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** **

 

** **

**UNITEDSTATES**

**SECURITIESAND EXCHANGE COMMISSION**

**Washington,D.C.  20549**

** **

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**FORM 10-Q**

** **

**x****      QUARTERLY REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**For theQuarterly Period Ended September 30, 2010**

 

**OR**

 

**o****         TRANSITION REPORT PURSUANT TO SECTION 13OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Commissionfile number 0-19972**

** **

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**HFFINANCIAL CORP.**

(Exact name of registrant asspecified in its charter)

 

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

 

(**605) 333-7556**

(Registrant’s telephonenumber, including area code)

 

Indicate by check mark whether the Registrant(1) has filed all reports required to be filed by Section 13 orSection 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.   Yes x No o

 

Indicate by check mark whether the Registranthas submitted electronically and posted on its corporate Web site, if any,every Interactive Data File required to be submitted and posted pursuant toRule 405 of Regulation S-T (Section 232.405 of this chapter) duringthe preceding 12 months (or for such shorter period that the Registrant wasrequired to submit and post such files).  Yes o No o

 

Indicate by check mark whether the registrantis a large accelerated filer, an accelerated filer, a non-accelerated filer, ora smaller reporting company. See the definitions of “large accelerated filer,” “acceleratedfiler” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.(Check one):

 

| Large accelerated filer o                                         |   | Accelerated filer o              |
|----------------------------------------------------------------------------------|--------|--------------------------------------------|
|                                                                             |   |                                       |
| Non-accelerated filer o  (Do not check if a smaller reporting company) |   | Smaller reporting company x |

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).   Yes o No x

 

As of November 5, 2010,there were 6,963,039 shares of the registrant’s common stock outstanding.

 

 

 

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Table ofContents

 

**QuarterlyReport on Form 10-Q**

**Table of Contents**

 
| ** **                                   | ** **                                                                                  | **Page Number** |
|----------------------------------------------|---------------------------------------------------------------------------------------------|----------------------|
| ** **                                   |                                                                                        |
| **PART I — FINANCIAL INFORMATION** |
|                                         |                                                                                        |                 |
| Item 1.                                      | Financial Statements (Unaudited):                                                           |                 |
|                                         |                                                                                        |                 |
|                                         | Consolidated Statements of  Financial Condition                                             |                 |
|                                         | At  September 30, 2010 and June 30, 2010                                          | 1                    |
|                                         |                                                                                        |                 |
|                                         | Consolidated  Statements of Income for the                                                  |                 |
|                                         | Three  Months Ended September 30, 2010 and 2009                                        | 2                    |
|                                         |                                                                                        |                 |
|                                         | Consolidated  Statements of Cash Flows for the                                              |                 |
|                                         | Three  Months Ended September 30, 2010 and 2009                                        | 3                    |
|                                         |                                                                                        |                 |
|                                         | Notes to Consolidated Financial Statements                                                  | 4                    |
|                                         |                                                                                        |                 |
| Item 2.                                      | Management’s  Discussion and Analysis of Financial Condition and Results of Operations | 20                   |
|                                         |                                                                                        |                 |
| Item 3.                                      | Quantitative  and Qualitative Disclosures about Market Risk                                 | 38                   |
|                                         |                                                                                        |                 |
| Item 4.                                      | Controls and  Procedures                                                                    | 39                   |
|                                         |                                                                                        |                 |
| **PART II  — OTHER INFORMATION**   |
|                                         |                                                                                        |                 |
| Item 1.                                      | Legal Proceedings                                                                           | 40                   |
|                                         |                                                                                        |                 |
| Item 1A.                                     | Risk Factors                                                                                | 40                   |
|                                         |                                                                                        |                 |
| Item 2.                                      | Unregistered  Sales of Equity Securities and Use of Proceeds                                | 40                   |
|                                         |                                                                                        |                 |
| Item 3.                                      | Defaults  upon Senior Securities                                                            | 40                   |
|                                         |                                                                                        |                 |
| Item 4.                                      | [Removed and  Reserved]                                                                     | 40                   |
|                                         |                                                                                        |                 |
| Item 5.                                      | Other Information                                                                           | 40                   |
|                                         |                                                                                        |                 |
| Item 6.                                      | Exhibits                                                                                    | 40                   |
|                                         |                                                                                        |                 |
| Form 10-Q                               | Signature Page                                                                              | 41                   |

 

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Table ofContents

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1.  *Financial Statements***

 

**HF FINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF FINANCIAL CONDITION**

**(Dollars in thousands, except share data)**

 
| ** **                                                                                                                                                          | ** ** | **September 30, 2010** | ** ** | **June 30, 2010** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                                          | ** ** | **(Unaudited)**                  | ** ** | **(Audited)**               | ** ** |
| **ASSETS**                                                                                                                                                          |       |                             | ** ** | ** **                  | ** ** |
| Cash and cash equivalents                                                                                                                                           |       | $                                | 21,838     |                        | $          | 20,805 |   |
| Securities available for sale                                                                                                                                       |       | 268,716                          |       | 264,442                     |       |
| Federal Home Loan Bank stock                                                                                                                                        |       | 11,648                           |       | 10,334                      |       |
| Loans held for sale                                                                                                                                                 |       | 18,120                           |       | 25,287                      |       |
|                                                                                                                                                                |       |                             |       |                        |       |
| Loans and leases receivable                                                                                                                                         |       | 880,067                          |       | 872,279                     |       |
| Allowance for loan and lease losses                                                                                                                                 |       | (12,319                          | )          | (9,575                      | )          |
| Net loans and leases receivable                                                                                                                                     |       | 867,748                          |       | 862,704                     |       |
|                                                                                                                                                                |       |                             |       |                        |       |
| Accrued interest receivable                                                                                                                                         |       | 10,688                           |       | 8,785                       |       |
| Office properties and equipment, net of  accumulated depreciation                                                                                                   |       | 15,305                           |       | 14,973                      |       |
| Foreclosed real estate and other properties                                                                                                                         |       | 942                              |       | 946                         |       |
| Cash value of life insurance                                                                                                                                        |       | 15,284                           |       | 15,144                      |       |
| Servicing rights                                                                                                                                                    |       | 12,970                           |       | 12,733                      |       |
| Goodwill, net                                                                                                                                                       |       | 4,366                            |       | 4,366                       |       |
| Other assets                                                                                                                                                        |       | 12,859                           |       | 12,496                      |       |
| Total assets                                                                                                                                                        |       | $                                | 1,260,484  |                        | $          | 1,253,015 |   |
|                                                                                                                                                                |       |                             |       |                        |       |
| **LIABILITIES AND STOCKHOLDERS’  EQUITY**                                                                                                                      |       |                             |       |                        |       |
| ** **                                                                                                                                                          |       |                             |       |                        |       |
| LIABILITIES                                                                                                                                                         |       |                             |       |                        |       |
| Deposits                                                                                                                                                            |       | $                                | 877,618    |                        | $          | 914,264 |   |
| Advances from Federal Home Loan Bank and other  borrowings                                                                                                          |       | 230,366                          |       | 190,719                     |       |
| Subordinated debentures payable to trusts                                                                                                                           |       | 27,837                           |       | 27,837                      |       |
| Advances by borrowers for taxes and insurance                                                                                                                       |       | 16,491                           |       | 11,460                      |       |
| Accrued expenses and other liabilities                                                                                                                              |       | 14,799                           |       | 14,300                      |       |
| Total liabilities                                                                                                                                                   |       | 1,167,111                        |       | 1,158,580                   |       |
|                                                                                                                                                                |       |                             |       |                        |       |
| STOCKHOLDERS’ EQUITY                                                                                                                                           |       |                             |       |                        |       |
| Preferred stock, $.01 par value, 500,000 shares  authorized, none outstanding                                                                                       |       | —                           |       | —                      |       |
| Common stock, $.01 par value, 10,000,000 shares  authorized, 9,046,494 and 9,025,792 shares issued at September 30, 2010 and  June 30, 2010, respectively |       | 90                               |       | 90                          |       |
| Common stock subscribed for but not issued                                                                                                                          |       | —                           |       | —                      |       |
| Additional paid-in capital                                                                                                                                          |       | 44,768                           |       | 44,496                      |       |
| Retained earnings, substantially restricted                                                                                                                         |       | 83,719                           |       | 84,011                      |       |
| Accumulated other comprehensive (loss), net of  related deferred tax effect                                                                                         |       | (4,307                           | )          | (3,265                      | )          |
| Less cost of treasury stock, 2,083,455 and  2,083,455 shares at September 30, 2010 and June 30, 2010,  respectively                                       |       | (30,897                          | )          | (30,897                     | )          |
| Total stockholders’ equity                                                                                                                                     |       | 93,373                           |       | 94,435                      |       |
| Total liabilities and stockholders’ equity                                                                                                                     |       | $                                | 1,260,484  |                        | $          | 1,253,015 |   |

 

*See accompanying notes to unaudited consolidatedfinancial statements.*

 

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**HF FINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(Dollars in thousands, except share data)**

**(Unaudited)**

 
| ** **                                                               | ** ** | **Three Months Ended** | ** ** |
|--------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                               | ** ** | **September 30,**           | ** ** |
| ** **                                                               | ** ** | **2010**                         | ** ** | **2009** | ** ** |
| Interest, dividend and loan fee income:                                  |       |                             |       |   |   |
| Loans and leases receivable                                              |       | $                                | 12,708     |   | $ | 12,343 |   |
| Investment securities and interest-earning  deposits                     |       | 1,483                            |       | 2,290 |   |
|                                                                     |       | 14,191                           |       | 14,633 |   |
| Interest expense:                                                        |       |                             |       |   |   |
| Deposits                                                                 |       | 2,612                            |       | 3,524 |   |
| Advances from Federal Home Loan Bank and other  borrowings               |       | 1,954                            |       | 2,358 |   |
|                                                                     |       | 4,566                            |       | 5,882 |   |
| Net interest income                                                      |       | 9,625                            |       | 8,751 |   |
| Provision for losses on loans and leases                                 |       | 3,367                            |       | 343 |   |
|                                                                     |       |                             |       |   |   |
| Net interest income after provision for losses on  loans and leases      |       | 6,258                            |       | 8,408 |   |
|                                                                     |       |                             |       |   |   |
| Noninterest income:                                                      |       |                             |       |   |   |
| Fees on deposits                                                         |       | 1,609                            |       | 1,446 |   |
| Loan servicing income                                                    |       | 502                              |       | 491 |   |
| Gain on sale of loans, net                                               |       | 747                              |       | 496 |   |
| Earnings on cash value of life insurance                                 |       | 166                              |       | 164 |   |
| Trust income                                                             |       | 154                              |       | 257 |   |
| Gain on sale of securities, net                                          |       | 397                              |       | 533 |   |
|                                                                     |       |                             |       |   |   |
| Total other-than-temporary impairment losses                             |       | —                           |       | (3,914 | ) |
| Portion of loss recognized in other comprehensive  income (before taxes) |       | —                           |       | 2,056 |   |
| Net impairment losses recognized in earnings                             |       | —                           |       | (1,858 | ) |
|                                                                     |       |                             |       |   |   |
| Other                                                                    |       | 207                              |       | 169 |   |
|                                                                     |       | 3,782                            |       | 1,698 |   |
| Noninterest expense:                                                     |       |                             |       |   |   |
| Compensation and employee benefits                                       |       | 5,547                            |       | 5,163 |   |
| Occupancy and equipment                                                  |       | 1,139                            |       | 1,084 |   |
| FDIC insurance                                                           |       | 344                              |       | 325 |   |
| Check and data processing expense                                        |       | 706                              |       | 698 |   |
| Professional fees                                                        |       | 591                              |       | 600 |   |
| Marketing and community investment                                       |       | 406                              |       | 471 |   |
| Foreclosed real estate and other properties, net                         |       | 25                               |       | 19 |   |
| Other                                                                    |       | 669                              |       | 589 |   |
|                                                                     |       | 9,427                            |       | 8,949 |   |
|                                                                     |       |                             |       |   |   |
| Income before income taxes                                               |       | 613                              |       | 1,157 |   |
|                                                                     |       |                             |       |   |   |
| Income tax expense                                                       |       | 123                              |       | 302 |   |
|                                                                     |       |                             |       |   |   |
| Net income                                                               |       | $                                | 490        |   | $ | 855 |   |
|                                                                     |       |                             |       |   |   |
| Comprehensive income (loss)                                              |       | $                                | (552       | ) | $ | 2,098 |   |
|                                                                     |       |                             |       |   |   |
| Basic earnings per common share:                                         |       | $                                | 0.07       |   | $ | 0.21 |   |
| Diluted earnings per common share:                                       |       | 0.07                             |       | 0.21 |   |
| Dividends declared per common share                                      |       | 0.11                             |       | 0.11 |   |

