capital ratio of 5.0% or more and is not subject to any written capital order or directive; (ii) “adequately capitalized” if it has a total risk-based capital ratio of 8.0% or more, a Tier I risk-based capital ratio of 4.0% or more and a Tier I leveraged capital ratio of 4.0% or more (3.0% under certain circumstance) and does not meet the definition of “well capitalized”; (iii) “undercapitalized” if it has a total risk-based capital ratio that is less than 8.0%, a Tier I risk-based capital ratio that is less than 4.0% or a Tier I leverage capital ratio that is less than 4.0% (3.0% under certain circumstances); (iv) “significantly undercapitalized” if it has a total risk-based capital ratio that is less than 6.0%, a Tier I risk-based capital ratio that is less than 3.0%; and (v) “critically undercapitalized” if it has a ratio of tangible equity to total assets that is equal to or less than 2.0%.  Federal law and regulations also specify circumstances under which a federal banking agency may reclassify a well capitalized institution as adequately capitalized and may require an adequately capitalized institution to comply with supervisory actions as if it were in the next lower category (except that the FDIC may not reclassify a significantly undercapitalized institution as critically undercapitalized).





The Federal Deposit Insurance Corporation may order savings banks which have insufficient capital to take corrective actions. For example, a savings bank which is categorized as “undercapitalized” would be subject to growth limitations and would be required to submit a capital restoration plan, and a holding company that controls such a savings bank would be required to guarantee that the savings bank complies with the restoration plan. A “significantly undercapitalized” savings bank would be subject to additional restrictions. Savings banks deemed by the Federal Deposit Insurance Corporation to be “critically undercapitalized” would be subject to the appointment of a receiver or conservator.





At December 31, 2010, WaterStone Bank was considered well-capitalized with a Tier 1 leverage ratio of 8.83%, a Tier 1 risk-based ratio of 12.87% and a total risk based capital ratio of 14.13%.







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Regulatory Development





On November 25, 2009, pursuant to a Stipulation and Consent to the Issuance of a Consent Order (Stipulations”), WaterStone Bank agreed to the issuance of a Consent Order jointly issued by the FDIC and the WDFI, the Bank’s primary banking regulators.  At the same time, pursuant to a Stipulation and Consent to Issuance of Order to Cease and Desist, Waterstone Financial, Inc. agreed to the issuance of an Order to Cease and Desist by the Office of Thrift Supervision (“OTS”), the Company’s thrift holding company regulator.  Collectively, the Stipulation and Consent to the Issuance of a Consent Order which became effective on December 18, 2009 and the Stipulation and Consent to Issuance of Order to Cease and Desist which became effective on December 1, 2009 are referred to as the “Orders”.





The Orders formalize a prior informal agreement entered into by the Bank, the FDIC and the WDFI in 2008.  The Bank and its federal and state regulators have been working in concert for the past two years to minimize the effects that the recession is having on the Bank and its borrowers.  The Orders require, among other things, that the Bank (i) maintain minimum Tier 1 capital of 8.5% of total average assets and minimum total risk-based capital of 12.0% of risk-weighted assts; (ii) perform a study to confirm that the Bank is a well managed institution; (iii) manage its bad loans and real estate acquired in foreclosure; and (iv) adopt a two year capital plan.  The Orders prohibit the payment of cash dividends or repurchases of common stock, and restrict the ability of the Company to incur debt, in each case without the prior non-objection of the OTS.  Failure to comply with the Orders could result in additional enforcement actions by the FDIC, the WDFI or the OTS.  Compliance with the Orders may have adverse effects on the operations and financial condition of the Company and the Bank.








Dividends





Under Wisconsin law and applicable regulations, a Wisconsin savings bank that meets its regulatory capital requirement may declare dividends on capital stock based upon net profits, provided that its paid-in surplus equals its capital stock.  If the paid-in surplus of the savings bank does not equal its capital stock, the board of directors may not declare a dividend unless at least 10% of the net profits of the preceding half year, in the case of quarterly or semi-annual dividends, or 10% of the net profits of the preceding year, in the case of annual dividends, has been transferred to paid-in surplus. In addition, prior WDFI approval is required before dividends exceeding 50% of profits for any calendar year may be declared and before a dividend may be declared out of retained earnings.  Under WDFI regulations, a Wisconsin savings bank which has converted from mutual to stock form also is prohibited from paying a dividend on its capital stock if the payment causes the regulatory capital of the savings bank to fall below the amount required for its liquidation account.  A consent order issued by state and federal regulators effective December 18, 2009 prohibits the Bank from paying dividends without the written consent of the WDFI and the FDIC.





The primary source of Waterstone Financial’s cash flow, including cash flow to pay dividends on Waterstone Financial’s Common Stock, is the payment of dividends to Waterstone Financial by WaterStone Bank.  The Federal Deposit Insurance Corporation has the authority to prohibit WaterStone Bank from paying dividends if, in its opinion, the payment of dividends would constitute an unsafe or unsound practice in light of the financial condition of WaterStone Bank.  In addition, since WaterStone Bank is a subsidiary of a savings and loan holding company, WaterStone Bank must file a notice with the Office of Thrift Supervision at least 30 days before the board declares a dividend or approves a capital distribution.  A cease and desist order issued by the Office of Thrift Supervision consistent with the consent order issued by state and federal regulators of WaterStone Bank, prohibits dividend payments without the written approval of the Office of Thrift Supervision.





The Dodd-Frank Act addressed the issue of dividend waivers in the context of the transfer of the supervision of savings and loan holding companies from the Office of Thrift Supervision to the Federal Reserve Board.  The Dodd-Frank Act specified that dividends may be waived if certain conditions are met, including that the Federal Reserve Board does not object after being given written notice of the dividend and proposed waiver.  The Dodd-Frank Act indicates that the Federal Reserve Board may not object to such a waiver (i) if the mutual holding company involved has, prior to December 1, 2009, reorganized into a mutual holding company structure, engaged in a minority stock offering and waived dividends; (ii) the board of directors of the mutual holding company expressly determines that a waiver of the dividend is consistent with its fiduciary duties to members and (iii) the waiver would not be detrimental to the safe and sound operation of the savings association subsidiaries of the holding company.  The Federal Reserve Board has not previously permitted dividend waivers by mutual bank holding companies and may object to dividend waivers involving mutual savings and loan holding companies, notwithstanding the referenced language in the Dodd-Frank Act.  Lamplight Financial, MHC was formed, engaged in a minority stock offering (through Waterstone Financial.) and waived dividends prior to December 1, 2009.






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Liquidity and Reserves





Wisconsin Law and Regulation.Under WDFI regulations, all Wisconsin savings banks are required to maintain a certain amount of their assets as liquid assets, consisting of cash and certain types of investments.  The exact amount of assets a savings bank is required to maintain as liquid assets is set by the WDFI, but generally ranges from 4% to 15% of the saving bank’s average daily balance of net withdrawable accounts plus short-term borrowings (the “Required Liquidity Ratio”).  At December 31, 2010, WaterStone Bank’s Required Liquidity Ratio was 8.0%, and WaterStone Bank was in compliance with this requirement.  In addition, 50% of the liquid assets maintained by Wisconsin savings banks must consist of “primary liquid assets,” which are defined to include securities issued by the United States government and United States government agencies.  At December 31, 2010, WaterStone Bank was in compliance with this requirement.





Federal Law and Regulation.   Under federal law and regulations, WaterStone Bank is required to maintain sufficient liquidity to ensure safe and sound banking practices.  Regulation D, promulgated by the FRB, imposes reserve requirements on all depository institutions, including WaterStone Bank, which maintain transaction accounts or non-personal time deposits.  Checking accounts, NOW accounts, Super NOW checking accounts, and certain other types of accounts that permit payments or transfers to third parties fall within the definition of transaction accounts and are subject to Regulation D reserve requirements, as are any non-personal time deposits (including certain money market deposit accounts) at a savings institution. For 2010, a depository institution was required to maintain average daily reserves equal to 3% on the first $58.8 million of transaction accounts and an initial reserve of $1.4 million, plus 10% of that portion of total transaction accounts in excess of $58.8 million. The first $10.7 million of otherwise reservable balances (subject to adjustment by the FRB) are exempt from the reserve requirements.  These percentages and threshold limits are subject to adjustment by the FRB.  Savings institutions have authority to borrow from the Federal Reserve’s “discount window,” but Federal Reserve policy generally requires savings institutions to exhaust all other sources before borrowing from the Federal Reserve.  As of December 31, 2010, WaterStone Bank met its Regulation D reserve requirements.





Transactions with Affiliates and Insiders





Wisconsin Law and Regulation.  Under Wisconsin law, WaterStone Bank may not make a loan to a person owning 10% or more of its stock, an affiliated person, agent, or attorney of the savings bank, either individually or as an agent or partner of another, except as approved by the WDFI and regulations of the FDIC.  In addition, unless the prior approval of the WDFI is obtained, WaterStone Bank may not purchase, lease or acquire a site for an office building or an interest in real estate from an affiliated person, including a shareholder owning more than 10% of its capital stock, or from any firm, corporation, entity or family in which an affiliated person or 10% shareholder has a direct or indirect interest.





Federal Law and Regulation.Sections 23A and 23B of the Federal Reserve Act govern transactions between an insured savings bank, such as WaterStone Bank, and any of its affiliates, including Waterstone Financial.  The Federal Reserve Board has adopted Regulation W, which comprehensively implements and interprets Sections 23A and 23B, in part by codifying prior Federal Reserve Board interpretations under Sections 23A and 23B.





An affiliate of a bank is any company or entity that controls, is controlled by or is under common control with the bank. A subsidiary of a bank that is not also a depository institution or a “financial subsidiary” under federal law is not treated as an affiliate of the bank for the purposes of Sections 23A and 23B; however, the FDIC has the discretion to treat subsidiaries of a bank as affiliates on a case-by-case basis. Sections 23A and 23B limit the extent to which a bank or its subsidiaries may engage in “covered transactions” with any one affiliate to an amount equal to 10% of such bank’s capital stock and surplus, and limit all such transactions with all affiliates to an amount equal to 20% of such capital stock and surplus.   The statutory sections also require that all such transactions be on terms that are consistent with safe and sound banking practices. The term “covered transaction” includes the making of loans, purchase of assets, issuance of guarantees and other similar types of transactions.   Further, most loans by a bank to any of its affiliates must be secured by collateral in amounts ranging from 100% to 130% of the loan amounts.   In addition, any covered transaction by an association with an affiliate and any purchase of assets or services by an association from an affiliate must be on terms that are substantially the same, or at least as favorable, to the bank as those that would be provided to a non-affiliate.






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A savings bank’s loans to its executive officers, directors, any owner of more than 10% of its stock (each, an insider) and any of certain entities affiliated with any such person (an insider’s related interest) are subject to the conditions and limitations imposed by Section 22(h) of the Federal Reserve Act and the FRB’s Regulation O thereunder.  Under these restrictions, the aggregate amount of the loans to any insider and the insider’s related interests may not exceed the loans-to-one-borrower limit applicable to national banks, which is comparable to the loans-to-one-borrower limit applicable to WaterStone Bank’s loans. All loans by a savings bank to all insiders and insiders’ related interests in the aggregate may not exceed the bank’s unimpaired capital and unimpaired surplus. With certain exceptions, loans to an executive officer, other than loans for the education of the officer’s children and certain loans secured by the officer’s residence, may not exceed the greater of $25,000 or 2.5% of the savings bank’s unimpaired capital and unimpaired surplus, but in no event more than $100,000. Regulation O also requires that any proposed loan to an insider or a related interest of that insider be approved in advance by a majority of the board of directors of the savings bank, with any interested director not participating in the voting, if such loan, when aggregated with any existing loans to that insider and the insider’s related interests, would exceed either $500,000 or the greater of $25,000 or 5% of the savings bank’s unimpaired capital and surplus.  Generally, such loans must be made on substantially the same terms as, and follow credit underwriting procedures that are no less stringent than, those that are prevailing at the time for comparable transactions with other persons and must not present more than a normal risk of collectibility.





An exception is made for extensions of credit made pursuant to a benefit or compensation plan of a bank that is widely available to employees of the savings bank and that does not give any preference to insiders of the bank over other employees of the bank.





Consistent with these requirements, the Bank offered employees special terms for home mortgage loans on their principal residences.  Effective April 1, 2006, this program was discontinued for new loan originations.  Under the terms of the discontinued program, the employee interest rate is based on the Bank’s cost of funds on December 31 of the immediately preceding year and is adjusted annually.  At December 31, 2010, the rate of interest on an employee rate mortgage loan was 2.71%, compared to the weighted average rate of 5.94% on all single family mortgage loans.  This rate decreased to 2.16% effective March 1, 2011.  Employee rate mortgage loans totaled $4.4 million, or 0.4%, of our residential mortgage loan portfolio on December 31, 2010.








Transactions between Bank Customers and Affiliates





Under Wisconsin and federal laws and regulations, Wisconsin savings banks, such as WaterStone Bank, are subject to the prohibitions on certain tying arrangements.  A savings bank is prohibited, subject to certain exceptions, from extending credit to or offering any other service to a customer, or fixing or varying the consideration for such extension of credit or service, on the condition that such customer obtain some additional service from the institution or certain of its affiliates or not obtain services of a competitor of the institution.





Examinations and Assessments





WaterStone Bank is required to file periodic reports with and is subject to periodic examinations by the WDFI and FDIC.   Federal regulations require annual on-site examinations for all depository institutions except those well-capitalized institutions with assets of less than $100 million; annual audits by independent public accountants for all insured institutions with assets in excess of $1 billion; the formation of independent audit committees of the boards of directors of insured depository institutions for institutions with assets of $500 million or more; and management of depository institutions to prepare certain financial reports annually and to establish internal compliance procedures.  WaterStone Bank is required to pay examination fees and annual assessments to fund its supervision.  WaterStone Bank paid an aggregate of $101,000 in assessments for the calendar year ended December 31, 2010.




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Customer Privacy





Under Wisconsin and federal law and regulations, savings banks, such as WaterStone Bank, are required to develop and maintain privacy policies relating to information on its customers, restrict access to and establish procedures to protect customer data.  Applicable privacy regulations further restrict the sharing of non-public customer data with non-affiliated parties if the customer requests.





Community Reinvestment Act





Under the Community Reinvestment Act (“CRA”), WaterStone Bank has a continuing and affirmative obligation consistent with its safe and sound operation to help meet the credit needs of its entire community, including low and moderate income neighborhoods. The CRA does not establish specific lending requirements or programs for financial institutions nor does it limit an institution’s discretion to develop the types of products and services that it believes are best suited to its particular community, consistent with the CRA. The CRA requires the Federal Deposit Insurance Corporation in connection with its examination of WaterStone Bank, to assess its record of meeting the credit needs of its community and to take that record into account in its evaluation of certain applications by WaterStone Bank. For example, the regulations specify that a bank’s CRA performance will be considered in its expansion (e.g., branching) proposals and may be the basis for approving, denying or conditioning the approval of an application. As of the date of its most recent regulatory examination, WaterStone Bank was rated “satisfactory” with respect to its CRA compliance.





Federal Home Loan Bank System





The Federal Home Loan Bank System, consisting of twelve FHLBCs, is under the jurisdiction of the Federal Housing Finance Board ("FHFB"). The designated duties of the FHFB are to supervise the FHLBCs; ensure that the FHLBCs carry out their housing finance mission; ensure that the FHLBCs remain adequately capitalized and able to raise funds in the capital markets; and ensure that the FHLBCs operate in a safe and sound manner.





WaterStone Bank, as a member of the FHLBC-Chicago, is required to acquire and hold shares of capital stock in the FHLBC-Chicago in an amount equal to the greater of (i) 1% of the aggregate outstanding principal amount of residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, or (ii) 0.3% of total assets. WaterStone Bank is in compliance with this requirement with an investment in FHLBC-Chicago stock of $21.7 million at December 31, 2010.  Potential risks identified with respect to the Company’s investment in FHLBC-Chicago stock is addressed in Item 1A. Risk Factors.





Among other benefits, the FHLBCs provide a central credit facility primarily for member institutions. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLBC System. It makes advances to members in accordance with policies and procedures established by the FHFB and the board of directors of the FHLBC-Chicago. At December 31, 2010, WaterStone Bank had $350.0 million in advances from the FHLBC-Chicago.






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USA PATRIOT  Act




The USA PATRIOT Act of 2001 gave the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing and broadened anti-money laundering requirements.  The USA PATRIOT Act also required the federal banking agencies to take into consideration the effectiveness of controls designed to combat money laundering activities in determining whether to approve a merger or other acquisition application of a member institution.  Accordingly, if we engage in a merger or other acquisition, our controls designed to combat money laundering would be considered as part of the application process.  We have established policies, procedures and systems designed to comply with these regulations.





Dodd-Frank Act




The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”) made extensive changes in the regulation of insured depository institution.  Under the Dodd-Frank Act, the Office of Thrift Supervision will be eliminated.  Responsibility for the supervision and regulation of federal savings banks will be transferred to the Office of the Comptroller of the Currency, which is the agency that is currently primarily responsible for the regulation and supervision of national banks.  The transfer of regulatory functions will take place over a transition period of up to one year from the Dodd-Frank Act enactment date of July 21, 2010, subject to a possible six-month extension.  At the same time, responsibility for the regulation and supervision of savings and loan holding companies, such as Lamplighter Financial and Waterstone Financial, will be transferred to the Federal Reserve Board, which currently supervises bank holding companies.




Additionally, the Dodd-Frank Act creates a new Consumer Financial Protection Bureau as an independent bureau of the Federal Reserve Board.  The Consumer Financial Protection Bureau will assume responsibility for the implementation of the federal financial consumer protection and fair lending laws and regulations, a function currently assigned to prudential regulators, and will have authority to impose new requirements.  However, institutions of less than $10 billion in assets, such as the Bank, will continue to be examined for compliance with consumer protection and fair lending laws and regulations by, and be subject to the primary enforcement authority of, their prudential regulator rather than the Consumer Financial Protection Bureau.




In addition to eliminating the Office of Thrift Supervision and creating the Consumer Financial Protection Bureau, the Dodd-Frank Act, among other things, directs changes in the way that institutions are assessed for deposit insurance, mandates the imposition of consolidated capital requirements on savings and loan holding companies, requires originators of securitized loans to retain a percentage of the risk for the transferred loans, regulatory rate-setting for certain debit card interchange fees, repeals restrictions on the payment of interest on commercial demand deposits and contains a number of reforms related to mortgage originations.  Many of the provisions of the Dodd-Frank Act are subject to delayed effective dates and/or require the issuance of implementing regulations.  Their impact on operations can not yet be fully assessed.  However, there is a significant possibility that the Dodd-Frank Act will, at a minimum, result in increased regulatory burden, compliance costs and interest expense for Waterstone Bank, Lamplighter Financial and Waterstone Financial.






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Regulation of Waterstone Financial





Holding Company Regulation





Wisconsin Law and Regulation. Any company that owns or controls, directly or indirectly, more than 25% of the voting securities of a state savings bank is subject to regulation as a savings bank holding company by the WDFI.   Waterstone Financial is subject to regulation as a savings bank holding company under Wisconsin law.  However, the WDFI has not yet issued specific regulations governing savings bank holding companies.





Federal Law and Regulation. Lamplighter Financial and Waterstone Financial are non-diversified savings and loan holding companies within the meaning of the Home Owners’ Loan Act.  They are registered with and regulated by the Office of Thrift Supervision.  Pursuant to Section 10(o) of the Home Owners’ Loan Act and Office of Thrift Supervision regulations and policy, a mutual holding company, such as Lamplighter Financial, MHC and a federally chartered mid-tier holding company, such as Waterstone Financial may engage in the following activities: (i) investing in the stock of a savings bank, (ii) acquiring a mutual savings bank through the merger of such savings bank into a savings bank subsidiary of such holding company or an interim savings bank subsidiary of such holding company, (iii) merging with or acquiring another holding company, one of whose subsidiaries is a savings bank, (iv) investing in a corporation, the capital stock of which is available for purchase by a savings bank under federal law or under the law of any state where the subsidiary savings bank or savings banks share their home offices, (v) furnishing or performing management services for a savings bank subsidiary of such company, (vi) holding, managing or liquidating assets owned or acquired from a savings subsidiary of such company, (vii) holding or managing properties used or occupied by a savings bank subsidiary of such company, (viii) acting as trustee under deeds of trust, (ix) any other activity (A) that the Federal Reserve Board, by regulation, has determined to be permissible for bank holding companies under Section 4(c) of the Bank Holding Company Act of 1956, unless the Director, by regulation, prohibits or limits any such activity for savings and loan holding companies; or (B) in which multiple savings and loan holding companies were authorized (by regulation) to directly engage on March 5, 1987, (x) any activity permissible for financial holding companies under Section 4(k) of the Bank Holding Company Act, including securities and insurance underwriting, and (xi) purchasing, holding, or disposing of stock acquired in connection with a qualified stock issuance if the purchase of such stock by such savings and loan holding company is approved by the Director of the Office of Thrift Supervision.  If a mutual holding company acquires or merges with another holding company, the holding company acquired or the holding company resulting from such merger or acquisition may only invest in assets and engage in activities listed in (i) through (xi) above, and has a period of two years to cease any nonconforming activities and divest of any nonconforming investments.





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





The Office of Thrift Supervision is prohibited from approving any acquisition that would result in a multiple savings and loan holding company controlling savings institutions in more than one state, subject to two exceptions: (i) the approval of interstate supervisory acquisitions by savings and loan holding companies, and (ii) the acquisition of a savings institution in another state if the laws of the state of the target savings institution specifically permit such acquisitions.





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Waivers of Dividends by Lamplighter Financial, MHC





Office of Thrift Supervision regulations require Lamplighter Financial, MHC to notify the Office of Thrift Supervision of any proposed waiver of its receipt of dividends from Waterstone Financial.  The Office of Thrift Supervision reviews dividend waiver notices on a case-by-case basis, and, in general, does not object to any such waiver if: the waiver would not be detrimental to the safe and sound operation of the subsidiary savings bank; and the mutual holding company’s board of directors determines that such waiver is consistent with such directors’ fiduciary duties to the mutual holding company’s depositors.  We anticipate that Lamplighter Financial, MHC will waive any dividends paid by Waterstone Financial.  As long as WaterStone Bank remains a Wisconsin chartered savings bank, (i) any dividends waived by Lamplighter Financial, MHC must be retained by Waterstone Financial or WaterStone Bank and segregated, earmarked, or otherwise identified on the books and records of Waterstone Financial or WaterStone Bank, (ii) such amounts must be taken into account in any valuation of the institution, and factored into the calculation used in establishing a fair and reasonable basis for exchanging shares in any subsequent conversion of Lamplighter Financial, MHC to stock form, and (iii) such amounts shall not be available for payment to, or the value thereof transferred to, minority shareholders, by any means, including through dividend payments or at liquidation.





Conversion of Lamplighter Financial, MHC to Stock Form





Office of Thrift Supervision regulations permit Lamplighter Financial, MHC to convert from the mutual form of organization to the capital stock form of organization (a “Conversion Transaction”).  There can be no assurance when, if ever, a Conversion Transaction will occur, and the board of directors has no current intention or plan to undertake a Conversion Transaction.  In a Conversion Transaction a new holding company would be formed as the successor to Waterstone Financial (the “New Holding Company”), Lamplighter Financial, MHC’s corporate existence would end, and certain depositors of WaterStone Bank would receive the right to subscribe for shares of the New Holding Company.  In a Conversion Transaction, each share of common stock held by shareholders other than Lamplighter Financial, MHC  (“Minority Shareholders”) would be automatically converted into a number of shares of common stock of the New Holding Company determined pursuant to an exchange ratio that ensures that Minority Shareholders own the same percentage of common stock in the New Holding Company as they owned in Waterstone Financial immediately prior to the Conversion Transaction subject to adjustment for any mutual holding company assets or waived dividends, as applicable.  The total number of shares of common stock held by Minority Shareholders after a Conversion Transaction also would be increased by any purchases by Minority Shareholders in the stock offering conducted as part of the Conversion Transaction.





Any Conversion Transaction would require the approval of a majority of the outstanding shares of common stock of Waterstone Financial held by Minority Shareholders and by two thirds of the total outstanding shares of common stock of Waterstone Financial.  Any Conversion Transaction also would require the approval of a majority of the eligible votes of depositors of Lamplighter Financial, MHC.





Federal Securities Laws Regulation




Securities Exchange Act.  Waterstone Financial common stock is registered with the Securities and Exchange Commission under the Securities Exchange Act of 1934. The Company is therefore subject to the information, proxy solicitation, insider trading restrictions and other requirements under the Securities Exchange Act.




Sarbanes-Oxley Act of 2002.    The Sarbanes-Oxley Act of 2002 was adopted in response to public concerns regarding corporate accountability and oversight.  The Sarbanes-Oxley Act is intended to improve corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.






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Federal and State Taxation





Federal Taxation





General.Waterstone Financial and subsidiaries and Lamplighter Financial, MHC are subject to federal income taxation in the same general manner as other corporations, with some exceptions discussed below.  Waterstone Financial and subsidiaries constitute an affiliated group of corporations and, therefore, are be eligible to report their income on a consolidated basis.  Because Lamplighter Financial, MHC owns less than 80% of the common stock of Waterstone Financial, it is not a member of that affiliated group and will report its income on a separate return.  The following discussion of federal taxation is intended only to summarize certain pertinent federal income tax matters and is not a comprehensive description of the tax rules applicable to Lamplighter Financial, MHC, Waterstone Financial or WaterStone Bank.




Method of Accounting.For federal income tax purposes, Waterstone Financial currently reports its income and expenses on the accrual method of accounting and uses a tax year ending December 31 for filing its federal income tax returns.




Bad Debt Reserves.Prior to the Small Business Protection Act of 1996 (the "1996 Act"), WaterStone Bank was permitted to establish a reserve for bad debts and to make annual additions to the reserve.  These additions could, within specified formula limits, be deducted in arriving at our taxable income.  As a result of the 1996 Act, WaterStone Bank was required to use the specific charge-off method in computing its bad debt deduction beginning with its 1996 federal tax return.  Savings institutions were required to recapture any excess reserves over those established as of December 31, 1987 (base year reserve).  At December 31, 2010, WaterStone Bank had no reserves subject to recapture in excess of its base year.




Taxable Distributions and Recapture.Prior to the 1996 Act, bad debt reserves created prior to January 1, 1988 were subject to recapture into taxable income if WaterStone Bank failed to meet certain thrift asset and definitional tests.  Federal legislation has eliminated these thrift-related recapture rules. At December 31, 2010, our total federal pre-1988 base year reserve was approximately $16.7 million.  However, under current law, pre-1988 base year reserves remain subject to recapture if WaterStone Bank makes certain non-dividend distributions, repurchases any of its stock, pays dividends in excess of tax earnings and profits, or ceases to maintain a bank charter.




