Table of Contents

 

 

 

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

** **
| **x**      | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                     |
|------------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| ** ** | ** **                                                                                                                                                                                 |
|       | **For  the Quarterly Period Ended December 31, 2008**                                                                                                                                 |
|       | ** **                                                                                                                                                                                 |
| **OR**     |
|       | ** **                                                                                                                                                                                 |
| **o**      | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF  THE SECURITIES EXCHANGE ACT OF 1934**                                                                                    |
|       |                                                                                                                                                                                       |
|       | **For  the transition period from               to              ** |

 

**Commission filenumber 0-19972**

 

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**HFFINANCIAL CORP.**

(Exact name of registrant as specified in itscharter)

 

| **Delaware**                             | ** ** | **46-0418532**      |
|------------------------------------------|------------|---------------------|
| (State or other  jurisdiction of         |       | (I.R.S. Employer    |
| incorporation or  organization)          |       | Identification No.) |
| * *                                 | * *   | * *            |
| **225  South Main Avenue,**              | ** ** | ** **          |
| **Sioux  Falls, SD**                     | * *   | **57104**           |
| (Address of principal executive offices) | * *   | (ZIP Code)          |

 

(**605) 333-7556**

(Registrant’stelephone number, including area code)

 

Indicate by checkmark whether the Registrant (1) has filed all reports required to be filedby Section 13 or Section 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theRegistrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days.

 

Yes x    No  o

 

Indicate by checkmark whether the Registrant is a large accelerated filer, an accelerated filer,a non-accelerated filer, or a smaller reporting company.  See the definitions of “large acceleratedfiler,” “accelerated filer” and “smaller reporting company” in Rule 12b-2of the Exchange Act.

 
| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated filer o |   | Smaller reporting company x |
|---------------------------|--------|---------------------|--------|-------------------------|--------|-----------------------------|

 

Indicate by checkmark whether the Registrant is a shell company (as defined in Rule 12b-2of the Exchange Act).

 

Yes o    No  x

 

As of February 6,2009, there were 4,021,121 shares of the Registrant’s common stock outstanding.

 

 

 

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Table of Contents

** **

**Quarterly Report on Form 10-Q**

**Table of Contents**

 
| ** **                                   | ** **                                                                                              | **Page Number** |
|----------------------------------------------|---------------------------------------------------------------------------------------------------------|----------------------|
| **PART I – FINANCIAL INFORMATION** |
| ** **                                   |
| Item 1.                                      | Financial Statements (Unaudited):                                                                       |                 |
|                                         |                                                                                                    |                 |
|                                         | Consolidated  Statements of Financial Condition   At December 31, 2008 and June 30, 2008      | 1                    |
|                                         |                                                                                                    |                 |
|                                         | Consolidated  Statements of Income for the   Three and Six Months Ended December 31, 2008 and 2007 | 2                    |
|                                         |                                                                                                    |                 |
|                                         | Consolidated  Statements of Cash Flows for the   Six Months Ended December 31, 2008 and 2007       | 3                    |
|                                         |                                                                                                    |                 |
|                                         | Notes to Consolidated Financial Statements                                                              | 4                    |
|                                         |                                                                                                    |                 |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations             | 15                   |
|                                         |                                                                                                    |                 |
| Item 3.                                      | Quantitative  and Qualitative Disclosures about Market Risk                                             | 34                   |
|                                         |                                                                                                    |                 |
| Item 4.                                      | Controls and  Procedures                                                                                | 36                   |
|                                         |                                                                                                    |                 |
| **PART II – OTHER  INFORMATION**   |
|                                         |                                                                                                    |                 |
| Item  1.                                     | Legal Proceedings                                                                                       | 36                   |
|                                         |                                                                                                    |                 |
| Item  1A.                                    | Risk Factors                                                                                            | 37                   |
|                                         |                                                                                                    |                 |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds                                            | 37                   |
|                                         |                                                                                                    |                 |
| Item 4.                                      | Submission of  Matters to a Vote of Security Holders                                                    | 37                   |
|                                         |                                                                                                    |                 |
| Item 6.                                      | Exhibits                                                                                                | 38                   |
|                                         |                                                                                                    |                 |
| Form 10-Q                               | Signature Page                                                                                          | 39                   |

 

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Table of Contents

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1.         FinancialStatements**

 

**HF FINANCIAL CORP.**

**CONSOLIDATED STATEMENTS OF FINANCIALCONDITION**

**(Dollars in Thousands)**

 
| ** **                                                                                                                                                         | ** ** | **December 31, 2008** | ** ** | **June 30, 2008** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                         | ** ** | **(Unaudited)**                 | ** ** | **(Audited)**               | ** ** |
| **ASSETS**                                                                                                                                                         | ** ** | ** **                      | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                                          |       | $                               | 25,882     |                        | $          | 21,170 |   |
| Securities available for sale                                                                                                                                      |       | 254,389                         |       | 225,004                     |       |
| Federal Home Loan Bank stock                                                                                                                                       |       | 12,476                          |       | 11,245                      |       |
| Loans held for sale                                                                                                                                                |       | 14,027                          |       | 8,796                       |       |
|                                                                                                                                                               |       |                            |       |                        |       |
| Loans and leases receivable                                                                                                                                        |       | 811,289                         |       | 783,710                     |       |
| Allowance for loan and lease losses                                                                                                                                |       | (8,133                          | )          | (5,933                      | )          |
| Net loans and  leases receivable                                                                                                                                   |       | 803,156                         |       | 777,777                     |       |
|                                                                                                                                                               |       |                            |       |                        |       |
| Accrued interest receivable                                                                                                                                        |       | 8,335                           |       | 7,540                       |       |
| Office properties and equipment, net of accumulated  depreciation                                                                                                  |       | 15,053                          |       | 14,849                      |       |
| Foreclosed real estate and other properties                                                                                                                        |       | 369                             |       | 643                         |       |
| Cash value of life insurance                                                                                                                                       |       | 14,323                          |       | 14,050                      |       |
| Servicing rights                                                                                                                                                   |       | 11,412                          |       | 11,189                      |       |
| Goodwill, net                                                                                                                                                      |       | 4,951                           |       | 4,951                       |       |
| Other assets                                                                                                                                                       |       | 8,779                           |       | 6,280                       |       |
| Total assets                                                                                                                                                       |       | $                               | 1,173,152  |                        | $          | 1,103,494 |   |
|                                                                                                                                                               |       |                            |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                     |       |                            |       |                        |       |
| ** **                                                                                                                                                         |       |                            |       |                        |       |
| **LIABILITIES**                                                                                                                                                    |       |                            |       |                        |       |
| Deposits                                                                                                                                                           |       | $                               | 772,917    |                        | $          | 784,237 |   |
| Advances from Federal Home Loan Bank and other  borrowings                                                                                                         |       | 252,769                         |       | 198,454                     |       |
| Subordinated debentures payable to trusts                                                                                                                          |       | 27,837                          |       | 27,837                      |       |
| Advances by borrowers for taxes and insurance                                                                                                                      |       | 10,988                          |       | 10,795                      |       |
| Accrued expenses and other liabilities                                                                                                                             |       | 16,981                          |       | 17,968                      |       |
| Total  liabilities                                                                                                                                                 |       | 1,081,492                       |       | 1,039,291                   |       |
|                                                                                                                                                               |       |                            |       |                        |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                                      |       |                            |       |                        |       |
| Preferred stock,  $.01 par value, 500,000 shares authorized, 25,000 shares issued at December 31,  2008                                                       |       | —                          |       | —                      |       |
| Series A  Junior Participating Preferred Stock, $1.00 stated value, 50,000 shares  authorized, none outstanding                                               |       | —                          |       | —                      |       |
| Common stock,  $.01 par value, 10,000,000 shares authorized, 6,104,822 and 6,035,447 shares  issued at December 31, 2008 and June 30, 2008, respectively |       | 61                              |       | 60                          |       |
| Common stock subscribed for but not issued                                                                                                                         |       | —                          |       | 95                          |       |
| Additional paid-in capital                                                                                                                                         |       | 47,792                          |       | 21,905                      |       |
| Retained earnings, substantially restricted                                                                                                                        |       | 78,951                          |       | 76,041                      |       |
| Accumulated other comprehensive (loss), net of  related deferred tax effect                                                                                        |       | (4,247                          | )          | (3,001                      | )          |
| Less cost of  treasury stock, 2,083,455 and 2,083,455 shares at December 31, 2008 and  June 30, 2008, respectively                                       |       | (30,897                         | )          | (30,897                     | )          |
| Total  stockholders’ equity                                                                                                                                   |       | 91,660                          |       | 64,203                      |       |
| Total  liabilities and stockholders’ equity                                                                                                                   |       | $                               | 1,173,152  |                        | $          | 1,103,494 |   |

 

*See accompanying notes to unauditedconsolidated financial statements.*

 

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**HF FINANCIAL CORP.**

**CONSOLIDATED STATEMENTS OF INCOME**

**(Dollars in Thousands, except sharedata)**

**(Unaudited)**

 
| ** **                                                                  | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                  | ** ** | **December 31,**            | ** ** | **December 31,**          | ** ** |
| ** **                                                                  | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| Interest,  dividend and loan fee income:                                    |       |                             |       |                           |       |   |   |   |   |
| Loans and leases  receivable                                                |       | $                                | 12,646     |                           | $          | 13,879 |   | $ | 25,664 |   | $ | 27,999 |   |
| Investment  securities and interest-earning deposits                        |       | 2,920                            |       | 2,206                          |       | 5,733 |   | 4,071 |   |
|                                                                        |       | 15,566                           |       | 16,085                         |       | 31,397 |   | 32,070 |   |
| Interest  expense:                                                          |       |                             |       |                           |       |   |   |   |   |
| Deposits                                                                    |       | 4,132                            |       | 6,913                          |       | 8,709 |   | 14,411 |   |
| Advances from  Federal Home Loan Bank and other borrowings                  |       | 2,427                            |       | 2,176                          |       | 4,992 |   | 3,995 |   |
|                                                                        |       | 6,559                            |       | 9,089                          |       | 13,701 |   | 18,406 |   |
| **Net  interest income**                                                    | ** ** | 9,007                            |       | 6,996                          |       | 17,696 |   | 13,664 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Provision for  losses on loans and leases                                   |       | —                           |       | 295                            |       | 387 |   | 620 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| **Net  interest income after provision****for losses  on loans and leases** | ** ** | 9,007                            |       | 6,701                          |       | 17,309 |   | 13,044 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Noninterest  income:                                                        |       |                             |       |                           |       |   |   |   |   |
| Fees on deposits                                                            |       | 1,518                            |       | 1,355                          |       | 3,069 |   | 2,768 |   |
| Loan servicing  income                                                      |       | 534                              |       | 542                            |       | 1,091 |   | 1,047 |   |
| Gain on sale of  loans, net                                                 |       | 285                              |       | 439                            |       | 536 |   | 698 |   |
| Trust income                                                                |       | 153                              |       | 249                            |       | 375 |   | 498 |   |
| Gain on sale of  securities, net                                            |       | 45                               |       | —                         |       | 125 |   | — |   |
| Other                                                                       |       | 394                              |       | 381                            |       | 782 |   | 770 |   |
|                                                                        |       | 2,929                            |       | 2,966                          |       | 5,978 |   | 5,781 |   |
| Noninterest  expense:                                                       |       |                             |       |                           |       |   |   |   |   |
| Compensation and  employee benefits                                         |       | 5,828                            |       | 4,788                          |       | 10,949 |   | 9,231 |   |
| Occupancy and  equipment                                                    |       | 1,012                            |       | 981                            |       | 1,989 |   | 1,918 |   |
| Check and data  processing expense                                          |       | 652                              |       | 608                            |       | 1,274 |   | 1,221 |   |
| Marketing                                                                   |       | 329                              |       | 299                            |       | 667 |   | 562 |   |
| Foreclosed real  estate and other properties, net                           |       | 96                               |       | 37                             |       | 213 |   | 80 |   |
| Other                                                                       |       | 1,259                            |       | 995                            |       | 2,487 |   | 1,840 |   |
|                                                                        |       | 9,176                            |       | 7,708                          |       | 17,579 |   | 14,852 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| **Income before  income taxes**                                             | ** ** | 2,760                            |       | 1,959                          |       | 5,708 |   | 3,973 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| Income tax  expense                                                         |       | 914                              |       | 708                            |       | 1,887 |   | 1,375 |   |
| **Net  income**                                                             | ** ** | $                                | 1,846      |                           | $          | 1,251 |   | $ | 3,821 |   | $ | 2,598 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| **Comprehensive  income**                                                   |       | $                                | 1,031      |                           | $          | 1,539 |   | $ | 2,574 |   | $ | 3,603 |   |
| ** **                                                                  |       |                             |       |                           |       |   |   |   |   |
| **Cash  dividends declared per share**                                      |       | $                                | 0.1125     |                           | $          | 0.1075 |   | $ | 0.1125 |   | $ | 0.2150 |   |
|                                                                        |       |                             |       |                           |       |   |   |   |   |
| **Earnings  per common share:**                                             |       |                             |       |                           |       |   |   |   |   |
| Basic                                                                       |       | $                                | 0.46       |                           | $          | 0.32 |   | $ | 0.96 |   | $ | 0.65 |   |
| Diluted                                                                     |       | $                                | 0.46       |                           | $          | 0.31 |   | $ | 0.95 |   | $ | 0.64 |   |

 

*Seeaccompanying notes to unaudited consolidated financial statements.*

 

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**HF FINANCIAL CORP.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(Dollars in Thousands)**

**(Unaudited)**

 
| ** **                                                                                    | ** ** | **Six Months Ended December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                    | ** ** | **2008**                                              | ** ** | **2007** | ** ** |
| **Cash  flows from operating activities**                                                     |       |                                                  |       |   |   |
| Net income                                                                                    |       | $                                                     | 3,821      |   | $ | 2,598 |   |
| Adjustments to  reconcile net income to net cash provided by (used in) operating activities:  |       |                                                  |       |   |   |
| Provision for losses  on loans and leases                                                     |       | 387                                                   |       | 620 |   |
| Depreciation                                                                                  |       | 842                                                   |       | 850 |   |
| Amortization of discounts  and premiums on securities and other                               |       | 955                                                   |       | 787 |   |
| Stock based compensation                                                                      |       | 194                                                   |       | 375 |   |
| Net change in loans  held for resale                                                          |       | (4,695                                                | )          | 3,938 |   |
| (Gain) on sale of  loans, net                                                                 |       | (536                                                  | )          | (698 | ) |
| Realized (gain) on  sale of securities, net                                                   |       | (125                                                  | )          | (75 | ) |
| Losses and provision  for losses on sales of foreclosed real estate and other properties, net |       | 17                                                    |       | 15 |   |
| Change in other assets  and liabilities                                                       |       | (4,793                                                | )          | (4,436 | ) |
| Net cash provided  by (used in) operating activities:                                         |       | (3,933                                                | )          | 3,974 |   |
|                                                                                          |       |                                                  |       |   |   |
| **Cash  flows from investing activities**                                                     |       |                                                  |       |   |   |
| Loan  participations purchased                                                                |       | (969                                                  | )          | (4,911 | ) |
| Net change in  loans outstanding                                                              |       | (25,209                                               | )          | 10,833 |   |
| Securities  available for sale:                                                               |       |                                                  |       |   |   |
| Sales and maturities  and repayments                                                          |       | 43,835                                                |       | 26,301 |   |
| Purchases                                                                                     |       | (74,342                                               | )          | (46,430 | ) |
| Purchase of  Federal Home Loan Bank stock                                                     |       | (5,565                                                | )          | (4,493 | ) |
| Redemption of  Federal Home Loan Bank stock                                                   |       | 4,334                                                 |       | 1,149 |   |
| Purchase of  office properties and equipment                                                  |       | (1,046                                                | )          | (889 | ) |
| Purchase of  servicing rights                                                                 |       | (769                                                  | )          | (955 | ) |
| Proceeds from  sale of foreclosed real estate and other properties, net                       |       | 405                                                   |       | 209 |   |
| Net cash (used in)  investing activities:                                                     |       | (59,326                                               | )          | (19,186 | ) |
|                                                                                          |       |                                                  |       |   |   |
| **Cash  flows from financing activities**                                                     |       |                                                  |       |   |   |
| Net (decrease)  in deposit accounts                                                           |       | (11,320                                               | )          | (43,968 | ) |
| Proceeds of  advances from Federal Home Loan Bank and other borrowings                        |       | 1,408,730                                             |       | 822,949 |   |
| Payments on  advances from Federal Home Loan Bank and other borrowings                        |       | (1,354,415                                            | )          | (761,092 | ) |
| Proceeds from  issuance of subordinated debentures                                            |       | —                                                |       | 5,000 |   |
| Redemption of  subordinated debentures                                                        |       | —                                                |       | (5,000 | ) |
| Increase in  advances by borrowers                                                            |       | 193                                                   |       | 616 |   |
| Purchase of  treasury stock                                                                   |       | —                                                |       | (1,243 | ) |
| Proceeds from  issuance of preferred stock                                                    |       | 25,000                                                |       | — |   |
| Proceeds from  issuance of common stock                                                       |       | 694                                                   |       | 364 |   |
| Cash dividends  paid                                                                          |       | (911                                                  | )          | (848 | ) |
| Net cash provided  by financing activities:                                                   |       | 67,971                                                |       | 16,778 |   |
| Increase in cash  and cash equivalents                                                        |       | 4,712                                                 |       | 1,566 |   |
| Cash and cash  equivalents                                                                    |       |                                                  |       |   |   |
| Beginning                                                                                     |       | 21,170                                                |       | 22,476 |   |
| Ending                                                                                        |       | $                                                     | 25,882     |   | $ | 24,042 |   |
|                                                                                          |       |                                                  |       |   |   |
| Supplemental  Disclosures of Cash Flows Information                                           |       |                                                  |       |   |   |
| Cash payments  for interest                                                                   |       | $                                                     | 15,147     |   | $ | 18,426 |   |
| Cash payments  for income and franchise taxes, net                                            |       | 1,669                                                 |       | 1,850 |   |

 

*Seeaccompanying notes to unaudited consolidated financial statements.*

 

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**HF FINANCIAL CORP.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

For The Six Months EndedDecember 31, 2008 and 2007

(Unaudited)

 

**NOTE 1.                SELECTEDACCOUNTING POLICIES**

 

*Basis of presentation:*

 

The consolidated financial information of HF Financial Corp. (the“Company”) and its wholly-owned subsidiaries included in this Quarterly Reporton Form 10-Q is unaudited.  However,in the opinion of management, adjustments (consisting of normal recurringadjustments) necessary for a fair presentation for the interim periods havebeen included.  Results for any interimperiod are not necessarily indicative of results to be expected for the fiscalyear.  Interim consolidated financialstatements and the notes thereto should be read in conjunction with theconsolidated financial statements and notes thereto included in the Company’sAnnual Report on Form 10-K for the fiscal year ended June 30, 2008(“Fiscal 2008”), filed with the Securities and Exchange Commission.  The accounting and reporting policies of theCompany and its subsidiaries conform to accounting principles generallyaccepted in the United States of America (“GAAP”) and to general practicewithin the industry.