* *

*See accompanying notes to unaudited consolidatedfinancial statements.*

 

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** **

**HF FINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(Dollars in thousands, except share data)**

**(Unaudited)**

 
| ** **                                                                                            | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                            | ** ** | **2010**                                                 | ** ** | **2009** | ** ** |
| Cash flows from operating activities                                                                  |       |                                                     |       |   |   |
| Net income                                                                                            |       | $                                                        | 490        |   | $ | 855 |   |
| Adjustments to reconcile net income to net cash provided  by (used in) operating activities           |       |                                                     |       |   |   |
| Provision for losses on loans and leases                                                              |       | 3,367                                                    |       | 343 |   |
| Depreciation                                                                                          |       | 490                                                      |       | 497 |   |
| Amortization of discounts and premiums on  securities and other                                       |       | 930                                                      |       | 707 |   |
| Stock based compensation                                                                              |       | 133                                                      |       | 152 |   |
| Net change in loans held for resale                                                                   |       | 7,914                                                    |       | (7,415 | ) |
| (Gain) on sale of loans, net                                                                          |       | (747                                                     | )          | (496 | ) |
| Realized (gain) on sale of securities, net                                                            |       | (395                                                     | )          | (533 | ) |
| Other-than-temporary impairments recognized in  noninterest income                                    |       | —                                                   |       | 1,858 |   |
| (Gains) losses and provision-for-losses on sales  of foreclosed real estate and other properties, net |       | 3                                                        |       | (5 | ) |
| Change in other assets and liabilities                                                                |       | (3,182                                                   | )          | (3,936 | ) |
| Net cash provided by (used in) operating  activities                                                  |       | 9,003                                                    |       | (7,973 | ) |
|                                                                                                  |       |                                                     |       |   |   |
| Cash flows from investing activities                                                                  |       |                                                     |       |   |   |
| Loan participations purchased                                                                         |       | (305                                                     | )          | (921 | ) |
| Net change in loans outstanding                                                                       |       | (8,135                                                   | )          | 17,536 |   |
| Securities available for sale                                                                         |       |                                                     |       |   |   |
| Sales, maturities, repayments and adjustments                                                         |       | 30,140                                                   |       | 23,783 |   |
| Purchases                                                                                             |       | (34,679                                                  | )          | (21,505 | ) |
| Purchase of Federal Home Loan Bank stock                                                              |       | (2,720                                                   | )          | — |   |
| Redemption of Federal Home Loan Bank stock                                                            |       | 1,406                                                    |       | — |   |
| Purchase of office properties and equipment                                                           |       | (822                                                     | )          | (936 | ) |
| Purchase of servicing rights                                                                          |       | (292                                                     | )          | (349 | ) |
| Proceeds from sale of foreclosed real estate and  other properties                                    |       | 48                                                       |       | 147 |   |
| Net cash provided by (used in) investing  activities                                                  |       | (15,359                                                  | )          | 17,755 |   |
|                                                                                                  |       |                                                     |       |   |   |
| Cash flows from financing activities                                                                  |       |                                                     |       |   |   |
| Net (decrease) in deposit accounts                                                                    |       | (36,646                                                  | )          | (7,627 | ) |
| Proceeds of advances from Federal Home Loan Bank  and other borrowings                                |       | 259,817                                                  |       | 991,599 |   |
| Payments on advances from Federal Home Loan Bank  and other borrowings                                |       | (220,170                                                 | )          | (997,190 | ) |
| Increase in advances by borrowers                                                                     |       | 5,031                                                    |       | 4,095 |   |
| Proceeds from issuance of common stock                                                                |       | 139                                                      |       | — |   |
| Cash dividends paid                                                                                   |       | (782                                                     | )          | (453 | ) |
| Net cash provided by (used in) financing  activities                                                  |       | 7,389                                                    |       | (9,576 | ) |
|                                                                                                  |       |                                                     |       |   |   |
| Increase in cash and cash equivalents                                                                 |       | 1,033                                                    |       | 206 |   |
| Cash and cash equivalents                                                                             |       |                                                     |       |   |   |
| Beginning                                                                                             |       | 20,805                                                   |       | 18,511 |   |
| Ending                                                                                                |       | $                                                        | 21,838     |   | $ | 18,717 |   |
|                                                                                                  |       |                                                     |       |   |   |
| Supplemental disclosures of cash flows information                                                    |       |                                                     |       |   |   |
| Cash payments for interest                                                                            |       | $                                                        | 4,405      |   | $ | 5,509 |   |
| Cash payments for income and franchise taxes, net                                                     |       | 13                                                       |       | 310 |   |

 

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**HFFINANCIAL CORP.**

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

**FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2010 AND 2009**

**(Unaudited)**

 

**NOTE 1—SELECTED ACCOUNTING POLICIES**

 

*Basisof Financial Statement Presentation*

 

The consolidated financial information of HF Financial Corp. (the “Company”)and its wholly-owned subsidiaries included in this Quarterly Report on Form 10-Qis unaudited.  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 Form 10-Kfor the fiscal year ended June 30, 2010 (“fiscal 2010”), 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 interim consolidated financial statements include the accounts ofthe Company, its wholly-owned subsidiaries, Home Federal Bank (the “Bank”), HFFinancial Group, Inc. (“HF Group”) and HomeFirst Mortgage Corp. (the “MortgageCorp.”), and the Bank’s wholly-owned subsidiaries, Mid America Capital Services, Inc.(“Mid America Capital”), Hometown Investment Services, Inc. (“Hometown”),Mid-America Service Corporation and PMD, Inc.  The interim consolidated financial statementsreflect the deconsolidation of the wholly-owned subsidiary trusts of theCompany: HF Financial Capital Trust III (“Trust III”), HF Financial CapitalTrust IV (“Trust IV”), HF Financial Capital Trust V (“Trust V”) and HFFinancial Capital Trust VI (“Trust VI”). See Note 10 of “Notes to ConsolidatedFinancial Statements.”  All intercompanybalances and transactions have been eliminated in consolidation.

 

Management has evaluated subsequent events for potential disclosure orrecognition through November 12, 2010, the date of the filing of theconsolidated financial statements with the Securities and Exchange Commission.

 

**NOTE2—REGULATORY CAPITAL**

 

The following table sets forth the Bank’s compliance with its minimumcapital requirements for a well-capitalized institution at September 30,2010:

 
| ** **                                           | ** ** | **Amount**                           | ** **    | **Percent** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|---------------|-------------|------------|
| ** **                                           | ** ** | **(Dollars in Thousands)** | ** **    |
| Tier I (core) capital (to adjusted total assets):    |       |                                 |          |        |       |
| Required                                             |       | $                                    |  62,750  |        | 5.00       | % |
| Actual                                               |       | 109,532                              |          | 8.73        |       |
| Excess over required                                 |       | 46,782                               |          | 3.73        |       |
|                                                 |       |                                 |          |        |       |
| Total Risk-based capital (to risk-weighted  assets): |       |                                 |          |        |       |
| Required                                             |       | $                                    |  101,441 |        | 10.00      | % |
| Actual                                               |       | 118,790                              |          | 11.71       |       |
| Excess over required                                 |       | 17,349                               |          | 1.71        |       |

 

**NOTE 3—EARNINGS PER COMMON SHARE**

 

Basic earnings per common share is computed by dividing incomeavailable to common stockholders (the numerator) by the weighted-average numberof common shares outstanding (the denominator) during the period.  Shares issued during the period and sharesreacquired during the period are weighted for the portion of the period theywere outstanding. The weighted average number of basic common sharesoutstanding for the three months ended September 30, 2010 and 2009 was6,946,303 and 4,030,391, respectively.

 

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Dilutive earnings per common share is similar to the computation ofbasic earnings per common share except the denominator is increased to includethe number of additional common shares that would have been outstanding if thedilutive options outstanding had been exercised. The weighted average number ofcommon and dilutive potential common shares outstanding for the three monthsended September 30, 2010 and 2009 was 6,946,547 and 4,041,650,respectively.

 

**NOTE 4****—****INVESTMENTS IN SECURITIES**

 

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

 
| ** **                             | ** ** | **September 30, 2010** | ** **    |
|----------------------------------------|------------|----------------------------------|---------------|
| ** **                             | ** ** | ** **                       | ** **    | **Total Other-Than** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **                       | ** **    | **Temporary** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **                       | ** **    | **Impairment** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **                       | ** **    | **Recognized in ** | ** ** | **Adjusted** | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amortized**                    | ** **    | **Accumulated Other** | ** ** | **Carrying** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                             | ** ** | **Cost**                         | ** **    | **Comprehensive Income** | ** ** | **Cost** | ** ** | **Gains** | ** ** | **( Losses )** | ** ** | **Value** | ** ** |
|                                   |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| Debt securities:                       |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies               |       | $                                |  4,550   |   | $ |  — |   | $ |  4,550 |   | $ |  30 |   | $ |  — |   | $ |  4,580 |   |
| Municipal bonds                        |       | 14,161                           |          | — |   | 14,161 |   | 583 |   | (12 | ) | 14,732 |   |
| Trust preferred securities             |       | 12,370                           |          | (3,080 | ) | 9,290 |   | — |   | (6,021 | ) | 3,269 |   |
|                                   |       | 31,081                           |          | (3,080 | ) | 28,001 |   | 613 |   | (6,033 | ) | 22,581 |   |
|                                   |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| Equity securities:                     |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| FNMA                                   |       | 8                                |          | (8 | ) | — |   | — |   | — |   | — |   |
| Federal Ag Mortgage                    |       | 7                                |          | — |   | 7 |   | — |   | (3 | ) | 4 |   |
| Other Investments                      |       | 253                              |          | — |   | 253 |   | — |   | — |   | 253 |   |
|                                   |       | 268                              |          | (8 | ) | 260 |   | — |   | (3 | ) | 257 |   |
|                                   |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| Residential mortgage-backed securities |       | 241,532                          |          | — |   | 241,532 |   | 4,632 |   | (286 | ) | 245,878 |   |
|                                   |       | $                                |  272,881 |   | $ |  (3,088 | ) | $ |  269,793 |   | $ |  5,245 |   | $ |  (6,322 | ) | $ |  268,716 |   |