Alternative Minimum Tax.The Internal Revenue Code of 1986, as amended (the "Code"), imposes an alternative minimum tax ("AMT") at a rate of 20% on a base of regular taxable income plus certain tax preferences which we refer to as "alternative minimum taxable income."  The AMT is payable to the extent such alternative minimum taxable income is in excess of an exemption amount and the AMT exceeds the regular income tax.  Net operating losses can offset no more than 90% of alternative minimum taxable income.  AMT payments may be used as credits against regular tax liabilities in future years.  Due to a federal net operating loss carry back generated in 2008, Waterstone Financial became subject to AMT for 2006 and 2007.  At December 31, 2010, the Company had no such amounts available as credits for carryover.




Net Operating Loss Carryovers.A company may carry back net operating losses to the preceding two taxable years and forward to the succeeding 20 taxable years.  A 2009 federal tax law change allows for a one-time carry back of either 2008 or 2009 taxable losses for up to five years.  At December 31, 2010, Waterstone Financial had net operating loss carry forwards of $1.8 million for federal income tax purposes.




Corporate Dividends-Received Deduction.Waterstone Financial may exclude from its income 100% of dividends received from WaterStone Bank as a member of the same affiliated group of corporations.  The corporate dividends-received deduction is 80% in the case of dividends received from corporations with which a corporate recipient does not file a consolidated tax return, and corporations that 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.




State Taxation





Wisconsin State Taxation.Lamplighter Financial, MHC and the Company are subject to the Wisconsin corporate franchise (income) tax.  Under current law, the state of Wisconsin imposes a corporate franchise tax of 7.9% on the combined taxable incomes of the members of our consolidated income tax group.  Prior to January 1, 2009, the income of the Nevada subsidiary was only subject to taxation in Nevada, which currently does not impose a corporate income or franchise tax.  In February 2009, the Wisconsin legislature passed legislation that requires combined state tax reporting effective January 1, 2009.  This legislation results in the income of the Nevada subsidiary being subject to the Wisconsin corporate franchise tax of 7.9%.




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Item 1A.   Risk Factors





The Company Operates in a Highly Regulated Environment and is Subject to Supervision, Examination and Enforcement Action by Various Regulatory Agencies.




As a savings bank holding company, the Company is regulated by the Office of Thrift Supervision, and the Bank is regulated separately by various federal and state banking regulators.  This regulation is primarily intended to protect the Bank’s depositors rather than the Company’s shareholders.  In addition, the Company’s common stock is registered under the Securities Exchange Act and it is subject to regulation by the Securities and Exchange Commission and to public reporting requirements.  As a result of the Dodd-Frank Act, the Company will be regulated by the Federal Reserve upon the sunset of the Office of Thrift Supervision.




Under applicable laws, the Office of Thrift Supervision, the FDIC, as the Bank’s primary federal regulator and deposit insurer, and the Wisconsin Department of Financial Institutions as the Bank’s chartering authority, have the ability to impose sanctions, restrictions and requirements on the Company and on the Bank if they determine, the Bank or the Company has violated laws or regulations or are not operating in a safe and sound manner.  Banking regulators can take actions at any time that may have an adverse impact on the Company and on the Bank.  On November 25, 2009, Bank agreed to a Consent Order issued by the WDFI and FDIC and the Company agreed to a Cease and Desist Order issued by the OTS, requiring among other things, the bank to maintain a minimum Tier I capital ratio of 8.5%, a minimum total risk based capital of 12.0%, and prohibiting dividend payments without written regulatory approval.  As a result of the Consent Order the bank is subject to restrictions regarding the maximum interest rates that it may offer on deposits.  As of December 31, 2010, the Company and the Bank were in compliance with all requirements of the regulatory orders issued.  Noncompliance can result in more severe restrictions and civil money penalties.  Complete copies of the regulatory orders were attached as exhibits to a Form 8-K filed with the SEC on November 27, 2009.




Challenges Posed bythe Weak Economy and Distressed Real Estate Market.




The Company is operating in a difficult and uncertain economic environment characterized by high unemployment rates, a weak real estate market and a weak economy.  As a result, capital raising alternatives, such as issuing common or preferred stock or borrowing funds at attractive rates are generally not available.  Sales of either fixed assets or pools of loans to increase capital ratios may also have a negative impact on the Company.  The economic recession and contraction of the local and national real estate markets have also resulted in higher provisions for loan losses and loan charge-offs, and these same trends may also cause further valuation changes and losses in our loan and investment portfolios.  These conditions have reduced our capital levels and regulatory capital ratios over the past three years and may continue to do so in future periods.







Changing Interest Rates May Have a Negative Impact on Our Results of Operations.





Our earnings and cash flows are largely dependent on our net interest income.  Interest rates are highly sensitive to many factors that are beyond our control, including general economic conditions and policies of various governmental and regulatory agencies and, in particular, the Federal Reserve.  If the interest rates paid on deposits and borrowings increase at a faster rate than the interest rates received on loans and other investments, our net interest income, and therefore our results of operations would be adversely affected.  Similarly, mortgage banking income varies directly with movements in interest rates.  Earnings would also be adversely affected if the interest rate received on our loans and other investments fall more quickly than the interest rates paid on our deposits and borrowings.  Although we believe that we have implemented effective asset and liability management strategies to reduce the adverse effects of changes in market interest rates on our results of operations, any substantial, unexpected or prolonged change in market interest rates could have an adverse effect on our financial condition and results of operations.






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During 2010 We Continued to Experience High Levels of Delinquencies, Non-performing Loans and Charge-offs.





During 2010, we continued to experience high levels of non-performing loans and loan delinquencies.  Our non-performing loans totaled $84.2 million, or 6.44% of total loans at December 31, 2010, compared to $75.3 million, or 5.30% of total loans at December 31, 2009.  Our loans past due totaled $90.7 million, or 6.9% of total loans receivable at December 31, 2010, compared to $113.4 million, or 8.0% of total loans at December 31, 2009.  The continued high level of non-performing and delinquent loans has resulted in high levels of loan charge-offs.  During 2010, net charge-offs totaled $25.2 million.  To the extent that our loan portfolio continues to deteriorate, our financial condition and results of operations will be materially and adversely affected.  Continued deterioration could also lead to additional actions by regulators that could have a direct material impact on our financial condition and results of operation.





If Our Allowance for Loan Losses is Not Sufficient to Cover Actual Loan Losses, Our Results of Operation Would be Negatively Impacted.





We make various assumptions and judgments about the collectibility of our loan portfolio, including the creditworthiness of our borrowers and the value of the real estate and other assets serving as collateral for the repayment of many of our loans.  In determining the amount of the allowance for loan losses, we analyze our loss and delinquency experience by loan categories and we consider the impact of existing economic conditions.  If the results of our analyses are incorrect, our allowance for loan losses may not be sufficient to cover losses inherent in our loan portfolio, which would require additions to our allowance and would decrease our net income.  Although we are unaware of any specific weaknesses in our loan portfolio that would require increases in our allowance at the present time, we may need to increase our allowance further in the future due to credit deterioration, our emphasis on loan growth and on increasing our portfolio of commercial real estate loans.




In addition, bank regulators periodically review our allowance for loan losses and may require us to increase our provision for loan losses or recognize further loan charge-offs.  Any increase in our allowance for loan losses or loan charge-offs as required by these regulatory authorities may have a material adverse effect on our results of operations and financial condition.




Deterioration of our Investment Portfolio Could Have a Negative Impact on Our Results of Operations.





The current sustained economic downturn has resulted in other than temporary impairment of securities in our overall investment portfolio, including a decline in value of mortgage related securities which are dependent upon the performance of the underlying mortgages that provide the principal and interest cash flow for the securities.  Similarly, growing state and municipality budget deficits resulting from declining tax revenues will result in related declines in the value of debt securities they have issued in prior years.  Continued weakness or deterioration in general economic market conditions could result in future impairment losses on these securities or other investment securities.





If Our Investment in the Federal Home Loan Bank of Chicago is Classified as Other Than Temporarily Impaired, Our Earnings and Stockholders’ Equity Could Decrease.




We own common stock of the Federal Home Loan Bank of Chicago (FHLBC) in order to qualify for membership in the Federal Home Loan Bank System and to be eligible to borrow funds under the FHLBC’s advance program.  The fair value of our FHLBC common stock as of December 31, 2010 was $21.7 million based on its cost.  There is no trading market for our FHLBC common stock.




Certain member banks of the Federal Home Loan Bank System may be subject to accounting rules and asset quality risks that could result in materially lower regulatory capital levels.  In an extreme situation, it is possible that the capitalization of a Federal Home Loan Bank, including the FHLBC, could be substantially diminished or reduced to zero.  Consequently, there is a risk that our investment in FHLBC common stock could be deemed other-than-temporarily impaired at some time in the future, and if this occurs, it would cause our earnings and stockholders’ equity to decrease by the after-tax amount of any impairment charge.




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Our Shareholders Own a Minority of Waterstone Financial Common Stock and Are Not Able to Exercise Voting Control Over Most Matters Put to a Vote of Shareholders.





Public shareholders own a minority of the outstanding shares of Waterstone Financial common stock.  As a result, public shareholders are not able to exercise voting control over most matters put to a vote of shareholders. Lamplighter Financial, MHC owns a majority of Waterstone Financial’s common stock and, through its Board of directors, is able to exercise voting control over most matters put to a vote of shareholders, including possible acquisitions.  The same directors who govern Waterstone Financial and WaterStone Bank also govern Lamplighter Financial, MHC.  The only matters which Lamplighter Financial, MHC is not able to exercise voting control are those requiring a separate vote of shareholders other than Lamplighter Financial, MHC.




Our Non-Interest Expense Will Continue to be Negatively Impacted by Increases in FDIC Insurance Premiums





The FDIC assesses premiums for deposit insurance on insured banks and savings banks.  This assessment is based on the risk category of the institution and currently ranges from 5 to 43 basis points of the institution’s deposits.  Federal law requires that the FDIC establish a reserve ratio for the deposit insurance fund at 1.15% to 2.00% of estimated insured deposits.  If this reserve ratio drops below 1.15% or the FDIC expects that it will do so within six months, the FDIC must, within 90 days, establish and implement a plan to restore the designated reserve ratio to 1.15% of estimated insured deposits within five years (absent extraordinary circumstances).





Recent bank failures coupled with sustained weakness in the economy have significantly reduced the Deposit Insurance Fund’s reserve ratio.  The FDIC imposed a 10 basis point special assessment that was collected on September 30, 2009.  On November 12, 2009, the FDIC issued a rule pursuant to which all insured depository institutions are required to prepay their estimated assessments for the fourth quarter of 2009, and for all of 2010, 2011 and 2012.  The prepayment was due on December 31, 2009.  Under the rule, the assessment rate for the fourth quarter of 2009 and for 2010 was based on each institution’s total base assessment rate for the third quarter of 2009, modified to assume that the assessment rate in effect on September 30, 2009 had been in effect for the entire third quarter, and the assessment rate for 2011 and 2012 was equal to the modified third quarter assessment rate plus an additional 3 basis points.  In addition, each institution’s base assessment rate for each period was calculated using its third quarter assessment base, adjusted quarterly for an estimated 5% annual growth rate in the assessment base through the end of 2012.  WaterStone Bank received a waiver from the FDIC with respect to the 2010, 2011 and 2012 insurance prepayment.





These actions significantly increased our non-interest expense in 2010 and 2009, and will continue to increase non-interest expense in future years as long as the FDIC designated reserve ratio remains low.







Item 1B.   Unresolved Staff Comments




None




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Item 2.   Properties







We conduct substantially all of our business through eight banking offices and automated teller machines ("ATM").  We believe that our facilities are adequate for our operations.









Owned Or
Year

December 31, 2010Location
Leased
Acquired

Net Book Value(In Thousands)Branches:7500 West State StreetWauwatosa, Wisconsin
Own
1971

$
8166560South27thStreetOak Creek, Wisconsin
Own
1986

$
93521505 East Moreland Blvd (1)Waukesha, Wisconsin
Own
2005

$
4,7471233 Corporate Center DriveOconomowoc, Wisconsin
Own
2003

$
2,4771230 George Towne DrivePewaukee, Wisconsin
Own
2004

$
3,5136555 S 108th StFranklin, Wisconsin
Own
2006

$
2,428W188N9820 Appleton AveGermantown, Wisconsin
Own
2006

$
2,40610101 W Greenfield AveWest Allis, Wisconsin
Own
2006

$
4,0687136 W State Street (1)Wauwatosa, Wiscsonsin
Own
2000

$
482Corporate Center:11200 West Plank CourtWauwatosa, Wisconsin
Own
2004

$
4,521Waterstone Mortgage Corporation1133 Quail CourtPewaukee, WI 53072
Lease
2006

$
226







(1)
Drive-up banking facility only.







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Item 3.   Legal Proceedings





We are not involved in any pending legal proceedings as a defendant other than routine legal proceedings occurring in the ordinary course of business.  At December 31, 2010, we were not involved in any legal proceedings, the outcome of which would be material to our financial condition or results of operations.  Other than the consent order we have entered into with the WDFI and FDIC and the cease and desist order entered into with the OTS, both of which are discussed under Item 1. Business and Item 1A. Risk Factors, we have no pending proceedings before any agency.







Item 4.   Submission of Matters to a Vote of Security Holders





Not applicable





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Part II





Item 5.   Market for Registrant's Common Equity and Related Stockholder Matters and Issuer Purchase of Equity Securities





The common stock of Waterstone Financial, Inc. is traded on The NASDAQ Global Select Market® under the symbol WSBF.





As of February 28, 2011, there were 31,250,097 shares of common stock outstanding and 3,698 shareholders of record of the common stock.  Waterstone Financial, Inc became a publicly-held corporation on October 4, 2005.


Waterstone Financial has never paid cash dividends on its common stock, and our board currently has no plan to pay cash dividends on the common stock.  If the board considers a cash dividend in the future, the payment of dividends will depend upon a number of factors, including capital requirements, our financial condition and results of operations, tax considerations, statutory and regulatory limitations and general economic conditions and regulatory restrictions that affect our ability to pay dividends.  We cannot assure you that any dividends will be paid or that, if paid, they will not be reduced or eliminated in the future.  Special cash or stock dividends, to the extent permitted by applicable policy and regulation, may be paid in addition to, or in lieu of, regular cash dividends.





Our ability to pay dividends will depend, in part, upon our receipt of dividends from WaterStone Bank, because we have no significant source of income other than dividends from WaterStone Bank, earnings on our investments and interest payments on our loan to WaterStone Bank’s employee stock ownership plan.  Wisconsin law generally allows WaterStone Bank to pay dividends to Waterstone Financial equal to up to 50% of WaterStone Bank’s net profit in the current year without prior regulatory approval and above such amount, including out of retained earnings, with prior regulatory approval. A consent order jointly issued by the WDFI and the FDIC effective December 18, 2009 prohibits the payment of a dividend without written regulatory approval.







Market Information





The high and low quarterly trading prices during fiscal 2010 and 2009 were as follows:








2010

High


Low1st Quarter


3.98



1.932nd Quarter


4.24



3.343rd Quarter


4.45



3.294th Quarter


4.05



3.342009

High


Low1st Quarter


3.73



1.842nd Quarter


4.98



1.903rd Quarter


5.59



2.954th Quarter


5.16



1.77














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PERFORMANCE GRAPH




Set forth below is a line graph comparing the cumulative total shareholder return on Waterstone Financial common stock, based on the market price of the common stock and assuming reinvestment of cash dividends, with the cumulative total return of companies on the NASDAQ Stock Market US Index and the America’s Community Bankers NASDAQ Index.  The graph assumes $100 was invested on October 5, 2005, the first date of Waterstone Financial trading, in Waterstone Financial common stock and each of those indices.



















Stock/Index

10/4/2005


12/31/2005


12/31/2006


12/31/2007


12/31/2008


12/31/2009


12/31/2010Waterstone Financial, Inc (WSBF)


100.00



114.40



178.20



128.20



33.50



20.50



32.50NASDAQ Stock Market (^IXIC)


100.00



103.08



112.90



123.98



73.72



106.07



124.00ABA NASDAQ Commumity Bank Index (^ABAQ)


100.00



102.75



116.49



89.87



74.55



60.24



67.14


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Item 6.   Selected Financial Data








SELECTED CONSOLIDATED FINANCIAL AND OTHER DATA





The summary financial information presented below is derived in part from the Company’s audited financial statements, although the table itself is not audited.  The following data should be read together with the Company’s consolidated financial statements and related notes and “Management’s Discussion and Analysis of Financial Condition and Results of Operations” later in this report.










At or for the Year Ended December 31,2010


2009


2008


2007


2006(In Thousands, except per share amounts)Selected Financial Condition Data:Total assets

$
1,808,966


$
1,868,266


$
1,885,432


$
1,710,202


$
1,648,470Securities available for sale


203,166



205,415



179,887



172,137



117,330Federal Home Loan Bank stock


21,653



21,653



21,653



19,289



17,213Loans receivable, net


1,277,262



1,391,516



1,534,591



1,389,209



1,365,712Cash and cash equivalents


75,331



71,120



23,849



17,884



73,807Deposits


1,145,529



1,164,890



1,195,897



994,535



1,036,218Borrowings


456,959



507,900



487,000



475,484



334,003Total shareholders' equity


172,220



168,592



171,267



201,819



241,272Allowance for loan losses


29,175



28,494



25,167



12,839



7,195Selected Operating Data:Interest income

$
89,933


$
98,488


$
104,078


$
96,975


$
92,228Interest expense


40,269



54,577



63,027



62,134



53,779Net interest income


49,664



43,911



41,051



34,841



38,449Provision for loan losses


25,832



26,687



37,629



11,697



2,201Net interest income afterprovision for loan losses


23,832



17,224



3,422



23,144



36,248Noninterest income


38,993



12,208



6,291



6,842



5,156Noninterest expense


64,627



40,876



33,860



28,682



28,652Income (loss) before income taxes


(1,802
)


(11,444
)


(24,147
)


1,304



12,752Provision for income taxes (benefit)


52



(1,306
)


2,299



(254
)


4,699Net income (loss)

$
(1,854
)

$
(10,138
)

$
(26,446
)

$
1,558


$
8,053Income (loss) per share – basic

$
(0.06
)

$
(0.33
)

$
(0.87
)

$
0.05


$
0.24Income (loss) per share – diluted

$
(0.06
)

$
(0.33
)

$
(0.87
)

$
0.05


$
0.24













- 48 -
 Table of Contents










At or for the Year Ended December 31,2010


2009


2008


2007


2006Selected Financial Ratios and Other Data:Performance Ratios:Return (loss) on average assets


(0.10
%)


(0.53
%)


(1.44
%)


0.09
%


0.50
%Return (loss) on average equity


(1.09
)


(6.12
)


(13.76
)


0.72



3.41Interest rate spread (1)


2.67



2.21



1.99



1.74



2.00Net interest margin (2)


2.83



2.41



2.32



2.19



2.52Noninterest expense to average assets


3.49



2.14



1.85



1.73



1.80Efficiency ratio (3)


72.90



72.84



71.52



68.85



66.19Average interest-earning assets to average interest-bearing liabilities


107.11



106.68



107.85



111.68



114.59Capital Ratios:Equity to total assets at end of period


9.52
%


9.02
%


9.08
%


11.80
%


14.64
%Average equity to average assets


9.18



8.67



10.44



13.07



14.79Total capital to risk-weighted assets


14.13



13.83



12.84



13.43



21.36Tier I capital to risk-weighted assets


12.87



12.57



11.58



12.52



20.75Tier I capital to average assets


8.83



8.77



8.93



10.08



14.47Asset Quality Ratios:Allowance for loan losses as a percent of total loans


2.23
%


2.01
%


1.61
%


0.92
%


0.52
%Allowance for loan losses as a percent of non-performing loans


34.66



37.83



23.36



15.98



24.91Net charge-offs to average outstanding loans during the period


1.75



1.54



1.67



0.44



0.02Non-performing loans as a percent of total loans


6.44



5.30



6.91



5.73



2.10Non-performing assets as a percent of total assets


7.85



6.76



7.02



5.20



1.78Other Data:Number of full service Bank offices


8



8



8



8



7Number of limited service Bank offices


1



1



1



1



1





(1)  Represents the difference between the weighted average yield on average interest-earning assets and the weighted average cost of


interest-bearing liabilities.


(2)  Represents net interest income as a percent of average interest-earning assets.


(3)  Represents non-interest expense divided by the sum of net interest income and non-interest income.





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 Table of Contents


Item 7.   Management's Discussion and Analysis of Financial Condition and Results of Operations





Overview





Our results of operations depend substantially on our net interest income and mortgage banking income.  Net interest income is the difference between the interest income we earn on our interest-earning assets, consisting primarily of residential loans, construction loans and debt and mortgage related securities and the interest we pay on our interest-bearing liabilities, consisting primarily of time deposits and borrowings from the FHLBC.  WaterStone Bank is primarily a mortgage lender with mortgage loans comprising 97.0% of total loans receivable at December 31, 2010.  Further, 88.9% of total loans receivable at December 31, 2010 were residential mortgage loans of which 43.3% were one– to four-family residential mortgage loans and 40.3% were over four-family residential mortgage loans.  WaterStone Bank funds loan production primarily with retail deposits.  Total deposits were 63.3% of total assets on December 31, 2010.  In addition, 85.1% of total deposits were time deposits, also known as certificates of deposit.  Deposits obtained from brokers totaled $14.4 million at December 31, 2010.  WaterStone Bank uses borrowings from the FHLBC and from other banks as a secondary source of funding.  FHLBC advances outstanding at December 31, 2010 totaled $350.0 million or 19.3% of total assets.  Two bank lines of credit were used as a secondary funding source for loans held for sale.  Outstanding draws on these two lines totaled $23.0 million as of December 31, 2010.




Our results of operations also are significantly affected by our provision for loan losses, non-interest income and non-interest expense.  During the past three years, the significant provision for loan losses has had the greatest impact on our results of operations.  Non-interest income currently consists of mortgage banking income, service fees, income from the increase on the cash surrender value of life insurance and miscellaneous other income, partially offset by impairment losses on securities.  Non-interest expense currently consists of compensation and employee benefits, occupancy, FDIC insurance premiums, real estate owned expense, data processing, advertising, professional fees and other operating expenses.  Our results of operations are also affected by general and local economic and competitive conditions, changes in market interest rates, governmental policies and actions of regulatory authorities.







Critical Accounting Policies





Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets.




Allowance for Loan Losses.WaterStone Bank establishes valuation allowances on loans deemed to be impaired. A loan is considered impaired when, based on current information and events, it is probable that WaterStone Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement. A valuation allowance is established for an amount equal to the impairment when the carrying amount of the loan exceeds the present value of the expected future cash flows, discounted at the loan’s original effective interest rate or the fair value of the underlying collateral.




WaterStone Bank also establishes valuation allowances based on an evaluation of the various risk components that are inherent in the credit portfolio. The risk components that are evaluated include past loan loss experience; the level of non-performing and classified assets; current economic conditions; volume, growth, and composition of the loan portfolio; adverse situations that may affect the borrower’s ability to repay; the estimated value of any underlying collateral; regulatory guidance; and other relevant factors. The allowance is increased by provisions charged to earnings and recoveries of previously charged-off loans and reduced by charge-offs. The adequacy of the allowance for loan losses is reviewed and approved quarterly by the WaterStone Bank board of directors. The allowance reflects management’s best estimate of the amount needed to provide for the probable loss on impaired loans and other inherent losses in the loan portfolio, and is based on a risk model developed and implemented by management and approved by the WaterStone Bank board of directors.




Actual results could differ from this estimate, and future additions to the allowance may be necessary based on unforeseen changes in loan quality and economic conditions.  More specifically, if our future charge-off experience increases substantially from our past experience; or if the value of underlying loan collateral, in our case real estate, declines in value by a substantial amount; or if unemployment in our primary market area increases significantly; our allowance for loan losses may be inadequate and we will incur higher provisions for loan losses and lower net income in the future.




In addition, state and federal regulators periodically review the WaterStone Bank allowance for loan losses. Such regulators have the authority to require WaterStone Bank to recognize additions to the allowance at the time of their examination.




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 Table of Contents





Income Taxes.The Company and its subsidiaries file consolidated federal and combined state income tax returns. The provision for income taxes is based upon income in the consolidated financial statements, rather than amounts reported on the income tax return.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases as well as for net operating loss carry forwards.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.





During 2008, the Company recorded net income tax expense of $2.3 million which included $13.2 million of additional income tax expense to establish a valuation allowance against the Company’s net deferred tax asset.  Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that a deferred tax asset will not be realized.  The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Examples of positive evidence may include the existence of taxes paid in available carry-back years as well as the probability that taxable income will be generated in future periods.  Examples of negative evidence may include cumulative losses in a current year and prior two years and general business and economic trends.  At both December 31, 2010 and 2009, the Company determined a valuation allowance continued to be necessary, largely based on the negative evidence represented by a cumulative loss in the most recent three-year period caused by the significant loan loss provisions recorded during those three years.  In addition, general uncertainty regarding the economy and the housing market has increased the potential volatility and uncertainty of projected earnings.  Management is required to re-evaluate the deferred tax asset and the related valuation allowance quarterly.




Positions taken in the Company’s tax returns are subject to challenge by the taxing authorities upon examination.  The benefit of uncertain tax positions are initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities.  Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts.   Interest and penalties on income tax uncertainties are classified within income tax expense in the income statement.




Management believes the Company’s tax policies and practices are critical because the determination of the tax provision and current and deferred tax assets and liabilities have a material impact on our net income and the carrying value of our assets.  We have no plans to change the tax recognition methodology in the future without hard evidence of sustainable earnings trends which are reliant on net interest income, mortgage banking income and significantly reduced credit losses.  If the estimated valuation allowance against our deferred asset is adjusted it will affect our future net income.  At December 31, 2010 and 2009, there was a valuation allowance of $16.9 million.  The net recorded deferred tax asset, after valuation allowance was $1.1 million at December 31, 2010 and $3.2 million at December 31, 2009.  The remaining net deferred tax assets at December 31, 2010 and 2009 were primarily supported by available tax planning strategies.




Fair Value Measurements.  The Company determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Company’s financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP. See the Notes to the Company’s consolidated financial statements for more information on fair value measurements.







- 51 -
 Table of Contents




Comparison of Financial Condition at December 31, 2010 and at December 31, 2009





Total Assets. Total assets decreased by $59.3 million, or 3.2%, to $1.81 billion at December 31, 2010 from $1.87 billion at December 31, 2009. The decrease in total assets resulted primarily from a $113.6 million decrease in loans receivable, partially offset by increases in loans held for sale of $51.1 million and real estate owned of $6.8 million.





Cash and Cash Equivalents.Cash and cash equivalents increased by $4.2 million, or 5.9%, to $75.3 million at December 31, 2010 from $71.1 million at December 31, 2009.  The increase in cash and cash equivalents reflects the Company’s decision to maintain higher levels of liquidity in the current weak economic and relatively low interest rate environment.





