**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**WASHINGTON, D.C.  20549**

 

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**FORM 10-Q**

 

**x****        QUARTERLY REPORT PURSUANTTO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period ended September 30, 2007**

 

**Commission File Number: 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 Identification Number) |
| incorporation or organization)          |       |                                    |
|                                    |       |                                    |
| **225 South Main Avenue,**              | ** ** | ** **                              |
| **Sioux Falls, SD**                     | ** ** | **57104**                               |
| (Address of principal executive office) |       | (ZIP Code)                              |

 

**(605) 333-7556**

(Registrant’s telephone number, includingarea code)

 

Indicate bycheck mark whether the registrant  (1)has filed all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2)has been subject to such filing requirements for the past 90 days.  YES x    NO o

 

Indicate by checkmark whether the registrant is a large accelerated filer, an accelerated fileror a non-accelerated filer.  Seedefinition of “accelerated filer and large accelerated filer” in Rule 12b-2 ofthe Exchange Act.

 

LARGE ACCELERATED FILER o    ACCELERATED FILER o     NON-ACCELERATED FILER x

 

Indicate by check mark whether the registrant is a shellcompany (as defined in Rule 12b-2 of the Exchange Act).   YES o   NO x

 

Indicatethe number of shares outstanding of each of the issuer’s classes of common stock,as of the latest practicable date.

 

Asof November 8, 2007 there were 3,971,124 issued and outstanding shares of theRegistrant’s Common Stock, with $.01 par value per share.

 

 

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**HF FINANCIAL CORP.**

 

**Form 10-Q**

 

**Table of Contents**

 
| ** **                              | **Page  Number**                                                                               |
|-----------------------------------------|------------------------------------------------------------------------------------------------|
| **PART I – FINANCIAL INFORMATION** | ** **                                                                                     |
| ** **                              | ** **                                                                                     | ** ** |
| Item 1.                                 | Financial Statements (Unaudited):                                                              |   |
|                                    |                                                                                           |   |
|                                    | Consolidated Statements of Financial  Condition As of September 30, 2007 and June 30, 2007     | 1 |
|                                    |                                                                                           |   |
|                                    | Consolidated Statements of Income for the Three  Months Ended September 30, 2007 and 2006      | 2 |
|                                    |                                                                                           |   |
|                                    | Consolidated  Statements of Cash Flows for the Three Months Ended September 30, 2007 and  2006 | 3 |
|                                    |                                                                                           |   |
|                                    | Notes to Consolidated Financial Statements                                                     | 5 |
|                                    |                                                                                           |   |
| Item  2.                                | Management’s  Discussion and Analysis of Financial Condition and Results of Operations    | 14 |
|                                    |                                                                                           |   |
| Item 3.                                 | Quantitative  and Qualitative Disclosures about Market Risk                                    | 31 |
|                                    |                                                                                           |   |
| Item 4.                                 | Controls and Procedures                                                                        | 32 |
|                                    |                                                                                           |   |
| **PART II – OTHER INFORMATION**    |                                                                                           |
|                                    |                                                                                           |   |
| Item 1.                                 | Legal Proceedings                                                                              | 33 |
|                                    |                                                                                           |   |
| Item  1A.                               | Risk  Factors                                                                                  | 33 |
|                                    |                                                                                           |   |
| Item 2.                                 | Unregistered  Sales of Equity Securities and Use of Proceeds                                   | 33 |
|                                    |                                                                                           |   |
| Item 6.                                 | Exhibits                                                                                       | 34 |
|                                    |                                                                                           |   |
| Form 10-Q                               | Signature Page                                                                                 | 35 |

 

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**PART I – FINANCIAL INFORMATION**

 

**Item 1.    FinancialStatements**

 

**HF FINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

**(Dollars in Thousands)**

 
| ** **                                                                                                                                                | ** ** | **September 30, 2007** | ** ** | **June 30, 2007** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|-------------------|------------|
| ** **                                                                                                                                                | ** ** | **(Unaudited)**        | ** ** | **(Audited)**     | ** ** |
| **ASSETS**                                                                                                                                                |       |                   |       |              |       |
| Cash and cash equivalents                                                                                                                                 |       | $                      | 17,082     |              | $          | 22,476 |   |
| Securities available for sale                                                                                                                             |       | 154,700                |       | 142,223           |       |
| Federal Home Loan Bank stock                                                                                                                              |       | 6,876                  |       | 5,058             |       |
| Loans held for sale                                                                                                                                       |       | 7,872                  |       | 8,776             |       |
| Loans and leases receivable                                                                                                                               |       | 772,446                |       | 767,471           |       |
| Allowance for loan and lease losses                                                                                                                       |       | (5,493                 | )          | (5,872            | )          |
| Net loans and leases receivable                                                                                                                           |       | 766,953                |       | 761,599           |       |
|                                                                                                                                                      |       |                   |       |              |       |
| Accrued interest receivable                                                                                                                               |       | 10,289                 |       | 8,495             |       |
| Office properties and equipment, net of  accumulated depreciation                                                                                         |       | 15,958                 |       | 15,830            |       |
| Foreclosed real estate and other properties                                                                                                               |       | 300                    |       | 508               |       |
| Cash value of life insurance                                                                                                                              |       | 13,651                 |       | 13,519            |       |
| Servicing rights                                                                                                                                          |       | 11,175                 |       | 10,871            |       |
| Goodwill, net                                                                                                                                             |       | 4,951                  |       | 4,951             |       |
| Other assets                                                                                                                                              |       | 5,969                  |       | 7,148             |       |
| Total assets                                                                                                                                              |       | $                      | 1,015,776  |              | $          | 1,001,454 |   |
|                                                                                                                                                      |       |                   |       |              |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                             | ** ** | ** **             | ** ** | ** **        | ** ** |
| **LIABILITIES**                                                                                                                                           | ** ** | ** **             | ** ** | ** **        | ** ** |
| Deposits                                                                                                                                                  |       | $                      | 772,360    |              | $          | 815,864 |   |
| Advances from Federal Home Loan Bank and  other borrowings                                                                                                |       | 121,220                |       | 68,600            |       |
| Subordinated debentures payable to trusts                                                                                                                 |       | 27,837                 |       | 27,837            |       |
| Advances by borrowers for taxes and  insurance                                                                                                            |       | 14,422                 |       | 10,337            |       |
| Accrued expenses and other liabilities                                                                                                                    |       | 16,793                 |       | 16,546            |       |
| Total liabilities                                                                                                                                         |       | 952,632                |       | 939,184           |       |
|                                                                                                                                                      |       |                   |       |              |       |
| **STOCKHOLDERS’ EQUITY**                                                                                                                             | ** ** | ** **             | ** ** | ** **        | ** ** |
| Preferred stock, $.01 par value, 500,000  shares authorized, none outstanding                                                                             |       | —                 |       | —            |       |
| 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, 6,012,378 and 5,991,200 shares issued at September 30,  2007 and June 30, 2007, respectively |       | 60                     |       | 60                |       |
| Common stock subscribed for but not issued,  5,146 shares at June 30, 2007                                                                                |       | —                 |       | 81                |       |
| Additional paid-in capital                                                                                                                                |       | 21,359                 |       | 20,898            |       |
| Retained earnings, substantially restricted                                                                                                               |       | 72,825                 |       | 71,900            |       |
| Accumulated other comprehensive income  (loss), net of related deferred tax effect                                                                        |       | (785                   | )          | (1,502            | )          |
| Less cost of treasury stock, 2,047,836 and  1,977,836 shares at September 30, 2007 and June 30, 2007, respectively                                        |       | (30,315                | )          | (29,167           | )          |
| Total stockholders’ equity                                                                                                                           |       | 63,144                 |       | 62,270            |       |
| Total liabilities and stockholders’ equity                                                                                                           |       | $                      | 1,015,776  |              | $          | 1,001,454 |   |

 

*See accompanying notes to unauditedconsolidated financial statements.*

 

1

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**HF FINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(Dollars in Thousands, Except Per Share Data)**

**(Unaudited)**

 
| ** **                                                              | ** ** | **Three Months Ended** | ** ** |
|-------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                              | ** ** | **September 30,**      | ** ** |
| ** **                                                              | ** ** | **2007**               | ** ** | **2006** | ** ** |
| Interest, dividend and loan fee income:                                 |       |                   |       |   |   |
| Loans and leases receivable                                             |       | $                      | 14,120     |   | $ | 13,240 |   |
| Investment securities and interest-earning  deposits                    |       | 1,865                  |       | 1,838 |   |
|                                                                    |       | 15,985                 |       | 15,078 |   |
| Interest expense:                                                       |       |                   |       |   |   |
| Deposits                                                                |       | 7,498                  |       | 6,541 |   |
| Advances from Federal Home Loan Bank and  other borrowings              |       | 1,819                  |       | 2,119 |   |
|                                                                    |       | 9,317                  |       | 8,660 |   |
| **Net interest income**                                                 |       | 6,668                  |       | 6,418 |   |
| ** **                                                              | ** ** | ** **             | ** ** | ** ** | ** ** |
| Provision for losses on loans and leases                                |       | 325                    |       | 291 |   |
|                                                                    |       |                   |       |   |   |
| **Net interest income after provision for  losses on loans and leases** |       | 6,343                  |       | 6,127 |   |
| ** **                                                              | ** ** | ** **             | ** ** | ** ** | ** ** |
| Noninterest income:                                                     |       |                   |       |   |   |
| Fees on deposits                                                        |       | 1,413                  |       | 1,193 |   |
| Loan servicing income                                                   |       | 505                    |       | 329 |   |
| Gain on sale of loans, net                                              |       | 259                    |       | 196 |   |
| Trust income                                                            |       | 249                    |       | 216 |   |
| Other                                                                   |       | 389                    |       | 410 |   |
|                                                                    |       | 2,815                  |       | 2,344 |   |
| Noninterest expense:                                                    |       |                   |       |   |   |
| Compensation and employee benefits                                      |       | 4,443                  |       | 4,156 |   |
| Occupancy and equipment                                                 |       | 937                    |       | 938 |   |
| Marketing                                                               |       | 263                    |       | 443 |   |
| Check and data processing expense                                       |       | 613                    |       | 552 |   |
| Other                                                                   |       | 888                    |       | 820 |   |
|                                                                    |       | 7,144                  |       | 6,909 |   |
| ** **                                                              | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Income before income taxes**                                          |       | 2,014                  |       | 1,562 |   |
| ** **                                                              | ** ** | ** **             | ** ** | ** ** | ** ** |
| Income tax expense                                                      |       | 667                    |       | 465 |   |
| **Net income**                                                          |       | $                      | 1,347      |   | $ | 1,097 |   |
|                                                                    |       |                   |       |   |   |
| **Comprehensive income**                                                |       | $                      | 2,064      |   | $ | 2,332 |   |
| **Cash dividends declared per share**                                   |       | $                      | 0.1075     |   | $ | 0.1050 |   |
| ** **                                                              | ** ** | ** **             | ** ** | ** ** | ** ** |
| **Earnings per share:**                                                 | ** ** | ** **             | ** ** | ** ** | ** ** |
| Basic                                                                   |       | $                      | 0.34       |   | $ | 0.28 |   |
| Diluted                                                                 |       | $                      | 0.33       |   | $ | 0.27 |   |

 

*Seeaccompanying notes to unaudited consolidated financial statements.*

 

2

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**HF FINANCIAL CORP. AND SUBSIDIARIES**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Dollars in Thousands)**