 

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| ** **                             | ** ** | **September 30, 2009** | ** **    |
|----------------------------------------|------------|----------------------------------|---------------|
| ** **                             | ** ** | ** **                       | ** **    | **Total Other-Than** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **                       | ** **    | **Temporary** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **                       | ** **    | **Impairment** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | ** **                       | ** **    | **Recognized in ** | ** ** | **Adjusted** | ** ** | **Gross** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                             | ** ** | **Amortized**                    | ** **    | **Accumulated Other** | ** ** | **Carrying** | ** ** | **Unrealized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                             | ** ** | **Cost**                         | ** **    | **Comprehensive Income** | ** ** | **Cost** | ** ** | **Gains** | ** ** | **( Losses )** | ** ** | **Value** | ** ** |
|                                   |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| Debt securities:                       |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies               |       | $                                |  2,632   |   | $ |  — |   | $ |  2,632 |   | $ |  40 |   | $ |  — |   | $ |  2,672 |   |
| Municipal bonds                        |       | 14,210                           |          | — |   | 14,210 |   | 444 |   | (37 | ) | 14,617 |   |
| Trust preferred securities             |       | 12,283                           |          | (2,255 | ) | 10,028 |   | — |   | (4,379 | ) | 5,649 |   |
|                                   |       | 29,125                           |          | (2,255 | ) | 26,870 |   | 484 |   | (4,416 | ) | 22,938 |   |
|                                   |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| Equity securities:                     |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| FNMA                                   |       | 8                                |          | (8 | ) | — |   | — |   | — |   | — |   |
| Federal Ag Mortgage                    |       | 7                                |          | — |   | 7 |   | — |   | (3 | ) | 4 |   |
| Other Investments                      |       | 253                              |          | — |   | 253 |   | — |   | — |   | 253 |   |
|                                   |       | 268                              |          | (8 | ) | 260 |   | — |   | (3 | ) | 257 |   |
|                                   |       |                             |          |   |   |   |   |   |   |   |   |   |   |
| Residential mortgage-backed securities |       | 194,819                          |          | — |   | 194,819 |   | 4,030 |   | (907 | ) | 197,942 |   |
|                                   |       | $                                |  224,212 |   | $ |  (2,263 | ) | $ |  221,949 |   | $ |  4,514 |   | $ |  (5,326 | ) | $ |  221,137 |   |

 

Management has implemented a process toidentify securities that could potentially have a credit impairment that isother-than-temporary.  This processinvolves evaluation of the length of time and extent to which the fair valuehas been less than the amortized cost basis, review of available informationregarding the financial position of the issuer, monitoring the rating of thesecurity, cash flow projections, and the Company’s intent to sell a security orwhether it is more likely than not it will be required to sell the securitybefore the recovery of its amortized cost which, in some cases, may extend tomaturity.  To the extent the Companydetermines that a security is deemed to be other-than-temporarily impaired, animpairment loss is recognized.

 

For all securities that are consideredtemporarily impaired, the Company does not intend to sell these securities (hasnot made a decision to sell) and it is not more likely than not that theCompany will be required to sell the security before recovery of its amortizedcost, which may occur at maturity.  TheCompany believes that it will collect all principal and interest due on allinvestments that have amortized cost in excess of fair value that areconsidered only temporarily impaired.

 

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The following tablepresents the fair value and age of gross unrealized losses by investmentcategory at September 30, 2010*:* 

 
| ** **                                    | ** ** | **Less than 12 Months** | ** **   | **12 Months or More** | ** ** | **Total**      | ** ** |
|-----------------------------------------------|------------|----------------------------------------|--------------|--------------------------------------|------------|----------------|------------|
| ** **                                    | ** ** | ** **                             | ** **   | **Gross**                            | ** ** | ** **     | ** ** | **Gross** | ** ** | ** ** | ** ** | **Gross** | ** ** |
| ** **                                    | ** ** | **Fair **                         | ** **   | **Unrealized **                 | ** ** | **Fair ** | ** ** | **Unrealized ** | ** ** | **Fair ** | ** ** | **Unrealized** | ** ** |
| ** **                                    | ** ** | **Value**                              | ** **   | **(Losses)**                         | ** ** | **Value**      | ** ** | **(Losses)** | ** ** | **Value** | ** ** | **(Losses)** | ** ** |
| ** **                                    | ** ** | **(Dollars in Thousands)**   |
| Debt securities:                              |       |                                   |         |                                 |       |           |       |   |   |   |   |   |   |
| Municipal bonds                               |       | $                                      |  669    |                                 | $          |  (7       | )          | $ |  514 |   | $ |  (5 | ) | $ |  1,183 |   | $ |  (12 | ) |
| Trust preferred securities                    |       | —                                 |         | —                               |       | 3,269          |       | (6,021 | ) | 3,269 |   | (6,021 | ) |
|                                          |       | 669                                    |         | (7                                   | )          | 3,783          |       | (6,026 | ) | 4,452 |   | (6,033 | ) |
| Equity securities:                            |       |                                   |         |                                 |       |           |       |   |   |   |   |   |   |
| Federal Ag Mortgage                           |       | 4                                      |         | (3                                   | )          | —         |       | — |   | 4 |   | (3 | ) |
|                                          |       | 4                                      |         | (3                                   | )          | —         |       | — |   | 4 |   | (3 | ) |
| Agency residential mortgage-backed securities |       | 46,053                                 |         | (286                                 | )          | 164            |       | — |   | 46,217 |   | (286 | ) |
|                                          |       | $                                      |  46,726 |                                 | $          |  (296     | )          | $ |  3,947 |   | $ |  (6,026 | ) | $ |  50,673 |   | $ |  (6,322 | ) |

 

For the three months ended September 30,2010, gross proceeds from the securities sold at again were $12.6 million, resulting in a gain on sale of securities of$397,000.  This compares to grossproceeds of $24.2 million, resulting in a gain on sale of securities of $1.1million for the three months ended September 30, 2009.  No securities were sold for a loss during thefirst quarters of fiscal 2011 and fiscal 2010.

 

The unrealized losses reported for municipal bonds relate to sixmunicipal general obligation or revenue bonds. The unrealized losses are primarily attributed to changes in creditspreads or market interest rate increases since the securities were originallyacquired, rather than due to credit or other causes.  Managementdoes not believe any individual unrealized losses as of September 30, 2010represent an other-than-temporary impairment for these investments.  The Company does not have the intent to sellthese securities (has not made a decision to sell) and has assessed that it isnot more likely than not that the Company will be required to sell thesesecurities before anticipated recovery of fair value.

 

The unrealized losses reported for agencyresidential mortgage-backed securities relate to 16 securities issued by theFederal National Mortgage Association (“FNMA”), the Government NationalMortgage Association (“GNMA”), or the Federal Home Loan Mortgage Corporation (“FHLMC”).  These unrealized losses are primarilyattributable to changes in interest rates and the contractual cash flows ofthose investments which are guaranteed by an agency of the U.S. government.  Management does not believe any of theseunrealized losses as of September 30, 2010 represent another-than-temporary impairment for those investments.  The Company does not have the intent to sellthese securities (has not made a decision to sell) and has assessed that it isnot more likely than not that the Company will be required to sell thesesecurities before anticipated recovery of fair value.

 

The unrealized lossesreported for trust preferred securities are attributable to six rated pooledsecurities. Rating downgrades regarding these investments have occurred placingeach in a below investment grade rating. The securities have an adjustedcarrying cost of $1.9 million rated Caa3, $2.4 million rated Caa1, and $5.0million rated Ca.  The market for thesesecurities is currently inactive. The CUSIPs of the trust preferred securitiesare 74042TAE1 rated Caa3, 740417AB6 and 74042CAE8 rated Caa1, and 74041EAC9,74041RAB2, and 55312HAE9 rated Ca. The Company performed assessments ofavailable information for each security during the first quarter ended September 30,2010, and also considered factors such as overall deal structure and itsposition within the structure, quality of underlying issuers within each pool,defaults and recoveries, loss severities and prepayments. Based upon scenariosdeveloped in regard to this information, management compared the present valueof best estimates of cash flows expected to be collected from each security atthe security’s effective interest rate to the amortized cost basis of eachsecurity. Management determined that no trust preferred securities exhibited another-than-temporary impairment credit loss for the quarter ended September 30,  2010. See Note 13 “Financial Instruments” for additional information relatedto the determination of fair value. The Company does not have the intent tosell these six securities (has not made a decision to sell) and has assessedthat it is not more likely than not that the Company will be required to sellthese securities before anticipated recovery of 

 

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fair value. Within this segment, five securitieswith amortized cost of $7.5 million are quarterly variable-rate securities tiedto 3-month LIBOR.

 

The following tablepresents the amounts recognized in the Consolidated Statements of Income forother-than-temporary impairments related to credit losses charged to earnings:  

 
| ** **                                                                                                                                                                              | ** ** | **Three Months Ended**                                                                                                                                                                         | ** **  |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|-------------|
| ** **                                                                                                                                                                              | ** ** | **September 30, 2010**                                                                                                                                                                         | ** **  |
| ** **                                                                                                                                                                              | ** ** | **(Dollars in Thousands)**                                                                                                                                                                     | ** **  |
| Beginning balance of credit losses on securities  held as of July 1, 2010 for which a portion of other-than-temporary  impairment was recognized in other comprehensive income (1) |       | $                                                                                                                                                                                                        |  3,088 |   |
|                                                                                                                                                                                    |       |                                                                                                                                                                                                     |        |
| Credit losses for which an other-than-temporary  impairment was not previously recognized                                                                                               |       |                                   — |        |
|                                                                                                                                                                                    |       |                                                                                                                                                                                                     |        |
| Increases to the amount related to the credit  losses for which other-than-temporary was previously recognized                                                                          |       |                                   — |        |
|                                                                                                                                                                                    |       |                                                                                                                                                                                                     |        |
| Ending balance of credit losses on securities held  as of September 30, 2010 for which a portion of other-than-temporary  impairment was recognized in other comprehensive income  |       | $                                                                                                                                                                                                        |  3,088 |   |

 

----

(1) Includes$8 of other-than-temporary impairment related to Fannie Mae common stock

 

The composition and maturities of the investment securities portfolio,excluding equity securities, are indicated in the following table:

 
| ** **                                    | ** ** | **At September 30, 2010** | ** ** |
|-----------------------------------------------|------------|------------------------------------------|------------|
| ** **                                    | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **TOTAL** | ** ** |
| ** **                                    | ** ** | **Less than**                       | ** ** | **1 to 5** | ** ** | **5 to 10** | ** ** | **Over 10** | ** ** | **Adjusted** | ** ** | **Fair** | ** ** |
| ** **                                    | ** ** | **1 Year**                          | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Carrying Cost** | ** ** | **Values** | ** ** |
| ** **                                    | ** ** | **(Dollars in Thousands)**     | ** ** |
|                                          |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies                      |       | $                                        | —     |   | $ | 4,550 |   | $ | — |   | $ | — |   | $ | 4,550 |   | $ | 4,580 |   |
| Municipal bonds                               |       | 1,302                                    |       | 5,085 |   | 4,973 |   | 2,801 |   | 14,161 |   | 14,732 |   |
| Trust preferred securities                    |       | —                                   |       | — |   | — |   | 9,290 |   | 9,290 |   | 3,269 |   |
| Agency residential mortgage-backed securities |       | —                                   |       | 1,644 |   | 8,402 |   | 231,486 |   | 241,532 |   | 245,878 |   |
| Total investment securities                   |       | $                                        | 1,302      |   | $ | 11,279 |   | $ | 13,375 |   | $ | 243,577 |   | $ | 269,533 |   | $ | 268,459 |   |

 

**NOTE 5—LOAN SERVICING**

 

Mortgage loans serviced for others (primarily theSouth Dakota Housing Development Authority) are not included in theaccompanying consolidated statements of financial condition.