Securities Available for Sale.  Securities available for sale decreased by $2.2 million, or 1.1%, to $203.2 million at December 31, 2010 from $205.4 million at December 31, 2009.  The decrease in the available for sale portfolio resulted from a $7.8 million decrease in mortgage-backed securities and collateralized mortgage obligations plus a $12.1 million decrease in municipal securities partially offset by a $17.1 million increase in government agency securities.





Mortgage-backed securities and collateralized mortgage obligations decreased by $7.8 million to $109.1 million at December 31, 2010 from $116.8 million at December 31, 2009.  The decrease in these securities was partially offset by a $5.5 million increase in debt securities to $94.1 million at December 31, 2010 from $88.6 million as of December 31, 2009.  The shift in the composition of the securities portfolio towards less volatile, shorter-term debt securities reflects a decision to increase portfolio liquidity.





As of December 31, 2010, the Company holds two available for sale securities with a total fair value of $20.3 million  and an amortized cost of $21.2 that were determined to be other than temporarily impaired.  The $881,000 unrealized loss (before taxes) is included in other comprehensive income.  During the year ended December 31, 2009, $1.1 million was identified as an other than temporary credit loss and was recognized as expense with respect to these two securities.





Securities Held to Maturity.  Securities held to maturity remained unchanged at $2.6 million at both December 31, 2010 and 2009.  As of December 31, 2010 and 2009, the Company held one security with an amortized cost of $2.6 million that has been designated as held to maturity.  The estimated fair value of this security was $2.5 million and $1.9 million as of December 31, 2010 and 2009, respectively.  The final maturity of this security is 2022, however, it is callable quarterly.  This higher yielding structured corporate note accrues interest based on the range of a constant maturity treasury yield spread and therefore has a higher potential for market value volatility.  As the Company has the intent and ability to hold this security until it matures, it has been classified as held to maturity rather than as available for sale.




Loans Held for Sale.Loans held for sale increased by $51.1 million, or 113.4%, to $96.1 million at December 31, 2010, from $45.1 million at December 31, 2009.  During the current year, Waterstone Mortgage Corporation entered into interim financing agreements with two external banks that provides for a total of $70.0 million in lines of credit.  Access to these lines of credit, along with additional internal financing allowed Waterstone Mortgage Corporation to capitalize on the low interest environment and significantly increase its loan origination activity.  At December 31, 2010, substantially all loans held for sale are less than forty-five days from origination and all loans held for sale are in process of being sold to third party investors.





Loans Receivable.  Loans receivable held for investment decreased $113.6 million, or 8.0%, to $1.31 billion at December 31, 2010 from $1.42 billion at December 31, 2009.  The 2010 decrease in total loans receivable was primarily attributable to a $97.6 million decrease in one- to four-family loans.  The decrease reflects a decline in loan demand for variable-rate real estate mortgage loans as recent borrowers have preferred long-term fixed-rate products that the Company does not generally retain in its portfolio.  Decreases in loan balances in this and other categories also reflect an overall decrease in demand due to current economic conditions combined with the Company’s more stringent loan underwriting requirements.  As a result of the low rate environment with respect to long-term fixed real estate mortgage products, the Company has experienced a shift in the composition of our loan originations during the year ended December 31, 2010 from one- to four-family residential variable-rate loans to residential real estate loans collateralized by over four-family properties, as this category of borrower displayed relatively stable levels of demand for our existing products.  Loans receivable were further decreased during the year ended December 31, 2010 by $41.8 million in loans transferred to real estate owned.





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 Table of Contents





Allowance for Loan Losses.  The Allowance for loan losses increased $681,000, or 2.4%, to $29.2 million at December 31, 2010 from $28.5 million at December 31, 2009.  The $681,000 increase in the allowance for loan losses during the year ended December 31, 2010 is attributable to a $2.1 million increase in the general valuation allowance, partially offset by a $1.4 million decrease in specific loan loss reserves related to impaired loans.  The increase in the general valuation allowance resulted from an increase in non-performing loans and loans that, while still performing, have been identified as having higher risk characteristics.  The increase in the amount and number of loans identified as exhibiting elevated levels of risk with respect to loss outweighed the decline in overall delinquent loans.  Loans with elevated risk profiles include loans internally classified as special mention and watch.  These loans resulted in a $3.3 million increase to the general valuation allowance during the year.  This was partially offset by a $1.2 million reduction to the general valuation allowance due primarily to a $113.6 million decrease in the balance of loans outstanding.  The $1.4 million decrease in specific loan loss reserves was primarily the result of a decrease in number and amount of impaired loans with significant collateral shortfalls.  As of December 31, 2010, the allowance for loan losses to total loans receivable was 2.23% and was equal to 34.66% of non-performing loans, compared to 2.01% and 37.83%, respectively, at December 31, 2009.Weakness in the residential real estate market has continued for the past three years and the risk of loss on loans secured by residential real estate remains at an elevated level.  That portion of the allowance for loan losses attributable to mortgage loans secured by one- to four-family residential real estate is substantially unchanged at 83.6% of the total allowance for loan losses at December 31, 2010 compared to 82.8% at December 31, 2009.





Cash Surrender Value of Life Insurance. Cash surrender value of life insurance increased $1.4 million, or 4.3%, to $35.4 million at December 31, 2010 from $33.9 million at December 31, 2009, primarily due to $1.1 million in earnings credited.





Real Estate Owned. Total real estate owned increased $6.8 million, or 13.4%, to $57.8 million at December 31, 2010 from $50.9 million at December 31, 2009.  During the year ended December 31, 2010, the Company transferred $41.8 to real estate owned from the loan portfolio.  During the same period the Company sold approximately $33.5 million of real estate owned.  The overall $6.8 million increase in real estate owned was primarily due to a $6.1 million increase in over four family properties.





Deposits. Total deposits decreased $19.4 million, or 1.7%, to $1.15 billion at December 31, 2010 from $1.16 billion at December 31, 2009.  Total time deposits decreased $37.1 million, or 3.7%, to $974.4 million at December 31, 2010 from $1.01 billion at December 31, 2009.  Time deposits originated through local retail outlets increased $12.1 million, or 1.3%, to $960.0 million at December 31, 2010 from $947.9 million at December 31, 2009.  The increase in time deposits originated through our local markets was partially offset by a decrease in time deposits originated through the wholesale market.  Time deposits originated through the wholesale market decreased $49.1 million, or 77.3%, to $14.4 million at December 31, 2010 from $63.6 million at December 31, 2009.  Because of the consent order issued by state and federal regulators effective December 18, 2009, the Bank is prohibited from accepting or renewing brokered deposits and all other deposit rates are capped by the FDIC.  Total money market and savings deposits increased $11.4 million, or 12.4%, to $103.4 million at December 31, 2010 from $92.0 million at December 31, 2009.  Total demand deposits increased $6.3 million, or 10.3%, to $67.7 million at December 31, 2010 from $61.4 million at December 31, 2009.





Borrowings. Total borrowings decreased $50.9 million, or 10.0%, to $457.0 million at December 31, 2010 from $507.9 million at December 31, 2009.  During the year ended December 31, 2010, five FHLBC advances totaling $73.9 million with an average rate of 3.61% matured.  The December 31, 2010 balance includes $23.0 million outstanding on two bank lines of credit totaling $70.0 million that were used to finance loans held for sale.  Interest rates on the lines of credit are based on the note rate of the loans financed and equaled 4.75% at December 31, 2010.  There was no comparable balance at December 31, 2009.





Other Liabilities. Other liabilities increased $5.6 million, or 21.4%, to $31.9 million at December 31, 2010 from $26.3 million at December 31, 2009.  The increase was primarily attributable to a $6.3 million increase in outstanding checks related to amounts disbursed related to funds previously held in escrow for borrowers’ tax payments and amounts disbursed related to the Company’s normal operating expenses.  These amounts remain classified as other liabilities until settled.





Shareholders’ Equity.  Shareholders’ equity increased $3.6 million, or 2.2%, to $172.2 million at December 31, 2010 from $168.6 million at December 31, 2009.  The increase was primarily due to a $3.6 million decrease in accumulated other comprehensive loss resulting from an increase in the fair value of available for sale securities.  Other comprehensive income totaled $1.6 million at December 31, 2010, compared to other comprehensive losses of $2.0 million at December 31, 2009.  In addition to the increase in accumulated other comprehensive income, shareholders’ equity was positively affected by a $1.1 million increase in additional paid in capital related to stock compensation benefits and a $854,000 decrease in unearned ESOP shares.  The aforementioned increases in shareholders’ equity were partially offset by a $1.9 million decrease in retained earnings reflecting the net loss for the year ended December 31, 2010.




--
 - 53 -
 Table of Contents


Average Balance Sheets, Interest and Yields/Costs




The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated.  No tax-equivalent yield adjustments were made, as the effect thereof was not material.  All average balances are daily average balances.  Non-accrual loans were included in the computation of average balances.  The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.




Years Ended December 31,2010

2009

2008Average



Average

Average



Average

Average



AverageBalance

Interest

Rate

Balance

Interest

Rate

Balance

Interest

Rate(Dollars in Thousands)Interest-earning assets:Loans receivable and held for sale
$1,440,417

$ 81,161(1)

5.63%

$1,519,348

$ 87,847(1)

5.78%

$1,510,952

$ 92,860(1)

6.13%Mortgage related securities(5) (6)
107,406

5,360

4.99

126,616

7,101

5.61

136,505

7,679

5.61Debt securities, federal funds sold andshort-term investments
206,066

3,412

1.66

174,593

3,540

2.03

116,395

3,539

3.03Total interest-earning assets
1,753,889

89,933

5.13

1,820,557

98,488

5.41

1,763,852

104,078

5.88Noninterest-earning assets
97,215





90,653





77,768Total assets
$1,851,104





$1,911,210





$1,841,620Interest-bearing liabilities:Demand accounts
37,852

37

0.10

34,025

35

0.10

32,248

151

0.47Money market and savings accounts
110,479

495

0.45

111,212

591

0.53

130,762

2,250

1.72Certificates of deposit
1,007,304

20,457

2.03

1,047,692

33,858

3.23

951,780

39,849

4.18Total interest-bearing deposits
1,155,635

20,989

1.82

1,192,929

34,484

2.89

1,114,790

42,250

3.78Borrowings
481,808

19,280

4.00

513,638

20,093

3.91

500,886

20,777

4.14Total interest-bearing liabilities
1,637,443

40,269

2.46

1,706,567

54,577

3.20

1,615,676

63,027

3.89Noninterest-bearing liabilitiesNon-interest bearing deposits
26,940





22,697





19,757Other non-interest bearing liabilities
16,789





16,332





13,971Total non-interest bearing liabilities
43,729





39,029





33,728Total liabilites
1,681,172





1,745,596





1,649,404Equity
169,932





165,614





192,216Total liabilities and equity
$1,851,104





$1,911,210





$1,841,620Net interest income


49,664





43,911





41,051Net interest rate spread (2)




2.67%





2.21%





1.99%Net interest-earning assets (3)
$116,446





$113,990





$148,176Net interest margin (4)




2.83%





2.41%





2.32%Average interest-earning assetsto average interest-bearingliabilities




107.11%





106.68%





109.17%





(1)   Includes net deferred loan fee amortization income of $739,000, $887,000 and $1,582,000 for the years ended


December 31, 2010, 2009 and 2008, respectively.


(2)    Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average


interest-bearing liabilities.


(3)    Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.


(4)    Net interest margin represents net interest income divided by average total interest-earning assets.


(5)  Average balance of available for sale securities is based on amortized historical cost.
 (6)




- 54 -
 Table of Contents


Rate/Volume Analysis







The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated.  The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume).  The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate).  The net column represents the sum of the prior columns.  For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.









Years Ended December 31,


Years Ended December 31,2010 vs. 2009


2009 vs. 2008Increase (Decrease) due to


Increase (Decrease) due toVolume


Rate


Net


Volume


Rate


Net(In Thousands)Interest and dividend income:Loans receivable and held for sale(1) (2)

$
(4,486
)


(2,200
)


(6,686
)

$
489



(5,502
)


(5,013
)Mortgage related securites


(1,008
)


(733
)


(1,741
)


(576
)


(2
)


(578
)Other interest-earning assets


580



(708
)


(128
)


1,408



(1,407
)


1Total interest-earning assets


(4,914
)


(3,641
)


(8,555
)


1,321



(6,911
)


(5,590
)Interest expense:Demand accounts


4



(2
)


2



8



(124
)


(116
)Money market and savings accounts


(4
)


(92
)


(96
)


(295
)


(1,362
)


(1,657
)Certificates of deposit


(1,260
)


(12,141
)


(13,401
)


3,692



(9,683
)


(5,991
)Total interest-bearing deposits


(1,260
)


(12,235
)


(13,495
)


3,405



(11,169
)


(7,764
)Borrowings


(1,267
)


454



(813
)


500



(1,186
)


(686
)Total interest-bearing liabilities


(2,527
)


(11,781
)


(14,308
)


3,905



(12,355
)


(8,450
)Net change in net interest income

$
(2,387
)


8,140



5,753


$
(2,584
)


5,444



2,860


_______________________________




(1)
Includes net deferred loan fee amortization income of $739,000, $887,000 and $1,582,000 for the years ended December 31, 2010, 2009 and 2008, respectively.


(2)
Non-accrual loans have been included in average loans receivable balance.








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 Table of Contents





Comparison of Operating Results for the Years Ended December 31, 2010 and 2009





General. Net loss for the year ended December 31, 2010 totaled $1.9 million, or $0.06 for both basic and diluted loss per share, compared to net loss of $10.1 million, or $0.33 for both basic and diluted loss per share, for the year ended December 31, 2009.  The year ended December 31, 2010 generated a loss on average assets of 0.10% and a loss on average equity of 1.09%, compared to a loss on average assets of 0.53% and a loss on average equity of 6.12% for the year ended December 31, 2009.  The net loss for the year ended December 31, 2010 reflected continuing deterioration in asset quality in a weak economic environment which resulted in a $25.8 million provision for loan losses in 2010.  The decrease in the net loss for the year ended December 31, 2010 reflected a $5.8 million increase in net interest income, a $2.0 million increase in pre-tax income from our mortgage banking operations, a $1.1 million decrease in other-than-temporary impairment investment loss, and $855,000 reduction in provisions for loan losses, partially offset by a $1.4 million reduction in income tax benefit.  Loan charge-off activity and specific loan reserves are discussed in additional detail in the Asset Quality section.  The net interest margin for the year ended December 31, 2010 was 2.83% compared to 2.41% for the year ended December 31, 2009.





Total Interest Income - Total interest income decreased $8.6 million, or 8.7%, to $89.9 million during the year ended December 31, 2010 from $98.5 million during the year ended December 31, 2009.





Interest income on loans decreased $6.7 million, or 7.6%, to $81.2 million during the year ended December 31, 2010 from $87.8 million during the year ended December 31, 2009.   The decrease in interest income was primarily due to a $78.9 million, or 5.2%, decrease in the average balance of loans outstanding to $1.44 billion during the year ended December 31, 2010 from $1.52 billion during the year ended December 31, 2009.  The decrease in the average balance of loans reflect an overall decrease in demand due to current economic conditions combined with the Company’s more stringent loan underwriting requirements.  The decrease in interest income attributable to the decrease in average balance was compounded by a 15 basis point decrease in the average yield on loans to 5.63% for the year ended December 31, 2010 from 5.78% for the year ended December 31, 2009.





Interest income from mortgage-related securities decreased $1.7 million, or 24.5%, to $5.4 million during the year ended December 31, 2010 from $7.1 million during the year ended December 31, 2009.  The decrease in interest income was primarily due to a $19.2 million, or 15.2%, decrease in the average balance of mortgage-related securities to $107.4 million for the year ended December 31, 2010 from $126.6 million during the year ended December 31, 2009.  The decrease in interest income attributable to the decrease in average balance was compounded by a decrease in average yield.  The average yield on mortgage-related securities decreased 62 basis points to 4.99% for the year ended December 31, 2010 from 5.61% for the year ended December 31, 2009.  The decline in the average balance of mortgage-related securities during the year ended December 31, 2010 reflects management’s decision to deemphasize investments in mortgage-related securities and emphasize more liquid, less volatile, government agency securities.





Finally, interest income from debt securities, federal funds sold and short-term investments decreased $128,000, or 3.6%, to $3.4 million during the year ended December 31, 2010 from $3.5 million during the year ended December 31, 2009.  Interest income decreased due to a 37 basis point decline in the average yield on other earning assets to 1.66% for the year ended December 31, 2010 from 2.03% for the year ended December 31, 2009.  The decline in average yield provided by these assets reflects the lower overall interest rate environment as opposed to a shift in investment strategy and product mix.  The decrease in average rate was partially offset by an increase of $31.5 million, or 18.0%, in the average balance of other earning assets to $206.1 million during the year ended December 31, 2010 from $174.6 million during the year ended December 31, 2009.  The increase in average balance reflects a strategic shift towards higher levels of liquidity.  The Company intends to maintain higher than usual liquidity given the current economic environment and relatively low rates of return available on loans and mortgage related securities.  The average balance of debt securities, federal funds sold and short-term investments includes FHLBC stock of $21.7 million for each of the years ended December 31, 2010 and 2009.  On October 10, 2007, the FHLBC entered into a consensual cease and desist order with its regulator, the Federal Housing Finance Board. Under the terms of the order, dividend declarations are subject to the prior written approval of the Federal Housing Finance Board.  On February 4, 2011, the FHLBC declared its first dividend since it entered into the cease and desist order.






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Total Interest Expense-Total interest expense decreased by $14.2 million, or 26.1%, to $40.3 million during the year ended December 31, 2010 from $54.6 million during the year ended December 31, 2009.  This decrease was primarily the result of a decrease of 74 basis points in the average cost of funds to 2.46% for the year ended December 31, 2010 from 3.20% for the year ended December 31, 2009.  The decrease in interest expense resulted from a decrease in the average cost of funds as well as a decrease of $69.1 million, or 4.1%, in average interest bearing deposits and borrowings outstanding to $1.64 billion for the year ended December 31, 2010 compared to an average balance of $1.71 billion for the year ended December 31, 2009.





Interest expense on deposits decreased $13.5 million, or 39.1%, to $21.0 million during the year ended December 31, 2010 from $34.5 million during the year ended December 31, 2009.  This was primarily due to a decrease in the average cost of deposits of 107 basis points to 1.82% for the year ended December 31, 2010 compared to 2.89% for the year ended December 31, 2009.  The decrease in interest expense attributable to the decrease in the cost of deposits was compounded by a decrease of $37.3 million, or 3.1%, in the average balance of interest bearing deposits to $1.16 billion during the year ended December 31, 2010 from $1.19 billion during the year ended December 31, 2009.  The decrease in the cost of deposits reflects the Federal Reserve’s historically low short-term interest rate policy.  These rates are typically used by financial institutions in pricing deposit products.  The decrease in the average balance of interest bearing deposits was primarily due to a $45.9 million decline in average non-local or brokered deposits.  The average balance of brokered deposits totaled $32.4 million for the year ended December 31, 2010 compared to $78.3 million for the year ended December 31, 2009.





Interest expense on borrowings decreased $813,000, or 4.0%, to $19.3 million during the year ended December 31, 2010 from $20.1 million during the year ended December 31, 2009.  The decrease resulted from a $31.8 million, or 6.2%, decrease in average borrowings outstanding to $481.8 million during the year ended December 31, 2010 from $513.6 million during the comparable period in 2009.  The decrease due to average balance was partially offset by a 9 basis point increase in the average cost of borrowings to 4.00% during the year ended December 31, 2010 from 3.91% during the comparable period in 2009.  The decreased use of borrowings as a source of funding during the year ended December 31, 2010 reflects our decision to utilize core deposits as our primary funding source.








Net Interest Income - Net interest income increased by $5.8 million or 13.1%, to $49.7 million during the year ended December 31, 2010 as compared to $43.9 million during the year ended December 31, 2009.  Net interest income continues to be positively affected by lower short and medium term interest rates in 2010, as compared to 2009.  The increase in net interest income resulted primarily from a 46 basis point increase in our interest rate spread to 2.67% for the year ended December 31, 2010 from 2.21% for the year ended December 31, 2009.  The 46 basis point increase in the interest rate spread resulted from a 74 basis point decrease in the average cost of interest bearing liabilities, which was partially offset by a 28 basis point decrease in the average yield on interest earning assets.  The increase in net interest income resulting from an increase in our net interest rate spread was partially offset by a decrease in net interest income resulting from a change in the composition of interest earning assets.  While net interest earning assets increased $2.5 million, or 2.2%, to $116.4 million for the year ended December 31, 2010 from $114.0 million from the year ended December 31, 2009, the composition of interest earning assets shifted from loans to debt securities and short term investments, which yield a lower return.  The shift from loans towards debt securities and short term investments reflects an overall decrease in demand for loan products due to current economic conditions combined with the Company’s more stringent loan underwriting requirements.  The change in composition also reflects a strategic shift towards higher levels of liquidity.





Provision for Loan Losses – Our provision for loan losses decreased $855,000, or 3.2%, to $25.8 million during the year ended December 31, 2010, from $26.7 million during the year ended December 31, 2009.  While the provision for loan losses has decreased from the prior year, it remained at historically high levels.  These levels remain high due to continued general economic stress resulting in reduced levels of income earned by many of our borrowers combined with loan collateral values, primarily real estate, that remain at levels below those estimated at the time the loans were originally made.  These factors result in higher levels of actual loss experience which when applied to the portfolio in general require higher loan loss provisions.  They also result in more loans exhibiting risk characteristics that require estimated loan loss provisions in excess of our historical average experience rates.  These risk characteristics include reduced borrower global cash flow, reduced borrower FICO scores and known declines in collateral value even though the loan may still be performing.  The provision for the year ended December 31, 2010 was the result of $25.2 million of net loan charge-offs combined with continued weakness in local real estate markets which required an overall increase to the allowance for loan losses.  See the Asset Quality section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions.






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Noninterest Income - Total noninterest income increased $26.8 million to $39.0 million during the year ended December 31, 2010 from $12.2 million during the year ended December 31, 2009.  The increase primarily resulted from an increase in mortgage banking income.  Mortgage banking income increased $25.5 million to $35.5 million for the year ended December 31, 2010, compared to $10.0 million during the comparable period in 2009.  In addition to the increase in mortgage banking activity, the increase in noninterest income compared to the prior period resulted from an $1.1 million decrease in impairment charge on securities considered to be other than temporarily impaired.




Mortgage Banking Income – Mortgage banking income increased $25.5 million to $35.5 million during the year ended December 31, 2010 from $10.0 million during the year ended December 31, 2009.  The increase was the combined result of increased volume, increased sales margins, expansion of the branch network and the addition of mandatory loan delivery terms.  During the year ended December 31, 2010, mortgage banking expanded from 21 to 30 branch locations outside of the Bank branch network.  New branches were added in Illinois, Maryland, North Carolina, Colorado, Florida and Minnesota.
 
 Volume and margin changes account for $16.7 million, or 65.0%, of the $25.5 million increase in mortgage banking income year over year.  The volume of loans sold during 2010 increased by $352.2 million, or 49.1%, to $1.07 billion in 2010 from $716.6 million in 2009.  In addition, the average sales margin increased by 81 basis points to 2.62% in 2010 from 1.82% in 2009.  This combination accounted for $14.5 million, or 86.8%, of the total volume and margin change in mortgage banking income.  The remaining $2.2 million increase in mortgage banking income due to volume and margin changes relates directly to the increase in processing income.  The branch expansion noted above was the primary driver in the 2010 volume increase over the prior year.  Volume at the new branches added during the year ended December 31, 2010 totaled $268.5 million, which represented 77.3% of the total increase in volume for the year.
 
 Improvement in sales margins were attributable to an increase in higher margin government guaranteed loans, an increase in loans for the purchase of residential real estate and an increase in volume in higher margin markets around the country.  In 2010, government guaranteed loans accounted for 36% of total mortgage banking volume, up from 34% in 2009.  The average 2010 sales margin on government guaranteed loans was 158 basis points higher than that on conventional mortgage loans.  Also in 2010, loans for the purchase of residential real estate accounted for 45% of total mortgage banking volume, up from 32% in 2009.  The average sales margin on loans for the purchase of real estate was 113 basis points higher than that on loan refinances.
 
 Sales margins vary from market to market around the country.  There was a 206 basis point spread between the Company’s highest margin branch and its lowest margin branch during the year ended December 31, 2010.  During 2010 sales volumes increased at high margin branches in Minnesota, Arizona and Maryland.  Branches in these three states produced 82.3% of the $352.2 million increase in volume for 2010 as compared to 2009.  The Minnesota branches accounted for $198.9 million in increased volume during 2010 with a sales margin that was 22 basis points higher the Company’s 2010 weighted average sales margin.  The Arizona branch accounted for $54.9 million in increased volume during 2010 with a sales margin that was 109 basis points higher than the Company’s 2010 weighted average sales margin.  The Maryland branch accounted for $35.9 million in increased volume during 2010 with a sales margin that was 93 basis points higher than the Company’s 2010 weighted average sales margin.
 
 Branches are operated on a net branch basis whereby predetermined margins and direct expenses are paid by the branch office to the corporate office and remaining net income accrues to the branch manager.  Successful branches generate higher levels of revenue and expense with an eye toward increasing branch manager net income.  Branch income accounts for $6.2 million, or 24.5%, of the increase in mortgage banking income for 2010 over the prior year.  This increase in mortgage banking income is offset by increases in mortgage banking expenses distributed among the noninterest expense categories of the income statement.  A full 80% of this increase, or $5.0 million, is offset by branch manager payroll which increased to $6.7 million in 2010 from $1.7 million in 2009 and is included in compensation, payroll taxes, and other employee benefits expense on the consolidated statements of operations.
 
 Prior to 2010, the Company originated loans held for sale on a “best efforts” delivery basis.  Under the best efforts delivery method, the buyer of the loan, or investor, assumed all interest rate risk.  Just prior to the end of 2009, the Company began to originate loans for sale on a “mandatory” delivery basis.  Under the mandatory delivery method, the investor committed to buy only those loans that were originated within a specified yield to the buyer.  Higher fees are paid by the investor to the originator for “mandatory” delivery as compared to “best efforts” delivery in exchange for the assumption of interest rate risk.  Mortgage banking income increased by $2.7 million in 2010 over 2009 as a result of loans sold on a “mandatory” delivery method net of hedging gains and losses.
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Noninterest Expense - Total noninterest expense increased $23.8 million, or 58.1%, to $64.6 million during the year ended December 31, 2010 from $40.9 million during the year December 31, 2009.  The increase was primarily attributable to increased compensation and other operating expenses.





Compensation, payroll taxes and other employee benefit expense increased $19.0 million, or 109.5%, to $36.3 million during the year ended December 31, 2010 compared to $17.3 million during the year ended December 31, 2009.  Total full-time equivalent employees increased by 77, or 14.9%, to 595 at December 31, 2010 from 518 at December 31, 2009 due to an expansion of our mortgage banking operations.  Total compensation, payroll taxes and other benefits at our mortgage banking subsidiary increased $18.8 million to $23.5 million for the year ended December 31, 2010 compared to $4.6 million during the year ended December 31, 2009.  This increase in expense is directly related to the 355% increase in mortgage banking income for the year ended December 31, 2010 compared to the year ended December 31, 2009.  The $18.8 million increase in mortgage banking compensation, payroll taxes and benefits was comprised of an $8.2 million increase in commissions paid to loan officers, a $5.0 million increase in branch manager compensation, a $4.1 million increase in administrative payroll and a $1.5 million increase in payroll taxes and benefits.