**(Unaudited)**

 
| ** **                                                                                    | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                    | ** ** | **2007**                             | ** ** | **2006** | ** ** |
| **Cash flows from operating activities**                                                      | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Net income                                                                                    |       | $                                    | 1,347      |   | $ | 1,097 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities:  |       |                                 |       |   |   |
| Provision for losses on loans and leases                                                      |       | 325                                  |       | 291 |   |
| Depreciation                                                                                  |       | 415                                  |       | 242 |   |
| Amortization of discounts and premiums on  securities and other                               |       | 505                                  |       | 269 |   |
| Stock based compensation                                                                      |       | 108                                  |       | 259 |   |
| Deferred income taxes (credits)                                                               |       | —                               |       | (12 | ) |
| Net change in loans held for resale                                                           |       | 1,163                                |       | (1,492 | ) |
| (Gain) on sale of loans, net                                                                  |       | (259                                 | )          | (196 | ) |
| Losses and provision for losses on sales of  foreclosed real estate and other properties, net |       | 2                                    |       | 19 |   |
| (Gain) loss on disposal of office  properties and equipment, net                              |       | —                               |       | 2 |   |
| Change in other assets and liabilities                                                        |       | (1,025                               | )          | 1,931 |   |
| Net cash provided by operating activities                                                     |       | 2,581                                |       | 2,410 |   |
|                                                                                          |       |                                 |       |   |   |
| **Cash flows from investing activities**                                                      | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Loan participations purchased                                                                 |       | (500                                 | )          | (6,010 | ) |
| Net change in loans outstanding                                                               |       | (5,361                               | )          | (14,557 | ) |
| Securities available for sale:                                                                |       | 9,451                                |       | 11,329 |   |
| Sales and maturities and repayments   Purchases                                               |       | (20,770                              | )          | (17,114 | ) |
| Purchase of Federal Home Loan Bank stock                                                      |       | (2,220                               | )          | (2,505 | ) |
| Redemption of Federal Home Loan Bank stock                                                    |       | 402                                  |       | 852 |   |
| Purchase of office properties and equipment                                                   |       | (543                                 | )          | (981 | ) |
| Purchase of servicing rights                                                                  |       | (550                                 | )          | (5,224 | ) |
| Proceeds from sale of foreclosed real  estate and other properties, net                       |       | 132                                  |       | 136 |   |
| Net cash (used in) investing activities                                                       |       | (19,959                              | )          | (34,074 | ) |
|                                                                                               |            |                                      |            |  |  |  |  |

 

*See accompanying notes to unaudited consolidated financialstatements.*

 

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| ** **                                                             | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                             | ** ** | **2007**                             | ** ** | **2006** | ** ** |
|                                                                   |       |                                 |       |   |   |
| **Cash flows from financing activities**                               | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Net increase (decrease) in deposit accounts                            |       | $                                    | (43,504    | ) | $ | (27,201 | ) |
| Proceeds of advances from Federal Home Loan  Bank and other borrowings |       | 311,767                              |       | 382,486 |   |
| Payments on advances from Federal Home Loan  Bank and other borrowings |       | (259,147                             | )          | (342,131 | ) |
| Proceeds from issuance of subordinated  debentures                     |       | 5,000                                |       | — |   |
| Redemption of subordinated debentures                                  |       | (5,000                               | )          | — |   |
| Increase (decrease) in advances by  borrowers                          |       | 4,085                                |       | 6,718 |   |
| Purchase of treasury stock                                             |       | (1,148                               | )          | — |   |
| Proceeds from issuance of common stock                                 |       | 353                                  |       | 80 |   |
| Cash dividends paid                                                    |       | (422                                 | )          | (406 | ) |
| Net cash provided by financing activities                              |       | 11,984                               |       | 19,546 |   |
|                                                                   |       |                                 |       |   |   |
| Increase (decrease) in cash and cash  equivalents                      |       | (5,394                               | )          | (12,118 | ) |
|                                                                   |       |                                 |       |   |   |
| Cash and cash equivalents                                              |       |                                 |       |   |   |
| Beginning                                                              |       | 22,476                               |       | 27,037 |   |
| Ending                                                                 |       | $                                    | 17,082     |   | $ | 14,919 |   |
|                                                                   |       |                                 |       |   |   |
| Supplemental Disclosures of Cash Flows Information                     |       |                                 |       |   |   |
| Cash payments for interest                                             |       | $                                    | 9,282      |   | $ | 7,999 |   |
| Cash payments for income and franchise  taxes, net                     |       | 364                                  |       | 27 |   |

 

*See accompanying notes to unaudited consolidated financialstatements.*

 

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**HF FINANCIAL CORP. AND SUBSIDIARIES**

**NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS**

For The Three Months Ended September 30,2007 and 2006

(Unaudited)

 

**NOTE1.                SELECTED ACCOUNTINGPOLICIES**

 

*Basis ofpresentation:*

 

Theconsolidated financial information of HF Financial Corp. (the “Company”) andits wholly-owned subsidiaries included in this Quarterly Report on Form 10-Q isunaudited.  However, in the opinion ofmanagement, adjustments (consisting of normal recurring adjustments) necessaryfor a fair presentation for the interim periods have been included.  Results for any interim period are notnecessarily indicative of results to be expected for the fiscal year.  Interim consolidated financial statements andthe notes thereto should be read in conjunction with the consolidated financialstatements and notes thereto included in the Company’s Annual Report on Form10-K for the fiscal year ended June 30, 2007 (“Fiscal 2007”), filed with theSecurities and Exchange Commission.  Theaccounting and reporting policies of the Company and its subsidiaries conformto accounting principles generally accepted in the United States of America (“GAAP”)and to general practice within the industry.

 

The interimconsolidated financial statements include the accounts of the Company, itswholly-owned subsidiaries, Home Federal Bank (the “Bank”), HF Financial Group,Inc. (“HF Group”) and HomeFirst Mortgage Corp. (the “Mortgage Corp.”), and theBank’s wholly-owned subsidiaries, Mid America Capital Services, Inc. (“MidAmerica Capital”), Hometown Insurors, Inc. (“Hometown”), Home FederalSecuritization Corp. (“HFSC”), Mid-America Service Corporation and PMD,Inc.  The interim consolidated financialstatements reflect the deconsolidation of the wholly-owned subsidiary trusts ofthe Company: 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”). Trust VI was formed during the fiscalfirst quarter ended September 30, 2007.  SeeNote 9 of “Notes to Consolidated Financial Statements.”  All intercompany balances and transactionshave been eliminated in consolidation.

 

 **NOTE 2.               REGULATORYCAPITAL**

 

Thefollowing table sets forth the Bank’s compliance with its minimum capital requirementsfor a well-capitalized institution at September 30, 2007:

 
| ** **                                         | ** ** | **Amount**                 | ** ** | **Percent** | ** ** |
|----------------------------------------------------|------------|----------------------------|------------|-------------|------------|
| ** **                                         | ** ** | **(Dollars in Thousands)** | ** ** |
| Tier I (core) capital (to adjusted total  assets): |       |                       |       |        |       |
| Required                                           |       | $                          | 50,511     |        | 5.00       | % |
| Actual                                             |       | 84,024                     |       | 8.32        |       |
| Excess over required                               |       | 33,513                     |       | 3.32        |       |
|                                               |       |                       |       |        |       |
| Risk-based capital (to risk-weighted  assets):     |       |                       |       |        |       |
| Required                                           |       | $                          | 80,902     |        | 10.00      | % |
| Actual                                             |       | 89,408                     |       | 11.05       |       |
| Excess over required                               |       | 8,506                      |       | 1.05        |       |

 

**NOTE 3.                EARNINGS PER SHARE**

 

Basicearnings per share is computed by dividing income available to commonstockholders (the numerator) by the weighted-average number of common sharesoutstanding  (the denominator) during theperiod.  Shares issued

 

5

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duringthe period and shares reacquired during the period are weighted for the portionof the period they were outstanding. The weighted average number of basiccommon shares outstanding for the three months ended September 30, 2007 and2006 was 4,002,458 and 3,959,622, respectively.

 

Dilutiveearnings per share is similar to the computation of basic earnings per shareexcept the denominator is increased to include the number of additional commonshares that would have been outstanding if the dilutive options outstanding hadbeen exercised. The weighted average number of common and dilutive potentialcommon shares outstanding for the three months ended September 30, 2007 and2006 was 4,067,075 and 4,035,493, respectively.

 

**NOTE 4.                INVESTMENTSIN 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:

 
| ** **                 | ** ** | **September 30, 2007**     | ** ** |
|----------------------------|------------|----------------------------|------------|
| ** **                 | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                 | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **(Losses)** | ** ** | **Value** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)** | ** ** |
|                       |       |                       |       |   |   |   |   |   |   |
| Debt securities:           |       |                       |       |   |   |   |   |   |   |
| U.S. government agencies   |       | $                          | 12,103     |   | $ | 75 |   | $ | (1 | ) | $ | 12,177 |   |
| Federal Home Loan Bank     |       | 17,449                     |       | 147 |   | — |   | 17,596 |   |
| Municipal bonds            |       | 8,019                      |       | 14 |   | (123 | ) | 7,910 |   |
| Preferred Term Securities  |       | 10,302                     |       | 0 |   | (126 | ) | 10,176 |   |
|                       |       | 47,873                     |       | 236 |   | (250 | ) | 47,859 |   |
|                       |       |                       |       |   |   |   |   |   |   |
| Equity securities:         |       |                       |       |   |   |   |   |   |   |
| FNMA                       |       | 8                          |       | 16 |   | — |   | 24 |   |
| Federal Ag Mortgage        |       | 7                          |       | 4 |   | — |   | 11 |   |
| Other Investments          |       | 199                        |       | — |   | — |   | 199 |   |
|                       |       | 214                        |       | 20 |   | — |   | 234 |   |
|                       |       |                       |       |   |   |   |   |   |   |
| Mortgage-backed securities |       | 107,665                    |       | 248 |   | (1,307 | ) | 106,606 |   |
|                       |       | $                          | 155,752    |   | $ | 504 |   | $ | (1,557 | ) | $ | 154,700 |   |
|                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

6

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| ** **                 | ** ** | **September 30, 2006**     | ** ** |
|----------------------------|------------|----------------------------|------------|
| ** **                 | ** ** | ** **                 | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | **Amortized**              | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                 | ** ** | **Cost**                   | ** ** | **Gains** | ** ** | **(Losses)** | ** ** | **Value** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)** | ** ** |
|                       |       |                       |       |   |   |   |   |   |   |
| Debt securities:           |       |                       |       |   |   |   |   |   |   |
| U.S. government agencies   |       | $                          | 12,043     |   | $ | 32 |   | $ | (79 | ) | $ | 11,996 |   |
| Federal Home Loan Bank     |       | 13,426                     |       | 18 |   | (89 | ) | 13,355 |   |
| Municipal bonds            |       | 7,604                      |       | 25 |   | (84 | ) | 7,545 |   |
| Preferred Term Securities  |       | 11,019                     |       | 68 |   | (81 | ) | 11,006 |   |
| Other Investments          |       | 5,423                      |       | 103 |   | — |   | 5,526 |   |
|                       |       | 49,515                     |       | 246 |   | (333 | ) | 49,428 |   |
|                       |       |                       |       |   |   |   |   |   |   |
| Common Stock:              |       |                       |       |   |   |   |   |   |   |
| FNMA                       |       | 8                          |       | 14 |   | — |   | 22 |   |
| Federal Ag Mortgage        |       | 7                          |       | 3 |   | — |   | 10 |   |
| Other Investments          |       | 66                         |       | — |   | — |   | 66 |   |
|                       |       | 81                         |       | 17 |   | — |   | 98 |   |
|                       |       |                       |       |   |   |   |   |   |   |
| Mortgage-backed securities |       | 105,551                    |       | 110 |   | (2,020 | ) | 103,641 |   |
|                       |       | $                          | 155,147    |   | $ | 373 |   | $ | (2,353 | ) | $ | 153,167 |   |
|                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |

 

The following table presents the fair valueand age of gross unrealized losses by investment category at September 30, 2007in accordance with FASB Staff Position (“FSP”) No. FAS 115-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments,*which supersedes EmergingIssues Task Force Issue No. 03-1:

* *
| ** **                 | ** ** | **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:           |       |                       |       |                  |       |       |       |   |   |   |   |   |   |
| U.S. government agencies   |       | $                          | —     |                  | $          | —     |       | $ | 2,442 |   | $ | (1 | ) | $ | 2,442 |   | $ | (1 | ) |
| Municipal bonds            |       | 2,561                      |       | (12                   | )          | 3,110      |       | (111 | ) | 5,671 |   | (123 | ) |
| Preferred term securities  |       | —                     |       | —                |       | 1,893      |       | (126 | ) | 1,893 |   | (126 | ) |
| Mortgage-backed securities |       | 26,060                     |       | (209                  | )          | 53,402     |       | (1,098 | ) | 79,462 |   | (1,307 | ) |
|                       |       | $                          | 28,621     |                  | $          | (221       | )          | $ | 60,847 |   | $ | (1,336 | ) | $ | 89,468 |   | $ | (1,557 | ) |

 

Management doesnot believe any individual unrealized losses as of September 30, 2007 representan other-than-temporary impairment.  Theunrealized losses reported for mortgage-backed securities relate to securitiesissued by the Federal National Mortgage Association (“FNMA”), the GovernmentNational Mortgage Association (“GNMA”), and the Federal Home Loan MortgageCorporation (“FHLMC”).  These unrealizedlosses in total are primarily attributable to changes in interest rates and thecontractual cashflows of those investments are guaranteed by an agency of theU.S. government.  As a group, theunrealized losses were less than 1.7% of their respective amortized cost basisat September 30, 2007.  Because thedecline in market value is attributable to changes in interest rates and notcredit quality, and because the Company has the ability and intent to holdthose investments until a recovery of fair value, which may be at maturity, theCompany does not consider those investments to be other-than-temporarilyimpaired at September 30, 2007.