 

The interim consolidated financial statements include the accounts ofthe Company, its wholly-owned subsidiaries, Home Federal Bank (the “Bank”), HFFinancial Group, Inc. (“HF Group”) and HomeFirst Mortgage Corp. (the“Mortgage Corp.”), and the Bank’s wholly-owned subsidiaries, Mid AmericaCapital Services, Inc. (“Mid America Capital”), Hometown InvestmentServices, Inc. (“Hometown”), Home Federal Securitization Corp. (“HFSC”),Mid-America Service Corporation and PMD, Inc.  The interim consolidated financial statementsreflect the deconsolidation of the wholly-owned subsidiary trusts of theCompany: HF Financial Capital Trust III (“Trust III”), HF Financial CapitalTrust IV (“Trust IV”), HF Financial Capital Trust V (“Trust V”) and HFFinancial Capital Trust VI (“Trust VI”). See Note 10 of “Notes to ConsolidatedFinancial Statements.”  All intercompanybalances and transactions have been eliminated in consolidation.

 

**NOTE2.                REGULATORY CAPITAL**

 

The following table sets forth the Bank’s compliance with its minimumcapital requirements for a well-capitalized institution at December 31,2008:

 
| ** **                                           | ** ** | **Amount**                           | ** ** | **Percent** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|-------------|------------|
| ** **                                           | ** ** | **(Dollars in Thousands)** | ** ** |
| Tier I (core) capital (to adjusted total  assets):   |       |                                 |       |        |       |
| Required                                             |       | $                                    | 58,589     |        | 5.00       | % |
| Actual                                               |       | 93,714                               |       | 8.00        |       |
| Excess over required                                 |       | 35,125                               |       | 3.00        |       |
|                                                 |       |                                 |       |        |       |
| Total Risk-based capital (to risk-weighted  assets): |       |                                 |       |        |       |
| Required                                             |       | $                                    | 89,049     |        | 10.00      | % |
| Actual                                               |       | 101,531                              |       | 11.40       |       |
| Excess over required                                 |       | 12,482                               |       | 1.40        |       |

 

**NOTE 3.****                                                 EARNINGSPER SHARE**

 

Basic earnings per share is computed by dividing income available tocommon stockholders (the numerator) by the weighted-average number of commonshares outstanding (the denominator) during the period.  Shares issued during the period and sharesreacquired during the period are weighted for the portion of the period theywere outstanding. The weighted average number of basic common sharesoutstanding for the three months ended December 31, 2008 and 2007 was4,007,870 and 3,955,388, respectively.  The weighted average number of basic common shares outstanding for thesix months ended December 31, 2008 and 2007 was 3,989,962 and 3,984,376,respectively.

 

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Dilutive earnings per share is similar to the computation of basicearnings per share except the denominator is increased to include the number ofadditional common shares that would have been outstanding if the dilutiveoptions outstanding had been exercised. The weighted average number of commonand dilutive potential common shares outstanding for the three months endedDecember 31, 2008 and 2007 was 4,023,791 and 4,009,060, respectively.  The weighted average number of common anddilutive potential common shares outstanding for the six months endedDecember 31, 2008 and 2007 was 4,019,280 and 4,043,022, respectively.

 

**NOTE 4.                INVESTMENTS IN SECURITIES**

 

The amortized cost and fair values ofinvestments in securities, all of which are classified as available for saleaccording to management’s intent, are as follows:

 
| ** **                  | ** ** | **December 31, 2008**      | ** ** | **December 31, 2007** | ** ** |
|-----------------------------|------------|--------------------------------------|------------|---------------------------------|------------|
| ** **                  | ** ** | ** **                           | ** ** | **Gross**                       | ** ** | ** ** | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                  | ** ** | **Amortized**                        | ** ** | **Unrealized**                  | ** ** | **Fair** | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                  | ** ** | **Cost**                             | ** ** | **Gains**                       | ** ** | **(Losses)** | ** ** | **Value** | ** ** | **Cost** | ** ** | **Gains** | ** ** | **(Losses)** | ** ** | **Value** | ** ** |
| ** **                  | ** ** | **(Dollars in Thousands)** | ** ** |
| Debt securities:            |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies    |       | $                                    | 6,373      |                            | $          | 435 |   | $ | — |   | $ | 6,808 |   | $ | 10,054 |   | $ | 122 |   | $ | — |   | $ | 10,176 |   |
| Federal Home Loan Bank      |       | 1,500                                |       | 23                              |       | — |   | 1,523 |   | 12,457 |   | 215 |   | — |   | 12,672 |   |
| Municipal bonds             |       | 13,862                               |       | 145                             |       | (255 | ) | 13,752 |   | 11,147 |   | 83 |   | (99 | ) | 11,131 |   |
| Trust preferred securities  |       | 12,310                               |       | —                          |       | (5,336 | ) | 6,974 |   | 10,931 |   | — |   | (505 | ) | 10,426 |   |
|                        |       | 34,045                               |       | 603                             |       | (5,591 | ) | 29,057 |   | 44,589 |   | 420 |   | (604 | ) | 44,405 |   |
|                        |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Equity securities:          |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| FNMA-common                 |       | 8                                    |       | —                          |       | (8 | ) | — |   | 8 |   | 8 |   | — |   | 16 |   |
| Farmer Mac-common           |       | 7                                    |       | —                          |       | (5 | ) | 2 |   | 7 |   | 2 |   | — |   | 9 |   |
| Other investments           |       | 253                                  |       | —                          |       | — |   | 253 |   | 232 |   | — |   | — |   | 232 |   |
|                        |       | 268                                  |       | —                          |       | (13 | ) | 255 |   | 247 |   | 10 |   | — |   | 257 |   |
|                        |       |                                 |       |                            |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Mortgage-backed  securities |       | 224,443                              |       | 2,881                           |       | (2,247 | ) | 225,077 |   | 119,876 |   | 860 |   | (1,046 | ) | 119,690 |   |
|                        |       | $                                    | 258,756    |                            | $          | 3,484 |   | $ | (7,851 | ) | $ | 254,389 |   | $ | 164,712 |   | $ | 1,290 |   | $ | (1,650 | ) | $ | 164,352 |   |

 

The following table presents thefair value and age of gross unrealized losses by investment category atDecember 31, 2008, in accordance with FASB Staff Position (“FSP”)No. FAS 115-1, *The Meaning ofOther-Than-Temporary Impairment and Its Application to Certain Investments:*

 

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| ** **                 | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total**  | ** ** |
|----------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|------------|------------|
| ** **                 | ** ** | ** **                             | ** ** | **Gross**                            | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                 | ** ** | **Fair**                               | ** ** | **Unrealized**                       | ** ** | **Fair**   | ** ** | **Unrealized** | ** ** | **Fair** | ** ** | **Unrealized** | ** ** |
| ** **                 | ** ** | **Value**                              | ** ** | **(Losses)**                         | ** ** | **Value**  | ** ** | **(Losses)** | ** ** | **Value** | ** ** | **(Losses)** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)**   | ** ** |
| Debt securities:           |       |                                   |       |                                 |       |       |       |   |   |   |   |   |   |
| Municipal bonds            |       | $                                      | 5,351      |                                 | $          | (165       | )          | $ | 1,124 |   | $ | (90 | ) | $ | 6,475 |   | $ | (255 | ) |
| Trust preferred securities |       | 1,181                                  |       | (662                                 | )          | 5,793      |       | (4,674 | ) | 6,974 |   | (5,336 | ) |
|                       |       | 6,532                                  |       | (827                                 | )          | 6,917      |       | (4,764 | ) | 13,449 |   | (5,591 | ) |
| Equity securities:         |       |                                   |       |                                 |       |       |       |   |   |   |   |   |   |
| FNMA-common                |       | —                                 |       | (8                                   | )          | —     |       | — |   | — |   | (8 | ) |
| Farmer Mac-common          |       | 2                                      |       | (5                                   | )          | —     |       | — |   | 2 |   | (5 | ) |
|                       |       | 2                                      |       | (13                                  | )          | —     |       | — |   | 2 |   | (13 | ) |
| Mortgage-backed securities |       | 47,722                                 |       | (649                                 | )          | 24,195     |       | (1,598 | ) | 71,917 |   | (2,247 | ) |
|                       |       | $                                      | 54,256     |                                 | $          | (1,489     | )          | $ | 31,112 |   | $ | (6,362 | ) | $ | 85,368 |   | $ | (7,851 | ) |

 

Management does not believe any individualunrealized losses as of December 31, 2008, represent another-than-temporary impairment.  TheCompany has the ability and intent to hold those investments until a recoveryof fair value.

 

The unrealized losses reported for municipal bonds relate to 37municipal general obligation or revenue bonds. The unrealized losses are primarily caused by market interest rateincreases since the securities were originally acquired, rather than due tocredit or other causes.

 

The unrealized losses reported formortgage-backed securities relate to 70 securities issued by the FederalNational Mortgage Association (“FNMA”), the Government National MortgageAssociation (“GNMA”), or the Federal Home Loan Mortgage Corporation(“FHLMC”).  These unrealized losses intotal are primarily attributable to changes in interest rates and thecontractual cash flows of those investments which are guaranteed by an agencyof the U.S. government.  Mortgage-backedsecurities also include one “private-label” collateralized mortgage obligationwhich has maintained its AAA rating as of December 31, 2008.

 

The unrealized losses reported for trustpreferred securities are attributable to six rated pooled securities.  There have been two rating downgradesregarding these investments during the current fiscal year.  The investment grade securities have anamortized cost of $5.6 million rated AA, $2.0 million rated A, $0.6 millionrated B3 and $4.0 million rated Caa2. The market for these securities is currently inactive.  Based upon information available at financialstatement date, management believes that it is not probable that all amountsdue according to contractual terms will not be collected.  Within this segment, five securities withamortized cost of $10.3 million are quarterly variable-rate securities tied to3-month LIBOR.

 

**NOTE 5.                SEGMENTREPORTING**

 

Operating segments are defined as components of an enterprise for whichseparate financial information is available that is evaluated regularly by thechief operating decision makers in deciding how to allocate resources and inassessing performance.  The Company’sreportable segments are “banking” (including leasing activities) and“other.”  The “banking” segment isconducted through the Bank and Mid America Capital and the “other” segment iscomposed of smaller nonreportable segments, the Company and inter-segmenteliminations.

 

The management approach is used as the conceptual basis for identifyingreportable segments and is based on the way that management organizes thesegments within the enterprise for making operating decisions, allocatingresources and monitoring performance, which is primarily based on products.

 

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| ** **                               | ** ** | **Three Months Ended December 31,** | ** ** |
|------------------------------------------|------------|---------------------------------------------------------|------------|
| ** **                               | ** ** | **2008**                                                | ** ** | **2007** | ** ** |
| ** **                               | ** ** | **Banking**                                             | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                               | ** ** | **(Dollars in Thousands)**                    | ** ** | **(Dollars in Thousands)** | ** ** |
|                                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                      |       | $                                                       | 9,460      |   | $ | (453 | ) | $ | 9,007 |   | $ | 7,503 |   | $ | (507 | ) | $ | 6,996 |   |
| Provision for losses on loans and leases |       | —                                                  |       | — |   | — |   | (295 | ) | — |   | (295 | ) |
| Noninterest income                       |       | 2,847                                                   |       | 82 |   | 2,929 |   | 2,923 |   | 43 |   | 2,966 |   |
| Intersegment noninterest income          |       | (26                                                     | )          | (35 | ) | (61 | ) | (22 | ) | (22 | ) | (44 | ) |
| Noninterest expense                      |       | (8,723                                                  | )          | (453 | ) | (9,176 | ) | (7,408 | ) | (300 | ) | (7,708 | ) |
| Intersegment noninterest expense         |       | —                                                  |       | 61 |   | 61 |   | — |   | 44 |   | 44 |   |
| Income (loss) before income taxes        |       | $                                                       | 3,558      |   | $ | (798 | ) | $ | 2,760 |   | $ | 2,701 |   | $ | (742 | ) | $ | 1,959 |   |
|                                     |       |                                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total assets at December 31         |       | $                                                       | 1,148,150  |   | $ | 25,002 |   | $ | 1,173,152 |   | $ | 1,016,060 |   | $ | 4,589 |   | $ | 1,020,649 |   |

** **
| ** **                               | ** ** | **Six Months Ended December 31,** | ** ** |
|------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                               | ** ** | **2008**                                              | ** ** | **2007** | ** ** |
| ** **                               | ** ** | **Banking**                                           | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                               | ** ** | **(Dollars in Thousands)**                  | ** ** |
|                                     |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income                      |       | $                                                     | 18,578     |   | $ | (882 | ) | $ | 17,696 |   | $ | 14,797 |   | $ | (1,133 | ) | $ | 13,664 |   |
| Provision for losses on loans and leases |       | (387                                                  | )          | — |   | (387 | ) | (620 | ) | — |   | (620 | ) |
| Noninterest income                       |       | 5,778                                                 |       | 200 |   | 5,978 |   | 5,692 |   | 89 |   | 5,781 |   |
| Intersegment noninterest income          |       | (64                                                   | )          | (57 | ) | (121 | ) | (54 | ) | (34 | ) | (88 | ) |
| Noninterest expense                      |       | (16,773                                               | )          | (806 | ) | (17,579 | ) | (14,313 | ) | (539 | ) | (14,852 | ) |
| Intersegment noninterest expense         |       | —                                                |       | 121 |   | 121 |   | — |   | 88 |   | 88 |   |
| Income (loss) before income taxes        |       | $                                                     | 7,132      |   | $ | (1,424 | ) | $ | 5,708 |   | $ | 5,502 |   | $ | (1,529 | ) | $ | 3,973 |   |
|                                     |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total assets at December 31         |       | $                                                     | 1,148,150  |   | $ | 25,002 |   | $ | 1,173,152 |   | $ | 1,016,060 |   | $ | 4,589 |   | $ | 1,020,649 |   |

 

**NOTE 6.                FAIRVALUE MEASUREMENT**

 

EffectiveJuly 1, 2008, the Company adopted Statement of Financial AccountingStandards (SFAS) No. 157, *Fair Value Measurements*.In accordance with the FASB Staff Position 157-2, *EffectiveDate of SFAS No. 157*, the Company has not applied theprovisions of this statement to non-financial assets and liabilities.  TheCompany adopted FASB Staff Position 157-3, *Determining the Fair Valueof a Financial Asset When the Market for That Asset Is Not Active,*which clarifies the application of SFAS 157 for a financial asset when themarket for that financial asset is not active. SFAS 157 defines fair value and establishes a consistent framework formeasuring fair value under GAAP and expands disclosure requirements for fairvalue measurements.  Fair values represent the estimated price that would bereceived from selling an asset or paid to transfer a liability in an orderlytransaction between market participants at the measurement date.  The standard describes three levels of inputsthat may be used to measure fair value:

 

Level1: Quoted prices (unadjusted) for identical assets or liabilities in activemarkets that the entity has the ability to access as of the measurement date.

 

Level2: Significant other observable inputs other than Level 1 prices such as quotedprices for similar assets or liabilities; quoted prices in markets that are notactive; or other inputs that are observable or can be corroborated byobservable market data.

 

Level3: Significant unobservable inputs that reflect a company’s own assumptionsabout the assumptions that market participants would use in pricing an asset orliability.  Level 3 assets and liabilities includefinancial instruments whose value is determined using pricing models,discounted cash flow methodologies, or similar techniques, as well asinstruments for which the determination of fair value requires significantmanagement judgment or estimation.

 

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Thetable below presents the Company’s balances of financial instruments measuredat fair value on a recurring basis by level within the hierarchy atDecember 31, 2008.

 
| ** **                     | ** ** | **December 31, 2008**      | ** ** |
|--------------------------------|------------|--------------------------------------|------------|
| ** **                     | ** ** | **Quoted Prices**               | ** ** | **Significant Other** | ** ** | **Significant** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **In Active**                   | ** ** | **Observable** | ** ** | **Unobservable** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **Markets**                          | ** ** | **Inputs** | ** ** | **Inputs** | ** ** | ** ** | ** ** |
| ** **                     | ** ** | **(Level 1)**                   | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **Total** | ** ** |
| ** **                     | ** ** | **(Dollars in Thousands)** | ** ** |
|                           |       |                                 |       |   |   |   |   |   |   |
| Securities  available for sale |       | $                                    | 2          |   | $ | 247,413 |   | $ | 6,974 |   | $ | 254,389 |   |
| Interest  rate swaps           |       | —                               |       | (1,041 | ) | — |   | (1,041 | ) |
|                                |            |                                      |            |  |  |  |  |  |  |  |  |  |  |

 

TheCompany used the following methods and significant assumptions to estimate thefair value of items:

 

Securitiesavailable for sale: The fair values of securities available for sale aredetermined by obtaining quoted prices on nationally recognized securities exchanges(Level 1 inputs), or matrix pricing, which is a mathematical technique widelyused in the industry to value debt securities without relying exclusively onquoted prices for the specific securities, but rather by relying on thesecurities’ relationship to other benchmark quoted securities (Level 2inputs).  The Company outsourcesvaluation primarily to a third party provider which utilizes several sourcesfor valuing fixed-income securities. Sources utilize evaluated pricing models that vary based by asset classand include available trade, bid, and other market information. Generally,methodology includes broker quotes, proprietary modes, vast descriptive termsand conditions databases, as well as extensive quality control programs.  As further valuation sources, the third partyprovider uses a proprietary valuation Matrices model and capital marketstrading staff.  The Matrices model isused for valuing municipals. The model includes a separate curve structure forBank-Qualified municipals. The grouping of municipals is further broken downaccording to insurer, credit support, state of issuance, and rating toincorporate additional spreads and municipal curves.

 

Thesecurities shown in Level 3 relate to trust preferred securities which arecurrently part of an inactive market. The inactivity was evidenced first by a significant widening of thebid-ask spread in the brokered markets in which these securities trade, andthen by a significant decrease in the volume of trades relative to historicallevels.  The new issue market is alsoinactive as no new pooled trust preferred securities have been issued since2007.  Given conditions in the debtmarkets and the absence of observable orderly transactions in the secondary andnew issue markets, management determined that an income valuation approachtechnique (present value technique) that maximizes the use of relevantobservable inputs and minimizes the use of unobservable inputs will be equallyor more representatives of fair value than the market approach valuationtechnique.

 

TheCompany utilized trust preferred security valuations prepared by an independentthird party.  Their approach todetermining fair value included these steps:

 
| 1. |   | The credit quality of the  collateral is estimated using average probability of default values (adjusted  for rating levels) for each issuer          |
|----|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| 2. |   | The default probabilities  also considered the potential for correlation among issuers within the same  industry                                      |
| 3. |   | The loss given default was  assumed to be 95% (i.e. a 5% recovery)                                                                                    |
| 4. |   | The cash flows were  forecast for the underlying collateral and applied to each tranche to  determine the resulting distribution among the securities |
| 5. |   | The expected cash flows  were discounted to calculate the present value of the security                                                               |
| 6. |   | The calculations were  modeled in several thousand scenarios using a Monte Carlo engine and the  average price was used for valuation purposes        |

 

InterestRate Swaps:  The fair values of interestrate swaps relate to cash flow hedges of trust preferred debt securities issuedby the Company.  The fair value isestimated by a third party using inputs that are observable or that can becorroborated by observable market data and, therefore, are classified withinLevel 2 of the valuation hierarchy. These fair value estimations includeprimarily market observable inputs, such as yield curves, and include the valueassociated with counterparty credit risk.