Other noninterest expense increased $3.1 million or 94.3%, to $6.4 million during the year ended December 31, 2010 from $3.3 million during the year ended December 31, 2009.  The increase in other noninterest expense is a direct result of the increase in operational costs related to the expansion of our mortgage banking operations.





Income Taxes –  Despite a pre-tax loss, we recorded income tax expense of $52,000 for the year ended December 31, 2010 primarily due to differences between prior year estimates and actual tax returns filed plus state income tax due to taxable income generated by the mortgage banking subsidiary.  Due to the valuation allowance on our deferred tax assets, we were not able to record an income tax benefit related to the pre-tax loss incurred.  A current income tax benefit that would normally result from a pre-tax loss was offset by additional deferred tax expense due to an increase in the required valuation allowance.





We recorded an income tax benefit of $1.3 million for the year ended December 31, 2009, primarily as a result of federal and Wisconsin tax law changes enacted during 2009.  In the first quarter a Wisconsin state tax law change was enacted (with retroactive effect to January 1, 2009) requiring combined filing in Wisconsin.  We recognized a state benefit in connection with the establishment of a Wisconsin deferred tax asset (which does not require a valuation allowance) related to the unrealized loss on securities available for sale owned by the Company’s Nevada subsidiary.  In addition, we recognized a federal tax benefit as a result of legislation passed in the fourth quarter of 2009 allowing for a one-time carry back of tax losses for up to five years.  The effective tax rate for the year ended December, 31, 2009 was 11.4%.





Net Loss-As a result of the foregoing factors, net loss for the year ended December 31, 2010 was $1.9 million as compared to a net loss of $10.1 million during the year ended December 31, 2009.








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Comparison of Operating Results for the Years Ended December 31, 2009 and 2008





General. Net loss for the year ended December 31, 2009 totaled $10.1 million, or $0.33 for both basic and diluted loss per share, compared to net loss of $26.4 million, or $0.87 for both basic and diluted loss per share, for the year ended December 31, 2008.  The year ended December 31, 2009 generated a loss on average assets of 0.53% and a loss on average equity of 6.12%, compared to a loss on average assets of 1.44% and a loss on average equity of 13.76% for the year ended December 31, 2008.  The net loss for the year ended December 31, 2009 reflected continuing deterioration in asset quality in a weak economic environment which resulted in a $26.7 million provision for loan losses in 2009.  The 2009 loan loss provision represents a $10.9 million decrease from the $37.6 million provision for loan losses in 2008.  Increases of $2.9 million in net interest income, $5.7 million in mortgage banking income, an $885,000 decrease in impairment charge on securities considered to be other than temporarily impaired and a decrease of $3.6 million in income tax expense for the year ended December 31, 2009 compared to 2008 were partially offset by a $7.0 million increase in noninterest expense.  The increase in noninterest expense resulted from a $4.1 million increase in FDIC insurance expense (which included an FDIC special assessment) and an increase in real estate owned expense of $1.9 million.  Loan charge-off activity and specific loan reserves are discussed in additional detail in the Asset Quality section.  The net interest margin for the year ended December 31, 2009 was 2.41% compared to 2.32% for the year ended December 31, 2008.





Total Interest Income - Total interest income decreased $5.6 million, or 5.4%, to $98.5 million during the year ended December 31, 2009 from $104.1 million during the year ended December 30, 2008, reflecting the decrease in market rates during 2009.





Interest income on loans decreased $5.0 million, or 5.4%, to $87.8 million during the year ended December 31, 2009 from $92.9 million during the year ended December 31, 2008.   The decrease in interest income was primarily due to a 35 basis point decrease in the average yield on loans to 5.78% for the year ended December 31, 2009 from 6.13% for the year ended December 31, 2008.  The decrease in interest income attributable to the decrease in the yield on loans was partially offset by an $8.4 million, or 0.6%, increase in the average balance of average loans outstanding to $1.52 billion during the year ended December 31, 2009 from $1.51 billion during the year ended December 31, 2008.  In addition to the decrease in interest income due to a decrease in the average yield, $1.5 million of the overall decrease compared to the prior year related to interest income recognized on a loan during the year ended December 31, 2008 that had previously been recorded on the cost recovery method.  The loan was originated to facilitate the sale of Company owned real estate during 2000 and the $1.5 million represented interest income that was collected but not recognized during the facilitation period.  The loan was paid in full during the third quarter of 2008, which resulted in full recognition of interest collected in prior periods.  This transaction had the effect of increasing the average yield on interest earning assets by 10 basis points for the year ended December 31, 2008.





Interest income on mortgage-related securities decreased $578,000, or 7.5%, to $7.1 million during the year ended December 31, 2009 from $7.7 million during the year ended December 31, 2008.  The decrease in interest income was primarily due to a $9.9 million, or 7.2%, decrease in the average balance of mortgage-related securities to $126.6 million for the year ended December 31, 2009 from $136.5 million during the year ended December 31, 2008.  The average yield on mortgage-related securities remained unchanged at 5.61% for the years ended December 31, 2009 and 2008.  The decline in the average balance of mortgage-related securities during the year ended December 31, 2009 reflects management’s decision to reinvest security portfolio cash flows in the more liquid government agency and higher yielding municipal debt securities.





Interest income on other earnings assets, consisting of debt securities, federal funds sold and short-term investments remained stable at $3.5 million for both the year ended December 31, 2009 and 2008, notwithstanding a 100 basis point decline in the average yield on other earning assets to 2.03% for the year ended December 31, 2009 from 3.03% for the comparable period in 2008.  The decrease in average yield on these investments reflected the decline in market interest rates as opposed to a shift in investment strategy or product mix.  The decrease in average yield was offset by a $58.2 million, or 50.0%, increase in the average balance of other earning assets to $174.6 million for the year ended December 31, 2009 from $116.4 million for the year ended December 31, 2008.  The increase in average balance reflected a strategic shift towards higher levels of liquidity.  The Company intends to maintain higher than usual liquidity given the current economic environment and relatively low rates of return available on loans and mortgage related securities.  The average balance of debt securities, federal funds sold and short-term investments includes FHLBC stock of $21.7 million and $20.9 million for the years ended December 31, 2009 and 2008, respectively.  On October 10, 2007, the FHLBC entered into a consensual cease and desist order with its regulator, the Federal Housing Finance Board. Under the terms of the order, dividend declarations are subject to the prior written approval of the Federal Housing Finance Board.  The FHLBC has not declared a dividend since it entered into the cease and desist order.  At the request of the FHLBC, on July 24, 2008, the Finance Board amended the cease and desist order to allow the FHLBC to redeem incremental purchases of capital stock tied to increased levels of borrowing through advances after repayment of those new advances.






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Total Interest Expense-Total interest expense decreased by $8.5 million, or 13.4%, to $54.6 million for  the year ended December 31, 2009 from $63.0 million for the year ended December 31, 2008.  This decrease was the result of a decrease of 68 basis point decrease in our cost of funds to 3.16% for the year ended December 31, 2009 from 3.84% for the year ended December 31, 2008, which was partially offset by a $93.8 million, or 5.7%, increase in average interest bearing deposits and borrowings outstanding to $1.73 billion for the year ended December 31, 2009 from $1.64 billion for the year ended December 31, 2008.





Interest expense on deposits decreased $7.8 million, or 18.4%, to $34.5 million during the year ended December 31, 2009 from $42.3 million during the comparable period in 2008.  This was due to a decrease in the average cost of deposits of 89 basis points to 2.87% for the year ended December 31, 2009 compared to 3.76% for the year ended December 31, 2008  The decrease in interest expense attributable to the decrease in the cost of deposits was partially offset by an increase of $82.2 million, or 7.3%, in the average balance of interest bearing deposits to $1.20 billion for the year ended December 31, 2009 from $1.12 billion during the year ended December 31, 2008.  The decrease in the average cost of deposits reflects the Federal Reserve’s reduction of short term interest rates which are typically used by financial institutions in pricing deposit products.





Interest expense on borrowings decreased $685,000, or 3.3%, to $20.1 million during the year ended December 31, 2009 from $20.8 million during the year ended December 31, 2008.  The decrease resulted primarily from a 21 basis point decrease in the average cost of borrowings to 3.90% for the year ended December 31, 2009 from 4.11% for the year ended December 31, 2008, which was partially offset by a $16.7 million, or 3.4%, increase in average borrowings outstanding to $511.4 million for the year ended December 31, 2009 from $494.7 million for the year ended December 31, 2008.  The increased use of borrowings as a source of funding for the year ended December 31, 2009 reflected our assessment that such sources of funds provided favorable rates and terms compared to retail funding sources.  The reduction in short term interest rates by the Federal Reserve allowed banks such as WaterStone Bank to borrow funds at lower rates, helping to reduce our cost of funds.





Net Interest Income - Net interest income increased by $2.9 million or 7.0%, to $43.9 million during the year ended December 31, 2009 as compared to $41.1 million during the year ended December 31, 2008.  Net interest income continues to be positively affected by lower short and medium term interest rates in 2009, as compared to 2008 and by our interest bearing liabilities repricing at a faster rate than our interest earning assets.  The increase in net interest income resulted primarily from a 21 basis point increase in our interest rate spread to 2.25% for the year ended December 31, 2009 from 2.04% for the year ended December 31, 2008.  The 21 basis point increase in the interest rate spread resulted from a 68 basis point decrease in the average cost of interest bearing liabilities, which was only partially offset by a 47 basis point decrease in the average yield on interest earning assets.  The increase in net interest income resulting from an increase in our net interest rate spread was partially offset by a decrease in average net earning assets of $37.1 million, or 28.9%, to $91.3 million for the year ended December 31, 2009 from $128.4 million from the year ended December 31, 2008.  The decrease in average net earning assets was primarily attributable to an increase in loans transferred to real estate owned.  The average balance of real estate owned totaled $39.5 million for the year ended December 31, 2009 compared to $15.6 million for the year ended December 31, 2008.





Provision for Loan Losses – Our provision for loan losses decreased $10.9 million, to $26.7 million during the year ended December 31, 2009, from $37.6 million during the year ended December 31, 2008.  While the provision for loan losses has decreased from the prior year, it remained at historically high levels.  These levels remain high due to continued general economic stress resulting in reduced levels of income earned by many of our borrowers combined with loan collateral values, primarily real estate, that remain at levels below those estimated at the time the loans were originally made.  These factors result in higher levels of actual loss experience which when applied to the portfolio in general require higher loan loss provisions.  They also result in more loans exhibiting risk characteristics that require estimated loan loss provisions in excess of our historical average experience rates.  These risk characteristics include reduced borrower global cash flow, reduced borrower FICO scores and known declines in collateral value even though the loan may still be performing.  The provision for the year ended December 31, 2009 was the result of $23.4 million of net loan charge-offs combined with continued weakness in local real estate markets which required an overall increase to the allowance for loan losses.  See the Asset Quality section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions.





Noninterest Income - Total noninterest income increased $5.9 million, or 94.1%, to $12.2 million during the year ended December 31, 2009 from $6.3 million during the year ended December 31, 2008.  The increase primarily resulted from an increase in mortgage banking income.  Mortgage banking income increased $5.7 million to $10.0 million for the year ended December 31, 2009, compared to $4.3 million during the comparable period in 2008.  The increase was the result of an expansion of the branch network of our mortgage banking subsidiary and increased mortgage loan refinancing triggered by declines in mortgage interest rates during the period.  During the year ended December 31, 2009, the Company sold $707.1 million of mortgage loans into the secondary market, as compared to $266.0 million during the comparable period in 2008.





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Noninterest Expense - Total noninterest expense increased $7.0 million, or 20.7%, to $40.9 million for the year ended December 31, 2009 from $33.9 million for the year ended December 31, 2008.  The increase was primarily attributable to higher FDIC insurance premiums, including a special assessment charged to income during the second quarter of 2009, and real estate owned expense.





Compensation, payroll taxes and other employee benefits expense increased $255,000, or 1.5%, to $17.3 million during the year ended December 31, 2009 compared to $17.1 million during the year ended December 31, 2008.  Due primarily to an expansion of our mortgage banking operations, total compensation, and payroll taxes increased $479,000, or 3.5%, to $14.1 million for the year ended December 31, 2009 compared to $13.6 million for the year ended December 31, 2008.  Company paid health insurance expense increased $133,000 to $1.1 million during the year ended December 31, 2009 compared to $963,000 during the year ended December 31, 2008.  Partially offsetting the increase in compensation and health insurance expense, ESOP expense decreased $526,000, to $250,000 for the year ended December 31, 2009 compared to $776,000 during the year ended December 31, 2008.  This decrease reflects the decrease in the Company’s average share price for the year ended December 31, 2009 compared to 2008.





Real estate owned expense increased $1.9 million, or 41.4%, to $6.4 million for the year ended December 31, 2009 compared to $4.6 million for the year ended December 31, 2008.  Real estate owned expense includes the net gain or loss recognized upon the sale of a foreclosed property, as well as the net operating and carrying costs related to the properties.  For the year ended December 31, 2009, net operational expenses increased $119,000 to $3.3 million from $3.2 million during the year ended December 31, 2008.  For the year ended December 31, 2009, the Company allocated additional resources to increasing occupancy rates and controlling costs at its income producing properties.  As a result, net operational expenses were relatively stable given the increase in properties under management.  The average balance of real estate owned totaled $39.5 million for the year ended December 31, 2009 compared to $15.6 million for the year ended December 31, 2008.  Net losses recognized on the write-down or sale of real estate owned totaled $3.1 million during the year ended December 31, 2009, compared to a net losses of $1.4 million during the year ended December 31, 2008.





Other noninterest expense increased $4.7 million, or 141.4%, to $8.0 million during the year ended December 31, 2009 from $3.3 million during the year ended December 31, 2008.  The increase resulted primarily from a $4.1 million increase in FDIC deposit insurance premiums to $4.7 million for the year ended December 31, 2009 from $545,000 for the year ended December 31, 2008.  The increase resulted from both an increase in the premium rate as well as a special assessment totaling $876,000 that was paid on September 30, 2009.





Income Taxes – We recorded an income tax benefit of $1.3 million for the year ended December 31, 2009, primarily as a result of federal and Wisconsin tax law changes enacted during 2009.  In the first quarter a Wisconsin state tax law change was enacted (with retroactive effect to January 1, 2009) requiring combined filing in Wisconsin.  We recognized a state benefit in connection with the establishment of a Wisconsin deferred tax asset (which does not require a valuation allowance) related to the unrealized loss on securities available for sale owned by the Company’s Nevada subsidiary.  In addition, we recognized a federal tax benefit as a result of legislation passed in the fourth quarter of 2009 allowing for a one-time carry back of tax losses for up to five years.  The effective tax rate for the year ended December, 31, 2009 was 11.4%.





Income tax expense of $2.3 million for the year ended December 31, 2008 is comprised of $7.6 million in deferred tax expense partially offset by current tax benefit of $5.3 million.  The deferred tax expense is the result of valuation allowances established in accordance with generally accepted accounting principles. The effective tax rate for the year ended December, 31, 2008 was (9.5%).





Net Loss-As a result of the foregoing factors, net loss for the year ended December 31, 2009 was $10.1 million as compared to a net loss of $26.4 million during the year ended December 31, 2008.








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Liquidity and Capital Resources





We maintain liquid assets at levels we consider adequate to meet our liquidity needs.  Our liquidity ratio averaged 4.8% and 4.5% for the years ended December 31, 2010 and 2009.  The liquidity ratio is equal to average daily cash and cash equivalents for the period divided by average total assets.  We adjust our liquidity levels to fund loan commitments, repay our borrowings, fund deposit outflows and pay real estate taxes on mortgage loans.  We also adjust liquidity as appropriate to meet asset and liability management objectives.  The operational adequacy of our liquidity position at any point in time is dependent upon the judgment of the Chief Financial Officer as supported by the full Asset/Liability Committee.  Liquidity is monitored on a daily, weekly and monthly basis using a variety of measurement tools and indicators.  Regulatory liquidity, as required by the Wisconsin Department of Financial Institutions, is based on current liquid assets as a percentage of the prior month’s average deposits and short-term borrowings.  Minimum primary liquidity is equal to 4.0% of deposits and short-term borrowings and minimum total regulatory liquidity is equal to 8.0% of deposits and short-term borrowings.  The Bank’s primary and total regulatory liquidity at December 31, 2010 were 12.49% and 14.68%, respectively.




Our primary sources of liquidity are deposits, repayment of loans, sales of loans held for sale, maturities of investment securities and other short-term investments, and earnings and funds provided from operations.  While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows, loan prepayments and the origination and sale of loans held for sale are greatly influenced by market interest rates, economic conditions, and rates offered by our competitors.  However, effective March 1, 2010, our deposit rates are capped by the FDIC as a result of the consent order issued by federal and state regulators.  We set the interest rates on our deposits to maintain a desired level of total deposits.  In addition, we invest excess funds in short-term interest-earning assets, which provide liquidity to meet lending requirements.  Additional sources of liquidity for the purpose of managing long- and short-term cash flows include advances from the FHLBC.




A portion of our liquidity consists of cash and cash equivalents, which are a product of our operating, investing and financing activities.  At December 31, 2010 and 2009, respectively, $75.3 million and $71.1 million of our assets were invested in cash and cash equivalents.  Our primary sources of cash are principal repayments on loans, proceeds from the calls and maturities of debt and mortgage related securities, increases in deposit accounts, Federal funds purchased and advances from the FHLBC.




On October 10, 2007, the FHLBC entered into a consensual cease and desist order with its regulator, the Federal Housing Finance Board. Under the terms of the order, capital stock repurchases and redemptions, including redemptions upon membership withdrawal or other termination, are prohibited unless the FHLBC has received approval of the Director of the Office of Supervision of the Federal Housing Finance Board ("OS Director"). The order also provides that dividend declarations are subject to the prior written approval of the OS Director.We currently hold, at cost, $21.7 million of FHLBC stock, all of which we believe we will ultimately be able to recover.  Based upon correspondence we received from the FHLBC, also incorporated into FHLBC’s 8-K, there is currently no expectation that this cease and desist order will impact the short- and long-term funding options provided by the FHLBC.




Our cash flows are derived from operating activities, investing activities and financing activities as reported in our Consolidated Statements of Cash Flows included in our Consolidated Financial Statements.




During the years ended December 31, 2010 and 2009, loan repayments net of loan originations generated positive cash flows of $46.6 million and $62.3 million, respectively.  The decrease in loans receivable is reflective of the general decline in loan demand for variable-rate residential real estate mortgage loans combined with the Company’s tightened underwriting standards given the current economic conditions.  During the year ended December 31, 2008 our loan originations, net of collected principal, totaled $216.0 million.  Cash received from the calls, maturities and principal repayments of debt and mortgage related securities totaled $87.8 million, $58.9 million and $24.7 million for the years ended December 31, 2010, 2009 and 2008, respectively.  We purchased $101.7 million, $72.4 million and $42.1 million in debt and mortgage related securities classified as available for sale during the years ended December 31, 2010, 2009 and 2008, respectively.  In addition, we purchased $4.3 million in securities classified as held to maturity during the year ended December 31, 2008.  We sold $20.7 million and $515,000 in available for sale debt and mortgage related securities during the years ended December 31, 2010 and 2009.  There were no securities sold during the year ended December 31, 2008.




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Deposit flows are generally affected by the level of interest rates, market conditions and products offered by local competitors and other factors.  The net decrease in deposits was $19.4 million during the year ended December 31, 2010.  This compares to a net decrease in deposits of $31.0 million for the year ended December 31, 2009 and an increase of $201.4 million for the year ended December 31, 2008.   As a result of the consent order issued by state and federal regulators effective December 18, 2009, the Bank is prohibited from accepting or renewing brokered deposits and all other deposit rates are capped by the FDIC.




Liquidity management is both a daily and longer-term function of business management.  If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLBC, which provide an additional source of funds.  At December 31, 2010, we had $350.0 million in fixed-rate advances from the FHLBC, of which none were due within 12 months, but all of which are putable at the option of the FHLBC.  The weighted average rate on these advances was 3.88% as of December 31, 2010.




At December 31, 2010, we had outstanding commitments to originate loans of $14.7 million and unfunded commitments under construction loans, lines of credit and standby letters of credit of $40.3 million.  At December 31, 2010, certificates of deposit scheduled to mature in less than one year totaled $347.5million.  Based on prior experience, management believes that a significant portion of such deposits will remain with us, although there can be no assurance that this will be the case.  In the event a significant portion of our deposits are not retained by us, we will have to utilize other funding sources, such as FHLBC advances to maintain our level of assets.  However, such borrowings may not be available on attractive terms, or at all, if and when needed.  Alternatively, we would reduce our level of liquid assets, such as our cash and cash equivalents and securities available for sale in order to meet funding needs.  In addition, the cost of such deposits may be significantly higher if market interest rates are higher or there is an increased amount of competition for deposits in our market area at the time of renewal.




Contractual Obligations, Commitments, Contingent Liabilities, and Off-balance Sheet Arrangements




WaterStone Bank has various financial obligations, including contractual obligations and commitments that may require future cash payments.  The following tables present information indicating various non-deposit contractual obligations and commitments of WaterStone Bank as of December 31, 2010 and the respective maturity dates.




Contractual Obligations





More Than


More ThanOne Year


Three YearsOne Year or


Through


Through Five


Over FiveTotal


Less


Three Years


Years


Years(In Thousands)Deposits without a stated maturity (4)

$
171,138


$
171,138


$
-


$
-


$
-Certificates of deposit (4)


974,391



347,537



614,412



12,390



52Bank lines of credit (4)


22,959



22,959



-



-



-Federal Home Loan Bank advances (1)


350,000



-



-



-



350,000Repurchase agreements (2) (4)


84,000



-



-



-



84,000Operating leases (3)


298



243



55



-



-Salary continuation agreements


1,105



170



340



340



255Total Contractual Obligations

$
1,603,891


$
542,047


$
614,807


$
12,730


$
434,307




(1)  Secured under a blanket security agreement on qualifying assets, principally, mortgage loans.  Excludes interest that will accrue on the advances.

All Federal Home Loan Bank advances with maturities exceeding five years are callable on a quarterly basis.


(2)  The repurchase agreements are callable on a quarterly basis.


(3)  Represents non-cancellable operating leases for offices and equipment.


(4)  Excludes interest.






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The following table details the amounts and expected maturities of significant off-balance sheet commitments as of December 31, 2010.





Other Commitments





More than


More thanOne Year


Threethrough


YearsOne Year


Three


Through


Over FiveTotal


or Less


Years


Five Years


Years(In Thousands)Real estate loan commitments(1)

$
14,681


$
14,681


$
-


$
-


$
-Unused portion of home equity lines of credit(2)


25,803



25,803



-



-



-Unused portion of construction loans(3)


2,832



2,832



-



-



-Unused portion of business lines of credit


10,630



10,630Standby letters of credit


991



901



90



-



-Total Other Commitments

$
54,937


$
54,847


$
90


$
-


$
-


_______________


General:  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 and generally have fixed expiration dates or other termination clauses.


(1)  Commitments for loans are extended to customers for up to 180 days after which they expire.


(2)  Unused portions of home equity loans are available to the borrower for up to 10 years.


(3)  Unused portions of construction loans are available to the borrower for up to 1 year.





Impact of Recent Accounting Pronouncements







In June 2009, the FASB issued ASC Topic 860-10-65, Accounting for Transfers of Financial Assets.  The standard removes the concept of a qualifying special-purpose entity from ASC Topic 860, Transfers and Servicing, and eliminates the exception for qualifying special-purpose entities from consolidation guidance.  In addition, the standard establishes specific conditions for reporting a transfer of a portion of a financial asset as a sale.  If the transfer does not meet established sale conditions, the transferor and transferee must account for the transfer as a secured borrowing.  An enterprise that continues to transfer portions of a financial asset that do not meet the established sale conditions would be eligible to record a sale only after it has transferred all of its interest in that asset.  The effective date is fiscal years beginning after November 15, 2009.  The adoption did not have an impact on our financial position, results of operation or liquidity.








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In June 2009, the FASB issued ASU No. 2009-17, “Consolidations (Topic 810) – Improvements to Financial Reporting for Enterprises involved with Variable Interest Entities”.  The standard replaces the quantitative-based risks and rewards calculation for determining which enterprise, if any, is the primary beneficiary and is required to consolidate the variable interest entity with a qualitative approach focused on identifying which enterprise has both the power to direct the activities of the variable interest entity that most significantly impact the entity’s economic performance and has the obligation to absorb losses or the right to receive benefits that could be significant to the entity.  In addition, the standard requires reconsideration of whether an entity is a variable interest entity when any changes in facts and circumstances occur such that the holders of the equity investment at risk, as a group, lose the power from voting rights or similar rights of those investments to direct the activities of the entity that most significantly impact the entity’s economic performance.  It also requires ongoing assessments of whether an enterprise is the primary beneficiary of a variable interest entity and additional disclosures about an enterprise’s involvement in variable interest entities. The effective date is for fiscal years beginning after November 15, 2009.  The adoption did not have an impact on our financial position, results of operation or liquidity.






In January 2010, the FASB issued ASU No. 2010-06, “Improving Disclosures about Fair Value Measurements”. The new standard requires disclosure regarding transfers in and out of Level 1 and Level 2 classifications within the fair value hierarchy as well as requiring further detail of activity within the Level 3 category of the fair value hierarchy. The new standard also requires disclosures regarding the fair value for each class of assets and liabilities, which is a subset of assets or liabilities within a line item in a company’s balance sheet. Additionally, the standard will require further disclosures surrounding inputs and valuation techniques used in fair value measurements. The new disclosures and clarifications of existing disclosures set forth in this ASU are effective for interim and annual reporting periods beginning after December 15, 2009, except for the additional disclosures regarding Level 3 fair value measurements, for which the effective date is for fiscal years and interim periods within those years beginning after December 15, 2010. The Company has partially adopted the provisions of this ASU as of January 1, 2010 for all new disclosure requirements except for the aforementioned requirements regarding Level 3 fair-value measurements, for which the Company will adopt that portion of the ASU on January 1, 2011. The portion of this ASU that was adopted on January 1, 2010 did not have a material impact on the Company’s consolidated financial statements. The adoption did not have an impact on our financial position, results of operation or liquidity.






In March 2010, the FASB issued ASU No. 2010-11 “Derivatives and Hedging (Topic 815) – Scope Exception Related to Embedded Credit Derivatives”.  The guidance eliminates the scope exception for bifurcation of embedded credit derivatives in interests in securitized financial assets, unless they are created solely by subordination of one financial debt instrument to another. The guidance is effective beginning in the first reporting period after June 15, 2010, with earlier adoption permitted for the quarter beginning after March 31, 2010. This clarification did not have a material impact to our financial position or results of operations.