 

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The following tables summarize the activity in, andthe main assumptions used to estimate the amortization of servicing rights:

 
| ** **                    | ** ** | **Three Months Ended**     | ** **   |
|-------------------------------|------------|--------------------------------------|--------------|
| ** **                    | ** ** | **September 30,**               | ** **   |
| ** **                    | ** ** | **2010**                             | ** **   | **2009** | ** ** |
| ** **                    | ** ** | **(Dollars in Thousands)** | ** **   |
|                          |       |                                 |         |   |   |
| Balance, beginning            |       | $                                    | 12,733       |   | $ |  11,768 |   |
| Additions                     |       | 621                                  |         | 654 |   |
| Amortization                  |       | (384                                 | )            | (424 | ) |
| Balance, ending               |       | $                                    |  12,970 |   | $ |  11,998 |   |
|                          |       |                                 |         |   |   |
| Servicing fees received       |       | $                                    |  886    |   | $ |  915 |   |
| Balance of loans serviced at: |       |                                 |         |   |   |
| Beginning of period           |       | 1,133,649                            |         | 1,046,600 |   |
| End of period                 |       | 1,154,502                            |         | 1,073,658 |   |

 

Amortization of servicing rights is adjusted eachquarter as the result of the evaluation of historical prepayment activity.  For the first quarter ended September 30,2010 and 2009, the constant prepayment rates (CPR) used to calculate theamortization was 8.00% and 11.00%, respectively.  Management utilized a discount rate of 9.00%and 10.00% for valuation purposes for both periods, respectively.

 

**NOTE 6—SEGMENT REPORTING**

 

Operating segments are defined as components of an enterprise for whichdiscrete financial information is available that is evaluated regularly by thechief operating decision makers in deciding how to allocate resources and inassessing performance.  The Company’sreportable segments are “banking” (including leasing activities) and “other.”  The “banking” segment is conducted throughthe Bank and Mid America Capital and the “other” segment is composed of smallernon-reportable segments, the Company and intersegment eliminations.

 

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

 
| ** **                               | ** ** | **Three Months Ended September 30,** | ** **   |
|------------------------------------------|------------|----------------------------------------------------------|--------------|
| ** **                               | ** ** | **2010 **                                           | ** **   | **2009** | ** ** |
| ** **                               | ** ** | **Banking**                                              | ** **   | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                               | ** ** | **(Dollars in Thousands)**                     | ** **   |
|                                     |       |                                                     |         |   |   |   |   |   |   |   |   |   |   |
| Net interest income                      |       | $                                                        |  10,076 |   | $ |  (451 | ) | $ |  9,625 |   | $ |  9,241 |   | $ |  (490 | ) | $ |  8,751 |   |
| Provision for losses on loans and leases |       | (3,367                                                   | )            | — |   | (3,367 | ) | (343 | ) | — |   | (343 | ) |
| Non-interest income                      |       | 3,666                                                    |         | 116 |   | 3,782 |   | 1,582 |   | 116 |   | 1,698 |   |
| Intersegment non-interest income         |       | (49                                                      | )            | (15 | ) | (64 | ) | (24 | ) | (39 | ) | (63 | ) |
| Non-interest expense                     |       | (8,937                                                   | )            | (490 | ) | (9,427 | ) | (8,530 | ) | (419 | ) | (8,949 | ) |
| Intersegment non-interest expense        |       | —                                                   |         | 64 |   | 64 |   | — |   | 63 |   | 63 |   |
| Income (loss) before income taxes        |       | $                                                        |  1,389  |   | $ |  (776 | ) | $ |  613 |   | $ |  1,926 |   | $ |  (769 | ) | $ |  1,157 |   |
|                                     |       |                                                     |         |   |   |   |   |   |   |   |   |   |   |
| Total assets at September 30        |       | $                                                        | 1,246,841    |   | $ |   13,643 |   | $ | 1,260,484 |   | $ | 1,163,296 |   | $ |     5,166 |   | $ | 1,168,462 |   |

 

**NOTE 7—DEFINED BENEFIT PLAN**

 

The Company has a noncontributory (cash balance) defined benefitpension plan covering all employees of the Company and its wholly-ownedsubsidiaries who have attained the age of 21 and have completed 1,000 hours ofservice 

 

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ina plan year.  The benefits are based on6% of each eligible participant’s annual compensation, plus income earned inthe accounts at a rate determined annually based on 30-year treasury noterates.  The Company’s funding policy isto make the minimum annual required contribution plus such amounts as theCompany may determine to be appropriate from time to time.  One hundred percent vesting occurs afterthree years with a retirement age of the later of age 65 or three years ofparticipation.  The Company has adoptedall plan provisions required by the Pension Protection Act of 2006.  Information relative to the components of netperiodic benefit cost for the Company’s defined benefit plan is presentedbelow:

 
| ** **                        | ** ** | **Three Months Ended**     | ** ** |
|-----------------------------------|------------|--------------------------------------|------------|
| ** **                        | ** ** | **September 30,**               | ** ** |
| ** **                        | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                        | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **                        | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Service cost                      |       | $                                    | 147        |   | $ |  142 |   |
| Interest cost                     |       | 154                                  |       | 144 |   |
| Amortization of prior losses      |       | 23                                   |       | 45 |   |
| Expected return on plan assets    |       | (159                                 | )          | (139 | ) |
| Total costs recognized in expense |       | $                                    |  165  |   | $ |  192 |   |

 

The Company previously disclosed in its consolidated financialstatements for fiscal 2010, which are included in Part II, Item 8 “FinancialStatements and Supplementary Data” of the Company’s Annual Report on Form 10-Kthat it contributed $425,000 in fiscal 2010 to fund its qualified pensionplan.  The Company anticipates that acontribution of $455,000 will be made in the second quarter of fiscal 2011.

 

**NOTE 8****—****SELF-INSURED HEALTHCARE PLAN**

 

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

 

The Company assumes the responsibility for funding the plan benefitsout of general assets; however, employees cover some of the costs of coveredbenefits through contributions, deductibles, co-pays and participationamounts.  An employee is eligible forcoverage upon completion 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.

 

The accrual estimate for pending and incurred but not reported healthclaims is based upon a pending claims lag report provided by a third partyprovider.  Although management believesthat it uses the best information available to determine the accrual,unforeseen health claims could result in adjustments and net earnings beingsignificantly affected if circumstances differ substantially from theassumptions used in estimating the accrual. Net healthcare costs are inclusive of health claims expenses andadministration fees offset by stop loss and employee reimbursement.  The following table is a summary of nethealthcare costs by quarter:

 
| ** **                      | ** ** | **Fiscal Years Ended June 30,** | ** ** |
|---------------------------------|------------|-----------------------------------------------------|------------|
| ** **                      | ** ** | **2011**                                            | ** ** | **2010** | ** ** |
| ** **                      | ** ** | **(Dollars in Thousands)**                | ** ** |
|                            |       |                                                |       |   |   |
| Quarter ended September 30 |       | $                                                   |  587  |   | $ |  748 |   |
| Quarter ended December 31  |       | —                                              |       | 311 |   |
| Quarter ended March 31     |       | —                                              |       | 486 |   |
| Quarter ended June 30      |       | —                                              |       | 602 |   |
| Net healthcare costs            |       | $                                                   |  587  |   | $ |  2,147 |   |

 

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

 

The fair value of each incentive stock option and each stockappreciation right grant is estimated at the grant date using the Black-Scholesoption-pricing model.  There were nostock appreciation rights (SARs) granted in the first quarter of fiscal2011.  The following assumptions wereused for grants in the three months ended September 30, 2009:

 
| Expected volatility      |   | 22.00 | %      |
|--------------------------|--------|-------|--------|
| Expected dividend yield  |   | 3.61  | %      |
| Risk-free interest rate  |   | 2.35  | %      |
| Expected term (in years) |   | 5     |   |

 

Stock option activity for the three months ended September 30,2010 was as follows:

 
| ** **             | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **             | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **             | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **             | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **             | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
|                   |       |       |       |         |       |            |       |          |       |
| Beginning balance      |       | 133,240    |       | $            | 13.15      |            |       |          |       |   |
| Granted                |       | —     |       | —       |       |            |       |          |       |
| Forfeited              |       | (379       | )          | 7.75         |       |            |       |          |       |
| Exercised              |       | (13,855    | )          | 10.05        |       |            |       |          |       |
|                   |       |       |       |         |       |            |       |          |       |
| Ending balance         |       | 119,006    |       | $            | 13.52      |            | 3.16       |          | $          | 3,153 |   |
|                   |       |       |       |         |       |            |       |          |       |
| Vested and exercisable |       | 119,006    |       | $            | 13.52      |            | 3.16       |          | $          | 3,153 |   |

 

Stock appreciation rights activity for the three months ended September 30,2010 was as follows:

 
| ** **             | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **             | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **             | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **             | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **             | ** ** | **SARs**   | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
|                   |       |       |       |         |       |            |       |          |       |
| Beginning balance      |       | 198,136    |       | $            | 13.70      |            |       |          |       |   |
| Granted                |       | —     |       | —       |       |            |       |          |       |
| Forfeited              |       | (1,005     | )          | 15.70        |       |            |       |          |       |
| Exercised              |       | —     |       | —       |       |            |       |          |       |
|                   |       |       |       |         |       |            |       |          |       |
| Ending balance         |       | 197,131    |       | $            | 13.69      |            | 8.25       |          | $          | — |   |
|                   | ** ** | ** ** | ** ** | ** **   |       |            |       |          |       |
| Vested and exercisable |       | 83,739     |       | $            | 14.49      |            | 7.71       |          | $          | — |   |

 

The total intrinsic value of options exercised during the three monthsended September 30, 2010 and 2009 was $3,000 and $0, respectively.  Cash received from the exercise of these optionswas $139,000 and $0, respectively.  Therewere no cashless option exercises or related tax benefit realized for the threemonths ended September 30, 2010 and 2009.  There were no stock appreciation rights (SARs) granted during the threemonths ended September 30, 2010, while the weighted-average grant datefair value of SARs granted during the three months ended September 30,2009 was $1.75.  The total unrecognizedcompensation cost related to nonvested SARs awards at September 30, 2010was $232,000.  This unrecognized cost isexpected to be recognized over a weighted average period of 23 months.