 

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The following table reconciles the beginningand ending balances of the assets or liabilities of the Company that aremeasured at fair value on a recurring basis using significant unobservableinputs.

 
| ** **                                    | ** ** | **Fair Value Measurements Using Significant** | ** ** |
|-----------------------------------------------|------------|-------------------------------------------------------------------|------------|
| ** **                                    | ** ** | **Unobservable Inputs (Level 3)**                  | ** ** |
| ** **                                    | ** ** | **Three Months Ended**                                  | ** ** | **Six Months Ended** | ** ** |
| ** **                                    | ** ** | **December 31, 2008**                                   | ** ** | **December 31, 2008** | ** ** |
| ** **                                    | ** ** | **Securities**                                                    | ** ** | ** ** | ** ** | **Securities** | ** ** | ** ** | ** ** |
| ** **                                    | ** ** | **Available**                                                     | ** ** | **Interest Rate** | ** ** | **Available** | ** ** | **Interest Rate** | ** ** |
| ** **                                    | ** ** | **for Sale**                                                 | ** ** | **Swaps** | ** ** | **for Sale** | ** ** | **Swaps** | ** ** |
| ** **                                    | ** ** | **(Dollars in Thousands)**                              | ** ** |
|                                          |       |                                                              |       |   |   |   |   |   |   |
| Beginning balance                             |       | $                                                                 | 9,499      |   | $ | — |   | $ | — |   | $ | — |   |
| Total realized/unrealized gains (losses)      |       |                                                              |       |   |   |   |   |   |   |
| Included in earnings                          |       | —                                                            |       | — |   | — |   | — |   |
| Included in other comprehensive loss          |       | (2,462                                                            | )          | — |   | (2,462 | ) | — |   |
| Purchases, issuances, (paydowns) and  (sales) |       | (63                                                               | )          | — |   | (62 | ) | — |   |
| Transfers into or (out) of Level 3            |       | —                                                            |       | — |   | 9,498 |   | — |   |
| Ending balance                                |       | $                                                                 | 6,974      |   | $ | — |   | $ | 6,974 |   | $ | — |   |

 

Thetable below presents the Company’s balances of financial instruments measured atfair value on a nonrecurring basis by level within the hierarchy atDecember 31, 2008.

 
| ** **     | ** ** | **December 31, 2008**      | ** ** |
|----------------|------------|--------------------------------------|------------|
| ** **     | ** ** | **Quoted Prices**               | ** ** | **Significant Other** | ** ** | **Significant** | ** ** | ** ** | ** ** |
| ** **     | ** ** | **In Active**                   | ** ** | **Observable** | ** ** | **Unobservable** | ** ** | ** ** | ** ** |
| ** **     | ** ** | **Markets**                          | ** ** | **Inputs** | ** ** | **Inputs** | ** ** | ** ** | ** ** |
| ** **     | ** ** | **(Level 1)**                   | ** ** | **(Level 2)** | ** ** | **(Level 3)** | ** ** | **Total** | ** ** |
|           |       | **(Dollars in Thousands)** |       |
|           |       |                                 |       |   |   |   |   |   |   |
| Impaired loans |       | $                                    | —     |   | $ | 705 |   | $ | — |   | $ | 705 |   |
|                |            |                                      |            |  |  |  |  |  |  |  |  |  |  |

 

Impairedloans are evaluated and valued at the time the loan is identified as impaired,at the lower of cost or market value. Market value is measured based onthe value of the collateral securing these loans.  Collateral isprimarily real estate and its fair value is generally determined based on realestate appraisals or other evaluations by qualified professionals. Impairedloans are reviewed and evaluated on at least a quarterly basis for additionalimpairment and adjusted accordingly, based on the same factors identifiedabove. Impaired loans that are collateral dependent are written down to theirfair value, less costs to sell, through the establishment of specific reservesor by recording charge-offs when the carrying value exceeds the fair value.Valuation techniques consistent with the market approach, income approach,and/or cost approach were used to measure fair value and primarily included observableinputs for the individual nonaccrual loans being evaluated such as recent salesof similar assets or observable market data for operational or carrying costs.

 

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**NOTE 7.                DEFINEDBENEFIT PLAN**

 

The Company has anoncontributory (cash balance) defined benefit pension plan covering allemployees of the Company and its wholly-owned subsidiaries who have attainedthe age of 21 and have completed 1,000 hours of service in a plan year.  The benefits are based on 6% of each eligibleparticipant’s annual compensation, plus income earned in the accounts at a ratedetermined annually based on 30-year Treasury note rates.  The Company’s funding policy is to make theminimum annual required contribution plus such amounts as the Company maydetermine to be appropriate from time to time. The Company has adopted all plan provisions required by the PensionProtection Act of 2006.  These provisionsare effective with the plan year beginning July 1, 2008.  Information relative to the components of netperiodic benefit cost for the Company’s defined benefit plan is presentedbelow:

 
| ** **                         | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                         | ** ** | **December 31,**            | ** ** | **December 31,**          | ** ** |
| ** **                         | ** ** | **2008**                         | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
|                               |       |                             |       |                           |       |   |   |   |   |
| Service cost                       |       | $                                | 118,602    |                           | $          | 111,830 |   | $ | 237,204 |   | $ | 223,660 |   |
| Interest cost                      |       | 119,983                          |       | 109,260                        |       | 239,966 |   | 218,520 |   |
| Amortization of  prior losses      |       | 15,499                           |       | —                         |       | 30,998 |   | — |   |
| Expected return  on plan assets    |       | (139,532                         | )          | (121,791                       | )          | (253,559 | ) | (243,582 | ) |
| Total costs  recognized in expense |       | $                                | 114,552    |                           | $          | 99,299 |   | $ | 254,609 |   | $ | 198,598 |   |

 

The Company previouslydisclosed in its consolidated financial statements for Fiscal 2008, which areincluded in Part II, Item 8 “Financial Statements and Supplementary Data”of the Company’s Annual Report on Form 10-K for Fiscal 2008, that itcontributed $532,000 to fund its qualified pension plan.  During the second quarter of the fiscal yearending June 30, 2009 (“Fiscal 2009”), the Company made contributions of$2.35 million to fund its qualified pension plan.  The Company anticipates no additionalcontributions for Fiscal 2009.

 

**NOTE 8.                SELF-INSUREDHEALTHCARE PLAN**

 

The Company has had a self-insured health plan for itsemployees, subject to certain limits, since January 1994.  The Bank is named the plan administrator forthis plan and has retained the services of an independent third partyadministrator to process claims and handle other duties for this plan.  The third party administrator does not assumeliability for benefits payable under this plan.

 

The Company assumes theresponsibility for funding the plan benefits out of general assets; however,employees cover some of the costs of covered benefits through contributions,deductibles, co-pays and participation amounts. An employee is eligible for coverage upon completion of 30 calendar daysof regular employment.  The plan, whichis on a calendar year basis, is intended to comply with, and be governed by,the Employee Retirement Income Security Act of 1974, as amended.

 

The accrual estimate forpending and incurred but not reported health claims is based upon a pendingclaims lag report provided by a third party provider.  Although management believes that it uses thebest information available to determine the accrual, unforeseen health claimscould result in adjustments and net earnings being significantly affected ifcircumstances differ substantially from the assumptions used in estimating theaccrual.  Net healthcare costs areinclusive of health claims expenses and administration fees offset by stop lossand employee reimbursement.

 

Reported below is asummary of net healthcare costs by quarter during Fiscal 2009 and Fiscal 2008:

 
| ** **                       | ** ** | **Fiscal Years Ended June 30,** | ** ** |
|----------------------------------|------------|-----------------------------------------------------|------------|
| ** **                       | ** ** | **2009**                                            | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **(Dollars in Thousands)**                | ** ** |
|                             |       |                                                |       |   |   |
| Quarter ended  September 30 |       | $                                                   | 358        |   | $ | 221 |   |
| Quarter ended  December 31  |       | 945                                                 |       | 409 |   |
| Quarter ended  March 31     |       | —                                              |       | 328 |   |
| Quarter ended  June 30      |       | —                                              |       | 524 |   |
| Net healthcare  costs            |       | $                                                   | 1,303      |   | $ | 1,482 |   |

 

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**NOTE 9.                STOCK-BASED COMPENSATION PLANS**

 

The fair value of each incentive stock option and eachstock appreciation right grant is estimated at the grant date using theBlack-Scholes option-pricing model.  Thefollowing assumptions were used for grants in the six months ended December 31,2008 and 2007:

 
| ** **                | ** ** | **Six Months Ended** | ** ** |
|---------------------------|------------|--------------------------------|------------|
| ** **                | ** ** | **December 31,**          | ** ** |
| ** **                | ** ** | **2008**                       | ** ** | **2007** | ** ** |
| ** **                | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Expected  volatility      |       | 19.00                          | %          | 22.00 | % |
| Expected  dividend yield  |       | 3.06                           |       | 2.61 |   |
| Risk-free  interest rate  |       | 2.87                           |       | 4.10 |   |
| Expected term  (in years) |       | 5                              |       | 4 |   |

 

Stock option activity forthe six months ended December 31, 2008 is as follows:

 
| ** **                      | ** ** | **2008**   | ** ** |
|---------------------------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Average** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                      | ** ** | **Shares** | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** |
|                            |       |       |       |   |   |   |   |   |   |
| Beginning  balance, July 1 |       | 203,554    |       | $ | 12.48 |   |   |   |   |   |
| Granted                         |       | —     |       | — |   |   |   |   |   |
| Forfeited                       |       | (4,232     | )          | 16.86 |   |   |   |   |   |
| Exercised                       |       | (47,078    | )          | 10.64 |   |   |   |   |   |
|                            |       |       |       |   |   |   |   |   |   |
| Ending balance                  |       | 152,244    |       | $ | 12.93 |   | 4.54 |   | $ | 195 |   |
|                            |       |       |       |   |   |   |   |   |   |
| Vested and  exercisable         |       | 152,244    |       | $ | 12.93 |   | 4.54 |   | $ | 195 |   |

 

Stock appreciation rightsactivity for the six months ended December 31, 2008, are as follows:

 
| ** **                      | ** ** | **2008**   | ** ** |
|---------------------------------|------------|------------|------------|
| ** **                      | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Average** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                      | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                      | ** ** | **SARs**   | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** |
|                            |       |       |       |   |   |   |   |   |   |
| Beginning  balance, July 1 |       | 44,622     |       | $ | 16.06 |   |   |   |   |   |
| Granted                         |       | 47,051     |       | 14.71 |   |   |   |   |   |
| Forfeited                       |       | (2,097     | )          | 16.06 |   |   |   |   |   |
| Exercised                       |       | —     |       | — |   |   |   |   |   |
|                            |       |       |       |   |   |   |   |   |   |
| Ending balance                  |       | 89,576     |       | $ | 15.35 |   | 9.04 |   | $ | — |   |
|                            |       |       |       |   |   |   |   |   |   |
| Vested and  exercisable         |       | 14,820     |       | $ | 16.04 |   | 8.14 |   | $ | — |   |

 

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The total intrinsic valueof options exercised during the six months ended December 31, 2008 and2007 was $174,000 and $106,000, respectively. Cash received from the exercise of options for the six months ended December 31,2008, and 2007 was $501,000 and $271,000, respectively.  The tax benefit realized for the taxdeductions from cashless option exercises totaled $700 and $2,600 for the sixmonths ended December 31, 2008, and 2007, respectively.  The weighted-average grant date fair value ofstock appreciation rights (SARs) granted during the six months ended December 31,2008, and 2007 was $2.06 and $2.89, respectively.  The total unrecognized compensation costrelated to nonvested SARs awards at December 31, 2008 was $189,000.  The cost is expected to be recognized over aweighted average period of 34 months.

 

Nonvested share activityfor the six months ended December 31 follows:

 
| ** **                    | ** ** | **2008**   | ** ** | **2007**            | ** ** |
|-------------------------------|------------|------------|------------|---------------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Weighted**        | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                    | ** ** | ** ** | ** ** | **Average**         | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                    | ** ** | ** ** | ** ** | **Grant Date** | ** ** | ** ** | ** ** | **Grant Date** | ** ** |
| ** **                    | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
|                          |       |       |       |                |       |   |   |   |   |
| Nonvested  balance, beginning |       | 121,746    |       | $                   | 16.57      |   | 144,711 |   | $ | 16.10 |   |
| Granted                       |       | 23,602     |       | 13.33               |       | 14,955 |   | 16.78 |   |
| Vested                        |       | (48,982    | )          | 16.43               |       | (30,925 | ) | 14.47 |   |
| Forfeited                     |       | (1,305     | )          | 16.95               |       | (10,894 | ) | 16.46 |   |
|                          |       |       |       |                |       |   |   |   |   |
| Nonvested  balance, ending    |       | 95,061     |       | $                   | 15.83      |   | 117,847 |   | $ | 16.58 |   |

 

Pretax compensationexpense recognized for nonvested shares for the six months ended December 31,2008, and 2007 was $179,000 and $216,000, respectively.  The tax benefit for the six months ended December 31,2008, and 2007 was $61,000 and $73,000, respectively.  As of December 31, 2008, there was$853,000 of total unrecognized compensation cost related to nonvested sharesgranted under the Company’s 2002 Stock Option and Incentive Plan, as amended (“thePlan”).  The cost is expected to berecognized over a weighted-average period of 20 months.  The total fair value of shares vested duringthe six months ended December 31, 2008, and 2007 was $805,000 and$447,000, respectively.

 

In association with the2002 Option Plan, awards of nonvested shares of the Company’s common stock aremade to outside directors of the Company. Each outside director is entitled to all voting, dividend anddistribution rights during the vesting period. During the second quarter of Fiscal 2009, 14,511 shares of nonvestedstock were awarded.  Nonvested sharesvest on the first anniversary of the date of grant.  As of December 31, 2008, there was$166,000 of total unrecognized compensation cost related to nonvested shares,which are expected to be recognized over the remaining 11 months.  For the six months ended December 31,2008 amortization expense was recorded in the amount of $71,000.

 

These stock option andincentive plans are described more fully in Part II, Item 8 “FinancialStatements and Supplementary Data” of the Company’s Annual Report on Form 10-Kfor Fiscal 2008, under Note 16 of “Notes to Consolidated Financial Statements.”

 

**NOTE 10.              SUBORDINATED DEBENTURES PAYABLE TO TRUSTS**

 

On July 5, 2007, theCompany issued 5,000 shares totaling $5.0 million of Company ObligatedMandatorily Redeemable Preferred Securities of Trust VI.  Trust VI was established and exists for thesole purpose of issuing trust preferred securities and investing the proceedsin subordinated debentures of the Company. These subordinated debentures constitute the sole asset of TrustVI.  The securities provide forcumulative cash distributions calculated at a rate based on three-month LIBORplus 1.65%, adjusted quarterly.  Refer toNote 10 in regards to the interest rate swap agreement, which converted thevariable-rate Trust Preferred VI security into a fixed-rate security for a termof five years.  The Company may, at oneor more times, defer interest payments on the capital securities for up to 20consecutive quarterly periods, but not beyond October 1, 2037.  At the end of the deferral period, allaccumulated and unpaid distributions must be paid.  The capital securities must be redeemed on October 1,2037; however, the Company has the option to shorten the maturity date to adate not earlier than October 1, 2012. Holders of the capital securities have no voting rights, are unsecured,and rank junior in priority of the payment to all of the Company’s indebtednessand senior to the Company’s capital stock.

 

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On July 7, 2007, theCompany exercised its option to redeem $5.0 million of Company ObligatedMandatorily Redeemable Preferred Securities of Trust II.

 

**NOTE 11.              INTERESTRATE CONTRACTS**

 

Interest rate swapcontracts are entered into primarily as an asset/liability management strategyof the Company to modify interest rate risk. The primary risk associated with all swaps is the exposure to movementsin interest rates and the ability of the counterparties to meet the terms of thecontract.  The Company is exposed tolosses if the counterparty fails to make its payments under a contract in whichthe Company is in a receiving status. The Company minimizes its risk bymonitoring the credit standing of the counterparty.  The Company anticipates the counterparty willbe able to fully satisfy its obligations under the remaining agreements.

 

During the first quarterof Fiscal 2008, the Company entered into an interest rate swap agreement with a$5.0 million notional amount to convert the variable-rate Trust Preferred VIsecurity into a fixed-rate instrument for a term of five years at a fixed rateof 6.69%. This rate swap is designated as a cash flow hedge. The fair value ofthe derivative was a $589,000 loss at December 31, 2008.

 

During the fourth quarterof Fiscal 2008, the Company entered into an interest rate swap agreement with a$7.0 million notional amount to convert the variable-rate Trust Preferred IVsecurity into a fixed-rate instrument for a term of three years at a fixed rateof 6.19%. This rate swap is designated as a cash flow hedge. The fair value ofthe derivative was a $207,000 loss at December 31, 2008.

 

During the first quarterof Fiscal 2009, the Company entered into an interest rate swap agreement with a$3.0 million notional amount to convert a portion of the variable-rate TrustPreferred III security into a fixed-rate instrument for a term of three yearsat a fixed rate of 6.70%.  The Companyalso entered into an interest rate swap agreement with a $2.0 million notionalamount to convert the remaining portion of variable rate Trust Preferred IIIsecurity into a fixed rate instrument for a term of four years at a fixed rateof 6.91%.  These rate swaps aredesignated as cash flow hedges.  The fairvalue of the $3.0 million notional amount derivative was a $128,000 loss, whilethe fair value of the $2.0 million notional amount derivative was a $117,000loss at December 31, 2008.

 

No gain or loss wasrecognized in earnings for the six months ended December 31, 2008, and2007 related to interest rate swaps.  Nodeferred net losses on interest rate swaps in other comprehensive loss as of December 31,2008, are expected to be reclassified into earnings during the fiscal year.