In July 2010, the FASB issued ASUNo. 2010-20—“Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses”.  The main objective of this guidance is to provide financial statement users with greater transparency about an entity’s allowance for credit losses and the credit quality of its financing receivables. This pronouncement requires additional disclosures to assist financial statement users in assessing an entity’s credit risk exposures and evaluating the adequacy of its allowance for credit losses.  The adoption did not have an impact on our financial position, results of operation or liquidity.





In January 2011, the FASB issued ASU No. 2011-01, Receivables (Topic 310): Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 (ASU 2011-01). For public entities, ASU 2011-01 delays the effective date for certain disclosures about loans modified under troubled debt restructurings included in ASU No. 2010-20, Receivables (Topic 310): Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses (ASU 2010-20). The new effective date for the loans modified under troubled debt restructuring disclosures will be concurrent with the effective date of FASB’s proposed ASU, Receivables (Topic 310): Clarifications to Accounting for Troubled Debt Restructurings by Creditors. ASU 2011-01 does not change the effective date for other disclosures required by public entities in ASU 2010-20. The adoption of ASU 2011-01 once effective is not expected to have a material impact on the Company’s consolidated financial condition or results of operations.




Impact of Inflation and Changing Prices





The financial statements and accompanying notes of WaterStone Bank have been prepared in accordance with accounting principles generally accepted in the United States ("GAAP").  GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration for changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations.  Unlike industrial companies, our assets and liabilities are primarily monetary in nature.  As a result, changes in market interest rates have a greater impact on performance than do the effects of inflation.


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Quarterly Financial Information





The following table sets forth certain unaudited quarterly data for the periods indicated:








Quarter EndedMarch 31


June 30


September 30


December 31(In thousands, except per share data)2010 (unaudited)Interest income

$
23,049


$
22,026


$
22,465


$
22,393Interest expense


10,616



10,051



9,935



9,667Net interest income


12,433



11,975



12,530



12,726Provision for loan losses


5,457



7,031



6,249



7,095Net interest income after provision for loan losses


6,976



4,944



6,281



5,631Total noninterest income


4,301



5,830



11,479



17,383Total noninterest expense


11,101



11,874



18,253



23,399Income (loss) before income taxes


176



(1,100
)


(493
)


(385
)Income taxes (benefit)


-



22



-



30Net income (loss)

$
176


$
(1,122
)

$
(493
)

$
(415
)Income (loss) per share – basic

$
0.01


$
(0.04
)

$
(0.02
)

$
(0.01
)Income (loss) per share - diluted

$
0.01


$
(0.04
)

$
(0.02
)

$
(0.01
)2009 (unaudited)Interest income

$
24,991


$
24,814


$
24,668


$
24,015Interest expense


14,709



14,361



13,424



12,083Net interest income


10,282



10,453



11,244



11,932Provision for loan losses


7,201



3,001



8,853



7,632Net income after provision for loan losses


3,081



7,452



2,391



4,300Total noninterest income


720



3,574



3,955



3,959Total noninterest expense


7,906



9,177



9,918



13,875Income (loss) before income taxes


(4,105
)


1,849



(3,572
)


(5,616
)Income taxes (benefit)


(503
)


498



-



(1,301
)Net income (loss)

$
(3,602
)

$
1,351


$
(3,572
)

$
(4,315
)Income (loss) per share – basic

$
(0.12
)

$
0.04


$
(0.12
)

$
(0.14
)Income (loss) per share - diluted

$
(0.12
)

$
0.04


$
(0.12
)

$
(0.14
)








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Item 7A.  Quantitative and Qualitative Disclosures About Market Risk





Management of Market Risk





General.The majority of our assets and liabilities are monetary in nature.  Consequently, our most significant form of market risk is interest rate risk.  Our assets, consisting primarily of mortgage loans, have longer maturities than our liabilities, consisting primarily of deposits.  As a result, a principal part of our business strategy is to manage interest rate risk and reduce the exposure of our net interest income to changes in market interest rates.  Accordingly, WaterStone Bank’s board of directors has established an Asset/Liability Committee which is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board of directors.  Management monitors the level of interest rate risk on a regular basis and the Asset/Liability Committee meets at least weekly to review our asset/liability policies and interest rate risk position, which are evaluated quarterly.





We have sought to manage our interest rate risk in order to minimize the exposure of our earnings and capital to changes in interest rates.  We have implemented the following strategies to manage our interest rate risk: (i) emphasizing variable rate loans including variable rate one- to four-family, and commercial real estate loans as well as three to five year commercial real estate balloon loans; (ii) reducing and shortening the expected average life of the investment portfolio; and (iii) whenever possible, lengthening the term structure of our deposit base and our borrowings from the FHLBC.  These measures should reduce the volatility of our net interest income in different interest rate environments.




Income Simulation.  Simulation analysis is an estimate of our interest rate risk exposure at a particular point in time.  At least quarterly we review the potential effect changes in interest rates may have on the repayment or repricing of rate sensitive assets and funding requirements of rate sensitive liabilities.  Our most recent simulation uses projected repricing of assets and liabilities at December 31, 2010 on the basis of contractual maturities, anticipated repayments and scheduled rate adjustments.  Prepayment rate assumptions may have a significant impact on interest income simulation results.  Because of the large percentage of loans and mortgage-backed securities we hold, rising or falling interest rates may have a significant impact on the actual prepayment speeds of our mortgage related assets that may in turn affect our interest rate sensitivity position.  When interest rates rise, prepayment speeds slow and the average expected lives of our assets would tend to lengthen more than the expected average lives of our liabilities and therefore would most likely have a negative impact on net interest income and earnings.









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Percentage

Increase (Decrease) in Estimated

Net Annual Interest Income

Over 12 Months300 basis point gradual rise in rates
0.89%200 basis point gradual rise in rates
(0.69%)100 basis point gradual rise in rates
(2.32%)100 basis point gradual decline in rates
(4.60%)200 basis point gradual decline in rates
(6.82%)300 basis point gradual decline in rates
(8.63%)







WaterStone Bank’s Asset/Liability policy limits projected changes in net average annual interest income to a maximum decline of 20% for various levels of interest rate changes measured over a 12-month period when compared to the flat rate scenario.  In addition, projected changes in the economic value of equity are limited to a maximum decline of 10% to 80% for interest rate movements of 100 to 300 basis points when compared to the flat rate scenario.  These limits are re-evaluated on a periodic basis and may be modified, as appropriate.  Because our balance sheet is asset sensitive, net interest income is projected to decline as interest rates fall.  At December 31, 2010, a 100 basis point gradual increase in interest rates had the effect of decreasing forecast net interest income by 2.32% while a 100 basis point decrease in rates had the effect of decreasing net interest income by 4.60%.  At December 31, 2010, a 100 basis point gradual increase in interest rates had the effect of decreasing the economic value of equity by 0.25% while a 100 basis point decrease in rates had the effect of decreasing the economic value of equity by 4.13%.  While we believe the assumptions used are reasonable, there can be no assurance that assumed prepayment rates will approximate actual future mortgage-backed security and loan repayment activity.






































































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Item 8.  Financial Statements and Supplementary Data
















Report of Independent Registered Public Accounting Firm









Board of directors




Waterstone Financial, Inc.:




We have audited the accompanying consolidated statements of financial condition of Waterstone Financial, Inc. and subsidiaries (the Company) as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated 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, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of the Company as of December 31, 2010 and 2009, and the results of its operations and its cash flows for each of the years in the three-year period ended December 31, 2010 in conformity with U.S. generally accepted accounting principles.




We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the Company’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Framework issued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO), and our report dated March 14, 2011 expressed an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting.






/s/ KPMG LLP




Milwaukee, Wisconsin


March 14, 2011


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 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Consolidated Statements of Financial Condition
 December 31, 2010 and 2009





December 31,2010


2009Assets

(In Thousands, except share data)Cash

$
65,900



57,234Federal funds sold


9,426



9,631Interest-earning deposits in other financial institutionsand other short term investments


5



4,255Cash and cash equivalents


75,331



71,120Securities available for sale (at fair value)


203,166



205,415Securities held to maturity (at amortized cost)fair value of $2,501 in 2010 and $1,930 in 2009


2,648



2,648Loans held for sale (at fair value)


96,133



45,052Loans receivable


1,306,437



1,420,010Less: Allowance for loan losses


29,175



28,494Loans receivable, net


1,277,262



1,391,516Office properties and equipment, net


28,196



29,144Federal Home Loan Bank stock (at cost)


21,653



21,653Cash surrender value of life insurance


35,385



33,941Real estate owned


57,752



50,929Prepaid expenses and other assets


11,440



16,848Total assets

$
1,808,966



1,868,266Liabilities and Shareholders’ EquityLiabilities:Demand deposits

$
67,735



61,420Money market and savings deposits


103,403



92,028Time deposits


974,391



1,011,442Total deposits


1,145,529



1,164,890Short-term borrowings


22,959



73,900Long-term borrowings


434,000



434,000Advance payments by borrowers for taxes


2,379



630Other liabilities


31,879



26,254Total liabilities


1,636,746



1,699,674Shareholders’ equity:Preferred stock (par value $.01 per share)Authorized - 20,000,000 shares, no shares issued


-



-Common stock (par value $.01 per share)Authorized - 200,000,000 shares in 2010 and 2009Issued - 33,974,450 in 2010 and 2009Outstanding -  31,250,097 in 2010 and 2009


340



340Additional paid-in capital


109,953



108,883Accumulated other comprehensive income (loss), net of taxes


1,558



(2,001
)Retained earnings


109,046



110,900Unearned ESOP shares


(3,416
)


(4,269
)Treasury shares (2,724,353 shares), at cost


(45,261
)


(45,261
)Total shareholders’ equity


172,220



168,592Total liabilities and shareholders’ equity

$
1,808,966



1,868,266





See accompanying notes to consolidated financial statements.
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 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Consolidated Statements of Operations
 Years Ended December 31, 2010, 2009 and 2008








Years ended December 31,2010


2009


2008(In Thousands, except per share amounts)Interest income:Loans

$
81,161



87,847



92,860Mortgage-related securities


5,360



7,101



7,679Debt securities, federal funds sold andshort-term investments


3,412



3,540



3,539Total interest income


89,933



98,488



104,078Interest expense:Deposits


20,989



34,484



42,250Borrowings


19,280



20,093



20,777Total interest expense


40,269



54,577



63,027Net interest income


49,664



43,911



41,051Provision for loan losses


25,832



26,687



37,629Net interest income after provision for loan losses


23,832



17,224



3,422Noninterest income:Service charges on loans and deposits


1,093



1,191



1,656Increase in cash surrender value of life insurance


1,138



1,236



1,444Total other-than-temporary investment loses


-



(7,255
)


-Portion of loss recognized in other comprehensive loss (before tax)


-



6,143



-Net impairment losses recognized in earnings


-



(1,112
)


(1,997
)Mortgage banking income


35,465



9,976



4,296Other


1,297



917



892Total noninterest income


38,993



12,208



6,291Noninterest expenses:Compensation, payroll taxes, and other employee benefits


36,323



17,335



17,080Occupancy, office furniture, and equipment


5,762



4,822



4,779Advertising


1,259



876



1,155Data processing


1,372



1,413



1,377Communications


902



693



692Professional fees


1,689



1,334



924Real estate owned


6,583



6,434



4,551FDIC insurance premiums


4,353



4,683



545Other


6,384



3,286



2,757Total noninterest expenses


64,627



40,876



33,860Loss before income taxes


(1,802
)


(11,444
)


(24,147
)Income tax (benefit) expense


52



(1,306
)


2,299Net loss

$
(1,854
)


(10,138
)


(26,446
)Loss per share:Basic

$
(0.06
)


(0.33
)


(0.87
)Diluted

$
(0.06
)


(0.33
)


(0.87
)Weighted average shares outstanding:Basic


30,804,063



30,680,285



30,556,004Diluted


30,804,063



30,680,285



30,556,004





See accompanying notes to consolidated financial statements
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 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Consolidated Statements of Changes in Shareholders’ Equity
 Years Ended December 31, 2010, 2009 and 2008





AccumulatedAdditional





Unearned


Other





TotalCommon Stock


Paid-In


Retained


ESOP


Comprehensive


Treasury


Shareholders'Shares


Amount


Capital


Earnings


Shares


Income (Loss)


Shares


Equity(In Thousands)Balances at December 31, 2007


31,251


$
340



106,306



146,367



(5,977
)


44



(45,261
)


201,819Comprehensive income:Net loss


—



—



—



(26,446
)


—



—



—



(26,446
)Other comprehensive income:Net unrealized holding losseson available for sale securities

arising during the period,net of taxes of $4,195


—



—



—



—



—



(7,791
)


—



(7,791
)Reclassification adjustment fornet losses onavailable for sale

securities realized in netincome, net of taxes of $699


—



—



—



—



—



1,298



—



1,298Total comprehensive income






























(32,939
)ESOP shares committed to bereleased to Plan participants


—



—



(78
)


—



854



—



—



776Stock based compensation


(1
)


—



1,611



—



—



—



—



1,611Balances at December 31, 2008


31,250


$
340



107,839



119,921



(5,123
)


(6,449
)


(45,261
)


171,267Cummulative effect adjustment

related to a change inaccounting principle related to

available for sale securities,

net of taxes of $448


—



—



—



1,117



—



(669
)


—



448Comprehensive income:Net loss


—



—



—



(10,138
)


—



—



—



(10,138
)Other comprehensive income:Net unrealized holding gainson available for sale securities

arising during the period,net of taxes of $1,804


—



—



—



—



—



4,451



—



4,451Reclassification adjustment fornet losses onavailable for sale

securities realized in netincome, net of taxes of $446


—



—



—



—



—



666



—



666Total comprehensive income






























(4,573
)ESOP shares committed to bereleased to Plan participants


—



—



(604
)


—



854



—



—



250Stock based compensation


—



—



1,648



—



—



—



—



1,648Balances at December 31, 2009


31,250


$
340



108,883



110,900



(4,269
)


(2,001
)


(45,261
)


168,592









See accompanying notes to consolidated financial statements.
 - 73 -
 Waterstone Financial, Inc. and Subsidiaries
 Consolidated Statements of Changes in Shareholders’ Equity
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents





AccumulatedAdditional





Unearned


Other





TotalCommon Stock


Paid-In


Retained


ESOP


Comprehensive


Treasury


Shareholders'Shares


Amount


Capital


Earnings


Shares


Income (Loss)


Shares


Equity(In Thousands)Balances at December 31, 2009


31,250



340



108,883



110,900



(4,269
)


(2,001
)


(45,261
)


168,592Comprehensive income:Net loss


—



—



—



(1,854
)


—



—



—



(1,854
)Other comprehensive income:Net unrealized holding gains onavailable for sale securities

arising during the period,net of taxes of $2,102


—



—



—



—



—



3,592



—



3,592Reclassification adjustment fornet gains onavailable for sale

securities realized in netincome, net of taxes of $22


—



—



—



—



—



(33
)


—



(33
)Total comprehensive income






























1,705ESOP shares committed to bereleased to Planparticipants


—



—



(589
)


—



853



—



—



264Stock based compensation


—



—



1,659



—



—



—



—



1,659Balances at December 31, 2010


31,250


$
340



109,953



109,046



(3,416
)


1,558



(45,261
)


172,220














See accompanying notes to consolidated financial statements.
 - 74 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Consolidated Statements of Cash Flows
 Years Ended December 31, 2010, 2009 and 2008




Years ended December 31,2010


2009


2008(In Thousands)Operating activities:Net loss

$
(1,854
)


(10,138
)


(26,446
)Adjustments to reconcile net loss to netcash provided by (used in) operating activities:Provision for loan losses


25,832



26,687



37,629Provision for depreciation


1,859



1,970



2,430Deferred income taxes


-



479



7,560Stock based compensation


1,659



1,648



1,611Net amortization of premium/discount on debt andmortgage related securities


70



(218
)


(445
)Amortization of unearned ESOP shares


264



250



776Gain on sale of loans held for sale


(35,465
)


(9,477
)


(3,437
)Loans originated for sale


(1,084,362
)


(739,179
)


(255,891
)Proceeds on sales of loans originated for sale


1,068,746



716,596



268,690(Increase) decrease in accrued interest receivable


424



(205
)


(1,207
)Increase in cash surrender value of life insurance


(1,138
)


(1,236
)


(1,444
)Increase (decrease) in accrued interest  on deposits and borrowings


(1,011
)


(2,468
)


1,240Increase (decrease) in other liabilities


7,565



1,626



(6,054
)(Increase) decrease in accrued tax receivable


5,606



(2,732
)


(5,351
)(Gain) loss on impairment or sale of securities


(55
)


1,112



1,997(Gain) loss on sale of office properties and equipment


(21
)


(49
)


233Net loss related to real estate owned


675



3,166



1,417Other


(1,922
)


284



760Net cash provided by (used in) operating activities


(13,128
)


(11,884
)


24,068Investing activities:Net (increase) decrease in loans receivable


46,642



62,316



(215,957
)Purchases of:Debt securities


(66,955
)


(54,731
)


(11,596
)Mortgage related securities


(34,700
)


(17,701
)


(30,525
)Structured notes, held to maturity


-



-



(4,289
)Premises and equipment, net


(925
)


(3,820
)


(1,284
)Bank owned life insurance


(306
)


(306
)


(5,306
)FHLB stock


-



-



(2,364
)Proceeds from:Principal repayments on mortgage-related securities


40,624



36,610



19,452Maturities of debt securities


47,202



14,988



3,244Sales of debt securities


14,023



515



—Sales of mortgage-related securities


6,710



—



—Calls of structured notes


—



7,289



1,998Sales of foreclosed properties and other assets


33,577



24,334



15,391Net cash provided by (used in) investing activities


85,892



69,494



(231,236
)




Financing activities:Net increase (decrease) in deposits


(19,361
)


(31,007
)


201,362Net change in short-term borrowings


(50,941
)


20,900



(53,484
)Proceeds from long-term borrowings


-



—



65,000Net increase (decrease) in advance payments by borrowers for taxes


1,749



(232
)


255Net cash (used) provided by financing activities


(68,553
)


(10,339
)


213,133Increase in cash and cash equivalents


4,211



47,271



5,965Cash and cash equivalents at beginning of period


71,120



23,849



17,884Cash and cash equivalents at end of period

$
75,331



71,120



23,849Supplemental information:Cash paid, credited or (received) during the period for:Income tax payments (refunds)


(5,554
)


(500
)


230Interest payments


41,013



57,045



61,787Noncash investing activities:Loans receivable transferred to other real estate


41,781



54,072



32,946Non Cash financing activities:Long-term FHLB advances reclassified to short-term


-



48,900



4,100




See Accompanying notes to consolidated financial statements.
 - 75 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008





1)
Summary of Accounting Policies




a)
Organization




The board of directors of WaterStone Bank (the Bank) adopted the Plan of Reorganization and related Stock Issuance Plan on May 17, 2005, as amended on June 3, 2005, under which Waterstone Financial, Inc. (the Company) was formed to become the mid-tier holding company for the Bank. In addition, Lamplighter Financial, MHC, a Federally-chartered mutual holding company, was formed to become the majority owner of Waterstone Financial, Inc. The Company’s outstanding common shares are 73.8% owned by Lamplighter Financial, MHC at December 31, 2010.




At a special meeting of shareholders held on July 18, 2008, the shareholders of Wauwatosa Holdings, Inc. approved an amendment to the Company’s charter changing its name to Waterstone Financial, Inc.  The charter amendment was effective August 1, 2008.




b)
Nature of Operations




The Company is a one-bank holding company with a single operating segment – community banking.  The Bank is principally engaged in the business of attracting deposits from the general public and using such deposits to originate real estate, business and consumer loans.




The Bank provides a full range of financial services to customers through branch locations in southeastern Wisconsin. The Bank is subject to the regulations of certain federal and state agencies and undergoes periodic examinations by those regulatory authorities.





The Bank owns a mortgage banking subsidiary that originates residential real estate loans held for sale at various branch offices across the country.  Mortgage banking volume fluctuates widely given movements in interest rates.  Mortgage banking income is reported as a single line item in the statements of operations while mortgage banking expense is distributed among the various noninterest expense lines.  Compensation, payroll taxes and other employee benefits expense varies directly with mortgage banking income.







c)
Principles of Consolidation




The consolidated financial statements include the accounts and operations of Waterstone Financial, Inc. and its wholly owned subsidiary, WaterStone Bank.  The Bank has the following wholly owned subsidiaries: Wauwatosa Investments, Inc. and Waterstone Mortgage Corporation. All significant intercompany accounts and transactions have been eliminated in consolidation.




d)
Use of Estimates




The preparation of the consolidated financial statements requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period. Significant items subject to such estimates and assumptions include: the allowance for loan losses, deferred income taxes, valuation of investments, evaluation of other than temporary impairment on investments and real estate owned. Actual results could differ from those estimates and the current economic environment has increased the degree of uncertainty inherent in those estimates and assumptions.




See accompanying notes to consolidated financial statements.
 - 76 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents






e)
Cash and Cash Equivalents




The Company considers federal funds sold and highly liquid debt instruments with a maturity of three months or less when purchased to be cash equivalents.




f)
Securities




Available for Sale Securities




At the time of purchase, investment securities are classified as available for sale, as management has the intent and ability to hold such securities for an indefinite period of time, but not necessarily to maturity.  Any decision to sell investment securities available for sale would be based on various factors, including, but not limited to asset/liability management strategies, changes in interest rates or prepayment risks, liquidity needs, or regulatory capital considerations.  Available for sale securities are carried at fair value, with the unrealized gains and losses, net of deferred tax, reported as a separate component of equity, accumulated other comprehensive income.  The cost of debt securities is adjusted for amortization of premiums and accretion of discounts to maturity or, in the case of mortgage-backed securities and collateralized mortgage obligations, over the estimated life of the security. Such amortization is included in interest income from securities.  Realized gains or losses on securities sales (using specific identification method) are included in other income.  Declines in value judged to be other than temporary are included in investment securities gains (losses), net, in the consolidated statements of income.




Held to Maturity Securities




Debt securities that the Company has the intent and ability to hold to maturity have been designated as held to maturity.  Such securities are stated at amortized cost.




Other Than Temporary Impairment




One of the significant estimates related to securities is the evaluation of investments for other than temporary impairment.  The Company assesses  investment securities with unrealized loss positions for other than temporary impairment on at least a quarterly basis.  When the fair value of an investment is less than its amortized cost at the balance sheet date of the reporting period for which impairment is assessed, the impairment is designated as either temporary or other than temporary.  In evaluating other than temporary impairment, management considers the length of time and extent to which the fair value has been less than cost and the expected recovery period of the security, the financial condition and near-term prospects of the issuer, and the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value in the near term.  Declines in the fair value of investment securities below amortized cost are deemed to be other than temporary when the Company cannot assert that it will recover its amortized cost basis, including whether the present value of cash flows expected to be collected is less than the amortized cost basis of the security. If it is more likely than not that the Company will be required to sell the security before recovery or if the Company has the intent to sell, an other than temporary impairment write down is recognized in earnings equal to the difference between the security’s amortized cost and its fair value.  If it is not more likely than not that the Company will be required to sell the security before recovery and if the Company does not intend to sell, the other than temporary impairment write down is separated into an amount representing credit loss, which is recognized in earnings, and an amount related to other factors, which is recognized as a separate component of equity.  Following the recognition of an other than temporary impairment representing credit loss, the book value of an investment less the impairment loss realized becomes the new cost basis.  Because the Company’s assessments are based on factual information as well as subjective information available at the time of assessment, the determination as to whether an other than temporary impairment exists and, if so, the amount considered other than temporarily impaired, or not impaired, is subjective and, therefore, the timing and amount of other than temporary impairments constitute material estimates that are subjective to significant change.






See accompanying notes to consolidated financial statements.
 - 77 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




Federal Home Loan Bank Stock




Federal Home Loan Bank stock is carried at cost, which is the amount that the stock is redeemable by tendering to the FHLBC or the amount at which shares can be sold to other FHLBC members.  FHLBC dividends are recognized as income on their ex-dividend date.




g)
Loans Held for Sale




The origination of residential real estate loans is an integral component of the business of the Company. The Company generally sells its originations of long-term fixed interest rate mortgage loans in the secondary market. Gains and losses on the sales of these loans are determined using the specific identification method. The Company sells mortgage loans in the secondary market on a servicing released basis. Mortgage loans originated for sale are generally sold within 45 days after closing.




The Company has elected to carry loans held for sale at fair value as of January 1, 2009.  Prior to that date, loans held for sale were carried at lower of cost or market.  Fair value is generally determined by estimating a gross premium or discount, which is derived from pricing currently observable in the market.  The amount by which cost differs from market value is accounted for as a valuation adjustment to the carrying value of the loans.  Changes in value are included in mortgage banking income in the consolidated statements of operations.  The carrying value of loans held for sale included a market valuation adjustment of $1.8 million at December 31, 2010.




Costs to originate loans held for sale are expensed as incurred and are included on the appropriate noninterest expense lines of the statements of operations.  Salaries, commissions and related payroll taxes are the primary costs to originate and comprise approximately 75% of total mortgage banking noninterest expense.  Prior to January 1, 2009, costs to originate loans held for sale were deferred and offset against mortgage banking income.




The value of mortgage loans held for sale and other residential mortgage loan commitments to customers are hedged by utilizing both best efforts and mandatory forward commitments to sell loans to investors in the secondary market. Such forward commitments are generally entered into at the time when applications are taken to protect the value of the mortgage loans from increases in market interest rates during the period held. The Corporation recognizes revenue associated with the expected future cash flows of servicing loans at the time a forward loan commitment is made, as required under Securities and Exchange Commission Staff Accounting Bulletin No. 109, Written Loan Commitments Recorded at Fair Value Through Earnings.




h)
Loans Receivable and Related Interest Income




Loans are classified as held for investment when management has both the intent and ability to hold the loan for the foreseeable future, or until maturity or payoff.  Loans are carried at the principal amount outstanding, net of any unearned income, charge-offs and unamortized deferred fees and costs.  Loan origination and commitment fees and certain direct loan origination costs are deferred and the net amount amortized as an adjustment of the related loan yield. Amortization is based on a level-yield method over the contractual life of the related loans or until the loan is paid in full.




Loan interest income is recognized on the accrual basis.  Accrual of interest is generally discontinued either when reasonable doubt exists as to the full, timely collection of interest or principal, or when a loan becomes contractually past due more than 90 days with respect to interest or principal. At that time, previously accrued and uncollected interest on such loans is reversed and additional income is recorded only to the extent that payments are received and the collection of principal is reasonably assured.  Generally, loans are restored to accrual status when the obligation is brought current, has performed in accordance with the contractual terms for a reasonable period of time, and the ultimate collectibility of the total contractual principal and interest is no longer in doubt.