 

7

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**NOTE5.                SEGMENT REPORTING**

 

Operatingsegments are defined as components of an enterprise for which separatefinancial information is available that is evaluated regularly by the chiefoperating 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 is conducted throughthe Bank and Mid America Capital and the “other” segment is composed of smallernonreportable segments, the Company and inter-segment eliminations.

 

The managementapproach is used as the conceptual basis for identifying reportable segmentsand is based on the way that management organizes the segments within theenterprise for making operating decisions, allocating resources and monitoringperformance, which is primarily based on products.

 
| **Three Months Ended September  30, 2007** | ** ** | **Banking**                | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|-----------|------------|-----------|------------|
| ** **                                 | ** ** | **(Dollars in Thousands)** | ** ** |
|                                       |       |                       |       |      |       |      |       |
| Net interest income                        |       | $                          | 7,294      |      | $          | (626      | )          | $ | 6,668 |   |
| Provision for losses on loans and leases   |       | (325                       | )          | —    |       | (325      | )          |
| Noninterest income                         |       | 2,769                      |       | 46        |       | 2,815     |       |
| Intersegment noninterest income            |       | (32                        | )          | (12       | )          | (44       | )          |
| Noninterest expense                        |       | (6,905                     | )          | (239      | )          | (7,144    | )          |
| Intersegment noninterest expense           |       |                       |       | 44        |       | 44        |       |
| Income (loss) before income taxes          |       | $                          | 2,801      |      | $          | (787      | )          | $ | 2,014 |   |
|                                       |       |                       |       |      |       |      |       |
| Total assets at September 30, 2007         |       | $                          | 1,013,252  |      | $          | 2,524     |       | $ | 1,015,776 |   |

 
| **Three Months Ended September  30, 2006** | ** ** | **Banking**                | ** ** | **Other** | ** ** | **Total** | ** ** |
|--------------------------------------------|------------|----------------------------|------------|-----------|------------|-----------|------------|
| ** **                                 | ** ** | **(Dollars in Thousands)** | ** ** |
|                                       |       |                       |       |      |       |      |       |
| Net interest income                        |       | $                          | 7,279      |      | $          | (861      | )          | $ | 6,418 |   |
| Intersegment interest income               |       | (247                       | )          | 247       |       | —    |       |
| Provision for losses on loans and leases   |       | (291                       | )          | —    |       | (291      | )          |
| Noninterest income                         |       | 2,426                      |       | (82       | )          | 2,344     |       |
| Intersegment noninterest income            |       | (7                         | )          | 7         |       | —    |       |
| Noninterest expense                        |       | (6,716                     | )          | (193      | )          | (6,909    | )          |
| Intersegment noninterest expense           |       | 1                          |       | (1        | )          | —    |       |
| Income (loss) before income taxes          |       | $                          | 2,445      |      | $          | (883      | )          | $ | 1,562 |   |
|                                       |       |                       |       |      |       |      |       |
| Total assets at September 30, 2006         |       | $                          | 985,464    |      | $          | 1,731     |       | $ | 987,195 |   |

 

8

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**NOTE6.                DEFINED BENEFIT PLAN**

 

The Companyhas a noncontributory (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. Participants are 100% vested after five years of service with aretirement age of the later of age 65 or five years of participation.  Information relative to the components of netperiodic benefit cost for the Company’s defined benefit plan is presentedbelow:

 
| ** **                        | ** ** | **Three Months Ended** | ** ** |
|-----------------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **September 30,**      | ** ** |
| ** **                        | ** ** | **2007**               | ** ** | **2006** | ** ** |
|                              |       |                   |       |   |   |
| Service cost                      |       | $                      | 111,830    |   | $ | 116,521 |   |
| Interest cost                     |       | 109,260                |       | 97,748 |   |
| Expected return on plan assets    |       | (121,791               | )          | (109,101 | ) |
| Total costs recognized in expense |       | $                      | 99,299     |   | $ | 105,168 |   |

 

The Companypreviously disclosed in its consolidated financial statements for Fiscal 2007,which are included in Part II, Item 8 “Financial Statements and SupplementaryData” of the Company’s Annual Report on Form 10-K for Fiscal 2007, that itcontributed $621,000 to fund its qualified pension plan.  During the first quarter of the fiscal yearending June 30, 2008 (“Fiscal 2008”), the Company made contributions of$532,000 to fund its qualified pension plan. The Company anticipates no additional contributions for Fiscal 2008.

 

**NOTE7.                SELF-INSURED HEALTHCAREPLAN**

 

TheCompany has had a self-insured health plan for its employees, subject tocertain limits, since January 1994.  TheBank is named the plan administrator for this plan and has retained theservices of an independent third party administrator to process claims andhandle other duties for this plan.  Thethird party administrator does not assume liability for benefits payable underthis plan.

 

The Company assumesthe responsibility for funding the plan benefits out of general assets;however, employees cover some of the costs of covered benefits throughcontributions, deductibles, co-pays and participation amounts.  An employee is eligible for coverage uponcompletion of 30 calendar days of regular employment.  The plan, which is on a calendar year basis,is intended to comply with, and be governed by, the Employee Retirement IncomeSecurity Act of 1974, as amended.

 

9

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Totalnet healthcare costs are inclusive of health claims expenses and administrationfees offset by stop loss and employee reimbursement.  Reported below is a summary of net healthcarecosts by quarter for the fiscal years ended June 30, 2008 and 2007.

 
| ** **                 | ** ** | **Fiscal Years Ended June 30,** | ** ** |
|----------------------------|------------|---------------------------------|------------|
| ** **                 | ** ** | **2008**                        | ** ** | **2007** | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)**      | ** ** |
|                       |       |                            |       |   |   |
| Quarter ended September 30 |       | $                               | 221        |   | $ | 436 |   |
| Quarter ended December 31  |       | —                          |       | 357 |   |
| Quarter ended March 31     |       | —                          |       | 760 |   |
| Quarter ended June 30      |       | —                          |       | 596 |   |
| Net healthcare costs       |       | $                               | 221        |   | $ | 2,149 |   |

 

**NOTE8.                STOCK-BASED COMPENSATIONPLANS**

 

Thefair value of each incentive stock option grant and stock appreciation right isestimated at the grant date using the Black-Scholes option-pricing model.  The following weighted average assumptionswere used for grants in the three months ended September 30, 2007 and 2006:

 
| ** **               | ** ** | **For the Three Months Ended** | ** ** |
|--------------------------|------------|--------------------------------|------------|
| ** **               | ** ** | **September 30,**              | ** ** |
| ** **               | ** ** | **2007**                       | ** ** | **2006** | ** ** |
|                     |       |                           |       |   |   |
| Expected volatility      |       | 22.00                          | %          | 23.00 | % |
| Expected dividend yield  |       | 2.61                           | %          | 2.63 | % |
| Risk-free interest rate  |       | 4.14                           | %          | 4.61 | % |
| Expected term (in years) |       | 4                              |       | 4 |   |

 

10

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Stock option and stockappreciation right activity for the three months ended September 30 follows:

 
| ** **                   | ** ** | **2007**   | ** ** |
|------------------------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Average** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                   | ** ** | **Shares** | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** |
|                         |       |       |       |   |   |   |   |   |   |
| Balance, beginning July 1    |       | 264,501    |       | $ | 12.75 |   |   |   |   |   |
| Granted                      |       | 29,204     |       | 16.10 |   |   |   |   |   |
| Forfeited                    |       | —     |       | — |   |   |   |   |   |
| Exercised                    |       | (7,874     | )          | 13.73 |   |   |   |   |   |
|                         |       |       |       |   |   |   |   |   |   |
| Balance, ending September 30 |       | 285,831    |       | $ | 13.07 |   | 5.76 |   | $ | 869 |   |
|                         |       |       |       |   |   |   |   |   |   |
| Exercisable at September 30  |       | 234,858    |       | $ | 12.38 |   | 4.97 |   | $ | 869 |   |

 
| ** **                   | ** ** | **2006**   | ** ** |
|------------------------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** | **Weighted** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average** | ** ** | ** ** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Average** | ** ** | **Remaining** | ** ** | **Aggregate** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **                   | ** ** | **Shares** | ** ** | **Price** | ** ** | **Term** | ** ** | **Value** | ** ** |
|                         |       |       |       |   |   |   |   |   |   |
| Balance, beginning July 1    |       | 318,977    |       | $ | 12.77 |   |   |   |   |   |
| Granted                      |       | 20,953     |       | 16.00 |   |   |   |   |   |
| Forfeited                    |       | (6,731     | )          | 16.49 |   |   |   |   |   |
| Exercised                    |       | (6,484     | )          | 10.66 |   |   |   |   |   |
|                         |       |       |       |   |   |   |   |   |   |
| Balance, ending September 30 |       | 326,715    |       | $ | 12.94 |   | 5.83 |   | $ | 1,080 |   |
|                         |       |       |       |   |   |   |   |   |   |
| Exercisable at September 30  |       | 260,425    |       | $ | 12.20 |   | 5.06 |   | $ | 1,041 |   |

 

11

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The weighted-average grant datefair value of options and stock appreciation rights (SARs) granted during thethree months ended September 30, 2007 and 2006 was $2.89 and $3.11,respectively.  The total intrinsic valueof options exercised during the three months ended September 30, 2007 and 2006was $18,000 and $36,000, respectively. As of September 30, 2007, there was $9,000 of total unrecognizedcompensation cost related to nonvested stock option awards.  The cost is expected to be recognized over aperiod of one year for stock option awards and three years for SARsawards.  Cash received from the exerciseof options for the three months ended September 30, 2007 and 2006 was $108,000and $55,000, respectively.  The taxbenefit realized for the tax deductions from cashless option exercises totaled$3,000 and $11,000 for the three months ended September 30, 2007 and 2006,respectively.

 

Restrictedshare activity for the three months ended September 30 follows:

 
| ** **                   | ** ** | **2007**   | ** ** | **2006**       | ** ** |
|------------------------------|------------|------------|------------|----------------|------------|
| ** **                   | ** ** | ** ** | ** ** | **Weighted**   | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Average**    | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Grant Date** | ** ** | ** ** | ** ** | **Grant Date** | ** ** |
| ** **                   | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
|                         |       |       |       |           |       |   |   |   |   |
| Nonvested Balance, beginning |       | 144,711    |       | $              | 16.10      |   | 158,159 |   | $ | 15.85 |   |
| Granted                      |       | 13,304     |       | 16.98          |       | 10,335 |   | 16.67 |   |
| Vested                       |       | (29,501    | )          | 14.72          |       | (15,004 | ) | 14.08 |   |
| Forfeited                    |       | —     |       | —         |       | (805 | ) | 19.86 |   |
|                         |       |       |       |           |       |   |   |   |   |
| Nonvested Balance, ending    |       | 128,514    |       | $              | 16.51      |   | 152,685 |   | $ | 15.95 |   |

 

Pretaxcompensation expense recognized for restricted shares for the three monthsended September 30, 2007 and 2006 was $111,000 and $118,000, respectively.  The tax benefit for the three months endedSeptember 30, 2007 and 2006 was $35,000 and $40,000, respectively.  As of September 30 2007, there was $1.3million of total unrecognized compensation cost related to restricted 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 four years.  The total fair value of shares vested duringthe three months ended September 30, 2007 and 2006 was $329,000 and $129,000,respectively.