 

**NOTE 12.              OTHERCOMPREHENSIVE INCOME**

 

Comprehensive income consists of two components, netincome and other comprehensive income. Other comprehensive income refers to revenues, expenses and gains andlosses under accounting principles generally accepted in the United States ofAmerica (“GAAP”) which are recorded as an element of shareholders’ equity butare excluded from net income.  Thecomponents of total comprehensive income follow:

 

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| ** **                                                          | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|---------------------------------------------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| ** **                                                          | ** ** | **December 31,**                | ** ** | **December 31,**          | ** ** |
| ** **                                                          | ** ** | **2008**                             | ** ** | **2007**                       | ** ** | **2008** | ** ** | **2007** | ** ** |
| ** **                                                          | ** ** | **(Dollars in Thousands)** | ** ** |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Net  income                                                         |       | $                                    | 1,846      |                           | $          | 1,251 |   | $ | 3,821 |   | $ | 2,598 |   |
| Other  comprehensive income (loss), net of tax:                     |       |                                 |       |                           |       |   |   |   |   |
| Securities  available for sale:                                     |       |                                 |       |                           |       |   |   |   |   |
| Net  unrealized gains (losses)                                      |       | (367                                 | )          | 693                            |       | (1,031 | ) | 1,904 |   |
| Income  tax benefit (expense)                                       |       | 138                                  |       | (263                           | )          | 391 |   | (723 | ) |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Other  comprehensive income (loss) on securities available for sale |       | (229                                 | )          | 430                            |       | (640 | ) | 1,181 |   |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Defined  benefit plan:                                              |       |                                 |       |                           |       |   |   |   |   |
| Net  unrealized (loss)                                              |       | —                               |       | —                         |       | — |   | — |   |
| Income  tax benefit                                                 |       | —                               |       | —                         |       | — |   | — |   |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Other  comprehensive (loss) on defined benefit plan                 |       | —                               |       | —                         |       | — |   | — |   |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Derivatives  and hedging activities:                                |       |                                 |       |                           |       |   |   |   |   |
| Net  unrealized (losses)                                            |       | (888                                 | )          | (215                           | )          | (920 | ) | (266 | ) |
| Income  tax benefit                                                 |       | 302                                  |       | 73                             |       | 313 |   | 90 |   |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Other  comprehensive (loss) on derivatives and hedging activities   |       | (586                                 | )          | (142                           | )          | (607 | ) | (176 | ) |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Total  other comprehensive income (loss)                            |       | (815                                 | )          | 288                            |       | (1,247 | ) | 1,005 |   |
|                                                                |       |                                 |       |                           |       |   |   |   |   |
| Other  comprehensive income                                         |       | $                                    | 1,031      |                           | $          | 1,539 |   | $ | 2,574 |   | $ | 3,603 |   |

 
| ** **                                                                                         | ** ** | **December 31,**                | ** ** |
|----------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                         | ** ** | **2008**                             | ** ** | **2007** | ** ** |
| ** **                                                                                         | ** ** | **(Dollars in Thousands)** | ** ** |
| Cumulative  other comprehensive (loss) balances were:                                              | ** ** | ** **                           | ** ** | ** ** | ** ** |
|                                                                                               | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Unrealized  loss on securities available for sale, net of related tax effect of $1,659  and $137   | ** ** | $                                    | (2,707     | ) | $ | (223 | ) |
| Unrealized  loss on defined benefit plan, net of related tax effect of $523 and $60                |       | (853                                 | )          | (98 | ) |
| Unrealized  loss on derivatives and hedging activities, net of related tax effect of $354  and $90 |       | (687                                 | )          | (176 | ) |
|                                                                                               |       |                                 |       |   |   |
|                                                                                               |       | $                                    | (4,247     | ) | $ | (497 | ) |

 

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**NOTE 13.              STOCKHOLDERS’ EQUITY**

 

As referenced inthe 8-K filed November 21, 2008, the Company entered into an agreementwith the U.S. Department of the Treasury pursuant to which the Company issuedand sold to the Treasury Department (i) 25,000 shares of Fixed RateCumulative Perpetual Preferred Stock, Series A, par value $0.01 per shareand having a liquidation preference of $1,000 per share, and (ii) aten-year warrant to purchase up to 302,419 shares of the Company’s commonstock, par value $0.01 per share, at an initial exercise price of $12.40 pershare, for an aggregate purchase price of $25.0 million in cash.  The securities were issued and sold in aprivate placement exempt from registration pursuant to Section 4(2) ofthe Securities Act of 1933, as amended. Cumulative dividends on the Preferred Stock will accrue on theliquidation preference at a rate of 5.00% per annum for the first five years,and at a rate of 9.00% per annum thereafter, but will be paid only if, as andwhen declared by the Company’s Board of Directors.  As the issuance of Preferred Stock includedwarrants for common stock, this transaction increased the weighted averagenumber of diluted common shares outstanding by a total of 5,377 for the sixmonth period ended December 31, 2008.

 

**Item 2.                    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

**Forward-Looking Statements**

 

This Quarterly Report on Form 10-Qand other reports issued by the Company, including reports filed with theSecurities and Exchange Commission, contain “forward-looking statements” thatdeal with future results, expectations, plans and performance.  In addition, the Company’s management maymake forward-looking statements orally to the media, securities analysts,investors or others.  Theseforward-looking statements might include one or more of the following:

 
| · |   | Projections of  income, loss, revenues, earnings or losses per share, dividends, capital  expenditures, capital structure, tax benefit or other financial items.                  |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| · |   | Descriptions of  plans or objectives of management for future operations, products or  services, transactions, investments and use of subordinated debentures  payable to trusts. |
| · |   | Forecasts of  future economic performance.                                                                                                                                        |
| · |   | Use and  descriptions of assumptions and estimates underlying or relating to such  matters.                                                                                       |

 

Forward-lookingstatements can be identified by the fact they do not relate strictly tohistorical or current facts.  They ofteninclude words such as “optimism,” “look-forward,” “bright,” “pleased,” “believe,”“expect,” “anticipate,” “intend,” “plan,” “estimate” or words of similarmeaning, or future or conditional verbs such as “will,” “would,” “should,” “could”or “may.”

 

Forward-lookingstatements about the Company’s expected financial results and other plans aresubject to certain risks, uncertainties and assumptions.  These include, but are not limited to, therisks discussed in Part I, Item 1A “Risk Factors” in the Company’s AnnualReport on Form 10-K for Fiscal 2008 and the following: possiblelegislative changes and adverse economic, business and competitive conditionsand developments (such as shrinking interest margins and continued short-termrate environments); deposit outflows; reduced demand for financial services andloan products; changes in accounting policies or guidelines, or in monetary andfiscal policies of the federal government; changes in credit and other risksposed by the Company’s loan and lease portfolios; the ability or inability ofthe Company to manage interest rate and other risks; unexpected, continuing orexcessive claims against the Company’s self-insured health plan; the Company’suse of trust preferred securities; the ability or inability of the Company tosuccessfully enter into a definitive agreement for and close anticipatedtransactions; technological, computer-related or operational difficulties;adverse changes in securities markets; results of litigation; or othersignificant uncertainties.

 

 Forward-looking statements speak only as of the date they aremade.  The Company does not undertake toupdate forward-looking statements to reflect circumstances or events that occurafter the date the forward-looking statements are made.  Although the Company believes itsexpectations are reasonable, it can give no assurance that such expectationswill prove to be correct.  Based upon changingconditions, should any one or more of these risks or uncertainties materialize,or should any underlying assumptions prove incorrect, actual results may varymaterially from those described in any forward-looking statements.

 

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**ExecutiveSummary**

 

The Company’s net incomefor the second quarter of Fiscal 2009 was $1.8 million, or $0.46 in dilutedearnings per share, compared to $1.3 million, or $0.31 in diluted earnings pershare, for the second quarter of Fiscal 2008. The Company’s net income for the six months ended December 31, 2008was $3.8 million, or $0.95 in diluted earnings per share, compared to $2.6million, or $0.64 in diluted earnings per share, for the first six months of Fiscal2008.  Return on average total equity was10.48% for the first six months of Fiscal 2009 as compared to 8.18% in theprior year comparable period.  Return oncommon equity, based upon net income available to common shareholders dividedby equity excluding preferred equity, was 11.63% for the first six months ofFiscal 2009 as compared to 8.18% in the prior year comparable period.

 

The net interest marginon a fully taxable equivalent basis for the six months ended December 31,2008 was 3.37%, compared to 2.96% for the same period a year ago, an increaseof 41 basis points.  The increase overthe same period last year is primarily attributable to lower costs onliabilities and a higher volume of earning assets.  During the first quarter of Fiscal 2008,there was $125,000 expense of unamortized debt issue costs related to the earlyredemption of the Trust II Trust Preferred Securities, causing a decrease ofthree basis points to the net interest margin for the six month comparison.

 

Net interest income forthe first six months of Fiscal 2009 was $17.7 million, an increase of $4.0million, or 29.5%, over the same period a year ago.  For the six months ended December 31,2008, average interest-earning assets and average interest-bearing liabilitiesincreased 13.1% and 13.0%, respectively, compared to the same period a yearago.  Yields on earning assets decreasedto 5.88% in the first six months of Fiscal 2009, compared to 6.81% a year ago,a decrease of 93 basis points.  For thesame period, cost of funds decreased to 2.87%, compared to 4.38%, a decrease of151 basis points.

 

Net interest margin ratiomay vary due to many factors, including Federal Reserve policies for short-terminterest rates, competitive and economic factors and customer preferences for variousproducts and services.  In the secondquarter of Fiscal 2009, the Federal Reserve decreased the Fed Funds Target Rateby a total of 175 basis points on three separate increments, the first decreasein short-term interest rates since April 30, 2008.  For Fiscal 2008, Fed Funds rates were cut 7times between September 2007 and April 2008 for a total of 325 basispoints.

 

The Company hadpreviously issued trust preferred securities primarily to provide funding forstock repurchases and to repay other borrowings.  Interest expense on the $27.8 million oftrust preferred securities outstanding decreased to $916,000 for the six monthsended December 31, 2008, compared to $1.2 million for the same period ayear ago, a decrease of $283,000 or 23.6%. This decrease is due in part to the expense of $125,000 unamortized debtissue costs related to the early redemption of the Trust II Trust PreferredSecurities in the first quarter of Fiscal 2008. The average rate paid on these securities decreased 190 basis points,from 8.57% at December 31, 2007 to 6.67% at December 31, 2008.

 

The allowance for loanand lease losses increased to $8.1 million at December 31, 2008, comparedto $5.4 million at December 31, 2007, an increase of $2.7 million or49.9%.  The ratio of allowance for loanand lease losses to total loans and leases was 0.99% as of December 31,2008 compared to 0.71% at December 31, 2007.  Total nonperforming assets at December 31,2008 were $4.5 million as compared to $3.7 million a year ago, an increase of$726,000 or 19.4%.  The ratio ofnonperforming assets to total assets increased to 0.38% at December 31,2008, compared to 0.34% at December 31, 2007.  The allowance for loan and lease losses iscalculated based on loan and lease levels, loan and lease loss history, creditquality of the loan and lease portfolio, and environmental factors such aseconomic health of the region and management experience.  This risk rating analysis is designed to givethe Company a consistent and systematic methodology to determine proper levelsfor the allowance at a given time.

 

As referenced in the 8-Kfiled October 27, 2008, the Company was involved in a lawsuit as plaintiffwhich was settled for $2.8 million inclusive of the remaining amount ofreceivables from certain loan participation interests in the amount of$223,000.  The settlement amount, lessattorney fees of $292,000, was recorded as a recovery of loan and leases lossesin the second quarter of Fiscal 2009. See Part II, Item 1 “Legal Proceedings” of this Form 10-Q formore details.

 

Total deposits at December 31,2008 were $772.9 million, a decrease of $11.3 million, or 1.4%, from June 30,2008.  The $11.3 million decrease indeposits was due to decreases in public funds of $11.8 million which arecategorized in multiple categories of deposits. Conversely, non-public funds increased from $628.0 million to $628.5million for the six month period, net of a decrease of $4.6 million inout-of-market deposits.  The primaryfactors affecting interest expense on deposits was the decrease in the averagerates paid from the six month period ended December 31, 2007 of 4.13%compared to 2.52% for the six month period ended December 31, 2008.

 

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During the second quarterof Fiscal 2009, an increase in equity occurred with participation in the U.S.Treasury Department Capital Purchase Program (“CPP”).  As referenced in the 8-K filed November 21,2008, the Company entered into an agreement with the U.S. Department of theTreasury pursuant to which the Company issued and sold to the TreasuryDepartment (i) 25,000 shares of Fixed Rate Cumulative Perpetual PreferredStock, Series A, par value $0.01 per share and having a liquidationpreference of $1,000 per share, and (ii) a ten-year warrant to purchase upto 302,419 shares of the Company’s common stock, par value $0.01 per share, atan initial exercise price of $12.40 per share, for an aggregate purchase priceof $25.0 million in cash.  The securitieswere issued and sold in a private placement exempt from registration pursuantto Section 4(2) of the Securities Act of 1933, as amended.  Cumulative dividends on the Preferred Stockwill accrue on the liquidation preference at a rate of 5.00% per annum for thefirst five years, and at a rate of 9.00% per annum thereafter, but will be paidonly if, as and when declared by the Company’s Board of Directors.  Since the transaction closing date, the Bankhas continued to lend money on a prudent basis to businesses, farmers andindividuals within its marketplace.  Newvolume and renewals of existing credit since the closing of the CPP transactiontotaled $64.4 million through December 31, 2008.

 

In January 2009,the Company announced it will pay a quarterly cash dividend of 11.25 cents percommon share for the second quarter of the 2009 fiscal year.  The dividend will be paid on February 12,2009 to stockholders of record on February 5, 2009.

 

The Company alsoannounced in January 2009, a quarterly cash dividend on its Fixed RateCumulative Perpetual Preferred Stock (Series A) issued to the U.S.Treasury Department under the CPP.  Thedividend amount is equal to $11.66 per preferred share.  This amount is based on a rate per annum of5.00%, and is pro-rated over the initial dividend period from the November 21,2008 closing date through February 15, 2009 using 30-day months.

 

Thetotal risk-based capital ratio of 11.40% at December 31, 2008, increasedby 57 basis points from 10.83% at June 30, 2008.  This continues to place the Bank in the “wellcapitalized” category within OTS regulation at December 31, 2008 and isconsistent with the “well capitalized” OTS category in which the Company plansto operate.  The Company historically hasbeen able to manage the size of its assets through secondary market loan salesof single-family mortgages and student loans.

 

In conjunction with theCompany’s participation in the CPP, the Company’s Board of Directors terminatedthe stock buyback program in the second quarter which had been in place throughNovember 21, 2008, in which up to 10% of the common stock of the Companyoutstanding on May 1, 2008 could be acquired through April 30,2009.  See Part II, Item 2 “UnregisteredSales of Equity Securities and Use of Proceeds” of this Form 10-Q for moredetails.

 

Non-interest income was$6.0 million for the six months ended December 31, 2008 as compared to$5.8 million for the same period in the prior fiscal year, an increase of$197,000, or 3.4%.  Fees on depositsincreased $301,000, or 10.9% for the six months ended December 31, 2008 ascompared to the same period in the prior fiscal year primarily due to increasedpoint-of-sale interchange revenue and fee schedule adjustments.  Loan servicing income increased $44,000, or4.2% primarily due to an increase of $38.0 million in the balances of loansserviced by the Bank from $1.03 billion at December 31, 2007 to $1.06billion at December 31, 2008.  Netgain on sale of securities increased $125,000 for the six months ended December 31,2008 as compared to the same period in the prior fiscal year primarily due tothe sale of securities, which did not occur in the prior year.

 

Non-interest expense was$17.6 million for the six months ended December 31, 2008 as compared to$14.9 million for the six months ended December 31, 2007, an increase of$2.7 million, or 18.4%.  Employeecompensation increased $562,000, or 9.1%, variable pay relating to employeeincentives and commissions increased $480,000, or 58.1% and net healthcarecosts increased $673,000, or 106.7%. Employee compensation increased due to annual raises awarded andsales-related personnel additions. Variable pay relating to employee incentive programs increased due tohigher production activity and increased financial performance outcomes.  Healthcare costs increased as a result ofhigher claim activity in the second quarter of Fiscal 2009.  The Company has had a self-insured healthplan since January 1994.  Managementcontinues to believe the current structure is a reasonable alternative totraditional healthcare plans over the long term.  The level of healthcare costs which theCompany incurs may vary from year to year. The increase in net healthcare costs does not necessarily indicate atrend.  Other non-interest expenseincreased primarily to increases in federal deposit insurance premiums of$216,000, legal and professional expenses of $302,000, and community investmentcontributions of $52,000.

 

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**General**

 

The Company is afinancial services provider and, as such, has inherent risks that must bemanaged in order to achieve net income. Primary risks that affect net income include credit risk, liquidityrisk, operational risk, regulatory compliance risk and reputation risk.  The Company’s net income is derived bymanaging net interest margin, the ability to collect fees from servicesprovided, by controlling the costs of delivering services and the management ofloan and lease losses.  The primarysource of revenues comes from the net interest margin, which represents thedifference between income on interest-earning assets (i.e. loans and investmentsecurities) and expense on interest-bearing liabilities (i.e. deposits andborrowed funding).  The net interestmargin is affected by regulatory, economic and competitive factors thatinfluence interest rates, loan demand and deposit flows.  Fees earned include charges for depositservices, trust services and loan services. Personnel costs are the primary expenses required to deliver theservices to customers.  Other costsinclude occupancy and equipment and general and administrative expenses.

 

**Financial Condition Data**

 

At December 31,2008, the Company had total assets of $1.2 billion, an increase of $69.7million from the level at June 30, 2008. The increase in assets since June 30, 2008 was due primarily toincreases in cash and cash equivalents of $4.7 million, securities availablefor sale of $29.4 million, net loans and leases receivable of $25.4 million,and loans held for sale of $5.2 million. The increase in liabilities of $42.2 million since June 30, 2008was primarily due to increases in advances from the FHLB and other borrowingsof $54.3 million.  These increases weresomewhat offset by a decrease in public funds deposits of $11.8 million.  In addition, stockholders’ equity increased$27.5 million to $91.7 million at December 31, 2008 from $64.2 million at June 30,2008, primarily due to participation in the CPP resulting in a $25.0 millionincrease to capital.  Capital alsoincreased due to the net income for the six months ended December 31, 2008of $3.8 million, but was partially offset by the net increase in unrealizedlosses, net of income tax benefits, of $1.2 million.

 

The increase in net loansand leases receivable of $25.4 million at December 31, 2008 as compared toJune 30, 2008, was primarily the result of increases in agricultural loansof $31.3 million to $191.6 million, increases in commercial business and realestate of $4.0 million to $307.5 million, increases of consumer direct loans of$7.0 million to $112.7 million and an increase in construction and developmentloans of $4.7 million to $10.3 million. These increases were partially offset by decreases in one-to four-familyloans of $7.0 million to $93.0 million and decreases in consumer indirect loansof $12.9 million to $31.4 million at December 31, 2008 as compared to June 30,2008.  Loans held for sale increased by$5.2 million at December 31, 2008, as compared to June 30, 2008, dueprimarily to seasonal fluctuation of student loan activity and increased singlefamily loan production activity.

 

Cash and cash equivalentsincreased $4.7 million at December 31, 2008 as compared to June 30,2008.  See the Consolidated Statement ofCash Flows for an in-depth analysis in the change in cash and cash equivalentsfor the six months ended December 31, 2008.

 

Advances from theFHLB and other borrowings increased $54.3 million to $252.8 million. Theoverall increase in FHLB borrowings was primarily the result of an increase insecurities available for sale, an increase in loans and leases receivable, theincrease in loans held for sale and the decrease in public fund deposits of$11.8 million.

 

The $11.3 million decrease in deposits was due todecreases in public funds of $11.8 million which are categorized in multiplecategories of deposits.  Public fundshave decreased, from $156.3 million at June 30, 2008 to $144.4 million at December 31,2008, as a result of seasonal fluctuations typical with these types ofmunicipal deposits.  For the same period,out-of-market deposits decreased from $27.3 million to $22.6 million, or 16.9%.  The in-market certificates of depositincreased since June 30, 2008 in the amount of $19.4 million.  This increase was offset by decreases innoninterest bearing and interest bearing checking accounts, money marketaccounts, and savings accounts of $4.5 million, $16.6 million, and $5.0million, respectively, when compared to the totals at June 30, 2008.