A loan is accounted for as a troubled debt restructuring if the Company, for economic reasons related to the borrower’s financial condition, grants a significant concession to the borrower that it would not otherwise consider.  A troubled debt restructuring typically involves a modification of terms such as a reduction of the stated interest rate, a deferral of principal payments or a combination of both for a temporary period of time.  If the borrower was performing in accordance with the original contractual terms at the time of the restructuring, the restructured loan is accounted for on an accruing basis as long as the borrower continues to comply with the modified terms.  If the loan was not accounted for on an accrual basis at the time of restructuring, the restructured loan remains in non-accrual status until the loan returns to its original contractual terms and a positive payment history is established.




See accompanying notes to consolidated financial statements.
 - 78 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents






i)
Allowance for Loan Losses




The allowance for loan losses is presented as a reserve against loans and represents the Bank’s assessment of probable loan losses inherent in the loan portfolio.  The allowance for loan losses is established as losses are estimated to have occurred through a provision for loan losses charged to income.  Estimated loan losses are charged against the allowance when the loan balance is confirmed to be uncollectible directly or indirectly by the borrower or upon initiation of a foreclosure action by the Bank.  Subsequent recoveries, if any, are credited to the allowance.




The allowance provides for probable losses that have been identified with specific customer relationships and for probable losses believed to be inherent in the loan portfolio, but have not been specifically identified.  The Bank utilizes its own loss history to estimate inherent losses on loans. Although the Bank allocates portions of the allowance to specific loans and loan types, the entire allowance is available for any loan losses that occur.




The Bank evaluates the need for specific valuation allowances on loans that are considered impaired. A loan is considered impaired when, based on current information and events, it is probable that the Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement. Within the loan portfolio, all non-accrual loans and loans modified under troubled debt restructurings have been determined by the Bank to meet the definition of an impaired loan.  In addition, other one- to four-family, over four-family, construction and land, commercial real estate and commercial loans may be considered impaired loans.  A valuation allowance is established for an amount equal to the impairment when the carrying amount of the loan exceeds the present value of the expected future cash flows, discounted at the loan’s original effective interest rate or the fair value of the underlying collateral.




The Bank also establishes valuation allowances based on an evaluation of the various risk components that are inherent in the loan portfolio. The risk components that are evaluated include past loan loss experience; the level of non-performing and classified assets; current economic conditions; volume, growth, and composition of the loan portfolio; adverse situations that may affect the borrower’s ability to repay; the estimated value of any underlying collateral; regulatory guidance; and other relevant factors.




The Bank’s allowance for loan losses is also intended to cover potential 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 notional amount of those instruments. The Company uses the same credit policies in making commitments and conditional obligations as it does for other financial instruments reflected in the consolidated financial statements.




The adequacy of the allowance for loan losses is approved quarterly by the Bank’s board of directors. The allowance reflects management’s best estimate of the amount needed to provide for the probable loss on impaired loans, as well as other credit risks of the Bank, and is based on a risk model developed and implemented by management and approved by the Bank’s board of directors.




Actual results could differ from this estimate, and future additions to the allowance may be necessary based on unforeseen changes in economic conditions. In addition, federal regulators periodically review the Bank’s allowance for loan losses. Such regulators have the authority to require the Bank to recognize additions to the allowance at the time of their examination.




j)
Real Estate Owned




Real estate owned consists of properties acquired through, or in lieu of, loan foreclosure.  Real estate owned is recorded at estimated fair value less anticipated selling costs based upon the property’s appraised value at the date of transfer, with any difference between the fair value of the property and the net carrying value of the loan charged to the allowance for loan losses.  Subsequent write-downs to reflect current fair market value, as well as gains and losses upon disposition and revenue and expenses incurred in maintaining such properties, are treated as period costs and included in real estate owned in the consolidated statements of operations.






See accompanying notes to consolidated financial statements.
 - 79 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




k)
Cash Surrender Value of Life Insurance




The Company purchased bank owned life insurance on the lives of certain employees.  The Company is the beneficiary of the life insurance policies.  The cash surrender value of life insurance is reported at the amount that would be received in cash if the polices were surrendered.  Increases in the cash value of the policies and proceeds of death benefits received are recorded in non-interest income.  The increase in cash surrender value of life insurance is not subject to income taxes, as long as the Company has the intent and ability to hold the policies until the death benefits are received.




l)
Office Properties and Equipment




Office properties and equipment, including leasehold improvements and software, are stated at cost, net of depreciation and amortization. Depreciation and amortization are computed on the straight-line method over the estimated useful lives of the related assets. Leasehold improvements are amortized over the lease term, if shorter than the estimated useful life. Maintenance and repairs are charged to expense as incurred, while additions or major improvements are capitalized and depreciated over their estimated useful lives. Estimated useful lives of the assets are 10 to 30 years for office properties, three to 10 years for equipment, and three years for software. Rent expense related to long-term operating leases is recorded on the accrual basis.




m)
Income Taxes




The Company and its subsidiaries file consolidated federal and combined state income tax returns. The provision for income taxes is based upon income in the consolidated financial statements, rather than amounts reported on the income tax returns.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases, as well as net operating loss carry fowards.  Deferred tax assets and liabilities are measured using enacted tax rates expected to apply to taxable income in the years in which those temporary differences are expected to be recovered or settled.  The effect on deferred tax assets and liabilities of a change in tax rates is recognized as income or expense in the period that includes the enactment date.
 
 The Company evaluates the realizability of its deferred tax assets on a quarterly basis.  Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that a deferred tax asset will not be realized.  The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions.
 
 Positions taken in the Company’s tax returns may be subject to challenge by the taxing authorities upon examination.  The benefit of uncertain tax positions are initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities.  Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that is greater than 50% likely of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts.   Interest and penalties on income tax uncertainties are classified within income tax expense in the income statement.





n)
Earnings Per Share




Earnings per share are computed using the two-class method.  Basic earnings per share is computed by dividing net income allocated to common shareholders by the weighted average number of common shares outstanding during the applicable period, excluding outstanding participating securities.  Diluted earnings per share is computed by dividing net income by the weighted average number of common shares outstanding adjusted for the dilutive effect of all potential common shares.  Diluted EPS reflects the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock.  Shares of the Employee Stock Ownership Plan committed to be released are considered outstanding for both common and diluted EPS.  Incentive stock compensation awards granted can result in dilution.





o)
Other Comprehensive Income




Comprehensive income is the total of reported net income and all other revenues, expenses, gains and losses that under generally accepted accounting principles bypass reported net income.  The Company includes unrealized gains or losses, net of tax, on securities available for sale in other comprehensive income.




See accompanying notes to consolidated financial statements.
 - 80 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




p)
Employee Stock Ownership Plan (ESOP)




Compensation expense under the ESOP is equal to the fair value of common shares released or committed to be released to participants in the ESOP in each respective period.  Common stock purchased by the ESOP and not committed to be released to participants is included in the consolidated statements of financial condition at cost as a reduction of shareholders’ equity.




2)
Securities




Securities Available for Sale




The amortized cost and fair values of the Company’s investment in securities follow:






December 31, 2010Gross


GrossAmortized


unrealized


unrealizedcost


gains


losses


Fair value(In Thousands)Mortgage-backed securities

$
42,607



1,839



(116
)


44,330Collateralized mortgage obligationsGovernment sponsored enterprise issued


38,262



1,141



(126
)


39,277Private label issued


26,199



280



(1,032
)


25,447Mortgage related securities


107,068



3,260



(1,274
)


109,054Government sponsored enterprise bonds


57,327



391



(20
)


57,698Municipal securities


31,804



721



(1,405
)


31,120Other debt securities


5,000



294



—



5,294Debt securities


94,131



1,406



(1,425
)


94,112$
201,199



4,666



(2,699
)


203,166December 31, 2009Gross


GrossAmortized


unrealized


unrealizedcost


gains


losses


Fair value(In Thousands)Mortgage-backed securities

$
39,785



1,728



—



41,513Collateralized mortgage obligationsGovernment sponsored enterprise issued


43,372



1,614



(26
)


44,960Private label issued


36,681



—



(6,319
)


30,362Mortgage related securities


119,838



3,342



(6,345
)


116,835Government sponsored enterprise bonds


40,400



238



(49
)


40,589Municipal securities


43,599



631



(989
)


43,241Other debt securities


5,250



—



(500
)


4,750Debt securities


89,249



869



(1,538
)


88,580$
209,087



4,211



(7,883
)


205,415







See accompanying notes to consolidated financial statements.
 - 81 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents





The majority of the Company’s mortgage-backed securities and collateralized mortgage obligations issued by government sponsored enterprises are guaranteed by one of the following government sponsored enterprises: FHLB, Fannie Mae or Freddie Mac.  At December 31, 2010, $44.8 million of the Company’s government sponsored enterprise bonds and $55.2 million of the Company’s mortgage related securities were pledged as collateral to secure repurchase agreement obligations of the Company.









The amortized cost and fair value of securities at December 31, 2010, by contractual maturity, are shown below. Expected maturities may differ from contractual maturities because issuers or borrowers may have the right to prepay obligations with or without prepayment penalties.









December 31, 2010Amortizedcost


Fair value(In Thousands)Debt securities:Due within one year

$
3,000



3,025Due after one year through five years


66,902



67,589Due after five years through ten years


8,208



8,570Due after ten years


16,021



14,928Mortgage-related securities


107,068



109,054$
201,199



203,166












Total proceeds and gross gains and losses from sales of investment securities available for sale for each of periods listed below.














December 31,2010


2009


2008Gross gains

$
136



12



-Gross losses


(81
)


-



-Gains on sale of investment securities, net

$
55



12



-Proceeds from sales of investment securities

$
20,733



515







See accompanying notes to consolidated financial statements.
 - 82 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 
 Table of Contents







Gross unrealized losses on securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position, were as follows:







December 31, 2010Less than 12 months


12 months or longer


TotalFair


Unrealized


Fair


Unrealized


Fair


Unrealizedvalue


loss


value


loss


value


loss(In Thousands)Mortgage-backed securities


14,215



(116
)


—



—



14,215



(116
)Collateralized mortgage obligationsGovernment sponsored entities


13,145



(126
)


—



—



13,145



(126
)Private-label issue


—



—



16,908



(1,032
)


16,908



(1,032
)Government sponsored enterprise bonds


7,553



(20
)


—



—



7,553



(20
)Municipal securities


7,206



(545
)


3,619



(860
)


10,825



(1,405
)$
42,119



(807
)


20,527



(1,892
)


62,646



(2,699
)December 31, 2009Less than 12 months


12 months or longer


TotalFair


Unrealized


Fair


Unrealized


Fair


Unrealizedvalue


loss


value


loss


value


loss(In Thousands)Collateralized mortgage obligationsGovernment sponsored entities

$
1,507



(26
)


—



—



1,507



(26
)Private-label issue


1,519



(7
)


28,843



(6,312
)


30,362



(6,319
)Government sponsored enterprise bonds


7,351



(49
)


—



—



7,351



(49
)Municipal securities


12,802



(114
)


7,713



(875
)


20,515



(989
)Other debt securities


—



—



4,500



(500
)


4,500



(500
)$
23,179



(196
)


41,056



(7,687
)


64,235



(7,883
)







See accompanying notes to consolidated financial statements.
 - 83 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment.  In evaluating whether a security’s decline in market value is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, financial condition of the issuer and the underlying obligors, quality of credit enhancements, volatility of the fair value of the security, the expected recovery period of the security and ratings agency evaluations.  In addition, with regard to its debt securities, the Company may also evaluate payment structure, whether there are defaulted payments or expected defaults, prepayment speeds and the value of any underlying collateral.  For certain debt securities in unrealized loss positions, the Company prepares cash flow analyses to compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.




As of December 31, 2010, the Company had seven securities which had been in an unrealized loss position for twelve months or longer, including: two private-label collateralized mortgage obligation securities and five municipal securities.  Based upon the aforementioned factors, the Company identified two collateralized mortgage obligation securities at December 31, 2010 with a combined amortized cost of $21.2 million for which a cash flow analysis was performed to determine whether an other than temporary impairment was warranted.  This evaluation indicated that the two collateralized mortgage obligations were other-than-temporarily impaired.  Estimates of discounted cash flows based on expected yield at time of original purchase, prepayment assumptions based on actual and anticipated prepayment speed, actual and anticipated default rates and estimated level of severity given the loan to value ratios, credit scores, geographic locations, vintage and levels of subordination related to the security and its underlying collateral resulted in a projected credit loss on the collateralized mortgage obligations.  One of these securities had been deemed other-than-temporarily impaired in 2008 and a cumulative-effect adjustment of $1.1 million was made to retained earnings as of January 1, 2009 to reflect the difference between the present value of cash flows expected to be collected and the amortized cost basis as of the beginning of the period in which the aforementioned accounting principals were adopted.  Additional estimated credit losses on the two collateralized mortgage obligations of $1.1 million were charged to earnings during the year ended December 31, 2009.  These two securities had an amortized cost of $21.2 million and a fair value of $20.3 million as of December 31, 2010.  As of December 31, 2010, unrealized losses on these collateralized mortgage obligations include other-than-temporary impairment recognized in other comprehensive income (before taxes) of $881,000.




The following table presents the change in other-than-temporary credit related impairment charges on collateralized mortgage obligations for which a portion of the other-than-temporary impairments related to other factors was recognized in other comprehensive loss.









(in thousands)Credit related impairments on securties as of December 31, 2008

$
1,872Cummulative effect of adjustment related to a change in accounting principle


(1,117
)Credit related impairments related to a security for which other-than-temporaryimpairment was not previously recognized


977Increase in credit related impairments related to securities for which an other-than-temporary impairment was previously recognized


135Credit related impairments on securities as of December 31, 2009


1,867Credit related impairments related to a security for which other-than-temporaryimpairment was not previously recognized


-Increase in credit related impairments related to securities for which an other-than-temporary impairment was previously recognized


-Credit related impairments on securities as of December 31, 2010

$
1,867




Exclusive of the two aforementioned collateralized mortgage obligations, the Company has determined that the decline in fair value of the remaining securities is not attributable to credit deterioration, and as the Company does not intend to sell nor is it more likely than not that it will be required to sell these securities before recovery of the amortized cost basis, these securities are not considered other-than-temporarily impaired.




Continued deterioration of general economic market conditions could result in the recognition of future other than temporary impairment losses within the investment portfolio and such amounts could be material to our consolidated financial statements.




See accompanying notes to consolidated financial statements.
 - 84 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




Securities Held to Maturity




As of December 31, 2010, the Company held one security that has been designated as held to maturity.  The security has an amortized cost of $2.6 million and an estimated fair value of $2.5 million.  The final maturity of this security is 2022, however, it is callable quarterly.  The Company has performed an assessment to determine whether this security is other than temporarily impaired and has determined that the security is not other than temporarily impaired at December 31, 2010.  During the year ended December 31, 2009, two securities that had been designated as held to maturity were called.  The securities had a total amortized cost of $7.3 million.




3)
Loans Receivable




Loans receivable at December 31, 2010 and 2009 are summarized as follows:









December 31,2010


2009Mortgage loans:

(In Thousands)Residential real estate:One- to four-family

$
584,014



681,578Over four-family


542,602



536,731Home equity


71,952



85,964Construction and land


56,794



69,814Commercial real estate


51,733



48,948Consumer


154



619Commercial loans


40,442



48,0941,347,691



1,471,748Less:Undisbursed loan proceeds


39,265



49,818Unearned loan fees


1,989



1,920$
1,306,437



1,420,010







The Company provides several types of loans to its customers, including residential, construction, commercial and consumer loans.  Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to one borrower or to multiple borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions.  While credit risks tend to be geographically concentrated in the Company’s Milwaukee metropolitan area and while 87.4% of the Company’s loan portfolio involves loans that are secured by real estate, there are no concentrations with individual or groups of related borrowers.  While the real estate collateralizing these loans is primarily residential in nature, it ranges from owner-occupied single family homes to large apartment complexes.  In addition, real estate collateralizing $123.3 million or 9.2% of total mortgage loans is located outside of the state of Wisconsin.   The Company does not have a concentration of loans in any specific industry.





The unpaid principal balance of loans serviced for others was $6.3 million and $4.7 million at December 31, 2010 and December 31, 2009, respectively. These loans are not reflected in the consolidated financial statements.




See Accompanying notes to consolidated financial statements.
 - 85 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008


An analysis of past due financing receivables as of December 31, 2010 and 2009 follows:









As of December 31, 20101-59 Days

Past Due (1)


60-89 Days

Past Due (2)


Greater Than

90 Days


Total Past Due


Current


Total LoansMortgage loans:

(In Thousands)Residential real estate:One- to four-family

$
13,220



7,887



44,055



65,162



516,864



582,026Over four-family


1,639



2,366



12,307



16,312



526,290



542,602Home equity


497



96



207



800



45,349



46,149Construction and land


586



1,326



2,754



4,666



49,295



53,961Commercial real estate


574



222



1,101



1,897



49,836



51,733Consumer


-



-



-



-



154



154Commercial loans


394



-



1,432



1,826



27,986



29,812Total

$
16,910



11,897



61,856



90,663



1,215,774



1,306,437As of December 31, 2009Mortgage loans:Residential real estate:One- to four-family

$
25,191



7,676



36,125



68,992



610,665



679,657Over four-family


9,898



1,997



15,572



27,467



509,264



536,731Home equity


411



131



962



1,504



56,084



57,588Construction and land


790



1,072



6,269



8,131



53,823



61,954Commercial real estate


479



555



2,652



3,686



45,262



48,948Consumer


-



-



-



-



619



619Commercial loans


2,667



196



773



3,636



30,877



34,513Total

$
39,436



11,627



62,353



113,416



1,306,594



1,420,010





(1)


(2)  Includes $3.0 million and $1.1 million for December 31, 2010 and 2009, respectively, which are on non-accrual status.







As of December 31, 2010 and 2009, there are no loans that are 90 or more days past due and still accruing.









See accompanying notes to consolidated financial statements.
 - 86 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents







A summary of the activity for the years ended December 31, 2010, 2009 and 2008 in the allowance for loan losses follows:









One- to Four- Family


Over Four Family


Home Equity


Construction and Land


Commercial Real Estate


Consumer


Commercial


Total(In Thousands)Year ended December 31, 2008Balance at beginning of period

$
5,433



4,369



536



2,087



280



99



35



12,839Provision for loan losses


16,869



12,500



884



5,013



2,003



(62
)


422



37,629Charge-offs


(8,397
)


(10,056
)


(394
)


(5,088
)


(1,838
)


(4
)


-



(25,777
)Recoveries


313



31



1



125



-



6



-



476Balance at end of period

$
14,218



6,844



1,027



2,137



445



39



457



25,167Year ended December 31, 2009Balance at beginning of period

$
14,218



6,844



1,027



2,137



445



39



457



25,167Provision for loan losses


17,078



1,645



1,475



4,378



1,185



12



914



26,687Charge-offs


(13,602
)


(3,304
)


(861
)


(3,957
)


(910
)


(9
)


(1,000
)


(23,643
)Recoveries


181



23



1



77



-



1



-



283Balance at end of period

$
17,875



5,208



1,642



2,635



720



43



371



28,494Year ended December 31, 2010Balance at beginning of period

$
17,875



5,208



1,642



2,635



720



43



371



28,494Provision for loan losses


15,054



5,053



170



2,934



525



(3
)


2,099



25,832Charge-offs


(16,906
)


(3,439
)


(619
)


(2,319
)


(575
)


(13
)


(1,470
)


(25,341
)Recoveries


127



55



3



2



1



1



1



190Balance at end of period

$
16,150



6,877



1,196



3,252



671



28



1,001



29,175

















See accompanying notes to consolidated financial statements.
 - 87 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




A summary of the allowance for loan loss by collateral class as of the year ended December 31, 2010 follows:




One- to Four- Family


Over Four Family


Home Equity


Construction and Land


Commercial Real Estate


Consumer


Commercial


Total(In Thousands)Allowance related to loansindividually evaluated for impairment

$
5,775



2,548



311



2,112



162



-



185



11,093Allowance related to loanscollectively evaluated for impairment


10,375



4,329



885



1,140



509



28



816



18,082Balance at end of period

$
16,150



6,877



1,196



3,252



671



28



1,001



29,175Loans individually evaluated for impairment

$
78,434



30,288



804



12,337



1,838



-



2,030



125,731Loans collectively evaluated for impairment


503,592



512,314



45,345



41,624



49,895



154



27,782



1,180,706Total gross loans

$
582,026



542,602



46,149



53,961



51,733



154



29,812



1,306,437





A summary of the allowance for loan loss by collateral class as of the year ended December 31, 2009 follows:




One- to Four- Family


Over Four Family


Home Equity


Construction and Land


Commercial Real Estate


Consumer


Commercial


Total(In Thousands)Allowance related to loansindividually evaluated for impairment

$
8,582



1,477



491



1,667



220



-



80



12,517Allowance related to loanscollectively evaluated for impairment


9,293



3,731



1,151



968



500



43



291



15,977Balance at end of period

$
17,875



5,208



1,642



2,635



720



43



371



28,494Loans individually evaluated for impairment

$
92,159



35,037



3,093



14,816



3,973



-



2,832



151,910Loans collectively evaluated for impairment


587,498



501,694



54,495



47,138



44,975



619



31,681



1,268,100Total gross loans

$
679,657



536,731



57,588



61,954



48,948



619



34,513



1,420,010







See Accompanying notes to consolidated financial statements.
 - 88 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008


The following table presents information relating to the Company’s internal risk ratings of its loans receivable as of December 31, 2010 and 2009:









One- to Four- Family


Over Four Family


Home Equity


Construction and Land


Commercial Real Estate


Consumer


Commercial


TotalAt December 31, 2010

(In Thousands)Substandard

$
72,846



25,071



1,874



9,569



1,936



-



2,557



113,853Watch


24,343



30,877



1,401



14,394



892



-



706



72,613Pass


484,837



486,654



42,874



29,998



48,905



154



26,549



1,119,971$
582,026



542,602



46,149



53,961



51,733



154



29,812



1,306,437At December 31, 2009Substandard

$
79,336



16,321



15,516



2,046



3,342



-



1,267



117,828Watch


32,190



24,732



593



3,656



450



-



1,256



62,877Pass


568,131



495,678



41,479



56,252



45,156



619



31,990



1,239,305$
679,657



536,731



57,588



61,954



48,948



619



34,513



1,420,010


See Accompanying notes to consolidated financial statements.
 - 89 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008


Factors that are important to managing overall credit quality include sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early identification of potential problems, an allowance for loan losses, and sound non-accrual and charge-off policies.  Our underwriting policies require an officers' loan committee review and approve all loans in excess of $500,000.  In addition, an independent loan review function exists for all residential loans.  Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans.  To do so, we maintain a loan review system under which our credit management personnel review non owner occupied one-to four-family, over four-family, construction and land, commercial real estate and commercial loans that individually, or as part of an overall borrower relationship exceed $1.0 million in potential exposure.  Loans meeting these criteria are reviewed on an annual basis, or more frequently, if the loan is renewal is less than one year.  With respect to this review process, management has determined that pass loans include credits that exhibit acceptable financial statements, cash flow and leverage.  Watch credits have potential weaknesses that deserve management’s attention, and if left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credit.  Substandard loans are considered inadequately protected by the current net worth and paying capacity of the obligor or the collateral pledged.  These loans generally have a well-defined weakness that may jeopardize liquidation of the debt and are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Finally, a loan is considered to be impaired when it is probable that the Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement.  Management has determined that all non-accrual loans and loans modified under troubled debt restructurings have been determined by the Bank to meet the definition of an impaired loan.







The following tables present data on impaired loans at December 31, 2010 and 2009.


































































See accompanying notes to consolidated financial statements.
 - 90 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




As of or for the Year Ended December 31, 2010Recorded Investment


Unpaid Principal


Reserve


Charge-Offs


Int Paid YTDTotal Impaired with ReserveOne- to four-family

$
42,186



44,505



5,775



2,319



1,277Over four-family


20,200



20,460



2,548



260



191Construction and land


9,550



9,770



2,112



220



243Commercial real estate


976



2,730



162



1,754



3Home equity


565



565



311



-



19Commercial


584



584



185



-



30$
74,061



78,614



11,093



4,553



1,763Total Impaired with no ReserveOne- to four-family

$
36,248



43,567



-



7,319



1,167Over four-family


10,088



13,527



-



3,439



481Construction and land


2,787



5,859



-



3,072



10Commercial real estate


862



1,030



-



168



27Home equity


239



239



-



-



13Commercial


1,446



1,446



-



-



16$
51,670



65,668



-



13,998



1,714Total ImpairedOne- to four-family

$
78,434



88,072



5,775



9,638



2,444Over four-family


30,288



33,987



2,548



3,699



672Construction and land


12,337



15,629



2,112



3,292



253Commercial real estate


1,838



3,760



162



1,922



30Home equity


804



804



311



-



32Commercial


2,030



2,030



185



-



46$
125,731



144,282



11,093



18,551



3,477







The difference between a loan’s recorded investment and the unpaid principal balance represents a partial charge-off resulting from a confirmed loss due to the value of the collateral securing the loan being below the loan balance and management’s assessment that the full collection of the loan balance is not likely.




See accompanying notes to consolidated financial statements.
 - 91 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 
 Table of Contents




As of or for the Year Ended December 31, 2009Recorded Investment


Unpaid Principal


Reserve


Charge Offs


Int Paid YTDTotal Impaired with ReserveOne- to four-family

$
51,852



54,109



8,581



2,257



2,215Over four-family


23,673



24,410



1,477



738



1,395Construction and land


12,567



13,616



1,668



1,049



327Commercial real estate


1,072



2,826



220



1,754



35Home equity


1,544



1,544



491



-



72Commercial


80



80



80



-



3$
90,788



96,585



12,517



5,798



4,047Total Impaired with no ReserveOne- to four-family

$
40,307



43,328



-



3,020



1,910Over four-family


11,364



13,882



-



2,518



375Construction and land


2,249



3,317



-



1,068



38Commercial real estate


2,901



2,901



-



-



65Home equity


1,549



1,725



-



176



70Commercial


2,752



3,752



-



1,000



146$
61,122



68,905



-



7,782



2,604Total ImpairedOne- to four-family

$
92,159



97,437



8,581



5,277



4,125Over four-family


35,037



38,292



1,477



3,256



1,770Construction and land


14,816



16,933



1,668



2,117



365Commercial real estate


3,973



5,727



220



1,754



100Home equity


3,093



3,269



491



176



142Commercial


2,832



3,832



80



1,000



149$
151,910



165,490



12,517



13,580



6,651


See Accompanying notes to consolidated financial statements
 - 92 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008


The determination as to whether an allowance is required with respect to impaired loans is based upon an analysis of the value of the underlying collateral and/or the borrower’s intent and ability to make all principal and interest payments in accordance with contractual terms.  The evaluation process is subject to the use of significant estimates and actual results could differ from estimates.  This analysis is primarily based upon third party appraisals and/or a discounted cash flow analysis.  In those cases in which no allowance has been provided for an impaired loan, the Company has determined that the estimated value of the underlying collateral exceeds the remaining outstanding balance of the loan.  Of the total $51.7 million of impaired loans for which no allowance has been provided, $14.0 million in charge-offs have been recorded to reduce the outstanding loans balance to an amount that is commensurate with the estimated fair value of the underlying collateral.  To the extent that further deterioration in property values continues, the Company may have to reevaluate the sufficiency of the collateral servicing these impaired loans resulting in additional provisions to the allowance for loans losses or charge-offs.