 

The Company hadin place a Director Restricted Stock Plan which provides that awards ofrestricted shares of the Company’s common stock be made to outside directors ofthe Company.  The plan is designed toallow for payment of the annual retainer fee in shares of the Company’s commonstock, with the inclusion of an annual cost of living adjustment based on theConsumer Price Index.  Each outsidedirector is entitled to all voting, dividend and distribution rights during therestriction period.  The effective dateof the plan was July 1, 1997.  The planhas 90,750 shares allocated to it and is in effect for a period of ten years.  The Director Restricted Stock Plan expired onDecember 31, 2006. Awards to directors after this date come from the Company’s2002 Stock Option and Incentive Plan (2002 Option Plan).

 

These stockoption and incentive 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 2007, under Note 16 of “Notes to Consolidated Financial Statements.”

 

12

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**NOTE 9.**                SUBORDINATEDDEBENTURESPAYABLE TO TRUSTS

 

On July 5,2007, the Company issued 5,000 shares totaling $5.0 million of CompanyObligated Mandatorily 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 11 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 onOctober 1, 2037; however, the Company has the option to shorten the maturitydate to a date not earlier than October 1, 2012.  Holders of the capital securities have novoting rights, are unsecured, and rank junior in priority of the payment to allof the Company’s indebtedness and senior to the Company’s capital stock.

 

On July 5,2007, the Company exercised its option to redeem $5.0 million of CompanyObligated Mandatorily Redeemable Preferred Securities of Trust II.

 

**NOTE 10.              SALE OF BRANCHES**

 

During the second quarter of Fiscal 2007, theBank closed on the sale of three branches and their associated book ofbusiness, along with one physical location, to Great Western Bank.  The Bank recognized a gain on sale of $2.8million that resulted in the sale of $4.2 million in loans and $33.6 million indeposits.

 

**NOTE11.              INTERESTRATE CONTRACTS**

 

During thefirst quarter of Fiscal 2008, the Company entered into an interest rate swapagreement with a $5.0 million notional amount to convert the variable rateTrust Preferred VI security into a fixed-rate security for a term of five yearsat a fixed rate of 6.69%.  This rate swapis designated as a cash flow hedge.  Forthe three months ended September 30, 2007, the Company recognized net interestincome of $2,355 and this was used to offset the interest expense for thesubordinated debentures.

 

The Company isexposed to losses if the counterparty fails to make its payments under acontract in which we are in a receiving status. We minimize our risk by monitoring the credit standing of ourcounterparty.  The Company anticipatesthe counterparty will be able to fully satisfy its obligations under theremaining agreement.

 

13

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**NOTE 12.              COMPREHENSIVE INCOME**

 

Comprehensiveincome consists of two components, net income and other comprehensiveincome.  Other comprehensive incomerefers to revenues, expenses and gains and losses under U.S. generally acceptedaccounting principles which are recorded as an element of shareholders’ equitybut are excluded from net income.  Thecomponents of total comprehensive income follows:

 
| ** **                                                                                    | ** ** | **For the Three Months Ended** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                                    | ** ** | **September 30,**              | ** ** |
| ** **                                                                                    | ** ** | **2007**                       | ** ** | **2006** | ** ** |
| ** **                                                                                    | ** ** | ** **                     | ** ** | ** ** | ** ** |
| Net Income                                                                                    |       | $                              | 1,347      |   | $ | 1,097 |   |
| Other comprehensive income:                                                                   |       |                           |       |   |   |
| Net change in unrealized gain (loss) on  securities available for sale, net of deferred taxes |       | 751                            |       | 1,235 |   |
| Net change in interest rate swap fair value                                                   |       | (34                            | )          | — |   |
| Total other comprehensive income                                                              |       | 717                            |       | 1,235 |   |
|                                                                                          |       |                           |       |   |   |
| Total comprehensive income                                                                    |       | $                              | 2,064      |   | $ | 2,332 |   |

 

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

 

**Forward-Looking Statements**

 

This Quarterly Report onForm 10-Q and other reports issued by the Company, including reports filed withthe Securities and Exchange Commission, contain “forward-looking statements”that deal 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:

 

•                  Projectionsof income, loss, revenues, earnings or losses per share, dividends, capitalexpenditures, capital structure, tax benefit or other financial items.

•                  Descriptionsof plans or objectives of management for future operations, products orservices, transactions, investments and use of subordinated debentures payableto trusts.

•                  Forecastsof future economic performance.

•                  Useand descriptions of assumptions and estimates underlying or relating to suchmatters.

 

Forward-looking statements can be identifiedby the fact they do not relate strictly to historical or current facts.  They often include words such as “optimism,” “look-forward,”“bright,” “believe,” “expect,” “anticipate,” “intend,” “plan,” “estimate” orwords of similar meaning, 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 2007 and the following: possible legislativechanges and adverse economic, business and competitive conditions anddevelopments (such as shrinking interest margins and continued short-term rateenvironments); deposit outflows; reduced demand for financial services and loanproducts; 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.

 

14

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 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 uponchanging conditions, should any one or more of these risks or uncertaintiesmaterialize, or should any underlying assumptions prove incorrect, actualresults may vary materially from those described in any forward-lookingstatements.

 

**Executive Summary**

 

The Company’s net income for the firstquarter of Fiscal 2008 was $1.3 million, or $0.33 per diluted share, comparedto $1.1 million, or $0.27 per diluted share, for the first quarter of Fiscal2007.  Return on average equity was 8.61%at September 30, 2007 compared to 7.67% at September 30, 2006.

 

The netinterest margin on a fully taxable equivalent basis for the three months endedSeptember 30, 2007 was 2.92%, compared to 2.86% for the same period a year ago,an increase of six basis points.  Theincrease over the same period last year is primarily attributable to higherearning asset yields.   During the firstquarter of Fiscal 2008, there was $125,000 expense of unamortized debt issuecosts related to the early redemption of the Trust II Trust PreferredSecurities, causing a decrease of four basis points to the net interest margin.

 

Net interestincome for the first three months of Fiscal 2008 was $6.7 million, an increaseof $250,000, or 3.9%, over the same period a year ago.  For the three months ended September 30,2007, average interest-earning assets and average interest-bearing liabilitiesincreased 2.7% and 2.0%, respectively, compared to the same period a yearago.  Yields on earning assets increasedto 6.86% in the first three months of Fiscal 2008, compared to 6.62% a yearago, an increase of 24 basis points.  Forthe same time period, cost of funds increased to 4.49%, compared to 4.25%, anincrease of 24 basis points.

 

Net interestmargin ratio may vary due to many factors, including Federal Reserve policiesfor short-term interest rates, competitive and economic factors and customerpreferences for various products and services. On September 18, 2007 the Federal Reserve decreased the Fed Funds TargetRate by 50 basis points, the first decrease in short-term interest rates sinceJune 25, 2003.

 

The Companyhad previously issued trust preferred securities primarily to provide fundingfor stock repurchases and to repay other borrowings.  Interest expense on the $27.8 million oftrust preferred securities outstanding increased to $665,000 for the threemonths ended September 30, 2007, compared to $645,000 for the same period ayear ago, an increase of $20,000 or 3.1%. The average rate paid on these securities increased 31 basis points,from 9.19% at September 30, 2006 to 9.50% at September 30, 2007.  In July 2007, the Company refinanced $5.0million of trust preferred securities, originally issued in July 2002.  This new funding was calculated at a ratebased on three-month LIBOR plus 1.65%, fixed for five years, and adjustedquarterly thereafter.  This compares tothe original issuance which is based on three-month LIBOR plus 3.65%.  The Company will evaluate the suitability torefinance additional trust preferred securities outstanding over the next yeardepending upon the yield curve spreads which exist at the time of refinancing

 

The allowancefor loan and lease losses decreased to $5.5 million at September 30, 2007,compared to $5.6 million at September 30, 2006, a decrease of $138,000 or2.5%.  The ratio of allowance for loanand lease losses to total loans and leases was 0.70% as of September 30, 2007compared to 0.74% at September 30, 2006. Total nonperforming assets at September 30, 2007 were $3.6 million ascompared to $4.3 million a year ago, a decrease of $635,000 or 14.9%.  The ratio of nonperforming assets to totalassets decreased to 0.36% at September 30, 2007, compared to 0.43% at September30, 2006.  The allowance for loan andlease losses is calculated based on loan and lease levels, loan and lease losshistory, credit quality of the loan and lease portfolio, and environmentalfactors such as economic 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.

 

15

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The Companymade a strategic decision during the quarter to stop originating indirectautomobile loans, and will continue to service the existing portfolio. As ofSeptember 30, 2007, the Consumer Indirect loan portfolio balance was $74.0million. The Company entered this line of business in the 1990’s as part of aninterest rate risk reduction strategy, as well as for further diversificationof the balance sheet.

 

Total depositsat September 30, 2007 were $772.4 million, an increase of $30.6 million, or4.1%, from September 30, 2006.  Interestexpense on these deposits was $7.5 million for the three months ended September30, 2007, an increase of $957,000, or 14.6%, over the same period a yearago.  In-market deposits increased from$670.5 million at September 30, 2006 to $714.9 million at September 30, 2007,an increase of $44.4 million, or 6.6%. For the same period, out-of-market deposits decreased from $71.3 millionto $57.5 million, respectively.  Publicfunds have increased, from $87.0 million at September 30, 2006 to $129.4million at September 30, 2007.  Theprimary factor affecting interest expense on deposits was the increase inaverage fiscal year-to-date volume of certificates of deposits by $28.8million, or 8.6%, from September 2006 to September 2007.  Interest expense for certificates of depositincreased by $865,000 or 23.8% in the first three months of Fiscal 2008,compared to the same period in the prior fiscal year, driving its average costof funds to 4.93% from 4.31%.

 

The totalrisk-based capital ratio of 11.05% at September 30, 2007 is above the 10.64% atSeptember 30, 2006, an increase of 41 basis points.  This continues to place the Bank in the “wellcapitalized” category within OTS regulation at September 30, 2007 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.

 

OnSeptember 30, 2007, the Company had in effect a stock buyback program in whichup to 10% of the common stock of the Company outstanding on May 1, 2007 couldbe acquired through April 30, 2008.  Thecompany utilized its stock buyback program during the first quarter,repurchasing 70,000 shares.  Under the current program, the company isauthorized to repurchase up to 329,141 additional shares of common stock.

 

Noninterestincome was $2.8 million for the quarter ended September 30, 2007 compared to$2.3 million at September 30, 2006, an increase of $471,000 or 20.1%.  The primary factors affecting noninterestincome were an increase of $220,000 in fees on deposits, due to higher activityand increased service pricing, and an increase of $176,000 in loan servicingincome.

 

Noninterestexpense was $7.1 million for the quarter ended September 30, 2007 compared to$6.9 million at September 30, 2006, an increase of $235,000 or 3.4%.  Compensation and employee benefits expenseincreased $287,000, or 6.9%, primarily attributable to an increase of $330,000in variable pay related to performance incentives.  Net healthcare costs decreased $215,000, or49.3%, due in part to lower claims incidence. Marketing expenses decreased $180,000, or 40.6%, in the first threemonths of Fiscal 2008 due to fewer promotions during the period, whileCommunity Investment expense increased $96,000, compared to the same period inthe prior fiscal year, primarily due to timing differences.

 

**General**

 

The Company is a financial servicesprovider and, as such, has inherent risks that must be managed in order toachieve net income.  Primary risks thataffect net income include credit risk, liquidity risk, operational risk,regulatory compliance risk and reputation risk. The Company’s net income is derived by managing net interest margin, theability to collect fees from services provided, by controlling the costs ofdelivering services and the management of loan and lease losses.  The primary source of revenues comes from thenet interest margin, which represents the difference between income oninterest-earning assets (i.e. loans and investment securities) and expense oninterest-bearing liabilities (i.e. deposits and borrowed funding).  The net interest margin is affected byregulatory, economic and competitive factors that influence interest rates,loan demand and deposit flows.  Feesearned include charges for deposit services, trust services and loanservices.  Personnel costs are theprimary expenses required to deliver the services to customers.  Other costs include occupancy and equipmentand general and administrative expenses.