 

18

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The following tables showthe composition of the Company’s loan and lease portfolio and deposit accounts:

 

**Loan and Lease Portfolio Composition**

 
| ** **                                        | ** ** | **December 31, 2008**      | ** ** | **June 30, 2008** | ** ** |
|---------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                                        | ** ** | **Amount**                           | ** ** | **Percent**                 | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                        | ** ** | **(Dollars in Thousands)** | ** ** |
|                                              |       |                                 |       |                        |       |   |   |   |   |
| One-to  four-family (1)                           |       | $                                    | 92,972     |                        | 11.46      | % | $ | 99,989 |   | 12.76 | % |
| Commercial  business and real estate (2) (3) |       | 307,458                              |       | 37.90                       |       | 303,415 |   | 38.72 |   |
| Multi-family  real estate                         |       | 45,912                               |       | 5.66                        |       | 45,093 |   | 5.75 |   |
| Equipment  finance leases                         |       | 18,985                               |       | 2.34                        |       | 19,288 |   | 2.46 |   |
| Consumer direct  (4)                              |       | 112,688                              |       | 13.89                       |       | 105,719 |   | 13.49 |   |
| Consumer  indirect (5)                            |       | 31,421                               |       | 3.87                        |       | 44,294 |   | 5.65 |   |
| Agricultural                                      |       | 191,556                              |       | 23.61                       |       | 160,267 |   | 20.45 |   |
| Construction and  development                     |       | 10,297                               |       | 1.27                        |       | 5,645 |   | 0.72 |   |
| Total loans and  leases receivable (6)            |       | $                                    | 811,289    |                        | 100.00     | % | $ | 783,710 |   | 100.00 | % |

 

----

(1) Excludes $10,710 and $7,958 loans held for sale atDecember 31, 2008 and June 30, 2008, respectively.

(2) Includes $2,912 and $3,012 tax exempt leases atDecember 31, 2008 and June 30, 2008, respectively.

(3) Excludes $0 and $223 commercial loans held for sale atDecember 31, 2008 and June 30, 2008, respectively.

(4) Excludes $3,318 and $614 student loans held for sale atDecember 31, 2008 and June 30, 2008, respectively.

(5) The Company announced Consumer Indirect originations ceasedduring the first quarter of Fiscal 2008.

(6) Includes deferred loan fees and discounts and undisbursedportion of loans in process.

 

**DepositComposition**

 
| ** **                             | ** ** | **December 31, 2008**      | ** ** | **June 30, 2008** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **Amount**                           | ** ** | **Percent**                 | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                             | ** ** | **(Dollars in Thousands)** | ** ** |
|                                   |       |                                 |       |                        |       |   |   |   |   |
| Noninterest  bearing checking accounts |       | $                                    | 88,762     |                        | 11.48      | % | $ | 90,598 |   | 11.55 | % |
| Interest bearing  checking accounts    |       | 87,486                               |       | 11.32                       |       | 90,125 |   | 11.49 |   |
| Money market  accounts                 |       | 155,123                              |       | 20.07                       |       | 171,689 |   | 21.89 |   |
| Savings accounts                       |       | 73,518                               |       | 9.51                        |       | 78,575 |   | 10.02 |   |
| In-market  certificates of deposit     |       | 345,411                              |       | 44.69                       |       | 325,995 |   | 41.57 |   |
| Out-of-market  certificates of deposit |       | 22,617                               |       | 2.93                        |       | 27,255 |   | 3.48 |   |
| Total deposits                         |       | $                                    | 772,917    |                        | 100.00     | % | $ | 784,237 |   | 100.00 | % |

 

**Analysis of Net Interest Income**

 

Net interest incomerepresents the difference between income on interest-earning assets and expenseon interest-bearing liabilities.  Netinterest income depends upon the volume of interest-earning assets andinterest-bearing liabilities and the interest rates earned or paid on them.

 

*AverageBalances, Interest Rates and Yields.*  The following table presents for the periodsindicated, the total dollar amount of interest income from averageinterest-earning assets and the resulting yields, as well as the interestexpense on average interest-bearing liabilities, expressed both in dollars andrates, and the net interest margin.  Thetable does not reflect any effect of income taxes, except where noted.  Average balances consist of daily averagebalances for the Bank with simple average balances for all other subsidiariesof the Company.  The average balancesinclude nonaccruing loans and leases. The yields on loans and leases include origination fees, net of costs,which are considered adjustments to yield.

 

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|                                           |   | **Three Months Ended December 31,** |      |
|------------------------------------------------|--------|---------------------------------------------------------|-----------|
|                                           |   | **2008**                                                |      | **2007** |   |
|                                           |   | **Average**                                             |      | **Interest** |   | ** ** | ** ** | **Average** | ** ** | **Interest** | ** ** | ** ** |   |
|                                           |   | **Outstanding**                                         |      | **Earned/** |   | **Yield/** | ** ** | **Outstanding** | ** ** | **Earned/** | ** ** | **Yield/** |   |
|                                           |   | **Balance**                                             |      | **Paid** |   | **Rate** | ** ** | **Balance** | ** ** | **Paid** | ** ** | **Rate** |   |
|                                           |   | **(Dollars  in Thousands)**                             |      |
| Interest-earning  assets:                      |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Loans and leases  receivable (1) (3)      |   | $                                                       | 819,530   |   | $ | 12,646 |   | 6.12 | % | $ | 775,089 |   | $ | 13,879 |   | 7.12 | % |
| Investment  securities (2) (3)            |   | 238,971                                                 |      | 2,883 |   | 4.79 | % | 162,701 |   | 2,119 |   | 5.18 | % |
| FHLB stock                                     |   | 12,069                                                  |      | 37 |   | 1.22 | % | 7,703 |   | 87 |   | 4.48 | % |
|                                           |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                 |   | 1,070,570                                               |      | $ | 15,566 |   | 5.77 | % | 945,493 |   | $ | 16,085 |   | 6.77 | % |
| Noninterest-earning  assets                    |   | 67,481                                                  |      |   |   |   |   | 72,793 |   |   |   |   |   |
| Total assets                                   |   | $                                                       | 1,138,051 |   |   |   |   |   | $ | 1,018,286 |   |   |   |   |   |
|                                           |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                 |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                      |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Checking and  money market                     |   | $                                                       | 236,596   |   | $ | 559 |   | 0.94 | % | $ | 265,510 |   | $ | 2,077 |   | 3.11 | % |
| Savings                                        |   | 64,029                                                  |      | 127 |   | 0.79 | % | 47,416 |   | 274 |   | 2.30 | % |
| Certificates of  deposit                       |   | 388,650                                                 |      | 3,446 |   | 3.52 | % | 371,511 |   | 4,562 |   | 4.89 | % |
| Total  interest-bearing deposits               |   | 689,275                                                 |      | 4,132 |   | 2.38 | % | 684,437 |   | 6,913 |   | 4.02 | % |
| FHLB advances  and other borrowings            |   | 233,474                                                 |      | 1,947 |   | 3.31 | % | 135,817 |   | 1,642 |   | 4.81 | % |
| Subordinated  debentures payable to trusts (4) |   | 27,837                                                  |      | 480 |   | 6.84 | % | 27,837 |   | 534 |   | 7.63 | % |
|                                           |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities            |   | 950,586                                                 |      | 6,559 |   | 2.74 | % | 848,091 |   | 9,089 |   | 4.26 | % |
| Noninterest-bearing  deposits                  |   | 72,626                                                  |      |   |   |   |   | 80,806 |   |   |   |   |   |
| Other  liabilities                             |   | 36,445                                                  |      |   |   |   |   | 25,674 |   |   |   |   |   |
| Total  liabilities                             |   | 1,059,657                                               |      |   |   |   |   | 954,571 |   |   |   |   |   |
| Equity                                         |   | 78,394                                                  |      |   |   |   |   | 63,715 |   |   |   |   |   |
| Total  liabilities and equity                  |   | $                                                       | 1,138,051 |   |   |   |   |   | $ | 1,018,286 |   |   |   |   |   |
|                                           |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Net interest  income; interest rate spread (5) |   |                                                    |      | $ | 9,007 |   | 3.03 | % |   |   | $ | 6,996 |   | 2.51 | % |
|                                           |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin (5) (6)              |   |                                                    |      |   |   | 3.34 | % |   |   |   |   | 2.94 | % |
|                                           |   |                                                    |      |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin, TE (7)                   |   |                                                    |      |   |   | 3.40 | % |   |   |   |   | 3.00 | % |

 

----

(1)  Includes loan fees and interest on accruing loans and leasespast due 90 days or more.

(2)  Includes federal funds sold.

(3) Yields do not reflect the tax-exempt nature of loans,equipment leases and municipal securities.

(4)  Includes $125 in July 2007 for unamortized debt issuancecosts.

(5)  Percentages for the three months ended December 31, 2008and December 31, 2007 have been annualized.

(6)  Net interest margin is net interest income divided by averageinterest-earning assets.

(7)  Net interest margin expressed on a fully taxable equivalentbasis.

 

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| ** **                                     | ** ** | **Six Months Ended December 31,** | ** ** |
|------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                     | ** ** | **2008**                                              | ** ** | **2007** | ** ** |
| ** **                                     | ** ** | **Average**                                           | ** ** | **Interest** | ** ** | ** ** | ** ** | **Average** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **Outstanding**                                       | ** ** | **Earned/** | ** ** | **Yield/** | ** ** | **Outstanding** | ** ** | **Earned/** | ** ** | **Yield/** | ** ** |
| ** **                                     | ** ** | **Balance**                                           | ** ** | **Paid** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Paid** | ** ** | **Rate** | ** ** |
| ** **                                     | ** ** | **(Dollars  in Thousands)**                           | ** ** |
| Interest-earning  assets:                      |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Loans and leases  receivable (1) (3)      |       | $                                                     | 812,657    |   | $ | 25,664 |   | 6.26 | % | $ | 775,583 |   | $ | 27,999 |   | 7.18 | % |
| Investment  securities (2) (3)            |       | 234,450                                               |       | 5,575 |   | 4.72 | % | 153,949 |   | 3,923 |   | 5.07 | % |
| FHLB stock                                     |       | 12,079                                                |       | 158 |   | 2.59 | % | 6,660 |   | 148 |   | 4.41 | % |
|                                           |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                 |       | 1,059,186                                             |       | $ | 31,397 |   | 5.88 | % | 936,192 |   | $ | 32,070 |   | 6.81 | % |
| Noninterest-earning  assets                    |       | 66,864                                                |       |   |   |   |   | 70,686 |   |   |   |   |   |
| Total assets                                   |       | $                                                     | 1,126,050  |   |   |   |   |   | $ | 1,006,878 |   |   |   |   |   |
|                                           |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                 |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                      |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Checking and  money market                     |       | $                                                     | 241,027    |   | $ | 1,417 |   | 1.17 | % | $ | 275,962 |   | $ | 4,658 |   | 3.36 | % |
| Savings                                        |       | 67,284                                                |       | 388 |   | 1.14 | % | 51,096 |   | 684 |   | 2.66 | % |
| Certificates of  deposit                       |       | 376,546                                               |       | 6,904 |   | 3.64 | % | 367,672 |   | 9,069 |   | 4.91 | % |
| Total  interest-bearing deposits               |       | 684,857                                               |       | 8,709 |   | 2.52 | % | 694,730 |   | 14,411 |   | 4.13 | % |
| FHLB advances  and other borrowings            |       | 233,055                                               |       | 4,056 |   | 3.45 | % | 114,057 |   | 2,796 |   | 4.88 | % |
| Subordinated  debentures payable to trusts (4) |       | 27,837                                                |       | 936 |   | 6.67 | % | 27,837 |   | 1,199 |   | 8.57 | % |
|                                           |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities            |       | 945,749                                               |       | 13,701 |   | 2.87 | % | 836,624 |   | 18,406 |   | 4.38 | % |
| Noninterest-bearing  deposits                  |       | 75,263                                                |       |   |   |   |   | 79,743 |   |   |   |   |   |
| Other  liabilities                             |       | 32,706                                                |       |   |   |   |   | 27,349 |   |   |   |   |   |
| Total  liabilities                             |       | 1,053,718                                             |       |   |   |   |   | 943,716 |   |   |   |   |   |
| Equity                                         |       | 72,332                                                |       |   |   |   |   | 63,162 |   |   |   |   |   |
| Total  liabilities and equity                  |       | $                                                     | 1,126,050  |   |   |   |   |   | $ | 1,006,878 |   |   |   |   |   |
|                                           |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  income; interest rate spread (5) |       |                                                  |       | $ | 17,696 |   | 3.01 | % |   |   | $ | 13,664 |   | 2.43 | % |
|                                           |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin (5) (6)              |       |                                                  |       |   |   | 3.31 | % |   |   |   |   | 2.90 | % |
|                                           |       |                                                  |       |   |   |   |   |   |   |   |   |   |   |
| Net interest  margin, TE (7)                   |       |                                                  |       |   |   | 3.37 | % |   |   |   |   | 2.96 | % |

 

----

(1)  Includes loan fees and interest on accruing loans and leasespast due 90 days or more.

(2)  Includes federal funds sold.

(3) Yields do not reflect the tax-exempt nature of loans,equipment leases and municipal securities.

(4)  Includes $125 in July 2007 for unamortized debt issuancecosts.

(5)  Percentages for the six months ended December 31, 2008and December 31,2007 have been annualized.

(6)  Net interest margin is net interest income divided by averageinterest-earning assets.

(7)  Net interest margin expressed on a fully taxable equivalentbasis.

 

**Rate/VolumeAnalysis of Net Interest Income**

 

The following schedulepresents the dollar amount of changes in interest income and interest expensefor major components of interest-earning assets and interest-bearingliabilities.  It distinguishes betweenthe increases and decreases due to fluctuating outstanding balances due to thelevels and volatility of interest rates. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (i) changesin volume (i.e., changes in volume multiplied by old rate) and (ii) changesin rate (i.e., changes in rate multiplied by old volume).  For purposes of this table, changesattributable to both rate and volume, which cannot be segregated, have beenallocated proportionately to the change due to volume and the change due torate.

 

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| ** **                                 | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                 | ** ** | **2008 vs 2007**                              | ** ** | **2008 vs 2007**                            | ** ** |
| ** **                                 | ** ** | **Increase**                                            | ** ** | **Increase**                                          | ** ** | ** ** | ** ** | **Increase** | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **(Decrease)**                                          | ** ** | **(Decrease)**                                        | ** ** | **Total** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** | **Total** | ** ** |
| ** **                                 | ** ** | **Due to**                                         | ** ** | **Due to**                                       | ** ** | **Increase** | ** ** | **Due to** | ** ** | **Due to** | ** ** | **Increase** | ** ** |
| ** **                                 | ** ** | **Volume**                                              | ** ** | **Rate**                                              | ** ** | **(Decrease)** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                 | ** ** | **(Dollars in Thousands)**                    | ** ** |
| Interest-earning  assets:                  |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Loans and leases  receivable (1)           |       | $                                                       | 808        |                                                  | $          | (2,041 | ) | $ | (1,233 | ) | $ | 1,366 |   | $ | (3,701 | ) | $ | (2,335 | ) |
| Investment  securities (2)                 |       | 998                                                     |       | (234                                                  | )          | 764 |   | 2,064 |   | (412 | ) | 1,652 |   |
| FHLB stock                                 |       | 49                                                      |       | (99                                                   | )          | (50 | ) | 121 |   | (111 | ) | 10 |   |
|                                       |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Total  interest-earning assets             |       | $                                                       | 1,855      |                                                  | $          | (2,374 | ) | $ | (519 | ) | $ | 3,551 |   | $ | (4,224 | ) | $ | (673 | ) |
|                                       |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:             |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Deposits:                                  |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Checking and  money market                 |       | $                                                       | (227       | )                                                     | $          | (1,291 | ) | $ | (1,518 | ) | $ | (590 | ) | $ | (2,651 | ) | $ | (3,241 | ) |
| Savings                                    |       | 96                                                      |       | (243                                                  | )          | (147 | ) | 218 |   | (514 | ) | (296 | ) |
| Certificates of  deposit                   |       | 213                                                     |       | (1,329                                                | )          | (1,116 | ) | 222 |   | (2,387 | ) | (2,165 | ) |
| Total  interest-bearing deposits           |       | 82                                                      |       | (2,863                                                | )          | (2,781 | ) | (150 | ) | (5,552 | ) | (5,702 | ) |
| FHLB advances  and other borrowings        |       | 1,186                                                   |       | (881                                                  | )          | 305 |   | 2,935 |   | (1,675 | ) | 1,260 |   |
| Subordinated  debentures payable to trusts |       | —                                                  |       | (54                                                   | )          | (54 | ) | — |   | (263 | ) | (263 | ) |
|                                       |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities        |       | $                                                       | 1,268      |                                                  | $          | (3,798 | ) | $ | (2,530 | ) | $ | 2,785 |   | $ | (7,490 | ) | $ | (4,705 | ) |
|                                       |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Net interest  income increase              |       |                                                    |       |                                                  |       | $ | 2,011 |   |   |   |   |   | $ | 4,032 |   |

 

----

(1)  Includes loan fees and interest on accruing loans and leasespast due 90 days or more.

(2)  Includes federal funds sold.

 

**Applicationof Critical Accounting Policies**

 

GAAP requires management to utilize estimates whenreporting financial results.  The Companyhas identified the policies discussed below as Critical Accounting Policiesbecause the accounting estimates require management to make certain assumptionsabout matters which may be uncertain at the time the estimate was made and adifferent method of estimating could have been reasonably made which could havea material impact on the presentation of the Company’s financial condition,changes in financial condition or results of operations.

 

*Allowance for Loan and Lease Losses*— GAAP requires the Company to set aside reserves or maintain an allowanceagainst probable loan and lease losses in the loan and lease portfolio.  Management must develop a consistent andsystematic approach to estimate the appropriate balances to cover the probablelosses.  Due to the uncertainty of futureevents, the approach includes a process that may differ significantly fromother methodologies and still produce an estimate in accordance with GAAP.

 

The allowance is compiledby utilizing the Company’s loan and lease risk rating system, which isstructured to identify weaknesses in the loan and lease portfolio.  The risk rating system has evolved to aprocess whereby management believes the system will properly identify thecredit risk associated with the loan and lease portfolio.  Due to the stratification of loans and leasesfor the allowance calculation, the estimate of the allowance for loan and leaselosses could change materially if the loan and lease risk rating system wouldnot properly identify the strength of a large or a few large loan and leasecustomers.  Although management believesit uses the best information available to determine the allowance, unforeseenmarket or borrower conditions could result in adjustments and net earnings beingsignificantly affected if circumstances differ substantially from theassumptions used in making the final determinations.

 

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*MortgageServicing Rights (“MSR”)* – The Company records aservicing asset for contractually separated servicing from the underlyingmortgage loans.   The asset is initiallyrecorded at fair value and represents an intangible asset backed by an incomestream from the serviced assets.  Theasset is amortized in proportion to and over the period of estimated netservicing income.

 

At each balance sheetdate, the MSRs are analyzed for impairment, which occurs when the fair value ofthe MSRs is lower than the amortized book value. The Company’s MSRs areprimarily servicing rights acquired on South Dakota Housing DevelopmentAuthority first time homebuyers program. Due to the lack of quoted markets for the Company’s servicing portfolio,the Company estimates the fair value of the MSRs using present value of futurecash flow analysis.  If the analysisproduces a fair value greater than or equal to the amortized book value of theMSRs, no impairment is recognized.  Ifthe fair value is less than the book value, an expense for the difference ischarged to earnings by initiating a MSR valuation account.  If the Company determines this impairment istemporary, any future changes in fair value are recorded as a change inearnings and the valuation.  If theCompany determines the impairment to be permanent, the valuation is written offagainst the MSRs, which results in a new amortized balance.