At December 31, 2010, total impaired loans includes $36.5 million of troubled debt restructurings, of which, $33.6 million are classified as performing.  The vast majority of debt restructurings include a modification of terms to allow for an interest only payment and/or reduction in interest rate.  The restructured terms are typically in place for six to twelve months.  At December 31, 2009, total impaired loans included $52.1 million of troubled debt restructurings, of which, $42.7 million are classified as performing.








The following table presents data on non-accrual loans and troubled debt restructurings at December 31, 2010 and 2009:









At December 31,2010


2009(Dollars in Thousands)Non-accrual loans:ResidentialOne- to four-family

$
56,759



45,988Over four-family


20,587



16,683Home equity


712



1,159Construction and land


3,013



6,269Commercial real estate


1,577



2,773Commercial


1,530



2,441Consumer


-



-Total non-accrual loans

$
84,178



75,313Total performing troubled debt restructurings

$
33,592



42,730Total non-accrual loans to total loans, net


6.44
%


5.30
%Total non-accrual loans and performing troubleddebt restructurings to total loans receivable


9.01
%


8.31
%Total non-accrual loans to total assets


4.65
%


4.03
%


See Accompanying notes to consolidated financial statements.
 - 93 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008







4)
Office Properties and Equipment




Office properties and equipment are summarized as follows:









December 31,2010


2009(In Thousands)Land

$
6,959



6,959Office buildings and improvements


29,400



29,291Furniture and equipment


10,379



9,75346,738



46,003Less accumulated depreciation


(18,542
)


(16,859
)$
28,196



29,144







During the year ended December 31, 2009, the Company exercised its $3.3 million purchase option on a capital lease related to facilities and equipment at one of the Company’s branch locations. The building has been occupied since September 2005.









5)
Real Estate Owned




Real estate owned is summarized as follows:









December 31,2010


2009(In Thousands)One- to four-family

$
28,142



27,016Over four-family


14,903



8,824Construction and land


9,926



10,458Commercial real estate


4,781



4,631$
57,752



50,929







During the year ended December 31, 2010, the Company transferred $41.8 to real estate owned from the loan portfolio.  During the same period the Company sold approximately $33.5 million of real estate owned.  The overall $6.8 million increase in real estate owned was primarily due to a $6.1 million increase in over four-family properties.







See accompanying notes to consolidated financial statements.
 - 94 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents






6)
Deposits




At December 31, 2010 and 2009, time deposits with balances greater than one hundred thousand dollars amounted to $271.7 million and $288.8 million, respectively.  Time deposits at December 31, 2010 and 2009 also include brokered deposits of $14.4 million and $63.6 million, respectively.









A summary of interest expense on deposits is as follows:









Years ended December 31,2010


2009


2008(In Thousands)$Interest-bearing demand deposits


37



35



151Money market and savings deposits


493



534



2,231Time deposits


20,459



33,915



39,868$
20,989



34,484



42,250







A summary of the contractual maturities of time deposits at December 31, 2010 is as follows:









(In Thousands)Within one year

$
347,537One to two years


607,643Two to three years


6,769Three to four years


3,114Four through five years


9,276After five years


52$
974,391










See accompanying notes to consolidated financial statements.
 - 95 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




7)
Borrowings




Borrowings consist of the following:






December 31, 2010


December 31, 2009Weighted





WeightedAverage





AverageBalance


Rate


Balance


Rate(In Thousands)Bank line of credit

$
22,959



4.75
%


-



-Federal Home Loan Bank (FHLB) advances maturing:2010


-



-



73,900



3.61
%2016


220,000



4.34
%


220,000



4.34
%2017


65,000



3.19
%


65,000



3.19
%2018


65,000



2.97
%


65,000



2.97
%Repurchase agreements maturing:2018


84,000



3.96
%


84,000



3.96
%$
456,959



3.94
%


507,900



3.85
%







The bank line of credit is the outstanding portion of revolving lines with two unrelated banks.  The $50.0 million and $20.0 million lines of credit are utilized by Waterstone Mortgage Corporation to finance loans originated for sale.  Related interest rates are based upon the note rate associated with the loans being financed.




The $220.0 million in advances due in 2016 consist of eight advances with rates ranging from 4.01% to 4.82% callable quarterly until maturity.




The $65.0 million in advances due in 2017 consist of three advances with rates ranging from 3.09% to 3.46% callable quarterly until maturity.




The $65.0 million in advances due in 2018 consist of three advances with rates ranging from 2.73% to 3.11% callable quarterly until maturity.




The $84 million in repurchase agreements have rates ranging from 2.89% to 4.31% callable quarterly until maturity.  The repurchase agreements are collateralized by securities available for sale with an estimated market value of $100.0 million at December 31, 2010.




The Company selects loans that meet underwriting criteria established by the FHLBC as collateral for outstanding advances. The Company’s borrowings at the FHLBC are limited to 60% of the carrying value of unencumbered one- to four-family mortgage loans, 50% of the carrying value of home equity loans and 60% of the carrying value of over four-family loans. In addition, these advances are collateralized by FHLBC stock of $21.7 million at December 31, 2010 and 2009, respectively. In the event of prepayment, the Company is obligated to pay all remaining contractual interest on the advance.




Since October 2007, the FHLBC Chicago has been under a consensual cease and desist order with its regulator.  Under the terms of the order, capital stock repurchases, redemptions of FHLBC Chicago stock and dividend declarations are subject to prior written approval from the FHLBC Chicago’s regulator.  The Company believes that all FHLBC Chicago stock held at December 31, 2010 will ultimately be recovered.




See accompanying notes to consolidated financial statements.
 - 96 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




8)
Regulatory Capital




The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements, or overall financial performance deemed by the regulators to be inadequate, can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’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 table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined). Management believes, as of December 31, 2010, that the Bank meets all capital adequacy requirements to which it is subject.  On December 18, 2009, WaterStone Bank entered into a consent order with its federal and state bank regulators whereby it has agreed to maintain a minimum Tier 1 capital ratio of 8.50% and a minimum total risk based capital ratio of 12.00%.  At December 31, 2010, these higher capital requirements were satisfied.  The consent order prohibits the Bank from paying dividends or repurchasing common stock without the written consent of the WDFI and FDIC.




As of December 31, 2010 the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as quantitatively “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios, as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank’s category, however, the outstanding consent order limits transactions otherwise available to “well capitalized” banks, such as acceptance of brokered deposits.




As a state-chartered savings bank, the Bank is required to meet minimum capital levels established by the state of Wisconsin in addition to federal requirements. For the state of Wisconsin, regulatory capital consists of retained income, paid-in-capital, capital stock equity and other forms of capital considered to be qualifying capital by the Federal Deposit Insurance Corporation.




The actual and required capital amounts and ratios for the Bank as of December 31, 2010 and 2009 are presented in the table below:







December 31, 2010To Be Well-CapitalizedFor Capital


Under Prompt CorrectiveActual


Adequacy Purposes


Action ProvisionsAmount


Ratio


Amount


Ratio


Amount


Ratio(Dollars In Thousands)WaterStone BankTotal capital (to risk-weighted assets)

$
180,718



14.13
%


102,324



8.00
%


127,905



10.00
%Tier I capital (to risk-weighted assets)


164,568



12.87
%


51,162



4.00
%


76,743



6.00
%Tier I capital (to average assets)


164,568



8.83
%


74,567



4.00
%


93,208



5.00
%State of Wisconsin (to total assets)


164,568



9.12
%


108,228



6.00
%


N/A



N/ADecember 31, 2009WaterStone BankTotal capital (to risk-weighted assets)

$
181,344



13.74
%


105,559



8.00
%


131,949



10.00
%Tier I capital (to risk-weighted assets)


164,693



12.48
%


52,780



4.00
%


79,170



6.00
%Tier I capital (to average assets)


164,693



8.71
%


75,674



4.00
%


94,592



5.00
%State of Wisconsin (to total assets)


164,693



8.86
%


111,484



6.00
%


N/A



N/A








See accompanying notes to consolidated financial statements.
 - 97 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents







9)
Stock Based Compensation




Stock-Based Compensation Plan




In 2006, the Company’s shareholders approved the 2006 Equity Incentive Plan.  All stock awards granted under these plans vest over a period of five years and are required to be settled in shares of the Company’s common stock.  The exercise price for all stock options granted is equal to the quoted NASDAQ market close price on the date that the awards were granted and expire ten years after the grant date, if not exercised.  All restricted stock grants are issued from previously unissued shares.




Accounting for Stock-Based Compensation Plan




The fair value of stock options granted is estimated on the grant date using a Black-Scholes pricing model.   The fair value of restricted shares is equal to the quoted NASDAQ market close price on the date of grant.  The fair value of stock grants is recognized as compensation expense on a straight-line basis over the vesting period of the grants.  Compensation expense is included in compensation, payroll taxes and other employee benefits in the consolidated statements of income.




Assumptions are used in estimating the fair value of stock options granted.  The weighted average expected life of the stock options represent the period of time that the options are expected to be outstanding and is based on the SEC simplified approach to calculating expected term.  The risk-free interest rate is based on the U.S. Treasury yield curve in effect at the time of grant.  The expected volatility is based on the historical volatility for a group of selected peers.  The following assumptions were used in estimating the fair value of options granted in the year ended December 31, 2010, 2009 and 2008.









2010


2009


2008Dividend Yield


0.00
%


0.00
%


1.32
%Risk-free interest rate


0.25
%


0.40
%


3.57
%Expected volatility


75.67
%


31.86
%


31.86
%Weighted average expected life

6.5 years


6.5 years


6.5 yearsWeighted average per share value of options

$
2.54


$
1.51


$
3.94







The Company estimates potential forfeitures of stock grants and adjusts compensation expense recorded accordingly.  The estimate of forfeitures will be adjusted over the requisite service period to the extent that actual forfeitures differ, or are expected to differ, from such estimates.  Changes in estimated forfeitures will be recognized in the period of change and will also impact the amount of stock compensation expense to be recognized in future periods.




A summary of the Company’s stock option activity for the years ended December 31, 2010, 2009 and 2008 is presented below.




See Accompanying notes to consolidated financial statements.
 - 98 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008




Weighted Average


AggregateWeighted Average


Years Remaining in


Instrinsic ValueStock Options

Shares


Exercise Price


Contractual Term


(000's)Outstanding December 31, 2007


782,500



17.63



9.02



-Options exercisable at December 31, 2007


-Granted


5,000


$
11.71







-Excercised


-











-Forfeited


(20,000
)


17.67







-Outstanding December 31, 2008


767,500



17.59



8.03



-Options exercisable at December 31, 2008


152,500



17.63



8.02



-Granted


10,000


$
4.65







-Excercised


-











-Forfeited


(20,000
)


17.67







-Outstanding December 31, 2009


757,500



17.41



7.07



-Options exercisable at December 31, 2009


298,000



17.60



7.03



-Granted


50,000


$
3.80







-Excercised


-











-Forfeited


(5,000
)


17.67







-Outstanding December 31, 2010


802,500



16.44



6.34



-Options exercisable at December 31, 2010


446,500



17.54



6.04



-







The following table summarizes information about the Company’s nonvested stock option activity for the years ended December 31, 2010 and 2009:









Weighted AverageStock Options

Shares


Grant Date Fair ValueNonvested at December 31, 2008


615,000


$
6.21Granted


10,000



1.51Vested


(149,500
)


6.23Forfeited


(16,000
)


6.27Nonvested at December 31, 2009


459,500



6.13Nonvested at December 31, 2009


459,500


$
6.13Granted


50,000



2.54Vested


(150,500
)


6.17Forfeited


(3,000
)


6.27Nonvested at December 31, 2010


356,000



5.60







See accompanying notes to consolidated financial statements.
 - 99 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




The Company amortizes the expense related to stock options as compensation expense over the vesting period.  During the year ended December 31, 2010, 50,000 options were granted and 5,000 were forfeited, of which 2,000 had vested in prior years.  During the year ended December 31, 2009, 10,000 options were granted and 20,000 were forfeited, of which 4,000 had vested in the prior year. During the year ended December 31, 2008, 5,000 options were granted and 20,000 were forfeited.  Expense for the stock options granted of $810,000, $804,000 and $746,000 was recognized during the years ended December 31, 2010, 2009 and 2008, respectively.  At December 31, 2010, the Company had $940,000 in estimated unrecognized compensation costs related to outstanding stock options that is expected to be recognized over a weighted average period of 15 months.




The following table summarizes information about the Company’s restricted stock shares activity for the years ended December 31, 2010 and 2009:









Weighted AverageRestricted Stock

Shares


Grant Date Fair ValueNonvested at December 31, 2008


200,200


$
17.46Granted


5,000



4.65Vested


(49,800
)


17.51Forfeited


(4,800
)


17.67Nonvested at December 31, 2009


150,600



17.02Nonvested at December 31, 2009


150,600


$
17.02Granted


-



-Vested


(49,200
)


17.24Forfeited


-



-Nonvested at December 31, 2010


101,400



16.91







The Company amortizes the expense related to restricted stock awards as compensation expense over the vesting period.  During the year ended December 31, 2010, no shares of restricted stock were awarded and no shares were forfeited.  During the year ended December 31, 2009, 5,000 shares of restricted stock were awarded and 4,800 were forfeited.  During the year ended December 31, 2008, 5,000 shares of restricted stock were awarded and 6,000 were forfeited.  Expense for the restricted stock awards of $848,000, $845,000 and $865,000 was recorded for the years ended December 31, 2010, 2009 and 2008, respectively.  At December 31, 2010, the Company had $877,000 of unrecognized compensation expense related to restricted stock shares that is expected to be recognized over a weighted average period 12 months.




10)
Employee Benefit Plans




The Company has two 401(k) profit sharing plans and trusts covering substantially all employees.  WaterStone Bank employees over 18 years of age are immediately eligible to participate in the Bank’s Plan.  Waterstone Mortgage employees over 21 years of age are eligible to participate in its Plan as of the first of the month following their date of employment.  Participating employees may annually contribute pretax compensation in accordance with IRS limits. The Company made no contributions to the Plans during the years ended December 31, 2010, 2009 and 2008.




The Company has a nonqualified salary continuation plan for one former employee. This agreement provides for payments of specific amounts over a 10-year period subsequent to the employee’s retirement. The deferred compensation liability was accrued ratably to the employee’s respective normal retirement date. Payments made to the retired employee reduce the liability. As of December 31, 2010 and 2009, approximately $960,000 and $1.1 million was accrued related to this plan. This agreement is funded by a life insurance policy with a death benefit of $5.8 million and a cash surrender value of $2.6 million and $2.3 million at December 31, 2010 and 2009, respectively. The former employee has no interest in this policy.  There was no expense for compensation under this agreement during the years ended December 31, 2010, 2009 and 2008.




During the year ended December 31, 2006, the Company established a nonqualified deferred compensation plan for executive officers.  The plan allows participants to defer a portion of regular salary and bonus to future periods.  The participant earns interest on the deferred balance.  During the year ended December 31, 2009, the balance of this plan was distributed to participants.  Earnings credited to deferred compensation totaled $26,000 for the year ended December 31, 2008.




See accompanying notes to consolidated financial statements.
 - 100 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




11)
Employee Stock Ownership Plan




All employees are eligible to participate in the WaterStone Bank Employee Stock Ownership Plan (the “Plan”) after they attain twenty-one years of age and complete twelve consecutive months of service in which they work at least 1,000 hours of service.  The Plan borrowed $8.5 million from the Company and purchased 761,515 shares of common stock of the Company in the open market.  The Plan debt is secured by shares of the Company.  The Company has committed to make annual contributions to the Plan necessary to repay the loan, including interest.  The loan is scheduled to be repaid in ten annual installments.  While the shares are not released and allocated to Plan participants until the loan payment is made, the shares are deemed to be earned and are therefore, committed to be released throughout the service period.  As such, one-tenth of the shares are scheduled to be released annually as shares are earned over a period of ten years, beginning with the period ended December 31, 2005.  As the debt is repaid, shares are released from collateral and allocated to active participant accounts.  The shares pledged as collateral are reported as unearned ESOP shares in the consolidated statement of financial condition.  As shares are committed to be released from collateral, the Company reports compensation expense equal to the average fair market price of the shares, and the shares become outstanding for earnings per share computations.  Compensation expense attributed to the ESOP was $265,000, $250,000, and $776,000, respectively for the years ended December 31, 2010, 2009 and 2008.




The aggregate activity in the number of unearned ESOP shares, considering the allocation of those shares committed to be released as of December 31, is as follows:









2010


2009Beginning ESOP shares


380,757



456,909Shares committed to be released


(76,152
)


(76,152
)Unreleased shares


304,605



380,757Fair value of unreleased shares (in thousands)

$
990



781







12)
Income Taxes




The provision (benefit) for income taxes for the year ended December 31, 2010, 2009 and 2008 consists of the following:









Years ended December 31,2010


2009


2008(In Thousands)Current:Federal

$
30



(1,319
)


(5,083
)State


22



(466
)


(178
)52



(1,785
)


(5,261
)Deferred:Federal


—



812



5,492State


—



(333
)


2,068—



479



7,560Total

$
52



(1,306
)


2,299










See accompanying notes to consolidated financial statements.
 - 101 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




The income tax provisions differ from that computed at the Federal statutory corporate tax rate for the years ended December 31, 2010, 2009 and 2008 as follows:









Years ended December 31,2010


2009


2008(Dollars In Thousands)Income before income taxes

$
(1,802
)


(11,444
)


(24,147
)Tax at Federal statutory rate (35%)


(631
)


(4,005
)


(8,451
)Add (deduct) effect of:State income taxesnet of Federal income tax benefit (expense)


14



(519
)


1,229Cash surrender value of life insurance


(398
)


(433
)


(505
)Non-deductible ESOP and stockoption expense


168



151



169Tax-exempt interest income


(294
)


(439
)


(397
)Change in valuation allowance on deferred taxes


1,281



3,983



10,227Other


(88
)


(44
)


27Income tax provision (benefit)


52



(1,306
)


2,299Effective tax rate


(2.9
%)


11.4
%


(9.5
%)







The increase in the required valuation allowance was largely due to an increase in the Company’s net deferred tax assets, partly offset by a reduction related to changes in the beginning of the year valuation allowance solely attributable to identifiable events recorded in other comprehensive income, primarily changes in unrealized gains on the available-for-sale investment portfolio, the tax effects of which were therefore allocated to other comprehensive income.




See Accompanying notes to consolidated financial statements.
 - 102 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008


The significant components of the Company’s net deferred tax assets (liabilities) included in prepaid expenses and other assets are as follows at December 31, 2010 and 2009:









December 31,2010


2009Gross deferred tax assets:

(In Thousands)Excess book depreciation

$
903



812Compensation agreements


374



595Restricted stock and stock options


1,047



898Allowance for loan losses


11,292



11,436Real estate owned write-downs


2,037



1,815Interest recognized for tax but not books


1,330



1,522Federal NOL carryforward


705



—State NOL carryforward


1,132



1,436Unrealized loss on impaired securities


635



799Unrealized loss on securities available for sale, net


—



1,474Charitable contributions carry forward


—



996Other


275



312Total gross deferred tax assets


19,730



22,095Valuation allowance


(15,990
)


(16,917
)Deferred tax assets


3,740



5,178Gross deferred tax liabilities:Unrealized gain on securities available for sale, net


(789
)


—FHLB stock dividends


(898
)


(931
)Deferred loan fees


(971
)


(1,083
)Deferred liabilities


(2,658
)


(2,014
)Net deferred tax assets

$
1,082



3,164






The Company has a Federal NOL carry forward of $2.0 million at December 31, 2010 which expires in 2030.  The Company has a Wisconsin NOL carry forward of $30.5 million at December 31, 2010 and $29.8 million at December 31, 2009, which will begin to expire in 2028.  The charitable contributions carry forward expired in 2010.




All of the deferred tax assets related to these NOLs are fully offset by valuation allowances.  Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that a deferred tax asset will not be realized.  The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Examples of positive evidence may include the existence of taxes paid in available carry back years as well as the probability that taxable income will be generated in future periods, while examples of negative evidence may include the cumulative losses in the current year and prior two years and general business and economic trends.  At both December 31, 2010 and 2009, the Company determined a valuation allowance was necessary, largely based on the negative evidence represented by a cumulative loss in the most recent three-year period caused by the significant loan loss provisions recorded during the past three years.  In addition, general uncertainty surrounding future economic and business conditions have increased the potential volatility and uncertainty of projected earnings.  Management is required to re-evaluate the deferred tax asset and the related valuation allowance quarterly.




See accompanying notes to consolidated financial statements.
 - 103 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




Under the Internal Revenue Code and Wisconsin Statutes, the Company was permitted to deduct, for tax years beginning before 1988, an annual addition to a reserve for bad debts. This amount differs from the provision for loan losses recorded for financial accounting purposes. Under prior law, bad debt deductions for income tax purposes were included in taxable income of later years only if the bad debt reserves were used for purposes other than to absorb bad debt losses. Because the Company did not intend to use the reserve for purposes other than to absorb losses, no deferred income taxes were provided. Retained earnings at December 31, 2010 include approximately $16.7 million for which no deferred Federal or state income taxes were provided.  Deferred income taxes have been provided on certain additions to the tax reserve for bad debts.





The Company and its subsidiaries file consolidated federal and state tax returns. One subsidiary also files separate state income tax returns in certain states.  The Company is no longer subject to federal or state income tax examinations by tax authorities for years before 2005.





A reconciliation of the beginning and ending amount of unrecognized tax benefits is as follows:








2010


2009Balance at Jaunary 1

$
15,000



20,000Increases related to current period positions


-



15,000Decreases related to prior period positions


(15,000
)


(20,000
)Balance at December 31

$
-



15,000





The Company recognizes interest and penalties related to unrecognized tax benefits in income tax expense.  During the years ended 2010, 2009 and 2008 the Company recorded $0 in interest and penalties.




13)
Financial Instruments with Off-Balance-Sheet Risk




The Company 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 and interest rate risk in excess of the amounts recognized in the consolidated balance sheets. The contract or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.









December 31,2010


2009(In Thousands)Financial instruments whose contractamounts represent potential credit risk:Commitments to extend credit underfirst mortgage loans

$
14,681



13,607Commitments to extend credit underhome equity lines of credit


25,803



28,376Unused portion of construction loans


2,832



7,861Unused portion of business lines of credit


10,630



13,581Standby letters of credit


991



1,001







See accompanying notes to consolidated financial statements.
 - 104 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents







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 and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements of the Company. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counter-party. Collateral obtained generally consists of mortgages on the underlying real estate.




Standby letters of credit are conditional commitments issued by the Company 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 Company holds mortgages on the underlying real estate as collateral supporting those commitments for which collateral is deemed necessary.




The Company has determined that there are no probable losses related to commitments to extend credit or the standby letters of credit as of December 31, 2010 and 2009.




14)
Derivative Financial Instruments




In connection with its mortgage banking activities, the Company enters into derivative financial instruments as part of its strategy to manage its exposure to changes in interest rates.   Mortgage banking derivatives include interest rate lock commitments provided to customers to fund mortgage loans to be sold in the secondary market and forward commitments for the future delivery of such loans.  It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of future changes in interest rates on its commitments to fund the loans as well as on its portfolio of mortgage loans held-for-sale.  The Company’s mortgage banking derivatives have not been designated as being in hedge relationships.  These instruments are used to manage the Company’s exposure to interest rate movements and other identified risks but do not meet the strict hedge accounting requirements of ASC 815.  Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings.  The Company does not use derivatives for speculative purposes.








Forward commitments to sell mortgage loans represent commitments obtained by the Company from a secondary market agency to purchase mortgages from the Company at specified interest rates and within specified periods of time.  Commitments to sell loans are made to mitigate interest rate risk on interest rate lock commitments to originate loans and loans held for sale.    At December 31, 2010, The Company had forward commitments to sell mortgage loans with an aggregate notional amount of approximately $79.5 million and interest rate lock commitments with an aggregate notional amount of approximately $78.5 million.  The fair value of the mortgage derivatives at December 31, 2010 included a net gain of $470,000 on forward commitments to sell residential mortgage loans to various investors and the net loss of $63,000 on interest rate lock commitments to originate residential mortgage loans held for sale to individuals.





In determining the fair value of its derivative loan commitments, the Company considers the value that would be generated when the loan arising from exercise of the loan commitment is sold in the secondary mortgage market. That value includes the price that the loan is expected to be sold for in the secondary mortgage market.  The fair value of these commitments is recorded on the consolidated statements of financial condition with the changes in fair value recorded as a component of mortgage banking income.








See accompanying notes to consolidated financial statements.
 - 105 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




15)
Fair Values Measurements




The FASB issued an accounting standard (subsequently codified into ASC Topic 820, “Fair Value Measurements and Disclosures”) which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This accounting standard applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements. The standard also emphasizes that fair value (i.e., the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date), among other things, is based on exit price versus entry price, should include assumptions about risk such as nonperformance risk in liability fair values, and is a market-based measurement, not an entity-specific measurement. When considering the assumptions that market participants would use in pricing the asset or liability, this accounting standard establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).





The fair value hierarchy prioritizes inputs used to measure fair value into three broad levels.





Level 1 inputs - In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that we have the ability to access.





Level 2 inputs - Fair values determined by Level 2 inputs use inputs other than quoted prices included in Level 1 inputs that are observable for the asset or liability, either directly or indirectly.  Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets where there are few transactions and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.





Level 3 inputs - Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability.





In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety.  The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.





The following table presents information about our assets recorded in our consolidated statement of financial position at their fair value on a recurring basis as of December 31, 2010 and December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.