 

16

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**Financial Condition Data**

 

AtSeptember 30, 2007, the Company had total assets of $1.0 billion, an increaseof $14.3 million from the level at June 30, 2007.  The increase in assets was due primarily toincreases in securities available for sale of $12.5 million, and net loans andleases receivable of $5.4 million, offset by a decrease in cash and cashequivalents of $5.4 million.  Theincrease in liabilities of $13.4 million from June 30, 2007 to September 30,2007 was primarily due to increases in advances from the FHLB and otherborrowings of $52.6 million and advances by borrowers for taxes and insuranceof $4.1 million, offset by a decrease in deposits of $43.5 million.  In addition, stockholders’ equity increased$874,000 to $63.1 million at September 30, 2007 from $62.3 million at June 30,2007, primarily due to net income of $1.3 million, offset by a decrease inaccumulated other comprehensive loss of $717,000.

 

The increase in securities available for saleof $12.5 million was primarily the result of purchases of $20.8 millionexceeding sales, maturities and repayments of $9.4 million.  The purchases of $20.8 million includedfixed-rate, mortgage-backed securities of $8.3 million.

 

The increasein net loans and leases receivable of $5.4 million was due primarily to anincrease in purchases and originations over sales, amortization and repaymentsof principal**.** In addition, net deferred (fees), costs anddiscounts decreased $256,000 from the levels at June 30, 2007 to $323,000 atSeptember 30, 2007.

 

Cash and cashequivalents decreased $5.4 million due primarily to a decrease in deposits of$43.5 million resulting primarily from seasonal fluctuation in public funddeposits.

 

Advances from the FHLB and other borrowings increased $52.6 million,which was primarily due to new borrowings of $312.8 million exceeding paydownsof borrowings of $259.1 million.  Theoverall increase in FHLB borrowings was primarily the result of a decrease inpublic funds of $37.9 million and a decrease in out-of-market certificates ofdeposit of $14.0 million.

 

Advances by borrowers for taxes and insurance increased $4.1 millionprimarily due to the timing of real estate taxes paid by the Bank.  Real estate taxes for South Dakota are paidin October and April.

 

The $43.5 million decrease in deposits was due to decreases in savingsaccounts of $25.4 million, money market accounts of $15.8 million,out-of-market certificates of deposit of $14.0 million and interest-bearingchecking accounts of $4.4 million. Public fund deposits decreased $37.9 million during the quarter due toseasonal fluctuations typical for these accounts, primarily affecting thesavings and money market account balances. These decreases were offset by increases within in-market certificatesof deposit of $13.8 million and noninterest-bearing checking accounts of $2.2million.

 

During the time period of fiscal years 2002 through 2004, the Companyissued a total of $27.8 million in subordinated debentures payable to trusts atvarious times through its trust subsidiaries. Each of the issuances included an option to shorten the maturity date ata specific time as stated in the contract. The issuance of $5.0 million of Company Obligated Mandatorily RedeemablePreferred Securities of Trust II on July 11, 2002 included an option to shortenthe maturity date to July 5, 2007.  TheCompany exercised this option to redeem $5.0 million of trust preferredsecurities.  Also during the firstquarter of Fiscal 2008, the Company issued $5.0 million of Company ObligatedMandatorily Redeemable Preferred Securities of Trust VI.  The new funding is calculated at a rate basedon three-month LIBOR plus 1.65%, fixed for five years, compared to the originalissuance which is based on three-month LIBOR plus 3.65%.  The unamortized amount of $125,000 deferreddebt issuance costs related to the original issuance was expensed.

 

17

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Thefollowing tables show the composition of the Company’s loan and lease portfolioand deposit accounts:

 

**HF Financial Corp.**

**Selected Consolidated Financial ConditionData**

**(Dollars in Thousands, Except per Share Data)**

**(Unaudited)**

 

**Loan andLease Portfolio Composition**

 
| ** **                                  | ** ** | **At September 30, 2007**  | ** ** | **At June 30, 2007** | ** ** |
|---------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                  | ** ** | **Amount**                 | ** ** | **Percent**          | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                                  | ** ** | **(Dollars in Thousands)** | ** ** |
|                                        |       |                       |       |                 |       |   |   |   |   |
| One-to four-family (1)                      |       | $                          | 121,391    |                 | 15.71      | % | $ | 116,544 |   | 15.18 | % |
| Commercial business and real estate (2) (3) |       | 273,601                    |       | 35.42                | %          | 275,646 |   | 35.92 | % |
| Multi-family real estate                    |       | 33,387                     |       | 4.32                 | %          | 34,047 |   | 4.44 | % |
| Equipment finance leases                    |       | 21,360                     |       | 2.77                 | %          | 22,307 |   | 2.91 | % |
| Consumer Direct (4)                         |       | 105,105                    |       | 13.61                | %          | 104,647 |   | 13.63 | % |
| Consumer Indirect (5)                       |       | 74,025                     |       | 9.58                 | %          | 83,094 |   | 10.83 | % |
| Agricultural                                |       | 125,818                    |       | 16.29                | %          | 116,710 |   | 15.21 | % |
| Construction and development                |       | 17,759                     |       | 2.30                 | %          | 14,476 |   | 1.88 | % |
| Total Loans and Leases Receivable (6)       |       | $                          | 772,446    |                 | 100.00     | % | $ | 767,471 |   | 100.00 | % |
|                                             |            |                            |            |                      |            |  |  |  |  |  |  |  |

----

(1) Excludes $6,128 and $8,290 loans held forsale at September 30, 2007 and June 30, 2007, respectively.

(2) Includes $3,205 and $3,297 tax exemptleases at September 30, 2007 and June 30, 2007, respectively.

(3) Excludes $223 commercial loans held forsale at September 30, 2007 and June 30, 2007.

(4) Excludes $1,520 and $263 student loansheld for sale at September 30, 2007 and June 30, 2007, respectively.

(5) The Company announced Consumer Indirectoriginations ceased during the first quarter of Fiscal 2008.

(6) Includes deferred loan fees and discountsand undisbursed portion of loans in process.

 

**Deposit Composition**

 
| ** **                            | ** ** | **At September 30, 2007**  | ** ** | **At June 30, 2007** | ** ** |
|---------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                            | ** ** | **Amount**                 | ** ** | **Percent**          | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                            | ** ** | **(Dollars in Thousands)** | ** ** |
|                                  |       |                       |       |                 |       |   |   |   |   |
| Noninterest bearing checking accounts |       | $                          | 88,901     |                 | 11.51      | % | $ | 86,679 |   | 10.62 | % |
| Interest bearing checking accounts    |       | 82,671                     |       | 10.70                | %          | 87,030 |   | 10.67 | % |
| Money market accounts                 |       | 196,779                    |       | 25.48                | %          | 212,546 |   | 26.05 | % |
| Savings accounts                      |       | 40,853                     |       | 5.29                 | %          | 66,235 |   | 8.12 | % |
| In-Market Certificates of deposit     |       | 305,656                    |       | 39.57                | %          | 291,858 |   | 35.77 | % |
| Out-of-Market Certificates of deposit |       | 57,500                     |       | 7.45                 | %          | 71,516 |   | 8.77 | % |
| Total Deposits                        |       | $                          | 772,360    |                 | 100.00     | % | $ | 815,864 |   | 100.00 | % |

 

18

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**Analysisof Net Interest Income**

 

Net interest income represents thedifference between income on interest-earning assets and expense oninterest-bearing liabilities.  Netinterest income depends upon the volume of interest-earning assets and interest-bearingliabilities 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.

 
| ** **                                     | ** ** | **Three Months Ended September 30,** | ** ** |
|------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                     | ** ** | **2007**                             | ** ** | **2006** | ** ** |
| ** **                                     | ** ** | **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)            |       | $                                    | 776,254    |   | $ | 14,120 |   | 7.24 | % | $ | 744,497 |   | $ | 13,240 |   | 7.06 | % |
| Investment securities (2) (3)                  |       | 145,195                              |       | 1,804 |   | 4.94 | % | 151,566 |   | 1,759 |   | 4.60 | % |
| FHLB stock                                     |       | 5,618                                |       | 61 |   | 4.32 | % | 6,974 |   | 79 |   | 4.49 | % |
|                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                  |       | 927,067                              |       | $ | 15,985 |   | 6.86 | % | 903,037 |   | $ | 15,078 |   | 6.62 | % |
| Noninterest-earning assets                     |       | 68,334                               |       |   |   |   |   | 62,233 |   |   |   |   |   |
| Total assets                                   |       | $                                    | 995,401    |   |   |   |   |   | $ | 965,270 |   |   |   |   |   |
|                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                      |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Checking and money market                      |       | $                                    | 285,936    |   | $ | 2,581 |   | 3.59 | % | $ | 280,114 |   | $ | 2,638 |   | 3.74 | % |
| Savings                                        |       | 54,777                               |       | 410 |   | 2.98 | % | 43,755 |   | 261 |   | 2.37 | % |
| Certificates of deposit                        |       | 363,832                              |       | 4,507 |   | 4.93 | % | 335,059 |   | 3,642 |   | 4.31 | % |
| Total interest-bearing deposits                |       | 704,545                              |       | 7,498 |   | 4.23 | % | 658,928 |   | 6,541 |   | 3.94 | % |
| FHLB advances and other borrowings             |       | 92,296                               |       | 1,154 |   | 4.97 | % | 121,867 |   | 1,474 |   | 4.80 | % |
| Subordinated debentures payable to trusts      |       | 27,837                               |       | 665 |   | 9.50 | % | 27,837 |   | 645 |   | 9.19 | % |
| Total interest-bearing liabilities             |       | 824,678                              |       | 9,317 |   | 4.49 | % | 808,632 |   | 8,660 |   | 4.25 | % |
| Noninterest-bearing deposits                   |       | 78,968                               |       |   |   |   |   | 79,497 |   |   |   |   |   |
| Other liabilities                              |       | 29,150                               |       |   |   |   |   | 19,939 |   |   |   |   |   |
| Total liabilities                              |       | 932,796                              |       |   |   |   |   | 908,068 |   |   |   |   |   |
| Equity                                         |       | 62,605                               |       |   |   |   |   | 57,202 |   |   |   |   |   |
| Total liabilities and equity                   |       | $                                    | 995,401    |   |   |   |   |   | $ | 965,270 |   |   |   |   |   |
|                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income; interest rate spread  (4) |       |                                 |       | $ | 6,668 |   | 2.37 | % |   |   | $ | 6,418 |   | 2.37 | % |
|                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin (4) (5)                    |       |                                 |       |   |   | 2.86 | % |   |   |   |   | 2.82 | % |
|                                           |       |                                 |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin, TE (6)                    |       |                                 |       |   |   | 2.92 | % |   |   |   |   | 2.86 | % |

 

----

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

(2)  Includesfederal funds sold.

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

(4)  Percentages for the threemonths ended September 30, 2007 and September 30, 2006 have been annualized.

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

(6) Net interest margin expressed on a fully taxable equivalent basis.