 

The Company has includedMSRs as a critical accounting policy because the use of estimates fordetermining fair value using present value concepts may produce results whichmay significantly differ from other fair value analysis perhaps even to thepoint of recording impairment.  The riskto earnings is when the underlying mortgages pay off significantly faster thanthe assumptions used in the previously recorded amortization.  Estimating future cash flows on theunderlying mortgages is a difficult analysis and requires judgment based on thebest information available.  The Companylooks at alternative assumptions and projections when preparing a reasonableand supportable analysis.  Based on theCompany’s quarterly analysis of MSRs, there was no impairment to the MSRs at December 31,2008.

 

*Self-Insurance*-The Company has a self-insured healthcare plan for its employees up to certainlimits.  To mitigate a portion of theserisks, the Company has a stop-loss insurance policy through a commercialinsurance carrier for coverage in excess of $65,000 per individual occurrencewith no maximum aggregate limitation. The estimate of self-insurance liability is based upon known claims andan estimate of incurred, but not reported (“IBNR”) claims.  IBNR claims are estimated using historicalclaims lag information received by a third party claims administrator.  Due to the uncertainty of health claims, theapproach includes a process which may differ significantly from othermethodologies and still produce an estimate in accordance with GAAP.  Although management believes it uses the bestinformation available to determine the accrual, unforeseen health claims couldresult in adjustments to the accrual. These adjustments could significantly affect net earnings ifcircumstances differ substantially from the assumptions used in estimating theaccrual.

 

**AssetQuality and Potential Problem Loans and Leases**

 

Nonperforming assets(nonaccrual loans and leases, accruing loans and leases delinquent more than 90days and foreclosed assets) increased to $4.5 million at December 31, 2008from $3.7 million at June 30, 2008, an increase of $726,000, or19.4%.  Accruing loans and leasesdelinquent more than 90 days increased $1.4 million to $2.2 million at December 31,2008 from $781,000 at June 30, 2008. Nonaccruing loans and leases decreased $385,000 to $1.9 million at December 31,2008 from $2.3 million at June 30, 2008. Foreclosed assets decreased $273,000 to $370,000 at December 31,2008, from $643,000 at June 30, 2008. In addition, the ratio of nonperforming assets to total assets, which isone indicator of credit risk exposure, was 0.38% at December 31, 2008,which is an increase from 0.34% as reported at June 30, 2008.

 

Nonaccruing loans andleases decreased 16.6%, or $385,000, to $1.9 million at December 31, 2008compared to $2.3 million at June 30, 2008. Included in nonaccruing loans and leases at December 31, 2008 wereeight loans totaling $441,000 secured by one- to four-family real estate, twoloans totaling $438,000 secured by commercial real estate, seven loans totaling$201,000 secured by commercial business, three loans totaling $252,000 securedby agriculture, one lease totaling $21,000 and 37 consumer loans totaling$586,000.

 

The risk rating system inplace is designed to identify and manage the nonperforming loans andleases.  Commercial and agriculturalloans and equipment finance leases will have specific reserve allocations basedon collateral values or based on the present value of expected cash flows ifthe loans and leases are deemed impaired. Loans and leases that are not performing do not necessarily result in aloss.

 

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As of December 31,2008, foreclosed assets decreased by $273,000, or 42.5%, to $370,000 ascompared to $643,000 at June 30, 2008. The balance at December 31, 2008 consisted of $265,000 ofsingle-family collateral owned, $25,000 of equipment finance leases and $80,000of consumer collateral owned.

 

At December 31,2008, the Company had designated $26.9 million of its assets as special mentionand $9.1 million of its assets as classified that management has determinedneed to be closely monitored because of possible credit problems of theborrowers or the cash flows of the secured properties.  The Company also classified $4.6 million oftrust preferred securities in accordance with OTS debt security classificationguidelines.  At December 31, 2008the Company had $17.0 million in multi-family, commercial business, commercialreal estate and agricultural participation loans purchased, of which $2.6million were classified as of December 31, 2008.  These loans and leases were considered indetermining the adequacy of the allowance for loan and lease losses.  The allowance for loan and lease losses isestablished based on management’s evaluation of the risks probable in the loanand lease portfolio and changes in the nature and volume of loan and leaseactivity.  Such evaluation, whichincludes a review of all loans and leases for which full collectability may notbe reasonably assured, considers the estimated fair market value of theunderlying collateral, present value of expected principal and interestpayments, economic conditions, historical loss experience and other factorsthat warrant recognition in providing for an adequate loan and lease lossallowance.

 

Although the Company’s management believes the December 31,2008 recorded allowance for loan and lease losses was adequate to provide forprobable losses on the related loans and leases, there can be no assurance theallowance existing at December 31, 2008, will be adequate in the future.

 

In accordance with the Company’s internalclassification of assets policy, management evaluates the loan and leaseportfolio on a monthly basis to identify loss potential and determines theadequacy of the allowance for loan and lease losses quarterly.  Loans and leases are placed on nonaccrualstatus when the collection of principal and/or interest becomes doubtful.  Foreclosed assets include assets acquired insettlement of loans and leases.

 

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The following table sets forth the amounts andcategories of the Company’s nonperforming assets for the periods indicated.

 
| ** **                                                                      | ** ** | **Nonperforming Assets**        | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                      | ** ** | **December 31, 2008**      | ** ** | **June 30, 2008** | ** ** |
| ** **                                                                      | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccruing  loans and leases:                                                  |       |                                 |       |   |   |
| One- to  four-family                                                            |       | $                                    | 441        |   | $ | 503 |   |
| Commercial real  estate                                                         |       | 438                                  |       | 429 |   |
| Commercial  business                                                            |       | 201                                  |       | 555 |   |
| Equipment  finance leases                                                       |       | 21                                   |       | 27 |   |
| Consumer                                                                        |       | 586                                  |       | 566 |   |
| Agricultural                                                                    |       | 252                                  |       | 244 |   |
| Total                                                                           |       | 1,939                                |       | 2,324 |   |
|                                                                            |       |                                 |       |   |   |
| Accruing loans  and leases delinquent more than 90 days:                        |       |                                 |       |   |   |
| One- to  four-family                                                            |       | 281                                  |       | 306 |   |
| Commercial real  estate                                                         |       | 988                                  |       | 24 |   |
| Commercial  business                                                            |       | 278                                  |       | 71 |   |
| Equipment  finance leases                                                       |       | 413                                  |       | 9 |   |
| Consumer                                                                        |       | 94                                   |       | 119 |   |
| Agricultural                                                                    |       | 111                                  |       | 252 |   |
| Total                                                                           |       | 2,165                                |       | 781 |   |
|                                                                            |       |                                 |       |   |   |
| Foreclosed  assets: (1)                                                         |       |                                 |       |   |   |
| One- to  four-family                                                            |       | 265                                  |       | 76 |   |
| Equipment  finance leases                                                       |       | 25                                   |       | 443 |   |
| Consumer                                                                        |       | 80                                   |       | 124 |   |
| Total                                                                           |       | 370                                  |       | 643 |   |
|                                                                            |       |                                 |       |   |   |
| Total nonperforming  assets                                                     |       | $                                    | 4,474      |   | $ | 3,748 |   |
|                                                                            |       |                                 |       |   |   |
| Ratio of  nonperforming assets to total assets                                  |       | 0.38                                 | %          | 0.34 | % |
|                                                                            |       |                                 |       |   |   |
| Ratio of  nonperforming loans and leases to total loans and leases (2) (3) |       | 0.50                                 | %          | 0.39 | % |

 

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(1)          Total foreclosed assetsdo not include land or other real estate owned held for sale.

(2)          Nonperforming loans andleases include both nonaccruing and accruing loans and leases delinquent morethan 90 days.

(3)          Total loans and leasesinclude loans held for sale.

 

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The following tablesets forth information with respect to activity in the Company’s allowance forloan and lease losses during the periods indicated.

 
| ** **                                                                                               | ** ** | **Six Months Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                                                                               | ** ** | **2008**                                              | ** ** | **2007** | ** ** |
| ** **                                                                                               | ** ** | **(Dollars in Thousands)**                  | ** ** |
|                                                                                                     |       |                                                  |       |   |   |
| Balance at  beginning of period                                                                          |       | $                                                     | 5,933      |   | $ | 5,872 |   |
| Charge-offs:                                                                                             |       |                                                  |       |   |   |
| One- to  four-family                                                                                     |       | (1                                                    | )          | (3 | ) |
| Commercial real  estate                                                                                  |       | (9                                                    | )          | — |   |
| Commercial  business                                                                                     |       | (23                                                   | )          | (620 | ) |
| Equipment  finance leases                                                                                |       | (34                                                   | )          | (171 | ) |
| Consumer                                                                                                 |       | (446                                                  | )          | (421 | ) |
| Total  charge-offs                                                                                       |       | (513                                                  | )          | (1,215 | ) |
|                                                                                                     |       |                                                  |       |   |   |
| Recoveries:                                                                                              |       |                                                  |       |   |   |
| One- to  four-family                                                                                     |       | 2                                                     |       | — |   |
| Commercial  business                                                                                     |       | 2,217                                                 |       | 8 |   |
| Consumer                                                                                                 |       | 102                                                   |       | 134 |   |
| Agricultural                                                                                             |       | 5                                                     |       | 5 |   |
| Total recoveries                                                                                         |       | 2,326                                                 |       | 147 |   |
|                                                                                                     |       |                                                  |       |   |   |
| Net recoveries  (charge-offs)                                                                            |       | 1,813                                                 |       | (1,068 | ) |
|                                                                                                     |       |                                                  |       |   |   |
| Additions  charged to operations                                                                         |       | 387                                                   |       | 620 |   |
|                                                                                                     |       |                                                  |       |   |   |
| Balance at end  of period                                                                                |       | $                                                     | 8,133      |   | $ | 5,424 |   |
|                                                                                                     |       |                                                  |       |   |   |
| Ratio of net  (charge-offs) during the period to average loans and leases outstanding  during the period |       | 0.22                                                  | %          | (0.14 | )% |
|                                                                                                     |       |                                                  |       |   |   |
| Ratio of  allowance for loan and lease losses to total loans and leases at end of  period (1)            |       | 0.99                                                  | %          | 0.71 | % |
|                                                                                                     |       |                                                  |       |   |   |
| Ratio of  allowance for loan and lease losses to nonperforming loans and leases at end  of period (2)    |       | 198.17                                                | %          | 182.75 | % |

 

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(1)  Totalloans and leases include loans held for sale.

(2) Nonperforming loans and leases include both nonaccruing and accruing loans andleases delinquent more than 90 days.

 

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The distribution of the Company’s allowance for loanand lease losses and impaired loss summary as required by FASB Statement No. 114,“Accounting by Creditors for Impairment of a Loan” are summarized in thefollowing tables.  The combination ofFASB Statement No. 5 “Accounting for Contingencies” and FASB Statement No. 114calculations comprise the Company’s allowance for loan and lease losses.

 
| ** **                             | ** ** | **Allowance**                        | ** ** | **Impaired Loan**      | ** ** | **Allowance**              | ** ** | **Impaired Loan** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                             | ** ** | **for Loan and**           | ** ** | **Valuation**               | ** ** | **for Loan and** | ** ** | **Valuation**          | ** ** |
| ** **                             | ** ** | **Lease Losses**                | ** ** | **Allowance**               | ** ** | **Lease Losses**      | ** ** | **Allowance**          | ** ** |
| **Loan and Lease Type** | ** ** | **December 31, 2008**      | ** ** | **June 30, 2008** | ** ** |
| ** **                             | ** ** | **(Dollars in Thousands)** | ** ** |
|                                   |       |                                 |       |                        |       |                       |       |                   |       |
| One- to  four-family                   |       | $                                    | 384        |                        | $          | —                     |       | $                      | 294        |   | $ | — |   |
| Commercial real  estate                |       | 1,022                                |       | 60                          |       | 740                        |       | —                 |       |
| Multi-family  real estate              |       | 179                                  |       | —                      |       | 135                        |       | —                 |       |
| Commercial  business                   |       | 2,339                                |       | 67                          |       | 1,678                      |       | —                 |       |
| Equipment  finance leases              |       | 503                                  |       | —                      |       | 496                        |       | —                 |       |
| Consumer                               |       | 1,181                                |       | —                      |       | 1,190                      |       | —                 |       |
| Agricultural                           |       | 2,268                                |       | 130                         |       | 1,270                      |       | 130                    |       |
| Total                                  |       | $                                    | 7,876      |                        | $          | 257                        |       | $                      | 5,803      |   | $ | 130 |   |

 

**ImpairedLoan Summary**

** **
| ** **                             | ** ** | ** **                           | ** ** | ** **                  | ** ** | **Impaired**  | ** ** | ** **       | ** ** | ** **  | ** ** | **Impaired**  | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|---------------|------------|------------------|------------|-------------|------------|---------------|------------|
| ** **                             | ** ** | **Number**                           | ** ** | ** **                  | ** ** | **Loan**      | ** ** | **Number**       | ** ** | ** **  | ** ** | **Loan**      | ** ** |
| **Loan**                               | ** ** | **of Loan**                     | ** ** | **Loan**                    | ** ** | **Valuation** | ** ** | **of Loan** | ** ** | **Loan**    | ** ** | **Valuation** | ** ** |
| **Balance**                            | ** ** | **Customers**                        | ** ** | **Balance**                 | ** ** | **Allowance** | ** ** | **Customers**    | ** ** | **Balance** | ** ** | **Allowance** | ** ** |
| **Loan and Lease Type** | ** ** | **December 31, 2008**      | ** ** | **June 30, 2008** | ** ** |
| ** **                             | ** ** | **(Dollars in Thousands)** | ** ** |
|                                   |       |                                 |       |                        |       |          |       |             |       |        |       |          |       |
| Commercial real  estate                |       | 3                                    |       | $                           | 445        |          | $          | 60               |       | —      |       | $             | —     |   | $ | — |   |
| Commercial  business                   |       | 2                                    |       | 155                         |       | 67            |       | —           |       | —      |       | —        |       |
| Agricultural                           |       | 2                                    |       | 362                         |       | 130           |       | 2                |       | 316         |       | 130           |       |
| Total                                  |       | 7                                    |       | $                           | 962        |          | $          | 257              |       | 2           |       | $             | 316        |   | $ | 130 |   |
|                                        |            |                                      |            |                             |            |               |            |                  |            |             |            |               |            |  |  |  |  |  |

 

The allowance for loanand lease losses was $8.1 million at December 31, 2008, as compared to$5.4 million at December 31, 2007. The ratio of the allowance for loan and lease losses to total loans andleases was 0.99% at December 31, 2008, compared to 0.71% at December 31,2007.  The Company’s management hasconsidered nonperforming loans and leases and potential problem loans andleases in establishing the allowance for loan and lease losses.  The Company continues to monitor itsallowance for probable loan and lease losses and make future additions orreductions in light of the level of loans and leases in its portfolio and aseconomic conditions dictate.  Thecurrent level of the allowance for loan and lease losses is a result ofmanagement’s assessment of the risks within the portfolio based on theinformation revealed in credit reporting processes. The Company utilizes arisk-rating system on all commercial business, agricultural, construction andmulti-family and commercial real estate loans, including purchased loans andleases.  A periodic credit review isperformed on all types of loans and leases to establish the necessary reservebased on the estimated risk within the portfolio. This assessment of risk takesinto account the composition of the loan and lease portfolio, historical lossexperience for each loan and lease category, previous loan and leaseexperience, concentrations of credit, current economic conditions and otherfactors that in management’s judgment deserve recognition.

 

Real estate propertiesacquired through foreclosure are recorded at the lower of cost or fair value(less a deduction for disposition costs). Valuations are periodically updated by management and a specificprovision for losses on such properties is established by a charge tooperations if the carrying values of the properties exceed their estimated netrealizable values.

 

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Althoughmanagement believes it uses the best information available to determine theallowances, unforeseen market conditions could result in adjustments and netearnings being significantly affected if circumstances differ substantiallyfrom the assumptions used in making the final determinations.  Future additions to the Company’s allowancesmay result from periodic loan, property or collateral reviews which cannot bepredicted at this time.

 

**Comparison of the Three Months Ended December 31,2008, and December 31, 2007**

 

*General*.  The Company’s net income was $1.8 million, or$0.46 in basic and $0.46 in diluted earnings per share for the three monthsended December 31, 2008, a $595,000 increase in earnings compared to $1.3million, or $0.32 in basic and $0.31 in diluted earnings per share for the sameperiod in the prior fiscal year.  For thethree months ended December 31, 2008, the return on average equity and thereturn on average assets were 9.34% and 0.64%, respectively, compared to 7.81%and 0.49%, respectively, for the same period in the prior fiscal year.  As discussed in more detail below, theincreases were due to a variety of key factors, with the increase in netinterest income of $2.0 million contributing the most to the net increase.  This increase was partially offset by anincrease of non-interest expense of $1.5 million for the second quarter of Fiscal2009 as compared to the second quarter of Fiscal 2008.

 

*Interest, Dividend and Loan Fee Income.*  Interest, dividend and loan fee income was$15.6 million for the three months ended December 31, 2008 as compared to$16.1 million for the same period in the prior fiscal year, a decrease of$519,000 or 3.2%.  This decrease wasprimarily the result of declining average yields on the interest earningassets.  Loans and leases receivable hadan average yield of 6.12% for the three months ended December 31, 2008,which is 100 basis points less than the average yield of 7.12% for the threemonths ended December 31, 2007. Investment securities also had a decline in average yield of 39 basispoints when comparing the second quarter of Fiscal 2009 against the same periodof the prior year.  The averageinterest-earning assets for loans and leases receivables increased $44.4million, or 5.7% to $819.5 million for the three months ended December 31,2008, when compared to the three months ended December 31, 2007.  Investment securities also increased inaverage balance by $76.3 million, or 46.9% to $239.0 million for the secondquarter of Fiscal 2009, when compared to the average balance of the samequarter of the prior fiscal year.  Thenet revenue decrease attributable to the overall declining yields was $2.4million when comparing the three months ended December 31, 2008 againstthe same period ended December 31, 2007. This net revenue decrease was offset by $1.9 million of revenueincreases from larger average assets invested for the second quarter of Fiscal2009 as compared to the second quarter of Fiscal 2008.

 

*InterestExpense.*  Interestexpense was $6.6 million for the three months ended December 31, 2008 ascompared to $9.1 million for the same period in the prior fiscal year, adecrease of $2.5 million or 27.8%.  A$2.9 million decrease in interest expense was the result of a decrease in theaverage rate paid of 4.02% on interest-bearing deposits for the three months endedDecember 31, 2007 to an average rate paid of 2.38% for the three monthsended December 31, 2008.  Anincrease of 0.71% in the average volume on interest-bearing deposits for thethree month period ended December 31, 2008, as compared to the three monthperiod ended December 31, 2007, slightly offset the overall decrease ininterest expense for interest-bearing deposits by $82,000.   Offsetting the overall decrease in interestexpense was an increase of $97.7 million or 71.9%, in the average volume of FHLBadvances and other borrowings.  This volumechange resulted in an increase to interest expense in the amount of $1.2million.  The average yield of FHLBadvances and other borrowings declined to 3.31% for the three months ended December 31,2008 from 4.81% for the three month period ended December 31, 2007,resulting in a reduction in interest expense of $881,000.  Interest expense for subordinated debenturespayable to trusts also declined by $54,000 as a result of the yield decliningfrom 7.63% to 6.84% during the same comparable quarters.  The average rate paid on totalinterest-bearing liabilities was 2.74% for the three months ended December 31,2008 as compared to 4.26% for the same period in the prior fiscal year.