See accompanying notes to consolidated financial statements.
 - 106 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents





Fair Value Measurements UsingDecember 31, 2010


Level 1


Level 2


Level 3(In Thousands)Available for sale securitiesMortgage-backed securities

$
44,330



-



44,330



-Collateralized mortgage obligations


64,724



-



44,423



20,301Government sponsored enterprise bonds


57,698



-



57,698



-Municipal securities


31,120



-



31,120



-Other debt securities


5,294



5,294



-



-Loans held for sale


96,133



-



96,133



-Mortgage banking derivative assets


470



-



-



470Mortgage banking derivative liabilities


63



-



-



63$
299,832



5,294



273,704



20,834Fair Value Measurements UsingDecember 31, 2009


Level 1


Level 2


Level 3(In Thousands)Available for sale securitiesMortgage-backed securities

$
41,513



-



41,513



-Collateralized mortgage obligations


75,322



-



59,523



15,799Government sponsored enterprise bonds


40,589



-



40,589



-Municipal securities


43,241



-



43,241



-Other debt securities


4,750



4,750



-



-Loans held for sale


45,052



-



45,052



-Mortgage banking derivative assets


252



-



-



252Mortgage banking derivative liabilities


211



-



-



211$
250,930



4,750



229,918



16,262





The following summarizes the valuation techniques for assets recorded in our consolidated statements of financial condition at their fair value on a recurring basis:





Available for sale securities – The Company’s investment securities classified as available for sale include: mortgage-backed securities, collateralized mortgage obligations, government sponsored enterprise bonds, municipal securities and other debt securities. The fair value of mortgage-backed securities, collateralized mortgage obligations and government sponsored enterprise bonds are determined by a third party valuation source using observable market data utilizing a matrix or multi-dimensional relational pricing model.  Standard inputs to these models include observable market data such as benchmark yields, reported trades, broker quotes, issuer spreads, benchmark securities, prepayment models and bid/offer market data.  For securities with an early redemption feature, an option adjusted spread model is utilized to adjust the issuer spread.  These model and matrix measurements are classified as Level 2 and Level 3 in the fair value hierarchy.  The fair value of municipal securities is determined by a third party valuation source using observable market data utilizing a multi-dimensional relational pricing model.  Standard inputs to this model include observable market data such as benchmark yields, reported trades, broker quotes, rating updates and issuer spreads.  These model measurements are classified as Level 2 in the fair value hierarchy.  The fair value of other debt securities, which includes a trust preferred security issued by a financial institution, is determined through quoted prices in active markets and is classified as Level 1 in the fair value hierarchy.





See accompanying notes to consolidated financial statements.
 - 107 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents





Loans held for sale – Effective January 1, 2009, the Company elected to carry loans held for sale at fair value under the fair value option model.  Fair value is generally determined by estimating a gross premium or discount, which is derived from pricing currently observable in the secondary market, principally from observable prices for forward sale commitments.  At December 31, 2010 and December 31, 2009, loans held-for-sale totaled $96.1 million and $45.1 million, respectively.  Loans held-for-sale are considered to be Level 2 in the fair value hierarchy of valuation techniques.





Mortgage banking derivatives - Mortgage banking derivatives include interest rate lock commitments to originate residential loans held for sale to individual customers and forward commitments to sell residential mortgage loans to various investors.  The Company relies on a valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes applying a pull through rate based upon historical experience and the current interest rate environment and then multiplying by quoted investor prices.  The Company also relies on a valuation model to estimate the fair value of its forward commitments to sell residential loans, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available.  While there are Level 2 and 3 inputs used in the valuation models, the Company has determined that one or more of the inputs significant in the valuation of both of the mortgage banking derivatives fall within Level 3 of the fair value hierarchy.





The table below presents reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during 2010 and 2009.




Available for sale securities


Mortgage banking derivatives(In Thousands)Balance at December 31, 2008

$
4,242



-Transfer into level 3


9,870



-Unrealized holding losses arising during the period:Included in other comprehensive income


2,427



-Other than temporary impairment included in net loss


(1,112
)


-Principal repayments


(750
)


-Net accretion of discount/amortization of premium


5



-Cummulative-effect adjustment


1,117



-Mortgage derivative gain, net


-



41Balance at December 31, 2009


15,799



41Transfer into level 3


-



-Unrealized holding losses arising during the period:Included in other comprehensive income


5,261



-Other than temporary impairment included in net loss


-



-Principal repayments


(881
)


-Net accretion of discount/amortization of premium


122



-Cummulative-effect adjustment


-



-Mortgage derivative gain, net


-



366Balance at December 31, 2010

$
20,301



407


Level 3 available-for-sale securities include two corporate collateralized mortgage obligations.  The market for these securities was not active as of December 31, 2010.  As such, the Company valued this security based on the present value of estimated future cash flows   Additional impairment may be incurred in future periods if estimated future cash flows are less than the cost basis of the securities. There were no transfers in or out of Level 1 or Level 2 measurements during the periods.




See accompanying notes to consolidated financial statements.
 - 108 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents





Assets Recorded at Fair Value on a Non-recurring Basis





The following table presents information about our assets recorded in our consolidated statement of financial position at their fair value on a non-recurring basis as of December 31, 2010 and December 31, 2009, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.








Fair Value Measurements UsingDecember 31, 2010


Level 1


Level 2


Level 3(In Thousands)Loans (1)

$
62,968



-



-



62,968Real estate owned


57,752



-



-



57,752Fair Value Measurements UsingDecember 31, 2009


Level 1


Level 2


Level 3(In Thousands)Loans (1)

$
78,271



-



-



78,271Real estate owned


50,929



-



-



50,929





(1) Represents collateral-dependent impaired loans, net, which are included in loans.





Loans – We do not record loans at fair value on a recurring basis.  On a non-recurring basis, loans determined to be impaired are analyzed to determine whether a collateral shortfall exists, and if such a shortfall exists, are recorded on our consolidated statements of financial condition at net realizable value of the underlying collateral.  Fair value is determined based on third party appraisals.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  Given the significance of the adjustments made to appraised values necessary to estimate the fair value of impaired loans, loans that have been deemed to be impaired are considered to be Level 3 in the fair value hierarchy of valuation techniques.  At December 31, 2010, loans determined to be impaired with an outstanding balance of $74.1 million were carried net of specific reserves of $11.1 million for a fair value of $63.0 million.  At December 31, 2009, loans determined to be impaired with an outstanding balance of $90.8 million were carried net of specific reserves of $12.5 million for a fair value of $78.3 million.  Impaired loans collateralized by assets which are valued in excess of the net investment in the loan do not require any specific reserves.





Real estate owned – On a non-recurring basis, real estate owned, is recorded in our consolidated statements of financial condition at the lower of cost or fair value.  Fair value is determined based on third party appraisals obtained at the time the Company takes title to the property and, if less than the carrying value of the loan, the carrying value of the loan is adjusted to the fair value.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  Given the significance of the adjustments made to appraised values necessary to estimate the fair value of the properties, real estate owned is considered to be Level 3 in the fair value hierarchy of valuation techniques.  Changes in the value of real estate owned totaled $2.1 million and $4.3 million during the years ended December 31, 2010 and 2009, respectively and are recorded in real estate owned expense. At December 31, 2010 and December 31, 2009, real estate owned totaled $57.8 million and $50.9 million, respectively.





Fair value information about financial instruments follows, whether or not recognized in the consolidated statements of financial condition, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.




See accompanying notes to consolidated financial statements.
 - 109 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents





The carrying amounts and fair values of the Company’s financial instruments consist of the following at December 31, 2010 and 2009:









December 31, 2010


December 31, 2009Carrying


Fair


Carrying


Fairamount


value


amount


value(In Thousands)Financial AssetsCash and cash equivalents

$
74,945



74,945



71,120



71,120Securities available-for-sale


203,166



203,166



205,415



205,415Securities held-to-maturity


2,648



2,501



2,648



1,930Loans held for sale


96,133



96,133



45,052



45,052Loans receivable


1,306,437



1,313,854



1,420,010



1,403,266FHLB stock


21,653



21,653



21,653



21,653Cash surrender value of life insurance


35,385



35,385



33,941



33,941Accrued interest receivable


4,101



4,101



4,525



4,525Mortgage banking derivative assets


470



470



252



252Financial LiabilitiesDeposits


1,145,529



1,153,065



1,164,890



1,167,834Advance payments byborrowers for taxes


2,379



2,379



630



630Borrowings


456,959



482,933



507,900



513,596Accrued interest payable


2,326



2,326



3,337



3,337Mortgage banking derivative liabilities


63



63



211



211Other Financial InstrumentsStand-by letters of credit


5



5



5



5







The following methods and assumptions were used by the Company in determining its fair value disclosures for financial instruments.




Cash and Cash Equivalents




The carrying amount reported in the consolidated statements of financial condition for cash and cash equivalents is a reasonable estimate of fair value.




Securities




The fair value of securities is determined by a third party valuation source using observable market data utilizing a matrix or multi-dimensional relational pricing model.  Standard inputs to these models include observable market data such as benchmark yields, reported trades, broker quotes, issuer spreads, benchmark securities and bid/offer market data.  For securities with an early redemption feature, an option adjusted spread model is utilized to adjust the issuer spread.  Prepayment models are used for mortgage related securities with prepayment features.




See accompanying notes to consolidated financial statements.
 - 110 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




Loans Held for Sale




Fair value is estimated using the prices of the Company’s existing commitments to sell such loans and/or the quoted market price for commitments to sell similar loans.




Loans Receivable




Loans determined to be impaired are analyzed to determine whether a collateral shortfall exists, and if such a shortfall exists, are recorded on our consolidated statements of financial condition at fair value.  Fair value is determined based on third party appraisals.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  With respect to loans that are not considered to be impaired, fair value is estimated by discounting the future contractual cash flows using discount rates that that reflect a current rate offered to borrowers of similar credit standing for the remaining term to maturity.  This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820-10 and generally produces a higher fair value.




FHLBC Stock




For FHLBC stock, the carrying amount is the amount at which shares can be redeemed with the FHLBC and is a reasonable estimate of fair value.




Cash Surrender Value of Life Insurance




The carrying amounts reported in the consolidated statements of financial condition for the cash surrender value of life insurance approximate those assets’ fair values.




Deposits and Advance Payments by Borrowers for Taxes




The fair values for interest-bearing and noninterest-bearing negotiable order of withdrawal accounts, savings accounts, and money market accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of similar remaining maturities to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit. The advance payments by borrowers for taxes are equal to their carrying amounts at the reporting date.




Borrowings




Fair values for borrowings are estimated using a discounted cash flow calculation that applies current interest rates to estimated future cash flows of the borrowings.




Accrued Interest Payable and Accrued Interest Receivable




For accrued interest payable and accrued interest receivable, the carrying amount is a reasonable estimate of fair value.




See accompanying notes to consolidated financial statements.
 - 111 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents




Commitments to Extend Credit and Standby Letters of Credit




Commitments to extend credit and standby letters of credit are generally not marketable. Furthermore, interest rates on any amounts drawn under such commitments would be generally established at market rates at the time of the draw. Fair values for the Company’s commitments to extend credit and standby letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the counterparty’s credit standing, and discounted cash flow analyses. The fair value of the Company’s commitments to extend credit is not material at December 31, 2010 and 2009.




Mortgage Banking Derivative Assets and Liabilities




Mortgage banking derivatives include interest rate lock commitments to originate residential loans held for sale to individual customers and forward commitments to sell residential mortgage loans to various investors.  The Company relies on a valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes applying a pull through rate based upon historical experience and the current interest rate environment, and then multiplying by quoted investor prices.  The Company also relies on a valuation model to estimate the fair value of its forward commitments to sell residential loans, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available.  On the Company’s Consolidated Statements of Condition, instruments that have a positive fair value are included in prepaid expenses and other assets, and those instruments that have a negative fair value are included in other assets.




16)
Earnings (loss) per share




Earnings per share are computed using the two-class method.  Basic earnings (loss) per share is computed by dividing net income (loss) allocated to common shares by the weighted average number of common shares outstanding during the applicable period, excluding outstanding participating securities.  Participating securities include unvested restricted shares.  Unvested restricted shares are considered participating securities because holders of these securities have the right to receive dividends at the same rate as holders of the Company’s common stock.  Diluted earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding adjusted for the dilutive effect of all potential common shares.  Unvested restricted stock and stock options are considered outstanding for diluted earnings per share only.  Unvested restricted stock and stock options totaling 101,400 and 356,000 shares for the year ended December 31, 2010 and 150,600 and 459,500 shares for the year ended December 31, 2009 and 200,200 and 615,000 shares for the year ended December 31, 2008 are antidilutive and are excluded from the loss per share calculation.  Presented below are the calculations for basic and diluted earnings loss per share.









For the year ended December 31,2010


2009


2008(In Thousands, except per share amounts)Net loss

$
(1,854
)


(10,138
)


(26,446
)Weighted average shares outstanding


30,804



30,680



30,556Effect of dilutive potential common shares


-



-



-Diluted weighted average shares outstanding


30,804



30,680



30,556Basic loss per share

$
(0.06
)


(0.33
)


(0.87
)Diluted loss per share

$
(0.06
)


(0.33
)


(0.87
)







See accompanying notes to consolidated financial statements.
 - 112 -
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008
 Table of Contents







17)
Condensed Parent Company Only Statements









Statements of Financial ConditionDecember 31,2010


2009(In Thousands)AssetsCash and cash equivalents

$
557



446Securities available for sale (at fair value)


5,294



4,500Investment in subsidiaries


166,555



163,602Receivable from ESOP


-



-Other assets


21



257Total Assets

$
172,427



168,805Liabilities and shareholders' equityLiabilities:Other liabilities


207



213Shareholders' equityPreferred Stock (par value $.01 per share)


-



-Authorized - 20,000,000 shares, no shares issuedCommon stock (par value $.01 per share)


340



340Authorized - 200,000,000 shares in 2009 and 2008Issued - 33,974,450 in 2010 and 2009Outstanding -  31,250,097 in 2010 and 2009Additional paid-in-capital


109,953



108,883Retained earnings


109,046



110,900Unearned ESOP shares


(3,416
)


(4,269
)Treasury stock (2,724,353 shares), at cost


(45,261
)


(45,261
)Accumulated other comprehensive loss (net of taxes)


1,558



(2,001
)Total shareholders' equity


172,220



168,592Total liabilities and shareholders' equity

$
172,427



168,805







See Accompanying notes to consolidated financial statements.
 - 113 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008






Statements of OperationsFor the year ended December 31,2010


2009


2008(In Thousands)Interest income

$
715



766



1,043Provision for loan losses


-



-



252Interest income after provision for loan losses


715



766



791Equity in loss of subsidiaries


(2,790
)


(11,201
)


(25,220
)Total loss


(2,075
)


(10,435
)


(24,429
)Compensation


(541
)


(557
)


(30
)Professional fees


40



51



47Other expense


280



131



557Total expense


(221
)


(375
)


574Loss before income tax


(1,854
)


(10,060
)


(25,003
)Income tax expense


-



78



1,443Net loss

$
(1,854
)


(10,138
)


(26,446
)







See Accompanying notes to consolidated financial statements.
 - 114 -
 Table of Contents
 Waterstone Financial, Inc. and Subsidiaries
 Notes to Consolidated Financial Statements
 Years Ended December 31, 2010, 2009 and 2008












Statements of Cash FlowsFor the year ended December 31,2010


2009


2008(In Thousands)Cash flows from operating activitiesNet income (loss)

$
(1,854
)


(10,138
)


(26,446
)Adjustments to reconcile net income (loss) to netcash provided by operating activities:Provision for loan losses


-



-



252Amortization of unearned ESOP


264



250



776Stock based compensation


1,659



1,648



1,611Deferred income taxes


319



(8
)


1,285Equity in earnings of subsidiaries


2,790



11,201



25,220Change in other assets and liabilities


(2,067
)


(562
)


1,088Net cash provided by operating activities


1,111



2,391



3,786Cash flows from investing activities:Net decrease in loans receivable


-



-



4,135Purchase of available for sale securities


-



-



(5,000
)Capital contributions to subsidiary


(1,000
)


(3,000
)


(26,218
)Net cash used in investing activities


(1,000
)


(3,000
)


(27,083
)Net cash provided by (used in) financing activities


-



-



-Net increase (decrease) in cash


111



(609
)


(23,297
)Cash and cash equivalents at beginning of period


446



1,055



24,352Cash and cash equivalents at end of period

$
557



446



1,055












18)
Segments and Related Information




The Company is required to report each operating segment based on materiality thresholds of 10% or more of certain amounts, such as revenue. Additionally, the Company is required to report separate operating segments until the revenue attributable to such segments is at least 75% of total consolidated revenue. The Company provides a broad range of financial services to individuals and companies in southeastern Wisconsin. These services include demand, time, and savings products, and commercial and retail lending. While the Company’s chief decision-maker monitors the revenue streams of the various products and services, operations are managed and financial performance is evaluated on a Company-wide basis. Since the Company’s business units have similar basic characteristics in the nature of the products, production processes, and type or class of customer for products or services, and do not meet materiality thresholds based on the requirements of reportable segments, these business units are considered one operating segment.







See Accompanying notes to consolidated financial statements.
 - 115 -
 Table of Contents


Item 9.                 Changes in and Disagreements with Accountants on Accounting and Financial Disclosure





None





Item 9A.                 Controls and Procedures





Disclosure Controls and Procedures:Waterstone Financial management, with the participation of Waterstone Financial’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of Waterstone Financial’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report.  Based on such evaluation, Waterstone Financial’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, Waterstone Financial’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by Waterstone Financial in the reports that it files or submits under the Exchange Act.





Change in Internal Control Over Financial Reporting:  There have not been any changes in Waterstone Financial’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the final fiscal quarter of the period to which this report relates that have materially affected, or are reasonably likely to materially affect, Waterstone Financial’s internal control over financial reporting.





Management’s Annual Report on Internal Control Over Financial Reporting





Management of Waterstone Financial Inc. (the “Company”) is responsible for establishing and maintaining adequate internal control over financial reporting. The Company’s internal control over financial reporting is a process designed to provide reasonable assurance regarding the reliability of financial reporting and the preparation of the Company’s financial statements for external purposes in accordance with generally accepted accounting principles. Internal control over financial reporting is defined in Rules 13a-15(f) and 15d-15(f) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
 
 As of December 31, 2010, management assessed the effectiveness of the Company’s internal control over financial reporting based on criteria for effective internal control over financial reporting established in “Internal Control—Integrated Framework,” issued by the Committee of Sponsoring Organization of the Treadway Commission (COSO). Based on this assessment, management has determined that the Company’s internal control over financial reporting as of December 31, 2010 is effective.
 
 KPMG LLP, the independent registered public accounting firm that audited the consolidated financial statements of the Company included in this Annual Report on Form 10-K, has issued a report on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010. The report, which expresses an unqualified opinion on the effectiveness of the Company’s internal control over financial reporting as of December 31, 2010, is included below under the heading “Report of Independent Registered Public Accounting Firm.”









- 116 -
 Table of Contents


REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM
 
 The Board of Directors and Stockholders
 Waterstone Financial, Inc.:


We have audited Waterstone Financial, Inc’s internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO). Waterstone Financial, Inc’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, included in the accompanying Management’s Annual Report on Internal Control Over Financial Reporting. Our responsibility is to express an opinion on 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, assessing the risk that a material weakness exists, and testing and evaluating the design and operating effectiveness of internal control based on the assessed risk.  Our audit also included performing such other procedures as we considered necessary in the circumstances. We believe that our audit provides a reasonable basis for our opinion.
 
 A company’s internal control over financial reporting is a process designed 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 its inherent limitations, internal control over financial reporting may not prevent or detect misstatements. Also, projections of any evaluation of effectiveness to future periods are subject to the risk that 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, Waterstone Financial, Inc. maintained, in all material respects, effective internal control over financial reporting as of December 31, 2010, based on criteria established in Internal Control-Integrated Frameworkissued by the Committee of Sponsoring Organizations of the Treadway Commission (COSO).





We also have audited, in accordance with the standards of the Public Company Accounting Oversight Board (United States), the consolidated statements of financial condition of Waterstone Financial, Inc and subsidiaries as of December 31, 2010 and 2009, and the related consolidated statements of operations, changes in shareholders’ equity, and cash flows for each of the years in the three-year period ended December 31, 2010 and our report dated March 14, 2011 expressed an unqualified opinion on those consolidated financial statements.





/s/ KPMG LLP


Milwaukee, Wisconsin


March 14, 2011


- 117 -
 Table of Contents





Item 9B.                 Other Information.





None


- 118 -
 Table of Contents





Part III





Item 10.                 Directors, Executive Officers and Corporate Governance





The information in the Company’s definitive Proxy Statement, prepared for the 2011 Annual Meeting of Shareholders, which contains information concerning directors of the Company under the caption “Election of Directors” and compliance with Section 16 reporting requirements under the caption “Section 16(a) Beneficial Ownership Reporting Compliance” and information concerning executive officers of the Company under the caption “Executive Officers of Waterstone Financial” and information concerning corporate governance under the caption “Other Board and Corporate Governance Matters” in Part I hereof is incorporated herein by reference.





Executive Officers of the Registrant





The table below sets forth certain information regarding the persons who have been determined, by our board of directors, to be executive officers of the Company. The executive officers of the Company are elected annually and hold office until their respective successors have been elected or until death, resignation, retirement or removal by the Board of directors.





Name and Age
Offices and Positions with Waterstone Financial and Subsidiaries*
Executive

Officer

SinceDouglas S. Gordon, 53
Chief Executive Officer and President of Waterstone Financial and of WaterStone Bank
2005Richard C. Larson, 53
Chief Financial Officer and Senior Vice President of Waterstone Financial and of WaterStone Bank
1990 (1)William F. Bruss, 41
General Counsel, Senior Vice President and Secretary of Waterstone Financial and of WaterStone Bank
2005Rebecca M. Arndt, 43
Vice President – Retail Operations of WaterStone Bank
2006Eric J. Egenhoefer, 35
President of Waterstone Mortgage Corporation
2008





*
Excluding directorships and excluding positions with Bank subsidiary positions which do not constitute a substantial part of the officers’ duties.


(1)
Indicates date when individual first held an executive officer position with the Bank.  This individual became an executive officer of Waterstone Financial upon its organization as noted.





- 119 -
 Table of Contents


Item 11.                 Executive Compensation





The information in the Company’s definitive Proxy Statement, prepared for the 2011 Annual Meeting of Shareholders, which contains information concerning this item under the captions “Executive Compensation,” “Director Compensation,” “Compensation Committee Interlocks and Insider Participation,” and “Compensation Discussion and Analysis” is incorporated herein by reference.





Item 12.                 Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters





The information in the Company’s definitive Proxy Statement, prepared for the 2011 Annual Meeting of Shareholders, which contains information concerning this item under the caption “Stock Ownership of Certain Beneficial Owners” is incorporated herein by reference.





Compensation Plans





Set forth below is information as of December 31, 2010 regarding equity compensation plans that have been approved by shareholders.  The Company has no equity based benefit plans, other than its employee stock ownership plan, that were not approved by shareholders.





Plan

Number of shares to be issued upon exercise of outstanding options and rights


Weighted average option exercise price


Number of securities remaining available for issuance under plan2006 Equity Incentive Plan


1,494,298
(1)

$
16.44



441,098


__________


(1)
Consists of 1,067,356 shares reserved for grants of stock options and 426,942 shares reserved for grants of restricted stock.  On December 31, 2010, 802,500 options were outstanding with a weighted average exercise price of $16.44 of which 446,500 were exercisable as of that date.








Item 13.                 Certain Relationships and Related Transactions and Director Independence





The information in the Company’s definitive Proxy Statement, prepared for the 2011 Annual Meeting of Shareholders, which contains information concerning this item under the captions “Certain Transactions with the Company” and “Board Meetings and Committee” is incorporated herein by reference.





Item 14.                 Principal Accountant Fees and Services





The information in the Company’s definitive Proxy Statement, prepared for the 2011 Annual Meeting of Shareholders, which contains information concerning this item under the caption “Independent Registered Public Accounting Firm,” is incorporated herein by reference.





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Part IV





Item 15.                 Exhibits and Financial Statement Schedules





(a)       Documents filed as part of the Report:


1. and 2.  Financial Statements and Financial Statement Schedules.





The following consolidated financial statements of Waterstone Financial, Inc. and subsidiaries are filed as part of this report under Item 8, “Financial Statements and Supplementary Data”:





Consolidated Statements of Financial Condition – December 31, 2010 and 2009.





Consolidated Statements of Operations – Years ended December 31, 2010, 2009 and 2008.





Consolidated Statements of Changes in Shareholders’ Equity – Years ended December 31, 2010, 2009 and 2008.





Consolidated Statements of Cash Flows – Years ended December 31, 2010, 2009 and 2008.





Notes to Consolidated Financial Statements.





Report of KPMG LLP, Independent Registered Public Accounting Firm, on consolidated financial statements.








All schedules for which provision is made in the applicable accounting regulations of the Securities and Exchange Commission are not required under the related instructions or are inapplicable, and therefore have been omitted.





(b)
Exhibits.  See Exhibit Index following the signature page of this report, which is incorporated herein by reference.  Each management contract or compensatory plan or arrangement required to be filed as an exhibit to this report is identified in the Exhibit Index by an asterisk following its exhibit number.











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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.





WATERSTONE FINANCIAL, INC.


March 14, 2011





By:/s/Douglas S. Gordon


Douglas S. Gordon


Chief Executive Officer





POWER OF ATTORNEY



Each person whose signature appears below hereby authorizes Douglas S. Gordon, Richard C. Larson and William F. Bruss, or any of them, as attorneys-in-fact with full power of substitution, to execute in the name and on behalf of such person, individually, and in each capacity stated below or otherwise, and to file, any and all amendments to this report.





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 indicated.*





Signature and Title


/s/Douglas S. Gordon

/s/Patrick S. LawtonDouglas S. Gordon,

Patrick S. Lawton, Chairman and DirectorChief Executive Officer and Director(Principal Executive Officer)/s/Richard C. Larson

/s/Thomas E. DalumRichard C. Larson, Senior Vice President

Chief Financial Officer

Thomas E. Dalum, Director(Principal Financial and Accounting Officer)/s/Michael L. HansenMichael L. Hansen, Director/s/Stephen J. SchmidtStephen J. Schmidt, Director








*Each of the above signatures is affixed as of March 14, 2011.


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WATERSTONE FINANCIAL, INC


(“Waterstone Financial” or the “Company”)


Commission File No. 000-51507





EXHIBIT INDEX


TO


2010 REPORT ON FORM 10-K





The following exhibits are filed with, or incorporated by reference in, this Annual Report on Form 10-K for the year ended December 31, 2010:





Exhibit
Description
Incorporated Herein

By Reference To
Filed

Herewith2.1
Plan of Reorganization from Mutual Savings Bank to Mutual Holding Company of Wauwatosa Savings Bank (the “Bank”), as adopted on May 17,2005 and amended on June 3, 2005 (the “Plan”)
Exhibit 2.1 to the Company’s Registration Statement on Form S-1, Registration No. 333-125715 (the “2005 S-1”)3.1
Articles of Incorporation of the Company
Exhibit 3.1 to 2005 S-13.2
Proposed Bylaws of the Company
Exhibit 3.1 to 2005 S-110.4*
Stock Compensation Plans
Exhibit 10.1 to the company’s Current Report on Form 8-K filed on May 22, 200611.1
Statement re: Computation of Per Share Earnings
See Note 13 in Part II Item 821.1
List of Subsidiaries

X23.1
Consent of Independent Registered Public Accounting Firm

X24.1
Powers of Attorney
Signature Page31.1
Sarbanes-Oxley Act Section 302 Certification signed by the Chief Executive Officer of Waterstone Financial

X31.2
Sarbanes-Oxley Act Section 302 Certification signed by the Chief Financial Officer of Waterstone Financial

X32.1
Certification pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Executive Officer of Waterstone Financial

X32.2
Certification pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Financial Officer of Waterstone Financial

X





* Designates management or compensatory agreements, plans or arrangements required to be filed as exhibits pursuant to Item 15(b) of Form 10-K.