 

19

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**Rate/VolumeAnalysis of Net Interest Income**

 

Thefollowing schedule presents the dollar amount of changes in interest income andinterest expense for major components of interest-earning assets andinterest-bearing liabilities.  Itdistinguishes between the increases and decreases due to fluctuating outstandingbalances due to the levels and volatility of interest rates.  For each category of interest-earning assetsand interest-bearing liabilities, information is provided on changesattributable to (i) changes in volume (i.e., changes in volume multiplied byold rate) and (ii) changes in rate (i.e., changes in rate multiplied by oldvolume).  For purposes of this table,changes attributable to both rate and volume, which cannot be segregated, havebeen allocated proportionately to the change due to volume and the change dueto rate.

 
| ** **                                | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|--------------------------------------|------------|
| ** **                                | ** ** | **2007 vs 2006**                     | ** ** |
| ** **                                | ** ** | **Increase**                         | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **(Decrease)**                       | ** ** | **(Decrease)** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **Due to**                           | ** ** | **Due to** | ** ** | **Increase** | ** ** |
| ** **                                | ** ** | **Volume**                           | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)**           | ** ** |
| Interest-earning assets:                  |       |                                 |       |   |   |   |   |
| Loans and leases receivable (1)           |       | $                                    | 545        |   | $ | 335 |   | $ | 880 |   |
| Investment securities (2)                 |       | (77                                  | )          | 122 |   | 45 |   |
| FHLB stock                                |       | (15                                  | )          | (3 | ) | (18 | ) |
|                                      |       |                                 |       |   |   |   |   |
| Total interest-earning assets             |       | $                                    | 453        |   | $ | 454 |   | $ | 907 |   |
|                                      |       |                                 |       |   |   |   |   |
| Interest-bearing liabilities:             |       |                                 |       |   |   |   |   |
| Deposits:                                 |       |                                 |       |   |   |   |   |
| Checking and money market                 |       | $                                    | 52         |   | $ | (109 | ) | $ | (57 | ) |
| Savings                                   |       | 66                                   |       | 83 |   | 149 |   |
| Certificates of deposit                   |       | 307                                  |       | 558 |   | 865 |   |
| Total interest-bearing deposits           |       | 425                                  |       | 532 |   | 957 |   |
| FHLB advances and other borrowings        |       | (359                                 | )          | 39 |   | (320 | ) |
| Subordinated debentures payable to trusts |       | —                               |       | 20 |   | 20 |   |
|                                      |       |                                 |       |   |   |   |   |
| Total interest-bearing liabilities        |       | $                                    | 66         |   | $ | 591 |   | $ | 657 |   |
|                                      |       |                                 |       |   |   |   |   |
| Net interest income increase              |       |                                 |       |   |   | $ | 250 |   |

 

----

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

(2) Includes federal funds sold.

 

20

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**Applicationof Critical Accounting Policies**

 

GAAPrequires management to utilize estimates when reporting financial results.  The Company has identified the policiesdiscussed below as Critical Accounting Policies because the accountingestimates require management to make certain assumptions about matters whichmay be uncertain at the time the estimate was made and a different method ofestimating could have been reasonably made which could have a material impacton the presentation of the Company’s financial condition, changes in financialcondition 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 allowanceis compiled by utilizing the Company’s loan and lease risk rating system, whichis structured 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.

 

*Mortgage Servicing Rights (“MSR”)*– The Company records a servicing asset for contractually separated servicingfrom the underlying mortgage loans.   Theasset is initially recorded at fair value and represents an intangible assetbacked by an income stream from the serviced assets.  The asset is amortized in proportion to andover the period of estimated net servicing income.

 

At eachbalance sheet date, the MSRs are analyzed for impairment, which occurs when thefair value of the MSRs is lower than the amortized book value. The Company’sMSRs are primarily servicing rights acquired on South Dakota HousingDevelopment Authority first time homebuyers program.  Due to the lack of quoted markets for theCompany’s servicing portfolio, the Company estimates the fair value of the MSRsusing present value of future cash flow analysis.  If the analysis produces a fair value greaterthan or equal to the amortized book value of the MSRs, no impairment isrecognized.  If the fair value is lessthan the book value, an expense for the difference is charged to earnings byinitiating a MSR valuation account.  If theCompany determines this impairment is temporary, any future changes in fairvalue are recorded as a change in earnings and the valuation.  If the Company determines the impairment tobe permanent, the valuation is written off against the MSRs, which results in anew amortized balance.

 

The Companyhas included MSRs as a critical accounting policy because the use of estimatesfor determining fair value using present value concepts may produce resultswhich may significantly differ from other fair value analysis perhaps even tothe point of recording impairment.  Therisk to earnings is when the underlying mortgages pay off significantly fasterthan the 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 atSeptember 30, 2007.

 

*Self-Insurance*- The Company has aself-insured healthcare plan for its employees up to certain limits.  To mitigate a portion of these risks, theCompany has a stop-loss insurance policy through a commercial insurance carrierfor coverage in excess of $65,000 per individual occurrence with a maximumaggregate limitation of $2.0 million. 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.

 

21

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**AssetQuality and Potential Problem Loans and Leases**

 

Nonperformingassets (nonaccrual loans and leases, accruing loans and leases delinquent morethan 90 days and foreclosed assets) decreased to $3.6 million at September 30,2007 from $4.0 million at June 30, 2007, a decrease of $383,000, or 9.6%.  Nonaccruing loans and leases decreased$789,000 to $1.4 million at September 30, 2007 from $2.2 million at June 30,2007.  In addition, the ratio ofnonperforming assets to total assets, which is one indicator of credit riskexposure, decreased to 0.36% at September 30, 2007 from 0.40% at June 30, 2007.

 

Nonaccruingloans and leases decreased 36.0%, or $789,000, to $1.4 million at September 30,2007 compared to $2.2 million at June 30, 2007. Included in nonaccruing loans and leases at September 30, 2007 werethree loans totaling $159,000 secured by one- to four-family real estate, oneloan totaling $25,000 secured by commercial real estate loans, twelve loanstotaling $842,000 secured by commercial business, one lease totaling $118,000and 30 consumer loans totaling $257,000.

 

The riskrating system in place is designed to identify and manage the nonperformingloans and leases.  Commercial andagricultural loans and equipment finance leases will have specific reserveallocations based on collateral values or based on the present value ofexpected cash flows if the loans and leases are deemed impaired.  Loans and leases that are not performing donot necessarily result in a loss.

 

As ofSeptember 30, 2007, the Company had $300,000 of foreclosed assets.  The balance of foreclosed assets at September30, 2007 consisted of $173,000 of single-family collateral owned, $5,000 ofequipment finance leases and $122,000 of consumer collateral owned.

 

At September30, 2007, the Company had designated $18.3million of its assets as special mention and classified $8.0 million of itsassets that management has determined need to be closely monitoredbecause of possible credit problems of the borrowers or the cash flows of thesecured properties.  At September 30,2007 the Company had $19.8 million in multi-family, commercial business, commercialreal estate and agricultural participation loans purchased, of which $243,000were classified as of September 30, 2007. These loans and leases were considered in determining the adequacy ofthe allowance for loan and lease losses. The allowance for loan and lease losses is established based onmanagement’s evaluation of the risks probable in the loan and lease portfolioand changes in the nature and volume of loan and lease activity.  Such evaluation, which includes a review ofall loans and leases for which full collectibility may not be reasonablyassured, considers the estimated fair market value of the underlyingcollateral, present value of expected principal and interest payments, economicconditions, historical loss experience and other factors that warrantrecognition in providing for an adequate loan and lease loss allowance.

 

Althoughthe Company’s management believes the September 30, 2007 recorded allowance forloan and lease losses was adequate to provide for probable losses on therelated loans and leases, there can be no assurance the allowance existing atSeptember 30, 2007 will be adequate in the future.

 

22

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Inaccordance with the Company’s internal classification of assets policy,management evaluates the loan and lease portfolio on a monthly basis toidentify loss potential and determines the adequacy of the allowance for loanand lease losses quarterly.  Loans andleases are placed on nonaccrual status when the collection of principal and/orinterest becomes doubtful.  Foreclosedassets include assets acquired in settlement of loans and leases.  The following table sets forth the amountsand categories of the Company’s nonperforming assets for the periods indicated.

 
| ** **                                                                 | ** ** | **Nonperforming Assets As Of** | ** ** |
|----------------------------------------------------------------------------|------------|--------------------------------|------------|
| ** **                                                                 | ** ** | **September 30,**              | ** ** | **June 30,** | ** ** |
| ** **                                                                 | ** ** | **2007**                       | ** ** | **2007** | ** ** |
| ** **                                                                 | ** ** | **(Dollars in Thousands)**     | ** ** |
| Nonaccruing loans and leases:                                              |       |                           |       |   |   |
| One- to four-family                                                        |       | $                              | 159        |   | $ | 228 |   |
| Commercial real estate                                                     |       | 25                             |       | 25 |   |
| Commercial business                                                        |       | 842                            |       | 1,441 |   |
| Equipment finance leases                                                   |       | 118                            |       | 118 |   |
| Consumer                                                                   |       | 257                            |       | 378 |   |
| Total                                                                      |       | 1,401                          |       | 2,190 |   |
|                                                                       |       |                           |       |   |   |
| Accruing loans and leases delinquent more  than 90 days:                   |       |                           |       |   |   |
| One- to four-family                                                        |       | 326                            |       | 470 |   |
| Commercial real estate                                                     |       | 153                            |       | 178 |   |
| Commercial business                                                        |       | 117                            |       | 213 |   |
| Equipment finance leases                                                   |       | 114                            |       | 88 |   |
| Consumer                                                                   |       | 64                             |       | 1 |   |
| Agricultural                                                               |       | 1,148                          |       | 358 |   |
| Total                                                                      |       | 1,922                          |       | 1,308 |   |
|                                                                       |       |                           |       |   |   |
| Foreclosed assets: (1)                                                     |       |                           |       |   |   |
| One- to four-family                                                        |       | 173                            |       | 158 |   |
| Equipment finance leases                                                   |       | 5                              |       | 180 |   |
| Consumer                                                                   |       | 122                            |       | 170 |   |
| Total                                                                      |       | 300                            |       | 508 |   |
|                                                                       |       |                           |       |   |   |
| Total nonperforming assets                                                 |       | $                              | 3,623      |   | $ | 4,006 |   |
|                                                                       |       |                           |       |   |   |
| Ratio of nonperforming assets to total  assets                             |       | 0.36                           | %          | 0.40 | % |
|                                                                       |       |                           |       |   |   |
| Ratio of nonperforming loans and leases to  total loans and leases (2) (3) |       | 0.43                           | %          | 0.45 | % |

 

----

(1)  Total foreclosed assets do not include landor other real estate owned held for sale.

(2)  Nonperforming loans and leases include bothnonaccruing and accruing loans and leases delinquent more than 90 days.

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

 

23

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Thefollowing table sets forth information with respect to activity in the Company’sallowance for loan and lease losses during the periods indicated.

 
| ** **                                                                                              | ** ** | **Three Months Ended September 30,** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                                              | ** ** | **2007**                             | ** ** | **2006** | ** ** |
| ** **                                                                                              | ** ** | **(Dollars in Thousands)**           | ** ** |
|                                                                                                    |       |                                 |       |   |   |
| Balance at beginning of period                                                                          |       | $                                    | 5,872      |   | $ | 5,657 |   |
| Charge-offs:                                                                                            |       |                                 |       |   |   |
| One- to four-family                                                                                     |       | (2                                   | )          | — |   |
| Commercial business                                                                                     |       | (557                                 | )          | (164 | ) |
| Equipment finance leases                                                                                |       | (33                                  | )          | (50 | ) |
| Consumer                                                                                                |       | (189                                 | )          | (214 | ) |
| Total charge-offs                                                                                       |       | (781                                 | )          | (428 | ) |
|                                                                                                    |       |                                 |       |   |   |
| Recoveries:                                                                                             |       |                                 |       |   |   |
| One- to four-family                                                                                     |       | —                               |       | 3 |   |
| Consumer                                                                                                |       | 77                                   |       | 51 |   |
| Agriculture                                                                                             |       | —                               |       | 57 |   |
| Total recoveries                                                                                        |       | 77                                   |       | 111 |   |
|                                                                                                    |       |                                 |       |   |   |
| Net (charge-offs)                                                                                       |       | (704                                 | )          | (317 | ) |
|                                                                                                    |       |                                 |       |   |   |
| Additions charged to operations                                                                         |       | 325                                  |       | 291 |   |
|                                                                                                    |       |                                 |       |   |   |
| Balance at end of period                                                                                |       | $                                    | 5,493      |   | $ | 5,631 |   |
|                                                                                                    |       |                                 |       |   |   |
| Ratio of net (charge-offs) during the  period to average loans and leases outstanding during the period |       | (0.09                                | )%         | (0.04 | )% |
|                                                                                                    |       |                                 |       |   |   |
| Ratio of allowance for loan and lease  losses to total loans and leases at end of period (1)            |       | 0.70                                 | %          | 0.74 | % |
|                                                                                                    |       |                                 |       |   |   |
| Ratio of allowance for loan and lease  losses to nonperforming loans and leases at end of period (2)    |       | 165.30                               | %          | 164.99 | % |
|                                                                                                         |            |                                      |            |  |  |  |  |  |

 

----

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

(2)  Nonperforming loans and leases include bothnonaccruing and accruing loans and leases delinquent more than 90 days.