 

*NetInterest Income.* The Company’s net interest income for thethree months ended December 31, 2008 increased $2.0 million or 28.7%, to$9.0 million compared to $7.0 million for the same period in the prior fiscalyear.  The increase in net interestincome was due primarily to decreases in the average rate paid on interest-bearingliabilities and increases in the average volume of interest-earning assets forthe three months ended December 31, 2008 compared to the same period inthe prior fiscal year.  The Company’s netinterest margin on a fully taxable equivalent basis was 3.40% for the threemonths ended December 31, 2008 as compared to 3.00% for the same period inthe prior fiscal year.

 

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*Provisionfor Losses on Loans and Leases.*The allowance for loan and lease losses is maintained at a levelwhich is considered by management to be adequate to absorb probable losses onexisting loans and leases that may become uncollectible, based on an evaluationof the collectability of loans and leases and prior loan and lease lossexperience.  The evaluation takes intoconsideration such factors as changes in the nature and volume of the loan andlease portfolio, overall portfolio quality, review of specific problem loansand leases, and current economic conditions that may affect the borrower’sability to pay.  The allowance for loanand lease losses is established through a provision for losses on loans andleases charged to expense.

 

During the three monthsended December 31, 2008, the Company did not record a provision for losseson loans and leases due in part to a large loan loss recovery which increasedthe allowance for loan and lease losses during the quarter.  In the three month period ended December 31,2007, a provision of $295,000 was incurred, which results in the current yearprovision decreasing by $295,000 from the same period of Fiscal 2008.  The Company previously announced a net loanloss recovery of $2.2 million from a settlement of a previously disclosedlawsuit against MetaBank.  During thequarter, the Company bolstered its methodology for calculating the allowancefor loan and lease losses to better capture the impact of the economic recessioncurrently being experienced across the country.   See “Asset Quality” for further discussion.

 

*Non-interestIncome.*  Non-interestincome was $2.9 million for the quarter ended December 31, 2008 comparedto $3.0 million at December 31, 2007, a decrease of $37,000 or 1.2%.  Gain on sale of loans and trust incomedecreased $154,000 and $96,000, respectively, while fees on deposits and netgain on sale of securities increased $163,000 and $45,000, respectively, whencompared to the same quarter of the prior fiscal year.

 

Gain on sale of loans decreased$154,000 to $285,000 for the three months ended December 31, 2008 from$439,000 for the three months ended December 31, 2007, primarily due to adecrease in pooled loan sales which occurred in the prior fiscal year.  Trust income decreased to $153,000 for thethree months ended December 31, 2008 from $249,000 for the three monthsended December 31, 2007, due in part to a decrease in managed assets fromfalling financial market values.  Fees ondeposits increased $163,000 for the three months ended December 31, 2008as compared to the same period in the prior fiscal year primarily due toincreased point-of-sale interchange revenue and fee schedule adjustments.  Net gain on sale of securities increased$45,000 for the three months ended December 31, 2008 as compared to thesame period in the prior fiscal year primarily due to the sale of securities,which did not occur in the prior year.

 

*Non-interestExpense.*  Non-interestexpense was $9.2 million for the three months ended December 31, 2008 ascompared to $7.7 million for the three months ended December 31, 2007, anincrease of $1.5 million, or 19.0%.  Theincrease in non-interest expense was primarily due to increases in compensationand employee benefits of $1.0 million, foreclosed real estate and otherproperties, net of $59,000, and other non-interest expense of $264,000.

 

Compensation and employeebenefits increased $1.0 million, or 21.7%, from $4.8 million for the threemonths ended December 31, 2007 to $5.8 million for the three months ended December 31,2008.  Employee compensation increased$346,000, or 10.9%, variable pay relating to employee incentives andcommissions increased $209,000, or 60.9% and net healthcare costs increased$537,000, or 131.1%.  Managementcontinues to believe the self-insured structure is a reasonable alternative totraditional healthcare plans over the long term.  The level of healthcare costs which theCompany incurs may vary from year to year, and the increase in net healthcarecosts does not necessarily indicate a trend. Employee compensation increased due to annual raises awarded andadditional personnel since the three month period ended December 31,2007.  Variable pay relating to employeeincentive programs increased due to higher production and net income.  Healthcare costs increased as a result ofhigher claim activity in the November and December of 2008.

 

Foreclosed real estateand other properties, net, increased $59,000 to $96,000 for the three monthsended December 31, 2008 as compared to the same period in the prior fiscalyear due to increased activity in repossessed equipment.

 

Other non-interestexpenses rose $264,000 largely due to increases in federal deposit insurancepremiums of $99,000, legal and professional expenses of $117,000, and communityinvestment contributions of $74,000. Previously, the Company had credits tooffset federal deposit insurance premiums. No future credits exist to offset this cost in the future.  Legal and consulting costs increased due inpart to a lawsuit which was settled in the second quarter of Fiscal 2009, inaddition to legal review costs related to the participation in the CPP asmentioned earlier.  Community investmentcontributions increased primarily due to the timing for which these investmentswere incurred.  Some of the investmentsincurred were previously incurred in both the first and third quarters ofFiscal 2008.  There has not been a largeincrease in new community investments from the prior fiscal year.

 

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*Income tax expense.*  The Company’s income tax expense for thethree months ended December 31, 2008 increased $206,000 or 29.1% to$914,000 compared to $708,000 for the same period in the prior fiscalyear.  The effective tax rate was 33.1%and 36.1% for the three months ended December 31, 2008 and 2007,respectively.

 

**Comparison of the Six Months Ended December 31,2008, and December 31, 2007**

 

*General*.  The Company’s net income was $3.8 million, or$0.96 in basic and $0.95 in diluted earnings per share for the three monthsended December 31, 2008, a $1.2 million increase in earnings compared to$2.6 million, or $0.65 in basic and $0.64 in diluted earnings per share for thesame period in the prior fiscal year. For the six months ended December 31, 2008, the return on averageequity and the return on average assets were 10.48% and 0.67%, respectively,compared to 8.18% and 0.51%, respectively, for the same period in the priorfiscal year.  As discussed in more detailbelow, the increases were due to a variety of key factors, including anincrease in net interest income of $4.0 million and non-interest income of$197,000.  These increases were offset byan increase of non-interest expense of $2.7 million for the six months ended December 31,2008 as compared to the same period in Fiscal 2008.

 

*Interest, Dividend and Loan Fee Income.*  Interest, dividend and loan fee income was$31.4 million for the six months ended December 31, 2008 as compared to$32.1 million for the same period in the prior fiscal year, a decrease of$673,000 or 2.1%.  This decrease wasprimarily the result of declining average yields on the interest earningassets.  Loans and leases receivable hadan average yield of 6.26% for the six months ended December 31, 2008,which is 92 basis points less than the average yield of 7.18% for the sixmonths ended December 31, 2007. Investment securities also had a decline in average yield of 35 basispoints when comparing the first six months of Fiscal 2009 against the sameperiod of the prior year.  The averageinterest-earning assets for loans and leases receivable increased $37.1 millionor 4.8%, to $812.7 million for the six months ended December 31,2008.   Investment securities alsoincreased in average balance by $80.5 million or 52.3%, to $234.5 million forthe first six months of Fiscal 2009, when compared to the average balance ofthe prior fiscal year.  The interestincome decrease attributable to the overall declining yields was $4.2 millionwhen comparing the six months ended December 31, 2008 against the sameperiod ended December 31, 2007. This interest income decrease was offset by $3.6 million of revenueincreases from larger average assets invested for the first six months ofFiscal 2009 as compared to the first six months of Fiscal 2008.

 

*InterestExpense.*  Interestexpense was $13.7 million for the six months ended December 31, 2008 ascompared to $18.4 million for the same period in the prior fiscal year, adecrease of $4.7 million or 25.6%.  A$5.6 million decrease in interest expense was the result of a decrease in theaverage rate paid of 4.13% on interest-bearing deposits for the six monthsended December 31, 2007 to an average rate paid of 2.52% for the sixmonths ended December 31, 2008.  A1.4% decrease in the average volume on interest-bearing deposits contributed to$150,000 of the total decrease in interest expense.  Offsetting the overall decrease in interestexpense was an increase of $2.9 million in interest expense due to a 104.3%increase in the average volume of FHLB advances and other borrowings.  This increase in average volume of FHLBadvances and other borrowings was partially offset by a $1.7 million reductionin interest expense due to this cost of funding declining from 4.88% for thesix months ended December 31, 2007 to 3.45% for the six months ended December 31,2008.  Interest expense for subordinateddebentures payable to trusts also declined by $263,000 as a result of the yielddeclining from 8.57% to 6.67% during the same comparable six monthperiods.  The average rate paid on totalinterest-bearing liabilities was 2.87% for the six months ended December 31,2008 as compared to 4.38% for the same period in the prior fiscal year.

 

*NetInterest Income.* The Company’s net interest income for thesix months ended December 31, 2008 increased $4.0 million, or 29.5%, to$17.7 million compared to $13.7 million for the same period in the prior fiscalyear.  The increase in net interestincome was due primarily to decreases in the average rate paid oninterest-bearing liabilities and increases in the average volume ofinterest-earning assets for the six months ended December 31, 2008compared to the same period in the prior fiscal year.  The Company’s net interest margin on a fullytaxable equivalent basis was 3.37% for the six months ended December 31,2008 as compared to 2.96% for the same period in the prior fiscal year.

 

*Provisionfor Losses on Loans and Leases.*The allowance for loan and lease losses is maintained at a levelwhich is considered by management to be adequate to absorb probable losses onexisting loans and leases that may become uncollectible, based on an evaluationof the collectability of loans and leases and prior loan and lease lossexperience.  The evaluation takes intoconsideration such factors as changes in the nature and volume of the loan andlease portfolio, overall portfolio quality, review of specific problem loans andleases, and current economic conditions that may affect the borrower’s abilityto pay.  The allowance for loan and leaselosses is established through a provision for losses on loans and leasescharged to expense.

 

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During the six monthsended December 31, 2008, the Company recorded a provision for losses onloans and leases of $387,000 compared to $620,000 for the six months ended December 31,2007, a decrease of $233,000.  Thereduction in the provision was due in part to a large loan loss recovery whichincreased the allowance for loan and lease losses during the second quarter ofFiscal 2009.  The Company previouslyannounced a net loan loss recovery of $2.2 million from a settlement of apreviously disclosed lawsuit against MetaBank. During the second quarter, the Company bolstered its methodology forcalculating the allowance for loan and lease losses to better capture theimpact of the economic recession currently being experienced across thecountry.  See “Asset Quality” for furtherdiscussion.

 

*Non-interestIncome.*  Non-interestincome was $6.0 million for the six months ended December 31, 2008 ascompared to $5.8 million for the same period in the prior fiscal year, anincrease of $197,000, or 3.4%.  Theincrease in non-interest income was attributable to increases of $301,000 infees on deposits, $44,000 in loan servicing income, and $125,000 in net gain onsale of securities.  These increases werepartially offset by a decrease of $162,000 in net gain on sale of loans and adecrease of $123,000 in trust income for the six months ended December 31,2008 as compared to the same period in the prior fiscal year.

 

Fees on depositsincreased $301,000, or 10.9% for the six months ended December 31, 2008 ascompared to the same period in the prior fiscal year primarily due to increasedpoint-of-sale interchange revenue and fee schedule adjustments.  Loan servicing income increased $44,000, or4.2% primarily due to an increase of $38.0 million in the balances of loansserviced by the Bank from $1.03 billion at December 31, 2007 to $1.06billion at December 31, 2008.  Netgain on sale of securities increased $125,000 for the six months ended December 31,2008 as compared to the same period in the prior fiscal year primarily due tothe sale of securities, which did not occur in the prior year.

 

*Non-interestExpense.*  Non-interestexpense was $17.6 million for the six months ended December 31, 2008 ascompared to $14.9 million for the six months ended December 31, 2007, anincrease of $2.7 million, or 18.4%.  Theincrease in non-interest expense was primarily due to increases in compensationand employee benefits of $1.7 million, marketing of $105,000, foreclosed realestate and other properties, net of $133,000, and other non-interest expense of$647,000.

 

Compensation and employeebenefits increased $1.7 million, or 18.6%, from $9.2 million for the six monthsended December 31, 2007 to $10.9 million for the six months ended December 31,2008.  Employee compensation increased$562,000, or 9.1%, variable pay relating to employee incentives and commissionsincreased $480,000, or 58.1% and net healthcare costs increased $673,000, or106.7%.  Employee compensation increaseddue to annual raises awarded and additional personnel since the six monthperiod ended December 31, 2007. Variable pay relating to employee incentive programs increased due tohigher production and net income. Healthcare costs increased as a result of higher claim activity in thesecond quarter of Fiscal  2009.  Management continues to believe theself-insured structure is a reasonable alternative to traditional healthcareplans over the long term.  The level ofhealthcare costs which the Company incurs may vary from year to year, and theincrease in net healthcare costs does not necessarily indicate a trend.

 

Marketing increased$105,000 from $562,000 for the six months ended December 31, 2007 to$667,000 for the six months ended December 31, 2008 due to increasedpromotional activities.

 

Foreclosed real estateand other properties, net, increased by $133,000 to $213,000 for the six monthsended December 31, 2008 as compared to the same period in the prior fiscalyear due to increased activity in repossessed equipment.

 

Other non-interestexpenses rose $647,000 largely due to increases in federal deposit insurancepremiums of $216,000, legal and professional expenses of $302,000, andcommunity investment contributions of $52,000. Previously, the Company had credits to offset federal deposit insurancepremiums.  No future credits exist tooffset this cost in the future.  Legaland consulting costs increased due in part to a lawsuit, which was settled inthe second quarter of Fiscal 2009, in addition to legal review costs related tothe participation in the CPP as mentioned earlier.  Community investment contributions increasedprimarily due to the timing for which these investments were incurred.  Some of the investments incurred werepreviously incurred in third quarter of Fiscal 2008.  There has not been a large increase in newcommunity investments from the prior fiscal year.

 

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*Income tax expense.*  The Company’s income tax expense for the sixmonths ended December 31, 2008 increased $512,000 or 37.2% to $1.9 millioncompared to $1.4 million for the same period in the prior fiscal year.  The effective tax rate was 33.1% and 34.6%for the six months ended December 31, 2008 and 2007, respectively.

 

**Liquidity and Capital Resources**

 

The Bank’s primarysources of funds are earnings, in-market deposits, FHLB advances and otherborrowings, repayments of loan principal, mortgage-backed securities andcallable agency securities and, to a lesser extent, sales of mortgage loans,sales and maturities of securities, out-of-market deposits and short-terminvestments.  While scheduled loanpayments and maturing securities are relatively predictable, deposit flows andloan and security prepayments are more influenced by interest rates, generaleconomic conditions and competition. The Bank attempts to price its deposits tomeet its asset/liability objectives consistent with local marketconditions.  Excess balances are investedin overnight funds.

 

Liquidity management isboth a daily and long-term responsibility of management.  The Bank adjusts its investments in liquidassets based upon management’s assessment of (i) expected loan demand, (ii) projectedloan sales, (iii) expected deposit flows, (iv) yields available oninterest-bearing deposits, and (v) the objectives of its asset/liabilitymanagement program.  Excess liquidity isinvested generally in interest-bearing overnight deposits and other short-termgovernment and agency obligations.

 

The Bank anticipates itwill have sufficient funds available to meet current loan commitments.  At December 31, 2008, the Bank hadoutstanding commitments to originate and purchase mortgage and commercial loansof $29.0 million.  In addition, the Bankhad outstanding commitments to sell mortgage loans of $20.1 million.  Commitments by the Bank to originate loans arenot necessarily executed by the customer. The Bank monitors the ratio of commitments to funding for use inliquidity management.  At December 31,2008, the Bank had no outstanding commitments to purchase investment securitiesavailable for sale and no commitments to sell investment securities availablefor sale.

 

Although in-marketdeposits are the Bank’s primary source of funds, the Bank’s policy has been toutilize borrowings where the funds can be invested in either loans orsecurities at a positive rate of return or to use the funds for short-termliquidity purposes.  The Bank hasunsecured federal funds accommodations totaling $15.0 million withcorrespondent banks.  In addition, theCompany has a revolving line of credit totaling $6.0 million with acorrespondent bank.  There were no fundsdrawn on either line of credit at December 31, 2008.  Additionally, as of December 31, 2008,the Bank had $22.6 million in out-of-market certificates of deposit.  The Bank may also seek other sources ofcontingent liquidity including additional federal funds purchased lines withcorrespondent banks and lines of credit with the Federal Reserve Bank.

 

The Company uses its capital resources to paydividends to its stockholders, to repurchase Company stock pursuant to Board ofDirectors approved plans, to support organic growth, to make acquisitions, toservice its debt obligations and to provide funding for investment into theBank of Tier 1 (core) capital.

 

In conjunction with theCompany’s participation in the CPP, the Company’s Board of Directors terminatedthe stock buyback program in the second quarter which had been in place throughNovember 21, 2008, in which up to 10% of the common stock of the Companyoutstanding on May 1, 2008 could be acquired through April 30,2009.  See Part II, Item 2 “UnregisteredSales of Equity Securities and Use of Proceeds” of this Form 10-Q for moredetails.

 

Savings institutionsinsured by the Federal Deposit Insurance Corporation are required by theFinancial Institutions Reform, Recovery and Enforcement Act of 1989 to meetthree regulatory capital requirements. If a requirement is not met, regulatory authorities may take legal oradministrative actions, including restrictions on growth or operations or, inextreme cases, seizure.  Institutions notin compliance may apply for an exemption from the requirements and submit arecapitalization plan.  At December 31,2008, the Bank met all current regulatory capital requirements.

 

The minimum OTS Tier 1(core) capital requirement for well-capitalized institutions is 5.00% of totaladjusted assets for thrifts.  The Bankhad Tier 1 (core) capital of 8.00% at December 31, 2008.  The minimum OTS total risk-based capitalrequirement for well-capitalized institutions is 10.00% of risk-weightedassets.  The Bank had total risk-basedcapital of 11.40% at December 31, 2008.

 

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**Impact of Inflation and ChangingPrices**

 

The unauditedconsolidated financial statements and notes thereto presented in this QuarterlyReport on Form 10-Q have been prepared in accordance with GAAP, whichrequire the measurement of financial position and operating results in terms ofhistorical dollars without considering the change in the relative purchasingpower of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Bank’soperations.  Unlike most industrialcompanies, nearly all the assets and liabilities of the Bank are monetary innature.  As a result, interest rates havea greater impact on the Bank’s performance than do the effects of generallevels of inflation.  Interest rates donot necessarily move in the same direction or to the same extent as the pricesof goods and services.

 

**Recent Accounting Pronouncements**

 

In September 2006,FASB issued Statement of Financial Accounting Standards No. 157 (SFAS157), “Fair Value Measurements.”  SFAS157 provides a common definition of fair value and a framework for measuringassets and liabilities at fair values when a particular standard prescribesit.  In addition, the Statement expandsdisclosures about fair value measurements. The Company adopted SFAS No. 157 effective July 1, 2008, andthe adoption did not have a material impact on its results of operations,financial position, and liquidity.