 

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Nonvested share activity for the three months ended September 30follows:

 
| ** **                   | ** ** | **2010**   | ** ** | **2009**            | ** ** |
|------------------------------|------------|------------|------------|---------------------|------------|
| ** **                   | ** ** | ** ** | ** ** | **Weighted**        | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Average**         | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                   | ** ** | ** ** | ** ** | **Grant Date** | ** ** | ** ** | ** ** | **Grant Date** | ** ** |
| ** **                   | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
|                         |       |       |       |                |       |   |   |   |   |
| Nonvested balance, beginning |       | 69,475     |       | $                   | 13.68      |   | 90,708 |   | $ | 15.81 |   |
| Granted                      |       | 6,847      |       | 9.92                |       | 18,436 |   | 12.48 |   |
| Vested                       |       | (31,190    | )          | 16.33               |       | (40,415 | ) | 16.31 |   |
| Forfeited                    |       | —     |       | —              |       | — |   | — |   |
|                         |       |       |       |                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Nonvested balance, ending    |       | 45,132     |       | $                   | 11.29      |   | 68,729 |   | $ | 14.62 |   |

 

Pretax compensation expense recognized for nonvested shares for thethree months ended September 30, 2010, and 2009 was $71,000 and $92,000,respectively.  The tax benefit for thethree months ended September 30, 2010, and 2009 was $24,000 and $31,000,respectively.  As of September 30,2010, there was $375,000 of total unrecognized compensation cost related tononvested shares granted under the Company’s 2002 Stock Option and IncentivePlan, as amended (“the Plan”).  The costis expected to be recognized over a weighted-average period of 22 months.  The total fair value of shares vested duringthe three months ended September 30, 2010 and 2009 was $648,000 and$659,000, respectively.

 

In association with the 2002 Option Plan, awards of nonvested shares ofthe Company’s common stock are made to outside directors of the Company.  Each outside director is entitled to allvoting, dividend and distribution rights during the vesting period.  During the second quarter of fiscal 2010, 19,626shares of nonvested stock were awarded, which vest on the first anniversary ofthe date of grant.  As of September 30,2010, there was $40,000 of total unrecognized compensation cost related tononvested shares, which are expected to be recognized over the remaining periodof three months.  For the three monthsended September 30, 2010, amortization expense was recorded in the amountof $40,000.

 

These stock option and incentive plans are described more fully in Part II, Item8 “Financial Statements and Supplementary Data” of the Company’s Annual Reporton Form 10-K for fiscal 2010, under Note 16 of “Notes to ConsolidatedFinancial Statements.”

 

**NOTE10—SUBORDINATED DEBENTURES PAYABLE TO TRUSTS**

 

On December 19, 2002, the Company issued 5,000 shares totaling$5.0 million of Company Obligated Mandatorily Redeemable Preferred Securitiesof Trust III. Trust III was established and exists for the sole purpose ofissuing trust preferred securities and investing the proceeds in subordinateddebentures of the Company. These subordinated debentures constitute the soleasset of Trust III. The securities provide for cumulative cash distributionscalculated at a rate based on three-month LIBOR plus 3.35% adjusted quarterly.The Company may, at one or more times, defer interest payments on the capitalsecurities for up to 20 consecutive quarterly periods, but not beyondJanuary 7, 2033. At the end of the deferral period, all accumulated andunpaid distributions must be paid. The capital securities must be redeemed onJanuary 7, 2033; however, the Company has the option to shorten thematurity date as the call option date has passed. Holders of the capitalsecurities have no voting rights, are unsecured, and rank junior in priority ofthe payment to all of the Company’s indebtedness and senior to the Company’scapital stock.

 

On September 25, 2003, the Company issued 7,000 shares totaling$7.0 million of Company Obligated Mandatorily Redeemable Preferred Securitiesof Trust IV. Trust IV was established and exists for the sole purpose ofissuing trust preferred securities and investing the proceeds in subordinateddebentures of the Company. These subordinated debentures constitute the soleasset of Trust IV. The securities provide for cumulative cash distributionscalculated at a rate based on three-month LIBOR plus 3.10% adjusted quarterly.The Company may, at one or more times, defer interest payments on the capitalsecurities for up to 20 consecutive quarterly periods, but not beyondOctober 8, 2033. At the end of the deferral period, all accumulated andunpaid distributions must be paid. The capital securities must 

 

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beredeemed on October 8, 2033; however, the Company has the option toshorten the maturity date as the call option date has passed. Holders of thecapital securities have no voting rights, are unsecured, and rank junior inpriority of the payment to all of the Company’s indebtedness and senior to theCompany’s capital stock.

 

On December 7, 2006, the Company issued 10,000 shares totaling$10.0 million of Company Obligated Mandatorily Redeemable Preferred Securitiesof Trust V. Trust V was established and exists for the sole purpose of issuingtrust preferred securities and investing the proceeds in subordinateddebentures of the Company. These subordinated debentures constitute the soleasset of Trust V. The securities provide for cumulative cash distributionscalculated at a rate based on three-month LIBOR plus 1.83%, fixed for fiveyears at 6.61%; thereafter, adjusted quarterly. The Company may, at one or moretimes, defer interest payments on the capital securities for up to 20consecutive quarterly periods, but not beyond March 1, 2037. At the end ofthe deferral period, all accumulated and unpaid distributions must be paid. Thecapital securities must be redeemed on March 1, 2037; however, the Companyhas the option to shorten the maturity date to a date not earlier thanMarch 1, 2012. Holders of the capital securities have no voting rights, areunsecured, and rank junior in priority of the payment to all of the Company’sindebtedness and senior to the Company’s capital stock.

 

On July 5, 2007, the Company issued 5,000 shares totaling $5.0million of Company Obligated Mandatorily Redeemable Preferred Securities ofTrust VI. Trust VI was established and exists for the sole purpose of issuingtrust preferred securities and investing the proceeds in subordinateddebentures of the Company. These subordinated debentures constitute the soleasset of Trust VI. The securities provide for cumulative cash distributionscalculated at a rate based on three- month LIBOR plus 1.65% adjusted quarterly.The Company may, at one or more times, defer interest payments on the capitalsecurities for up to 20 consecutive quarterly periods, but not beyondOctober 1, 2037. At the end of the deferral period, all accumulated andunpaid distributions must be paid. The capital securities must be redeemed onOctober 1, 2037; however, the Company has the option to shorten thematurity date to a date not earlier than October 1, 2012. Holders of thecapital securities have no voting rights, are unsecured, and rank junior inpriority of the payment to all of the Company’s indebtedness and senior to theCompany’s capital stock.

 

**NOTE 11****—****INTEREST RATE CONTRACTS**

 

Interest rate swap contracts are entered into primarily as anasset/liability management strategy of the Company to modify interest raterisk.  The primary risk associated withall swaps is the exposure to movements in interest rates and the ability of thecounterparties to meet the terms of the contract.  The Company is exposed to losses if thecounterparty fails to make its payments under a contract in which the Companyis in a receiving status. The Company minimizes its risk by monitoring thecredit standing of the counterparties. The Company anticipates the counterparties will be able to fully satisfythe obligations under the remaining agreements. These contracts are designated as cash flow hedges.

 

During the first quarter of fiscal 2008, the Company entered into aninterest rate swap agreement with a $5.0 million notional amount to convert thevariable-rate Trust Preferred VI security into a fixed-rate instrument for aterm of five years at a fixed rate of 6.69%. The fair value of the derivativewas an unrealized loss of $507,000 and $534,000 at September 30, 2010, and2009, respectively.   During the secondquarter of fiscal 2010, the Company entered into a forward-starting interestrate swap agreement and will replace the existing swap agreement for thevariable-rate Trust Preferred VI security upon the existing swap’smaturity.  The $5.0 million notionalamount fixed-rate instrument has a term of five years at a fixed rate of 5.95%,effective October 1, 2012.  The fairvalue of the derivative was an unrealized loss of $396,000 at September 30,2010.

 

During the fourth quarter of fiscal 2008, the Company entered into aninterest rate swap agreement with a $7.0 million notional amount to convert thevariable-rate Trust Preferred IV security into a fixed-rate instrument for aterm of three years at a fixed rate of 6.19%. The fair value of the derivative was an unrealized loss of $97,000 and$250,000 at September 30, 2010, and 2009, respectively.  During the second quarter of fiscal 2010, theCompany entered into a forward-starting interest rate swap agreement and willreplace the existing swap agreement for the variable-rate Trust Preferred IVsecurity upon the existing swap’s maturity. The $7.0 million notional amount fixed-rate instrument has a term ofthree years at a fixed rate of 5.93%, effective January 8, 2011.  The fair value of the derivative was anunrealized loss of $381,000 at September 30, 2010.

 

During the first quarter of fiscal 2009, the Company entered into aninterest rate swap agreement with a $3.0 million notional amount to convert aportion of the variable-rate Trust Preferred III security into a fixed-rateinstrument for a term of three years at a fixed rate of 6.70%. The Company alsoentered into an interest rate swap agreement with a $2.0 million notionalamount to convert the remaining portion of variable-rate Trust Preferred IIIsecurity into a fixed rate 

 

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instrumentfor a term of four years at a fixed rate of 6.91%. The fair value of the $3.0million notional derivative was an unrealized loss of $111,000 and $147,000 atSeptember 30, 2010, and 2009, respectively.  The fair value of the $2.0 million notionalderivative was an unrealized loss of $136,000 and $117,000 atSeptember 30, 2010, and 2009, respectively.  During the fourth quarter of fiscal 2010, theCompany entered into two forward-starting interest rate swap agreements andwill replace the existing swap agreements for the variable-rate Trust PreferredIII security upon the existing swaps’ maturity. The $3.0 million notional amount fixed-rate instrument has a term offour years at a fixed rate of 6.58%, effective October 7, 2011.  The $2.0 million notional amount fixed-rateinstrument has a term of two years at a fixed rate of 6.58%, effective October 9,2012.  The fair values of the $3.0million and $2.0 million notional amount derivatives were unrealized losses of$172,000 and $57,000, respectively, at September 30, 2010.

 

During the second quarter of fiscal 2010, the Company entered into aforward-starting interest rate swap agreement with a $10.0 million notionalamount to convert the variable-rate Trust Preferred V security into afixed-rate instrument.  The $10.0 millionnotional amount fixed-rate instrument has a term of five years at a fixed rateof 5.68%, effective December 1, 2011. The fair value of the derivative was an unrealized loss of $818,000 at September 30,2010.

 

During the fourth quarter of fiscal 2010, the Bank entered into fiveforward-starting interest rate swap agreements with notional amounts totaling$35.0 million to convert the variable-rate attributes of a pool of deposits intofixed-rate instruments.  The $3.0 millionnotional amount fixed-rate instrument has a term of four years at a fixed rateof 2.20%, effective November 18, 2010. The $7.0 million notional amount fixed-rate instrument has a term of 30months at a fixed rate of 2.09%, effective March 7, 2011. The $10.0million notional amount fixed-rate instrument has a term of 42 months at afixed rate of 2.44%, effective May 10, 2011.  The $10.0 million notional amount fixed-rateinstrument has a term of three years at a fixed rate of 2.56%, effective April 21,2011.  The $5.0 million notional amountfixed-rate instrument has a term of three years at a fixed rate of 2.30%,effective January 21, 2011.  Thefair values of the $3.0 million, $7.0 million, $10.0 million, $10.0 million and$5.0 million notional amount derivatives were unrealized losses of $161,000,$275,000, $519,000, $542,000 and $253,000, respectively, at September 30,2010.