 

24

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Thedistribution of the Company’s allowance for loan and lease losses and impairedloss summary as required by FASB Statement No. 114, “Accounting by Creditorsfor Impairment of a Loan” are summarized in the following tables.  The combination of FASB Statement No. 5 “Accountingfor Contingencies” and FASB Statement No. 114 calculations comprise the Company’sallowance 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**  | ** ** | **At September 30, 2007**  | ** ** | **At June 30, 2007** | ** ** |
| ** **               | ** ** | **(Dollars in Thousands)** | ** ** |
|                     |       |                       |       |                 |       |             |       |              |       |
| One- to four-family      |       | $                          | 377        |                 | $          | —           |       | $                 | 342        |   | $ | — |   |
| Commercial real estate   |       | 573                        |       | —               |       | 524              |       | —            |       |
| Multi-family real estate |       | 122                        |       | —               |       | 123              |       | —            |       |
| Commercial business      |       | 1,944                      |       | —               |       | 1,974            |       | 335               |       |
| Equipment finance leases |       | 469                        |       | —               |       | 486              |       | —            |       |
| Consumer                 |       | 1,081                      |       | —               |       | 1,178            |       | —            |       |
| Agricultural             |       | 877                        |       | 50                   |       | 860              |       | 50                |       |
|                     |       |                       |       |                 |       |             |       |              |       |
| Total                    |       | $                          | 5,443      |                 | 50         |             | $          | 5,487             |       | 385 |   |
|                          |            |                            |            |                      |            |                  |            |                   |            |  |  |  |  |

 

**Impaired Loan Summary**

 
| ** **              | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Impaired**  | ** ** | ** **    | ** ** | ** **  | ** ** | **Impaired**  | ** ** |
|-------------------------|------------|----------------------------|------------|----------------------------|------------|---------------|------------|---------------|------------|-------------|------------|---------------|------------|
| ** **              | ** ** | **Number**                 | ** ** | ** **                 | ** ** | **Loan**      | ** ** | **Number**    | ** ** | ** **  | ** ** | **Loan**      | ** ** |
| ** **              | ** ** | **of Loan**                | ** ** | **Loan**                   | ** ** | **Valuation** | ** ** | **of Loan**   | ** ** | **Loan**    | ** ** | **Valuation** | ** ** |
| ** **              | ** ** | **Customers**              | ** ** | **Balance**                | ** ** | **Allowance** | ** ** | **Customers** | ** ** | **Balance** | ** ** | **Allowance** | ** ** |
| **Loan and Lease Type** | ** ** | **At September 30, 2007**  | ** ** | **At June 30, 2007**       | ** ** |
| ** **              | ** ** | **(Dollars in Thousands)** | ** ** | **(Dollars in Thousands)** | ** ** |
|                    |       |                       |       |                       |       |          |       |          |       |        |       |          |       |
| Commercial business     |       | 7                          |       | $                          | 775        |          | —     |          | 7          |        | $          | 1,360         |       | 335 |   |
| Agricultural            |       | 1                          |       | 107                        |       | 50            |       | 1             |       | 121         |       | 50            |       |
| Total                   |       | 8                          |       | $                          | 882        |          | 50         |          | 8          |        | $          | 1,481         |       | 385 |   |

 

25

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The allowancefor loan and lease losses was $5.5 million at September 30, 2007 as compared to$5.6 million at September 30, 2006.  Theratio of the allowance for loan and lease losses to total loans and leases was0.70% at September 30, 2007 compared to 0.74% at September 30, 2006.  The Company’s management has considerednonperforming loans and leases and potential problem loans and leases inestablishing 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 a risk-ratingsystem on all commercial business, agricultural, construction and multi-familyand commercial real estate loans, including purchased loans and leases.  A periodic credit review is performed on alltypes of loans and leases to establish the necessary reserve based on theestimated risk within the portfolio. This assessment of risk takes into accountthe composition of the loan and lease portfolio, historical loss experience foreach loan and lease category, previous loan and lease experience, concentrationsof credit, current economic conditions and other factors that in management’sjudgment deserve recognition.

 

Realestate properties acquired throughforeclosure are recorded at the lower of cost or fair value (less a deductionfor disposition costs).  Valuations areperiodically updated by management and a specific provision for losses on suchproperties is established by a charge to operations if the carrying values ofthe properties exceed their estimated net realizable values.

 

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.

 

26

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**Comparison of the Three Months Ended September 30,2007 and September 30, 2006**

 

*General*.  The Company’s net income was $1.3 million, or$0.34 in basic and $0.33 in diluted earnings per share for the three monthsended September 30, 2007, a $250,000 increase in earnings compared to $1.1million, or $0.28 in basic and $0.27 in diluted earnings per share for the sameperiod in the prior fiscal year.  For thethree months ended September 30, 2007, the return on average equity was 8.61%,a 12.3% increase compared to 7.67% for the same period in the prior fiscalyear.  For the three months endedSeptember 30, 2007, the return on average assets was 0.54%, an increase of20.0% compared to 0.45% for the same period in the prior fiscal year.  As discussed in more detail below, theincreases were due to a variety of key factors, including increases innoninterest income of $471,000 and net interest income of $250,000 offset byincreases in noninterest expense of $235,000 and provision for losses on loansand leases of $34,000.

 

*Interest, Dividend and Loan FeeIncome.*  Interest, dividendand loan fee income was $16.0 million for the three months ended September 30,2007 as compared to $15.1 million for the same period in the prior fiscal year,an increase of $907,000 or 6.0%.  A$545,000 increase in interest, dividend and loan fee income was due to a 4.3%increase in the average volume of loans and leases receivable and a $335,000increase in interest, dividend and loan fee income was the result of anincrease in the average yield on loans and leases receivable from 7.06% for thethree months ended September 30, 2006 to 7.24% for the three months endedSeptember 30, 2007.  The average yield ontotal interest-earning assets was 6.86% for the three months ended September30, 2007 as compared to 6.62% for the same period in the prior fiscal year.

 

*InterestExpense.* Interest expense was $9.3 million for the three months ended September30, 2007 as compared to $8.7 million for the same period in the prior fiscalyear, an increase of $657,000 or 7.6%.  A$532,000 increase in interest expense was the result of an increase in averagerate paid on interest-bearing deposits from 3.94% for the three months endedSeptember 30, 2006 to 4.23% for the three months ended September 30, 2007.  An increase of $591,000 in interest expensewas the result of an increase in the average rate paid on totalinterest-bearing liabilities from 4.25% for the three months ended September30, 2006 to 4.49% for the three months ended September 30, 2007.

 

*NetInterest Income.* The Company’s net interest income forthe three months ended September 30, 2007 increased $250,000, or 3.9%, to $6.7million compared to $6.4 million for the same period in the prior fiscalyear.  The increase in net interest incomewas due primarily to increases in the average yield on interest-earning assetsand average volume of interest-earning assets offset by increases in theaverage rate paid on interest-bearing liabilities for the three months endedSeptember, 2007 compared to the same period in the prior fiscal year.  The Company’s net interest margin was 2.86%for the three months ended September 30, 2007 as compared to 2.82% for the sameperiod in the prior fiscal year.

 

*Provisionfor Losses on Loans and Leases.*The allowance for loan and leaselosses is maintained at a level which is considered by management to beadequate to absorb probable losses on existing loans and leases that may becomeuncollectible, based on an evaluation of the collectibility of loans and leasesand prior loan and lease loss experience. The evaluation takes into consideration such factors as changes in thenature and volume of the loan and lease portfolio, overall portfolio quality,review of specific problem loans and leases, and current economic conditionsthat may affect the borrower’s ability to pay. The allowance for loan and lease losses is established through aprovision for losses on loans and leases charged to expense.

 

During thethree months ended September 30, 2007, the Company recorded a provision forlosses on loans and leases of $325,000 compared to $291,000 for the threemonths ended September 30, 2006, an increase of $34,000.  See “Asset Quality” for further discussion.

 

*NoninterestIncome.* Noninterest income was $2.8 million for the three months ended September30, 2007 as compared to $2.3 million for the same period in the prior fiscalyear, an increase of $471,000, or 20.1%. The increase in noninterest income was primarily attributable toincreases in fees on deposits of $220,000, loan servicing income of $176,000and net gain on sale of loans of $63,000 for the three months ended September30, 2007 as compared to the same period in the prior fiscal year.

 

27

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Fees ondeposits increased $220,000 to $1.4 million for the three months endedSeptember 30, 2007 from $1.2 million the same period in the prior fiscal yearprimarily due to an increase in higher activity and increased service pricing.

 

Loanservicing income increased $176,000 from $329,000 for the three months endedSeptember 30, 2006 to $505,000 for the three months ended September 30, 2007primarily due to an increase of $86.3 million in the balances of loans servicedby the Bank from $915.5 million at September 30, 2006 to $1.0 billion atSeptember 30, 2007.

 

*NoninterestExpense.* Noninterest expense was $7.1 million for the three months endedSeptember 30, 2007 as compared to $6.9 million for the three months endedSeptember 30, 2006, an increase of $235,000, or 3.4%.  The increase in noninterest expense wasprimarily due to an increase in compensation and employee benefits of $287,000offset by a decrease in other noninterest expense of $51,000.

 

Compensationand employee benefits increased $287,000, or 6.9%, from $4.2 million for thethree months ended September 30, 2006 to $4.4 million for the three monthsended September 30, 2007.

 

Othernoninterest expense decreased $51,000 for the three months ended September 30,2007 compared to the same period in the prior fiscal year.

 

*Income tax expense.*  The Company’s income tax expense for thethree months ended September 30, 2007 increased $202,000 or 43.4% to $667,000compared to $465,000 for the same period in the prior fiscal year.  The effective tax rate was 33.1% and 29.8%for the three months ended September 30, 2007 and 2006, respectively.

 

28

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**Liquidity and Capital Resources**

 

TheBank’s primary sources of funds are earnings, in-market deposits, FHLB advancesand other borrowings, repayments of loan principal, mortgage-backed securitiesand callable agency securities and, to a lesser extent, sales of mortgageloans, sales and maturities of securities, out-of-market deposits andshort-term investments.  While scheduledloan payments and maturing securities are relatively predictable, deposit flowsand loan and security prepayments are more influenced by interest rates,general economic conditions and competition. The Bank attempts to price itsdeposits to meet its asset/liability objectives consistent with local marketconditions.  Excess balances are investedin overnight funds.

 

Liquiditymanagement is both 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)projected loan 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 Bankanticipates that it will have sufficient funds available to meet current loancommitments.  At September 30, 2007, theBank had outstanding commitments to originate residential mortgage loans of$24.2 million and commercial business loans of $3.1 million.  In addition, the Bank had outstandingcommitments to sell residential mortgage loans of $10.0 million, commercialbusiness loans of $223,000 and consumer student loans of $1.5 million.  Commitments by the Bank to originate loansare not necessarily executed by the customer. The Bank monitors the ratio of commitments to funding for use inliquidity management.  At September 30,2007, the Bank had no commitments to purchase securities available for sale andno commitments to sell securities available for sale.

 

Althoughin-market deposits are the Bank’s primary source of funds, the Bank’s policyhas been to utilize borrowings where the funds can be invested in either loansor securities at a positive rate of return or to use the funds for short-termliquidity purposes.  The Bank hasunsecured federal funds accommodations totaling $25.0 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 September 30, 2007.  Additionally, as of September 30, 2007, theBank had $57.5 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.

 

TheCompany uses its capital resources to pay dividends to its stockholders, torepurchase Company stock pursuant to Board of Directors approved plans, tosupport organic growth, to make acquisitions, to service its debt obligationsand to provide funding for investment into the Bank of Tier 1 (core) capital.

 

OnSeptember 30, 2007, the Company had in effect a stock buyback program in whichup to 10% of the common stock of the Company outstanding on May 1, 2007 couldbe acquired through April 30, 2008.  Asof September 30, 2007, 70,000 shares of common stock had been purchasedpursuant to the program.  See Part II,Item 2 “Unregistered Sales of Equity Securities and Use of Proceeds” of thisForm 10-Q.