 

In February 2007,FASB issued Statement of Financial Accounting Standards No. 159 (SFAS159), “The Fair Value Option for Financial Assets and Financial Liabilities —Including an Amendment of FASB Statement No. 115.”  SFAS 159 allows companies the choice tomeasure many financial instruments and certain other items at fair value.  This gives a company the opportunity tomitigate volatility in reported earnings caused by measuring related assets andliabilities differently without having to apply complex hedge accountingprovisions.  The Company adopted SFAS No. 159effective July 1, 2008, and the adoption did not have a material impact onits results of operations, financial position, and liquidity.  The Company did not adopt fair value for anyadditional financial instruments or other items.

 

In December 2007, FASB issued Statement ofFinancial Accounting Standards No. 141R (SFAS 141R), “BusinessCombinations.”  SFAS 141R improvesreporting by creating greater consistency in the accounting and financialreporting of business combinations, resulting in more complete, comparable, andrelevant information for investors and other users of financialstatements.  SFAS 141R is effective July 1,2009.  Management has reviewed SFAS 141Rand does not expect the adoption of this statement to have a material impact onthe Company’s consolidated financial condition, results of operations or cashflow.

 

In December 2007, FASB issued Statement ofFinancial Accounting Standards No. 160 (SFAS 160), “NoncontrollingInterests in Consolidated Financial Statements — an amendment of ARB No. 51.”  SFAS 160 is effective for the Companybeginning July 1, 2009.  SFAS 160improves the relevance, comparability, and transparency of financialinformation provided to investors by requiring all entities to reportnoncontrolling (minority) interest in subsidiaries in the same way — as equityin the consolidated financial statements. The Company does not currently have any noncontrolling interest in theconsolidated financial statements.

 

In March 2008, FASB issued Statement of FinancialAccounting Standards No. 161 (SFAS 161), “Disclosures about DerivativeInstruments and Hedging Activities.” SFAS 161 is intended to improve financial reporting about derivative instrumentsand hedging activities by requiring enhanced disclosures to enable investors tobetter understand their effects on an entity’s financial position, financialperformance, and cash flows.  The Companywill adopt SFAS 161 effective January 1, 2009.  Management has reviewed SFAS 161 and does notexpect the adoption of this statement to have a material impact on the Company’sconsolidated financial condition, results of operations or cash flow.

 

In May 2008, the FASB issued SFAS No. 162, “TheHierarchy of Generally Accepted Accounting Principles” (SFAS 162).  This statement makes the hierarchy explicitlyand directly applicable to preparers of financial statements, a step thatrecognizes preparers’ responsibilities for selecting the accounting principlesfor their financial statements.  SFAS 162provides for slight modifications to the current hierarchy in place by addingFASB Staff Positions, Statement 133 Implementation Issues, and EITF D-Topics toit.  The Company adopted SFAS No. 162effective November 15, 2008, and the adoption did not have a materialimpact on its results of consolidated financial condition, results ofoperations or cash flow.

 

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In May 2008,the FASB issued SFAS No. 163, “Accounting for Financial GuaranteeInsurance Contracts – An Interpretation of FASB Statement No. 60” (SFAS163).  This statement requires that aninsurance enterprise recognize a claim liability prior to an event of defaultwhen there is evidence that credit deterioration has occurred in an insuredfinancial obligation.  SFAS 163 alsoclarifies how Statement 60 applies to financial guarantee insurance contracts,including the recognition and measurement to be used to account for premiumrevenue and claim liabilities.  Expandeddisclosures about financial guarantee insurance contracts are also required bythis statement.  SFAS 163 is effective July 1,2009.  The Company is in the process ofassessing the impact on its results of operations, financial position, and cashflow.

 

In October 2008,the FASB issued SFAS No. 157-3, which clarifies the application of SFAS157, *Fair Value Measurements*, in an inactivemarket and illustrates how an entity would determine fair value when the marketfor a financial asset is not active.  TheFSP states that an entity should not automatically conclude that a particulartransaction price is determinative of fair value.  In a dislocated market, judgment is requiredto evaluate whether individual transactions are forced liquidations ordistressed sales.  When relevant observablemarket information is not available, a valuation approach that incorporatesmanagement’s judgments about the assumptions that market participants would usein pricing the asset in a current sale transaction would be acceptable.  The FSP also indicates that quotes frombrokers or pricing services may be relevant inputs when measuring fair value,but are not necessarily determinative in the absence of an active market forthe asset.  The FSP is effectiveimmediately and applies to prior periods for which financial statements havenot been issued, including interim or annual periods ending on or before September 30,2008. Accordingly, we adopted the FSP beginning July 1, 2008.  The adoption of the FSP did not have amaterial impact on our financial results or fair value determinations.

 

In December 2008,the FASB issued Staff Position No. FAS 132(R)-1, amending the disclosureguidance in FASB Statement No. 132, “Employers’ Disclosures about Pensionsand Other Postretirement Benefits”.  TheFSP states  that the purpose is toincrease the transparency in the disclosure of Postretirement Benefit PlanAssets and to provide users an understanding of the following:  investment allocation decision-making,including the factors that are pertinent to the investment policies andstrategies; the major categories of plan assets; the valuation techniques usedto measure the fair value of plan assets, the effect of fair value measurementsusing significant unobservable inputs (Level 3) on changes in plan assets forthe period; and significant concentrations of risk with plan assets.  FAS 132(R)-1 is effective for annualreporting for the fiscal year beginning July 1, 2009.  The Company is in the process of assessingthe impact on its results of operations, financial position, and cash flow.

 

In December 2008, the FASB issued Staff Position No. FAS140-4, amending FASB Statement No. 140, “Accounting for Transfers andServicing of Financial Assets and Extinguishments of Liabilities”.  It also amends FASB Interpretation No. 46“Consolidation of Variable Interest Entities” to require public enterprises toprovide additional disclosures about their involvement with variable interestentities.  FAS 140-4 is effectiveimmediately and management does not expect the adoption of this statement tohave a material impact on the Company’s consolidated financial condition,results of operations or cash flow.

 

In January 2009,the FASB issued Staff Position No. EITF 99-20-1, amending the impairmentguidance in EITF Issue No. 99-20, “Recognition of Interest Income andImpairment on Purchased Beneficial Interests and Beneficial Interests ThatContinue to Be Held by a Transferor in Securitized Financial Assets,” (EITF99-20-1).  For debt securities that arenot within the scope of Issue 99-20, SFAS No. 115 applies.  SFAS No. 115 does not require exclusivereliance on market participant assumptions about future cash flows.  Rather, SFAS No. 115 permits the use ofreasonable management judgment of the probability that the holder will beunable to collect all amounts due.  TheFSP is effective immediately and the application of the FSP did not have amaterial impact on our financial results or fair value determinations.

 

**Item 3.                    Quantitativeand Qualitative Disclosures About Market Risk**

 

The Company’s netincome is largely dependent on its net interest income.  Net interest income is susceptible tointerest rate risk to the degree that interest-bearing liabilities with short-and medium-term maturities mature or reprice more rapidly than itsinterest-earning assets.  When interest-bearingliabilities mature or reprice more quickly than interest-earning assets in agiven period, a significant increase in market rates of interest couldadversely affect net interest income. Similarly, when interest-earning assets mature or reprice more quicklythan interest-bearing liabilities, falling interest rates could result in adecrease in net income.

 

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In an attempt to manage its exposure to change in interest rates,management monitors the Company’s interest rate risk.  The Company’s Asset/Liability Committee meetsperiodically to review the Company’s interest rate risk position andprofitability, and to recommend adjustments for consideration by executivemanagement.  Management also reviews theBank’s securities portfolio, formulates investment strategies, and oversees thetiming and implementation of transactions to assure attainment of the Board’sobjectives in the most effective manner. In managing market risk and the asset/liability mix, the Bank has placedits emphasis on developing a portfolio in which, to the extent practicable,assets and liabilities reprice within similar periods.  Notwithstanding the Company’s interest raterisk management activities, the potential for changing interest rates is anuncertainty which may have an adverse effect on net income.

 

The Companyadjusts its asset/liability position to mitigate the Company’s interest raterisk.  At times, depending on the levelof general interest rates, the relationship between long- and short-terminterest rates, market conditions and competitive factors, management mayincrease the Company’s interest rate risk position in order to increase its netinterest margin.  The Company’s resultsof operations and net portfolio values remain vulnerable to increases ininterest rates and to fluctuations in the difference between long- andshort-term interest rates.

 

As set forth below, the volatility of a rate change, the change in assetor liability mix of the Company or other factors may produce a decrease in netinterest margin in an upward moving rate environment even as the net portfoliovalue (“NPV”) estimate indicates an increase in net value.  The inverse situation may also occur.  One approach used by the Company to quantifyinterest rate risk is an NPV analysis. This analysis calculates the difference between the present value of theliabilities and the present value of expected cash flows from assets andoff-balance sheet contracts.  Thefollowing tables set forth, at December 31, 2008 and 2007, respectively,an analysis of the Company’s interest rate risk as measured by the estimatedchanges in NPV resulting from instantaneous and sustained parallel shifts inthe yield curve.  Management does notbelieve that the Company has experienced any material changes in its marketrisk position from that disclosed in the Company’s Annual Report on Form 10-Kfor Fiscal 2008 or that the Company’s primary market risk exposures and how thoseexposures were managed during the six months ended December 31, 2008changed significantly when compared to June 30, 2008.

 

Even if interest rates change in the designated amounts, there can beno assurance that the Company’s assets and liabilities would perform as setforth below.  In addition, a change inU.S. Treasury rates in the designated amounts accompanied by a change in theshape of the Treasury yield curve would cause significantly different changesto the NPV than indicated below.

 
| **December 31, 2008** | ** ** |
|---------------------------------|------------|
| ** **                      | ** ** | ** ** | ** ** | **Estimated Increase** | ** ** |
| **Change in**              | ** ** | **Estimated** | ** ** | **(Decrease) in NPV** | ** ** |
| **Interest Rates**         | ** ** | **NPV Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Basis Points**                | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
|                            |       |   |   |   |   |   |   |
| +300                            |       | $ | 106,719 |   | $ | (6,122 | ) | (5 | )% |
| +200                            |       | 111,462 |   | (1,379 | ) | (1 | ) |
| +100                            |       | 114,871 |   | 2,030 |   | 2 |   |
| —                          |       | 112,841 |   | — |   | — |   |
| -100                            |       | 105,266 |   | (7,575 | ) | (7 | ) |
|                                 |            |  |  |  |  |  |  |  |  |

 

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| **December 31, 2007** | ** ** |
|---------------------------------|------------|
| ** **                      | ** ** | ** ** | ** ** | **Estimated Increase** | ** ** |
| **Change in**              | ** ** | **Estimated** | ** ** | **(Decrease) in NPV** | ** ** |
| **Interest Rates**         | ** ** | **NPV Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Basis Points**                | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
|                            |       |   |   |   |   |   |   |
| +300                            |       | $ | 100,026 |   | $ | (23,435 | ) | (19 | )% |
| +200                            |       | 109,065 |   | (14,396 | ) | (12 | ) |
| +100                            |       | 117,085 |   | (6,376 | ) | (5 | ) |
| —                          |       | 123,461 |   | — |   | — |   |
| -100                            |       | 125,554 |   | 2,093 |   | 2 |   |
| -200                            |       | 124,386 |   | 925 |   | 1 |   |
|                                 |            |  |  |  |  |  |  |  |  |

 

In managing market risk and the asset/liability mix,the Bank has placed an emphasis on developing a portfolio in which, to theextent practicable, assets and liabilities reprice within similar periods.  The goal of this policy is to provide arelatively consistent level of net interest income in varying interest ratecycles and to minimize the potential for significant fluctuations from periodto period.

 

**Item 4.                    Controlsand Procedures**

 

The Company’s management hasevaluated, under the supervision and with the participation of the Company’sChairman, President and Chief Executive Officer and the Company’s ExecutiveVice President, Chief Financial Officer and Treasurer, the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures, asdefined in Rule 13a-15(e), and have concluded that, as of the end of theperiod covered by this Quarterly Report, the Company’s disclosure controls andprocedures are effective for gathering, analyzing and disclosing informationthe Company is required to disclose in its periodic reports filed under theExchange Act.  There were no significantchanges in the Company’s internal control over financial reporting during theperiod covered by the Quarterly Report that materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.                    Legal Proceedings**

 

On June 26, 2006, the Company filed a $3.8 million lawsuit against MetaBank and two individuals, J. Tyler Haahr and DanielA. Nelson, for their role in a participation loan,alleging fraud, breach of fiduciary duty, conspiracy and negligentmisrepresentation.  These damages were the result of a failure by the leadbank to make disclosures regarding an investigation of the commercial customerby the Iowa Attorney General at the time the Bank agreed to an extension ofloan participation agreements.  Asreferenced in the 8-K filed October 27, 2008, the lawsuit was settled for$2.8 million inclusive of the remaining amount of receivables from certain loanparticipation interests of $223,000.  Thesettlement amount, less attorney fees of $292,000, was recorded as a net loanloss recovery of $2.2 million in the second quarter of Fiscal 2009.  No further action or expense relating to thismatter is expected in the future.

 

In addition, the Company,the Bank and each of their subsidiaries are, from time to time, involved asplaintiff or defendant in various legal actions arising in the normal course oftheir businesses.  While the ultimateoutcome of any such proceedings cannot be predicted with certainty, it isgenerally the opinion of management, after consultation with counselrepresenting the Bank and the Company in any such proceedings, the resolutionof any such proceedings should not have a material effect on the Company’sconsolidated financial position or results of operations.  The Company, the Bank and each of theirsubsidiaries are not aware of any legal actions or other proceedingscontemplated by governmental authorities outside of the normal course ofbusiness.

 

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**Item 1A.                 Risk Factors**

 

There have been nomaterial changes from the risk factors disclosed in Part 1, Item 1A “RiskFactors” in the Company’s Annual Report on Form 10-K for Fiscal 2008.

 

**Item 2.                    Unregistered Sales of Equity Securities andUse of Proceeds**

 

The followingtable sets forth the purchases by the Company of its common stock and theremaining amount that can be purchased in the current program during thequarterly period ended December 31, 2008:

 
| ** **                        | ** ** | **Total**                                   | ** ** | ** **          | ** ** | **Total Number**                  | ** ** | **Maximum Number of**        | ** ** |
|-----------------------------------|------------|---------------------------------------------|------------|---------------------|------------|----------------------------------------|------------|----------------------------------------|------------|
| ** **                        | ** ** | **Number**                                  | ** ** | **Average**         | ** ** | **of Shares Purchased**      | ** ** | **Shares that May Yet** | ** ** |
| ** **                        | ** ** | **of Shares**                          | ** ** | **Price Paid** | ** ** | **as Part of Publicly** | ** ** | **Be Purchased Under**       | ** ** |
| **Period**                        | ** ** | **Purchased**                               | ** ** | **per Share**  | ** ** | **Announced Programs**            | ** ** | **the Current Program**      | ** ** |
| October 1 - 31, 2008         |       | —                                      |       | $                   | 0.00       |                                   | —     |                                   | 388,794    |   |
| November 1 - 21, 2008        |       | —                                      |       | $                   | 0.00       |                                   | —     |                                   | 388,794    |   |
| Nov. 22 - Dec. 31, 2008 |       | TERMINATION OF  PROGRAM-NO SHARES AVAILABLE |       | 0                   |       |
| 2nd Quarter  Total                |       | —                                      |       | $                   | 0.00       |                                   | —     |                                   |       |   |

 

In conjunctionwith the Company’s participation in the CPP, the Company’s Board of Directorsterminated the stock buyback program in the second quarter which had been inplace through November 21, 2008, in which up to 10% of the common stock ofthe Company outstanding on May 1, 2008 could be acquired through April 30,2009.

 

**Item 4.                    Submission of Matters toa Vote of Security Holders**

 

At the Company’sAnnual Meeting of Stockholders held on November 19, 2008, (the “AnnualMeeting”), the stockholders elected the three individuals nominated to serve asClass III directors until 2011 or until their respective successors areelected and qualified, as set forth in Proposal 1 in the Company’s ProxyStatement relating to the Annual Meeting. The three individuals elected, and the number of votes cast for, orwithheld, with respected to each of them, is as follows:

 
| Curtis L. Hage        |   | For: 2,920,856 |   | Vote Withheld: 192,221 |
|-----------------------|--------|----------------|--------|------------------------|
| Christine E. Hamilton |   | For: 2,938,563 |   | Vote Withheld: 174,513 |
| Thomas L. Van Wyhe    |   | For: 2,942,957 |   | Vote Withheld: 170,121 |

 

The followingdirectors continue to serve on the Board of Directors following the AnnualMeeting:  Curtis J. Bernard, Charles T.Day, Robert L. Hanson and Wm. G. Pederson.

 

The Company alsovoted and approved the ratification of the re-appointment of Eide Bailly, LLPas the Company’s auditors for fiscal year ending June 30, 2009.  The number of votes for ratification and therelated percentage of votes actually cast are as follows:

 
| For:     | 3,077,299 |   | Actually Cast: | 98.85% |   |
|----------|-----------|--------|----------------|--------|--------|
| Against: | 17,100    |   | Actually Cast: | 0.55%  |   |
| Abstain: | 18,679    |   | Actually Cast: | 0.60%  |   |

 

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**Item 6.                    Exhibits**

 
| **Regulation  S-K   Exhibit Number** | ** ** | **Document**                                                                                                                                      |
|-------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                                      |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                 |
| 31.2                                      |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1                                      |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                 |
| 32.2                                      |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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**HF FINANCIAL CORP.**

 

**FORM 10-QSIGNATURES**

 

Pursuant to therequirements of the Securities Exchange Act of 1934, the registrant has dulycaused this report to be signed on its behalf by the undersigned thereunto dulyauthorized.

 

 
|   |                   |   | HF  Financial Corp.                            |
|--------|------------------------|--------|------------------------------------------------|
|   |                   |   |                                           |   |
|   |                   |   | (Registrant)                                   |
|   |                   |   |                                           |
| Date:  | February 12, 2009 |   | By:                                            |      /s/  Curtis L. Hage |
|   |                   |   | Curtis L. Hage,  Chairman, President           |
|   |                   |   | and Chief Executive  Officer                   |
|   |                   |   | (Principal Executive  Officer)                 |
|   |                   |   |                                           |
| Date:  | February 12, 2009 |   | By:                                            |      /s/  Darrel L. Posegate |
|   |                   |   | Darrel L. Posegate,  Executive Vice President, |
|   |                   |   | Chief Financial Officer  and Treasurer         |
|   |                   |   | (Principal Financial  and Accounting Officer)  |
|        |                        |        |                                                |  |  |  |  |

 

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**Index to Exhibits**

 
| **Exhibit Number** | ** ** | ** **                                                                                                                                        |
|-------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
| 31.1                    |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002                 |
| 31.2                    |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 302 of the Sarbanes-Oxley Act of 2002 |
| 32.1                    |       | Certification  of Chairman, President and Chief Executive Officer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002                 |
| 32.2                    |       | Certification  of Executive Vice President, Chief Financial Officer and Treasurer Pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

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