 

No gain or loss was recognized in earnings for the three months ended September 30,2010, and 2009 related to interest rate swaps. No deferred net losses on interest rate swaps in other comprehensiveloss as of September 30, 2010, are expected to be reclassified intoearnings during the current fiscal year. See Note 12 “Accumulated Other Comprehensive Loss” for amounts reportedas other comprehensive loss.

 

The Company posted $2.7 million in cash and $2.4 million in investmentsecurities under collateral arrangements as of September 30, 2010, tosatisfy collateral requirements associated with its interest rate swapcontracts.

 

The following table summarizes the derivative financial instrumentsutilized as of September 30, 2010:

 
| ** **                    | ** ** | **Balance**                            | ** ** | **Notional**                         | ** ** | **Estimated Fair Value** | ** ** |
|-------------------------------|------------|----------------------------------------|------------|--------------------------------------|------------|------------------------------------|------------|
| **Cash flow hedge** | ** ** | **Sheet Location**                | ** ** | **Amount**                           | ** ** | **Gain**                           | ** ** | **Loss** | ** ** |
| ** **                    | ** ** | ** **                             | ** ** | **(Dollars in Thousands)** | ** ** |
|                          |       |                                   |       |                                 |       |                               |       |   |   |
| Interest rate swap contracts  |       | Other assets                           |       | $                                    | 44,000     |                               | $          | — |   | $ | (2,675 | ) |
| Interest rate swap contracts  |       | Accrued expenses and other liabilities |       | 35,000                               |       | —                             |       | (1,750 | ) |
|                          |       |                                   |       |                                 |       |                               |       |   |   |
|                          |       |                                   |       | $                                    | 79,000     |                               | $          | — |   | $ | (4,425 | ) |

 

Thefollowing table details the derivative financial instruments, the averageremaining maturities and the weighted-average interest rates being paid andreceived as of September 30, 2010:  

 
| ** **                               | ** ** | ** **                           | ** ** | **Average**  | ** ** | ** ** | ** ** | ** **                          | ** ** | ** ** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|--------------|------------|------------|------------|-------------------------------------|------------|------------|------------|
| ** **                               | ** ** | **Notional**                         | ** ** | **Maturity** | ** ** | **Fair**   | ** ** | **Weighted Average Rate** | ** ** |
| **Liability conversion swaps** | ** ** | **Amount**                           | ** ** | **(years)**  | ** ** | **Value**  | ** ** | **Receive**                         | ** ** | **Pay**    | ** ** |
| ** **                               | ** ** | **(Dollars in Thousands)** | ** ** |
|                                     |       |                                 |       |         |       |       |       |                                |       |       |       |
| Interest rate swap contracts             |       | $                                    | 79,000     |         | 3.1        |       | $          | (4,425                              | )          | 3.3        | %          | 4.5 | % |
|                                          |            |                                      |            |              |            |            |            |                                     |            |            |            |  |  |

 

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**NOTE 12****—****ACCUMULATEDOTHER COMPREHENSIVE LOSS**

 

Thecomponents of accumulated other comprehensive loss are as follows:

 
| ** **                                                                                                                                               | ** ** | **Three Months Ended**     | ** **   |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|--------------|
| ** **                                                                                                                                               | ** ** | **September 30,**               | ** **   |
| ** **                                                                                                                                               | ** ** | **2010**                             | ** **   | **2009** | ** ** |
| ** **                                                                                                                                               | ** ** | **(Dollars in Thousands)** | ** **   |
|                                                                                                                                                     |       |                                 |         |   |   |
| Net income                                                                                                                                               |       | $                                    | 490          |   | $ | 855 |   |
| Other comprehensive income (loss), net of tax:                                                                                                           |       |                                 |         |   |   |
| Securities available for sale:                                                                                                                           |       |                                 |         |   |   |
| Change in unrealized losses on available-for-sale  securities for which a portion of an other-than-temporary impairment has been  recognized in earnings |       | —                               |         | (418 | ) |
| Change in unrealized gain (losses) on other  securities available for sale                                                                               |       | 278                                  |         | 1,202 |   |
| Reclassification adjustment:                                                                                                                             |       |                                 |         |   |   |
| Net impairment credit loss recognized in earnings                                                                                                        |       | —                               |         | 1,858 |   |
| Security (gains) recognized in earnings                                                                                                                  |       | (397                                 | )            | (533 | ) |
| Net unrealized gains (losses)                                                                                                                            |       | (119                                 | )            | 2,109 |   |
| Income tax benefit (expense)                                                                                                                             |       | 45                                   |         | (802 | ) |
| Other comprehensive income (loss) on securities available  for sale                                                                                      |       | (74                                  | )            | 1,307 |   |
|                                                                                                                                                     |       |                                 |         |   |   |
| Defined benefit plan:                                                                                                                                    |       |                                 |         |   |   |
| Other comprehensive (loss) on defined benefit plan                                                                                                       |       | —                               |         | — |   |
|                                                                                                                                                     |       |                                 |         |   |   |
| Cash flow hedging activities-interest rate swap  contracts:                                                                                              |       |                                 |         |   |   |
| Net unrealized gains (losses)                                                                                                                            |       | (1,467                               | )            | (96 | ) |
| Income tax benefit (expense)                                                                                                                             |       | 499                                  |         | 32 |   |
| Other comprehensive income (loss) on cash flow  hedging activities-interest rate swap contracts                                                          |       | (968                                 | )            | (64 | ) |
|                                                                                                                                                     |       |                                 |         |   |   |
| Total other comprehensive income (loss)                                                                                                                  |       | (1,042                               | )            | 1,243 |   |
|                                                                                                                                                     |       |                                 |         |   |   |
| Comprehensive income                                                                                                                                     |       | $                                    | (552         | ) | $ | 2,098 |   |
|                                                                                                                                                     |       |                                 |         |   |   |
| Cumulative other comprehensive (loss) balances  were:                                                                                                    | ** ** | ** **                           | ** **   | ** ** | ** ** |
| ** **                                                                                                                                               | ** ** | ** **                           | ** **   | ** ** | ** ** |
| Unrealized loss on securities available for sale,  net of related tax effect of $409 and $308                                                            |       | $                                    | (668         | ) | $ | (504 | ) |
| Unrealized loss on defined benefit plan, net of related  tax effect of $441 and $1,177                                                                   |       | (719                                 | )            | (1,920 | ) |
| Unrealized loss on cash flow hedging activities,  net of related tax effect of $1,504 and $356                                                           |       | (2,920                               | )            | (692 | ) |
|                                                                                                                                                     |       |                                 |         |   |   |
|                                                                                                                                                     |       | $                                    |  (4,307 | ) | $ | (3,116 | ) |

** **

**NOTE 13****—****FINANCIAL INSTRUMENTS AND FAIR VALUE MEASUREMENT**

 

The Bank is a party to financial instruments with off-balance sheetrisk in the normal course of business to meet the financing needs of itscustomers. These financial instruments include commitments to extend credit,standby letters of credit and financial guarantees. Those instruments involve,to varying degrees, elements of credit and interest-rate risk in excess ofamounts recognized in the consolidated statements of financial condition. Thecontract or notional amounts of those instruments reflect the extent of theBank’s involvement in particular classes of financial instruments.

 

The Bank’s exposure to credit loss in the event of nonperformance bythe other party to the financial instrument for commitments to extend credit,standby letters of credit, and financial guarantees written is represented bythe 

 

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contractualnotional amount of those instruments. The Bank uses the same credit policies inmaking commitments and conditional obligations as it does for on-balance sheetinstruments.

 

Unless noted otherwise, the Bank does not require collateral or othersecurity to support financial instruments with credit risk.

 

The following methods and assumptions were used by the Company inestimating the fair value of its financial instruments:

 

Cash and cash equivalents—The carrying amounts reported in thestatements of financial condition for cash and cash equivalents approximatetheir fair values.

 

Securities—Fair values for investment securities are based on quotedmarket prices or whose value is determined using discounted cash flowmethodologies, except for stock in the Federal Home Loan Bank for which fairvalue is assumed to equal cost.

 

Loans and leases, net—The fair values for loans are estimated usingdiscounted cash flow analyses, using interest rates currently being offered forloans with similar terms and credit quality. Leases are stated at cost whichequals fair value.

 

Accrued interest receivable—The carrying value of accrued interestreceivable approximates its fair value.

 

Servicing rights—Fair values are estimated using discounted cash flowsbased on current market rates of interest.

 

Interest rate swap contracts—Valuations of interest rate swap contractsare based on inputs observed in active markets for similar instruments. Typicalinputs include the LIBOR curve, option volatility and option skew.

 

Off-balance sheet instruments - Loan commitments are negotiated atcurrent market rates and are relatively short-term in nature.  Therefore, the estimated value of loancommitments approximates the face amount.  Rates for these commitments are set at time of loan closing, such thatno adjustment is necessary to reflect these commitments at market value.

 

Deposits—The fair values for deposits with no defined maturities equaltheir carrying amounts, which represent the amount payable on demand. Fairvalues for fixed-rate certificates of deposit are estimated using a discountedcash flow calculation that applies interest rates currently being offered on acomparably termed wholesale funding alternative (i.e., FHLB borrowings).

 

Interest rate swap contracts on deposits—Valuations of interest rateswap contracts are based on inputs observed in active markets for similarinstruments. Typical inputs include the LIBOR curve, option volatility andoption skew.

 

Borrowed funds—The carrying amounts reported for variable rate advancesapproximate their fair values. Fair values for fixed-rate advances and otherborrowings are estimated using a discounted cash flow calculation that appliesinterest rates currently being offered on advances and borrowings withcorresponding maturity dates.

 

Subordinated debentures payable to trusts—Fair values for subordinateddebentures are estimated using a discounted cash flow calculation that appliesinterest rates on comparable borrowing instruments with corresponding maturitydates.

 

Accrued interest payable and advances by borrowers for taxes andinsurance—The carrying values of accrued interest payable and advances byborrowers for taxes and insurance approximate their fair values.