 

Savingsinstitutions insured by the Federal Deposit Insurance Corporation are requiredby the Financial Institutions Reform, Recovery and Enforcement Act of 1989 tomeet three 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 September 30,2007, the Bank met all current regulatory capital requirements.

 

The minimumOTS Tier 1 (core) capital requirement for well-capitalized institutions is5.00% of total adjusted assets for thrifts. The Bank had Tier 1 (core) capital of 8.32% at September 30, 2007.  The minimum OTS total risk-based capitalrequirement for well-capitalized institutions is 10.00% of risk-weightedassets.  The Bank had total risk-basedcapital of 11.05% at September 30, 2007.

 

29

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**Impact ofInflation and Changing Prices**

 

Theunaudited consolidated financial statements and notes thereto presented in thisQuarterly Report 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 industrial companies, nearly all the assets andliabilities of the Bank are monetary in nature. As a result, interest rates have a greater impact on the Bank’sperformance than do the effects of general levels of inflation.  Interest rates do not necessarily move in thesame direction or to the same extent as the prices of goods and services.

 

**RecentAccounting Pronouncements**

 

In March 2006,FASB issued SFAS No. 156, “Accounting for Servicing of Financial Assets,” whichamends SFAS No. 140.  SFAS No. 156requires the recognition of all separately recognized servicing assets andservicing liabilities to be initially measured at fair value utilizing theamortization method or fair market value method. SFAS 156 is effective thebeginning of the first fiscal year that begins after September 15, 2006.  The Company adopted this new accountingstandard effective July 1, 2007.  Underthe amortization method, an entity shall amortize the value of servicing assetsor liabilities in proportion to and over the period of estimated net servicingincome or net servicing loss and assess servicing assets or liabilities forimpairment or increased obligation based on fair value at each reporting date.Under the fair value method, an entity shall measure servicing assets orliabilities at fair value at each reporting date and report changes in fairvalue in earnings in the period in which the changes occur. The adoption ofSFAS No. 156 has not had a material affect on the Company’s financialstatements.

 

In June 2006,FASB issued FIN 48, “Accounting for Uncertainty in Income Taxes - aninterpretation of FASB Statement No. 109” to create a single model to addressaccounting for uncertainty in tax positions. FIN 48 clarifies that a tax position must be more likely than not ofbeing sustained before being recognized in the financial statements.  As required, the Company adopted FIN 48effective July 1, 2007.  The adoptionof  FIN 48 did not have a material impacton our financial statements.

 

In September2006, FASB issued Statement of Financial Accounting Standards No. 157 (SFAS157), “Fair Value Measurements” and is effective for financial statementsissued for fiscal years beginning after November 15, 2007.  SFAS 157 provides a common definition of fairvalue and a framework for measuring assets and liabilities at fair values whena particular standard prescribes it.  Inaddition, the Statement expands disclosures about fair value measurements.  As required by SFAS 157, the Company willadopt this new accounting standard effective July 1, 2008.  Management is currently reviewing the impactof SFAS 157 on our financial statements.

 

In September 2006, FASB issued Statement ofFinancial Accounting Standards No. 158 (SFAS 158), “Employers’ Accounting forDefined Benefit Pension and Other Postretirement Plans – an amendment of FASBStatements No. 87, 88, 106 and 132R.” SFAS 158 requires recognition of the overfunded or underfunded status ofpension and other postretirement benefit plans on the balance sheet.  Under SFAS 158, gains and losses, priorservice costs and credits and any remaining transition amounts under SFAS 87and SFAS 106 that have not yet been recognized through net periodic benefitcost will be recognized in accumulated other comprehensive income, net of taxeffects, until they are amortized as a component of net periodic cost.  Also, the measurement date – the date atwhich the benefit obligation and plan assets are measured – is required to bethe company’s fiscal year-end.  Asrequired by SFAS 158, the Company adopted the balance sheet recognitionprovisions at June 30, 2007 and will adopt the year-end measurement date in2009.

 

In February 2007, FASB issued Statement of Financial AccountingStandards No. 159 (SFAS 159), “The Fair Value Option for Financial Assets andFinancial Liabilities – Including an Amendment of FASB Statement No. 115.”  SFAS 159 is effective as of the beginning ofan entity’s first fiscal year after November 15, 2007.  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 will adopt this newaccounting standard effective July 1, 2008. Management is currently reviewing the impact of SFAS 159 on ourfinancial statements.

 

30

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**Item 3.  Quantitative andQualitative Disclosures About Market Risk**

 

The Company’snet income 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.  Wheninterest-bearing liabilities mature or reprice more quickly than interest-earningassets in a given period, a significant increase in market rates of interestcould adversely 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.

 

Inan attempt to manage its exposure to change in interest rates, managementmonitors the Company’s interest rate risk. The Company’s Asset/Liability Committee meets periodically to review theCompany’s interest rate risk position and profitability, and to recommendadjustments for consideration by executive management. Management also reviewsthe Bank’s securities portfolio, formulates investment strategies, and overseesthe timing 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 inasset or liability mix of the Company or other factors may produce a decreasein net interest margin in an upward moving rate environment even as the netportfolio value (“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 June 30, 2007 (the most recent report available)and September 30, 2006, an analysis of the Company’s interest rate risk asmeasured by the estimated changes in NPV resulting from instantaneous andsustained parallel shifts in the yield curve (+300 or –200 basis points,measured in 100 basis point increments). Management does not believe that the Company has experienced anymaterial changes in its market risk position from that disclosed in the Company’sAnnual Report on Form 10-K for Fiscal 2007 or that the Company’s primary marketrisk exposures and how those exposures were managed during the three monthsended September 30, 2007 changed significantly when compared to June 30, 2007.

 

Thedata in the following tables is based on assumptions utilized by the OTS inassessing interest rate risk of thrift institutions and published in “SelectedAsset and Liability Price Tables as of June 30, 2007” and “Selected Asset and LiabilityPrice Tables as of September 30, 2006.” Even if interest rates change in the designated amounts, there can be noassurance that the Company’s assets and liabilities would perform as set forthbelow.

 

31

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| ** **         | ** ** | **June 30, 2007**           | ** ** |
|--------------------|------------|-----------------------------|------------|
| **Change in**      | ** ** | **Estimated  NPV**          | ** ** | **Estimated Increase  (Decrease) in NPV** | ** ** |
| **Interest Rates** | ** ** | **Amount**                  | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|               |       | **(Dollars  in Thousands)** |       |
| Basis Points       |       |                        |       |   |   |   |   |
|               |       |                        |       |   |   |   |   |
| +300               |       | $                           | 101,843    |   | $ | (25,309 | ) | (20 | )% |
| +200               |       | 110,655                     |       | (16,497 | ) | (13 | ) |
| +100               |       | 119,202                     |       | (7,950 | ) | (6 | ) |
| —             |       | 127,152                     |       | — |   | — |   |
| -100               |       | 131,950                     |       | 4,798 |   | 4 |   |
| -200               |       | 131,297                     |       | 4,146 |   | 3 |   |
|                    |            |                             |            |  |  |  |  |  |  |

 

| ** **         | ** ** | **September 30, 2006**      | ** ** |
|--------------------|------------|-----------------------------|------------|
| **Change in**      | ** ** | **Estimated  NPV**          | ** ** | **Estimated Increase  (Decrease) in NPV** | ** ** |
| **Interest Rates** | ** ** | **Amount**                  | ** ** | **Amount** | ** ** | **Percent** | ** ** |
|               |       | **(Dollars  in Thousands)** |       |
| Basis Points       |       |                        |       |   |   |   |   |
|               |       |                        |       |   |   |   |   |
| +300               |       | $                           | 86,907     |   | ($26,413 | ) | (23 | )% |
| +200               |       | 96,391                      |       | (16,929 | ) | (15 | ) |
| +100               |       | 105,509                     |       | (7,811 | ) | (7 | ) |
| —             |       | 113,320                     |       | — |   | — |   |
| -100               |       | 117,771                     |       | 4,451 |   | 4 |   |
| -200               |       | 119,032                     |       | 5,712 |   | 5 |   |
|                    |            |                             |            |  |  |  |  |  |

 

In managingmarket risk and the asset/liability mix, the Bank has placed an emphasis ondeveloping a portfolio in which, to the extent practicable, assets andliabilities reprice within similar periods. The goal of this policy is to provide a relatively consistent level ofnet interest income in varying interest rate cycles and to minimize thepotential for significant fluctuations from period to period.

 

**Item 4.  Controls andProcedures**

 

TheCompany’s management has evaluated, under the supervision and with the participationof the Company’s Chairman, President and Chief Executive Officer and theCompany’s Executive Vice President, Chief Financial Officer and Treasurer, theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures, as defined in Rule 13a-15(e), and have concluded that, as ofthe end of the period covered by this Quarterly Report, the Company’sdisclosure controls and procedures are effective for gathering, analyzing anddisclosing information the Company is required to disclose in its periodicreports filed under the Exchange Act. There were no significant changes in the Company’s internal control overfinancial reporting during the period

 

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covered by the Quarterly Reportthat materially affected, or are reasonably likely to materially affect, theCompany’s internal control over financial reporting.

 

**PART II — OTHER INFORMATION**

 

**Item 1.****                                                           LegalProceedings**

 

On June 26, 2006,the Company filed a$3.8 million lawsuit against MetaBank and two individuals, J. Tyler Haahr and Daniel A. 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.  Legalproceedings are currently pending in the Second Judicial Circuit Court,Minnehaha County, South Dakota.

 

In addition, the Company, the Bank and each of their subsidiaries are, from time totime, involved as plaintiff or defendant in various legal actions arising inthe normal course of their businesses. While the ultimate outcome of any such proceedings cannot be predictedwith certainty, it is generally the opinion of management, after consultationwith counsel representing the Bank and the Company in any such proceedings, theresolution of any such proceedings should not have a material effect on theCompany’s consolidated 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.

 

**Item 1A.****                                                  RiskFactors**

 

There have been no material changes from the risk factors disclosed inPart 1, Item 1A “Risk Factors” in the Company’s Annual Report on Form 10-K forFiscal 2007.

 

 

**Item 2.****                                                           UnregisteredSales of Equity Securities and Use of Proceeds**

 

The following table sets forth the purchases by the Company of itscommon stock during the quarterly period ended September 30, 2007.

 
| ** **               | ** ** | **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** | ** ** |
| July 1 - 31, 2007        |       | —        |       | $              | 0.00       |                    | —     |                    | 399,141    |   |
| August 1 - 31, 2007      |       | 70,000        |       | $              | 16.35      |                    | 70,000     |                    | 329,141    |   |
| September 1 - 30, 2007   |       | —        |       | $              | 0.00       |                    | —     |                    | 329,141    |   |
|  1st  Quarter Total |       | 70,000        |       | $              | 16.35      |                    | 70,000     |                    |       |   |

 

The Company currently has in effect a stock buyback program, which waspublicly announced on April 30, 2007 and pursuant to which up to 10% of thecommon stock of the Company that was outstanding on May 1, 2007, which equals399,141 shares, may be acquired through April 30, 2008.  As of September 30, 2007, 70,000 shares ofcommon stock have been purchased pursuant to this program.

 

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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-Q**

**SIGNATURES**

 

Pursuant tothe requirements of the Securities Exchange Act of 1934, the registrant hasduly caused this report to be signed on its behalf by the undersigned thereuntoduly authorized.

 

 
|   |              |   |   |   | HF Financial  Corp.                            |
|--------|-------------------|--------|--------|--------|------------------------------------------------|
|   |              |   |   |   | (Registrant)                                   |
|   |              |   |   |   |                                           |
|   |              |   |   |   |                                           |
| Date:  | November 14, 2007 |   |   | By:    | /s/ Curtis  L. Hage                            |
|   |              |   |   |   | Curtis L.  Hage, Chairman, President           |
|   |              |   |   |   | And Chief  Executive Officer                   |
|   |              |   |   |   | (Principal  Executive Officer)                 |
|   |              |   |   |   |                                           |
| Date:  | November 14, 2007 |   |   | 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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