 

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Estimated fair values of the Company’s financial instruments are asfollows:

 
| ** **                                                                  | ** ** | **September 30, 2010**     | ** ** | **June 30, 2010** | ** ** |
|-----------------------------------------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                                                                  | ** ** | **Carrying**                         | ** ** | **Fair**                    | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                                                  | ** ** | **Amount**                           | ** ** | **Value**                   | ** ** | **Amount** | ** ** | **Value** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in Thousands)** | ** ** |
| Financial Assets                                                            |       |                                 |       |                        |       |   |   |   |   |
| Cash and cash equivalents                                                   |       | $                                    | 21,838     |                        | $          | 21,838 |   | $ | 20,805 |   | $ | 20,805 |   |
| Securities                                                                  |       | 268,716                              |       | 268,716                     |       | 264,442 |   | 264,442 |   |
| Federal Home Loan Bank Stock                                                |       | 11,648                               |       | 11,648                      |       | 10,334 |   | 10,334 |   |
| Loans and leases                                                            |       | 885,868                              |       | 891,684                     |       | 887,991 |   | 893,282 |   |
| Accrued interest receivable                                                 |       | 10,688                               |       | 10,688                      |       | 8,785 |   | 8,785 |   |
| Servicing rights                                                            |       | 12,970                               |       | 14,795                      |       | 12,733 |   | 17,022 |   |
| Interest rate swap contracts                                                |       | (2,675                               | )          | (2,675                      | )          | (1,957 | ) | (1,957 | ) |
|                                                                        |       |                                 |       |                        |       |   |   |   |   |
| Financial liabilities                                                       |       |                                 |       |                        |       |   |   |   |   |
| Deposits                                                                    |       | 877,618                              |       | 885,217                     |       | 914,264 |   | 921,410 |   |
| Interest rate swap contracts on deposits                                    |       | 1,750                                |       | 1,750                       |       | 1,000 |   | 1,000 |   |
| Borrowed funds                                                              |       | 230,366                              |       | 241,171                     |       | 190,719 |   | 199,323 |   |
| Subordinated debentures payable to trusts                                   |       | 27,837                               |       | 20,838                      |       | 27,837 |   | 16,344 |   |
| Accrued interest payable and advances by borrowers  for taxes and insurance |       | 20,397                               |       | 20,397                      |       | 15,205 |   | 15,205 |   |
|                                                                             |            |                                      |            |                             |            |  |  |  |  |  |  |  |  |

 

*Fair Value Measurement*

 

ASC Topic 820 applies the provisions of fair value measurement tonon-financial assets and liabilities.  Inaddition, ASC 820-10-65 defines fair value and establishes a consistentframework for measuring fair value under GAAP and expands disclosure requirementsfor fair value measurements. Fair values represent the estimated price thatwould be received from selling an asset or paid to transfer a liability in anorderly transaction between market participants at the measurement date undercurrent market conditions. The standard describes three levels of inputs thatmay be used to measure fair value:

 

Level 1:  Quoted prices(unadjusted) for identical assets or liabilities in active markets that theentity has the ability to access as of the measurement date.

 

Level 2:  Significant otherobservable inputs other than Level 1 prices such as quoted prices forsimilar assets or liabilities; quoted prices in markets that are not active; orother inputs that are observable or can be corroborated by observable marketdata.

 

Level 3:  Significantunobservable inputs that reflect a company’s own assumptions about theassumptions that market participants would use in pricing an asset orliability. Level 3 assets and liabilities include financial instrumentswhose value is determined using pricing models, discounted cash flowmethodologies, or similar techniques, as well as instruments for which thedetermination of fair value requires significant management judgment orestimation.

 

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The table below presents theCompany’s assets and liabilities measured at fair value on a recurring basis bylevel within the hierarchy at September 30, 2010:

 
| ** **                                    | ** ** | **Quoted Prices**               | ** ** | **Significant**           | ** ** | **Significant**    | ** ** | ** **          | ** ** |
|-----------------------------------------------|------------|--------------------------------------|------------|---------------------------|------------|--------------------|------------|---------------------|------------|
| ** **                                    | ** ** | **In Active**                   | ** ** | **Other Observable** | ** ** | **Unobservable**   | ** ** | ** **          | ** ** |
| ** **                                    | ** ** | **Markets**                          | ** ** | **Inputs**                | ** ** | **Inputs**         | ** ** | **Total at**   | ** ** |
| ** **                                    | ** ** | **(Level 1)**                   | ** ** | **(Level 2)**        | ** ** | **(Level 3)** | ** ** | **Fair Value** | ** ** |
| ** **                                    | ** ** | **(Dollars in Thousands)** | ** ** |
| Securities available for sale                 |       |                                 |       |                      |       |               |       |                |       |
| Debt securities:                              |       |                                 |       |                      |       |               |       |                |       |
| U.S. government agencies                      |       | $                                    | —     |                      | $          | 4,580              |       | $                   | —     |   | $ | 4,580 |   |
| Municipal bonds                               |       | —                               |       | 14,732                    |       | —             |       | 14,732              |       |
| Trust preferred securities                    |       | —                               |       | —                    |       | 3,269              |       | 3,269               |       |
| Equity securities:                            |       |                                 |       |                      |       |               |       |                |       |
| Federal Ag Mortgage                           |       | 4                                    |       | —                    |       | —             |       | 4                   |       |
| Other investments                             |       | —                               |       | 253                       |       | —             |       | 253                 |       |
| Agency residential mortgage-backed securities |       | —                               |       | 245,878                   |       | —             |       | 245,878             |       |
| Securities available for sale                 |       | 4                                    |       | 265,443                   |       | 3,269              |       | 268,716             |       |
| Interest rate swaps                           |       | —                               |       | (2,675                    | )          | —             |       | (2,675              | )          |
| Total assets                                  |       | 4                                    |       | 262,768                   |       | 3,269              |       | 266,041             |       |
|                                          |       |                                 |       |                      |       |               |       |                |       |
| Interest rate swaps on deposits               |       | —                               |       | 1,750                     |       | —             |       | 1,750               |       |
| Total liabilities                             |       | $                                    | —     |                      | $          | 1,750              |       | $                   | —     |   | $ | 1,750 |   |

 

The Company used thefollowing methods and significant assumptions to estimate the fair value ofitems:

 

Securities available forsale: The fair values of securities available for sale are determined byobtaining quoted prices on nationally recognized securities exchanges (Level 1inputs), or matrix pricing, which is a mathematical technique widely used inthe industry to value debt securities without relying exclusively on quotedprices for the specific securities, but rather by relying on the securities’relationship to other benchmark quoted securities (Level 2 inputs).  The Company outsources this valuationprimarily to a third party provider which utilizes several sources for valuingfixed-income securities.  Sourcesutilized by the third party provider include pricing models that vary based byasset class and include available trade, bid, and other market information.  This methodology includes broker quotes,proprietary models, descriptive terms and conditions databases, as well asextensive quality control programs.  Asfurther valuation sources, the third party provider uses a proprietaryvaluation model and capital markets trading staff.  This proprietary valuation model is used forvaluing municipal securities. This model includes a separate curve structurefor Bank-Qualified municipal securities. The grouping of municipal securitiesis further broken down according to insurer, credit support, state of issuance,and rating to incorporate additional spreads and municipal curves.

 

The securities shown inLevel 3 relate to trust preferred securities which are currently part of aninactive market.  The inactivity wasevidenced first by a significant widening of the bid-ask spread in the brokeredmarkets in which these securities trade, and then by a significant decrease inthe volume of trades relative to historical levels.  Given conditions in the debt markets and theabsence of observable orderly transactions in the secondary and new issuemarkets, management determined that an income valuation approach technique(present value technique) that maximizes the use of relevant observable inputsand minimizes the use of unobservable inputs will be equally or morerepresentative of fair value than the market approach valuation technique. Theresults of third party valuation and valuation derived by management cash flowscenarios were weighted each at 50% and used to measure fair value for eachsecurity.

 

The approaches to determiningfair value for the trust preferred securities included the following factors:

 

1.              The creditquality of the collateral is estimated using average probability of defaultvalues.

 

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2.              The loss givendefault was assumed to be 100% (i.e. no recovery) for third partyvaluations.  Management utilized a rangeof loss given default based upon a review of the financial condition ofunderlying issuers in each pool.

 

3.              The cash flowswere forecasted for the underlying collateral and applied to each tranche todetermine the resulting distribution among the securities.

 

4.              The bestestimates of expected cash flows were discounted to calculate the present valueof the security. Management considered a range of discount rates based uponthree factors: (1) a risk-free rate based on the rate of return ongovernment debt securities, (2) the credit spread for BBB Bank Corporate DebtIndex, and (3) a liquidity or “risk premium”.

 

5.              Thecalculations were modeled in several thousand scenarios and the average pricewas used for the third party valuations. Management utilized an average price derived from various cash flowscenarios.

 

Interest rate swaps:  The fair values of interest rate swaps relateto cash flow hedges of trust preferred debt securities issued by the Company,as well as cash flow hedges of a pool of variable rate deposits.  The fair value is estimated by a third partyusing inputs that are observable or that can be corroborated by observablemarket data and, therefore, are classified within Level 2 of the valuationhierarchy. These fair value estimations include primarily market observableinputs, such as yield curves, and include the value associated withcounterparty credit risk.

 

The following table reconciles the beginning and ending balances of theassets or liabilities of the Company that are measured at fair value on arecurring basis using significant unobservable inputs:

 

**Fair Value Measurements Using Significant**

**Unobservable Inputs (Level 3)**

** **
| ** **                                   | ** ** | **Three Months Ended**     | ** ** |
|----------------------------------------------|------------|--------------------------------------|------------|
| ** **                                   | ** ** | **September 30,**               | ** ** |
| ** **                                   | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                                   | ** ** | **(Dollars in Thousands)** | ** ** |
|                                         | ** ** | ** **                           |       |   |   |
| Beginning balance                            |       | $                                    | 3,902      |   | $ | 6,051 |   |
| Total realized/unrealized gains (losses)     |       |                                 |       |   |   |
| Included in earnings                         |       | —                               |       | (1,858 | ) |
| Included in other comprehensive loss         |       | (666                                 | )          | 1,449 |   |
| Purchases, issuances, (paydowns) and (sales) |       | 33                                   |       | 7 |   |
| Transfers into or (out) of Level 3           |       | —                               |       | — |   |
| Ending balance                               |       | $                                    | 3,269      |   | $ | 5,649 |   |

 

The table below presents theCompany’s assets subject to the nonrecurring fair value measurements by levelwithin the hierarchy at September 30, 2010:

 
| ** **                | ** ** | **Quoted Prices** | ** ** | **Significant Other** | ** ** | **Significant**    | ** ** | ** **           | ** ** |
|---------------------------|------------|------------------------|------------|----------------------------|------------|--------------------|------------|----------------------|------------|
| ** **                | ** ** | **In Active**     | ** ** | **Observable**             | ** ** | **Unobservable**   | ** ** | **Fiscal 2011** | ** ** |
| ** **                | ** ** | **Markets**            | ** ** | **Inputs**                 | ** ** | **Inputs**         | ** ** | **Incurred**         | ** ** |
| ** **                | ** ** | **(Level 1)**     | ** ** | **(Level 2)**         | ** ** | **(Level 3)** | ** ** | **Losses**           | ** ** |
|                      | ** ** | ** **             | ** ** | ** **                 | ** ** | ** **         | ** ** | ** **           | ** ** |
| Loans held for sale       |       | $                      | —     |                       | $          | 18,120             |       | $                    | —     |   | $ | — |   |
| Impaired loans            |       | —                 |       | 10,450                     |       | 6,671              |       | —               |       |
| Mortgage servicing rights |       | —                 |       | —                     |       | 12,970             |       | —               |       |
| Foreclosed assets         |       | —                 |       | —                     |       | 36                 |       | —               |       |
|                           |            |                        |            |                            |            |                    |            |                      |            |  |  |  |  |

 

Loans held for sale, whichconsist generally of current production of certain fixed-rate, first-lienresidential mortgage loans and student loans, are carried at the lower of costor estimated fair value. The estimated fair value is based 

 

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on what secondary marketsare currently offering for portfolios with similar characteristics, which theCompany classifies as a Level 2 nonrecurring fair value measurement.

 

Impaired loans are evaluatedand valued at the time the loan is identified as impaired, at the lower of costor market value. Market value is measured based on the value of thecollateral securing these loans.  Collateral is primarily real estateand its fair value is generally determined based on real estate appraisals orother evaluations by qualified professionals, for which the Company classifieswithin Level 2 of the fair value hierarchy. Impaired loans are reviewed and evaluatedon at least a quarterly basis for additional impairment and adjustedaccordingly, based on the same factors identified above. Impaired loans thatare collateral dependent are written down to their fair value, less costs tosell, through the establishment of specific reserves or by recordingcharge-offs when the carrying value exceeds the fair value. Valuationtechniques consistent with the market approach, income approach, and/or costapproach were used to measure fair value and primarily included observableinputs such as recent sales of similar assets or observable market data foroperational or carrying costs, for which the Company classifies within Level 3of the fair value hierarchy.

 

Mortgage servicing rights do not trade in an active, open market withreadily observable prices. While sales of mortgage servicing rights do occur,the precise terms and conditions typically are not readily available to allowfor a “quoted price for similar assets” comparison. Accordingly, the Companyrelies on an internal discounted cash flow model to estimate the fair value ofits mortgage servicing rights. The Company uses a valuation model to projectmortgage servicing rights cash flows based on the current interest ratescenario, which is then discounted to estimate an expected fair value of themortgage servicing rights. The valuation model considers portfoliocharacteristics of the underlying mortgages, contractually specified servicingfees, prepayment assumptions, discount rate assumptions, other ancillary revenue,costs to service, and other economic factors. The Company reassesses andperiodically adjusts the underlying inputs and assumptions used in the model toreflect market conditions and assumptions that a market participant wouldconsider in valuing the mortgage servicing rights asset. In addition, theCompany compares its fair value estimates and assumptions to observable marketdata for mortgage servicing rights, where available, and to recent marketactivity and actual portfolio experience. Due to the nature of the valuationinputs, mortgage servicing rights are classified within Level 3 of thefair value hierarchy. The Company uses the amortization method(i.e., lower of amortized cost or estimated fair value measured on anonrecurring basis), not fair value measurement accounting, for its mortgageservicing rights assets.

 

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

 

**Forward-Looking Statements**

 

This Quarterly Report on Form 10-Q (“Form 10-Q”), as well asother reports issued by the Company include “forward-looking statements” withinthe meaning of Section 27A of the Securities Act of 1933, as amended, andSection 21E of the Securities Exchange Act of 1934, as amended. Inaddition, the Company’s management may make forward-looking statements orallyto the media, securities analysts, investors and others from time to time.Forward-looking statements can be identified by the fact that they do notrelate strictly to historical or current facts. Words such as “optimism,” “look-forward,”“bright,” “believe,” “expect,” “anticipate,” “intend,” “hope,” “plan,” “estimate”or words of similar meaning, or future or conditional verbs such as “will,” “would,”“should,” “could” or “may,” are intended to identify these forward-lookingstatements.

 

These forward-looking statements might include one or more of thefollowing:

 

·                  projections of income, loss,revenues, earnings or losses per share, dividends, capital expenditures,capital structure, tax benefit or other financial items.

 

·                  descriptions of plans orobjectives of management for future operations, products or services,transactions, investments and use of subordinated debentures payable to trusts.

 

·      forecastsof future economic performance.

 

·      use anddescriptions of assumptions and estimates underlying or relating to suchmatters.

 

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Forward-looking statements are subject to certain risks anduncertainties that could cause actual results to differ materially from ourhistorical experience and our present expectations or projections. Factors thatcould cause actual results to differ from those discussed in theforward-looking statements include, but are not limited to:

 

·                  adverse economic and marketconditions of the financial services industry in general, including, withoutlimitation, the credit markets;

 

·                  the effect of recentlegislation to help stabilize the financial markets;

 

·      futurelosses on our holdings of trust preferred securities;

 

·      increaseof non-performing loans and additional provisions for loan losses;

 

·      thefailure of assumptions underlying the establishment of reserves for loan lossesand other estimates;

 

·      thefailure to maintain our reputation in our market area;

 

·      prevailingeconomic, political and business conditions in South Dakota;

 

·                  the effects of competitionfrom a wide variety of local, regional, national and other providers offinancial services;

 

·                  compliance with existing andfuture banking laws and regulations, including, without limitation, regulatorycapital requirements and FDIC insurance coverages and costs;

 

·      changesin the availability and cost of credit and capital in the financial markets;

 

·      theeffects of FDIC deposit insurance premiums and assessments;

 

·                  the risks of changes inmarket interest rates on the composition and costs of deposits, loan demand,net interest income, and the values and liquidity of loan collateral, and ourability or inability to manage interest rate and other risks;

 

·                  changes in the prices,values and sales volumes of residential and commercial real estate;

 

·                  an extended period of lowcommodity prices, significantly reduced yields on crops, reduced levels ofgovernmental assistance to the agricultural industry, and reduced farmlandvalues;

 

·      soundnessof other financial institutions;

 

·                  the risks of futureacquisitions and other expansion opportunities, including, without limitation,the related time and costs of implementing such transactions, integratingoperations as part of these transactions and possible failures to achieveexpected gains, revenue growth and expense savings from such transactions;

 

·      securityand operations risks associated with the use of technology;

 

·                  the loss of one or more ofour key personnel, or the failure to attract, assimilate and retain otherhighly qualified personnel in the future;

 

·      changesin or interpretations of accounting standards, rules or principles; and

 

·                  other factors and risksdescribed under Part I, Item 2—“Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and Item 3—“Quantitativeand Qualitative Disclosures About Market Risk” in this Form 10-Q.

 

Forward-looking statements speak only as of the date they are made.Forward-looking statements are based upon management’s then-current beliefs andassumptions, but management does not give any assurance that such beliefs and 

 

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assumptionswill prove to be correct. We undertake no obligation to publicly update orrevise any forward-looking statements included or incorporated by reference inthis Form 10-Q or to update the reasons why actual results could differfrom those contained in such statements, whether as a result of newinformation, future events or otherwise, except to the extent required byfederal securities laws. Based upon changing conditions, should any one or moreof the above risks or uncertainties materialize, or should any of ourunderlying beliefs or assumptions prove incorrect, actual results may varymaterially from those described in any forward-looking statement.

 

References in this Form 10-Q to “we,” “our,” “us” and othersimilar references are to the Company, unless otherwise expressly stated or thecontext requires otherwise.

 

**Executive Summary**

 

The Company’s net income for the first quarter of fiscal 2011 was$490,000, or $0.07 in diluted earnings per common share, compared to $855,000,or $0.21 in diluted earnings per common share, for the first quarter of fiscal2010.

 

Netinterest income for the first three months of fiscal 2011 was $9.6 million, anincrease of $874,000, or 10.0%, compared to the same period a year ago.  For the three months ended September 30,2010, average interest-earning assets and average interest-bearing liabilitiesincreased 6.6% and 4.4%, respectively, compared to the same period a yearago.  Yields on earning assets decreasedto 4.85% for the first three months of fiscal 2011, compared to 5.33% a yearago, a decrease of 48 basis points.  Forthe same period, interest-bearing cost of funds decreased to 1.80%, compared to2.42%, a decrease of 62 basis points.

 

Thenet interest margin on a fully taxable equivalent basis (“Net Interest Margin,TE”) for the three months ended September 30, 2010 was 3.33%, compared to3.24% for the same period a year ago, an increase of 9 basis points.  During the first quarter of fiscal 2011, aninterest income reversal  due to loansplaced in nonaccrual status negatively impacted the Net Interest Margin, TEpercentage by 7 basis points for the period. A sustained overall decline in the interest rate yield curve hasaffected both the yield for the interest-earning assets and theinterest-bearing liabilities, while the average balances for these categoriesincreased over the comparable period of the prior year.  Net Interest Margin, TE is a non-GAAPfinancial measure.  See “Analysis of NetInterest Income” for a calculation of this non-GAAP financial measure and forfurther discussion as to the reasons we believe this non-GAAP financial measureis useful.

 

Theallowance for loan and lease losses increased $2.7 million to $12.3 million at September 30,2010, compared to June 30, 2010. The ratio of allowance for loan and lease losses to total loans andleases was 1.37% as of September 30, 2010 compared to 1.07% at June 30,2010.  Total nonperforming assets at September 30,2010 were $23.1 million as compared to $9.2 million at June 30, 2010, anincrease of $14.0 million.  The ratio ofnonperforming assets to total assets increased to 1.84% at September 30,2010, compared to 0.73% at June 30, 2010. The overall increase in nonperforming assets was primarily attributed tothe deterioration in certain dairy operations which caused three of our dairyloan relationships to be moved to nonaccrual status this quarter.  The recent deterioration in the sector isrelated to continued low commodity prices for milk combined with increases inthe cost of feed and operations. The specific valuation allowance on identifiedimpaired loans increased to $2.9 million at September 30, 2010, comparedto $325,000 at June 30, 2010.  Allidentified impaired loans are reviewed to assess the borrower’s inability tomake payments under the terms of the loan and/or a shortfall in collateralvalue that would result in charging off the loan or the portion of the loanthat was impaired.

 

Theallowance for loan and lease losses is calculated based on loan and leaselevels, loan and lease loss history over 12, 36, and 60 month time periods,credit quality of the loan and lease portfolio, and environmental factors suchas 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. Management intends to continue its disciplined credit administration andloan underwriting processes and to remain focused on the creditworthiness ofnew loan originations.  Managementbelieves that it has identified the most significant nonperforming assets inits loan portfolio and is working to clarify and resolve the credit, creditadministration, and environmental factor issues related to these assets toobtain the most favorable outcome for the Company.

 

The Company held $9.3 million in trust preferred securities at September 30,2010 that are currently impaired under applicable accounting rules.  These are comprised of pooled securitiesissued primarily by banks throughout the United States, and were downgraded toa below investment grade rating.  TheCompany performed analysis to determine if any of the securities had a creditloss by estimating if any of the cash flows are not expected to be received as 

 

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contracted.  Based upon the analysis, the Companyrecognized no other-than-temporary impairment credit loss for the three monthsended September 30, 2010, compared to $1.9 million for the first quarterof the prior year.  Fair value on theseinvestments was recorded at $3.3 million at September 30, 2010.

 

Total deposits at September 30, 2010, were $877.6 million, adecrease of $36.7 million, or 4.0% from June 30, 2010.  During the three month period, in-marketdeposits decreased $43.2 million while out-of-market deposits increased $6.5million.  This decrease is primarily dueto the decrease in public fund deposits of $37.1 million since June 30,2010, due to seasonal trends and fluctuations associated with publicfunds.   The primary factor affectinginterest expense was the decrease in the average rates paid on total depositsfor the three month period ended September 30, 2010, of 1.32% compared to1.92% for the three month period ended September 30, 2009.

 

On October 25, 2010, the Company announced it will pay a quarterlycash dividend of 11.25 cents per common share for the first quarter of fiscal2011.  The dividend will be paid on November 12,2010, to stockholders of record on November 5, 2010.

 

Thetotal risk-based capital ratio of 11.71% at September 30, 2010, increasedby 3 basis points from 11.68% at June 30, 2010.  This continues to place the Bank in the “well-capitalized”category within OTS regulation at September 30, 2010 and is consistentwith the “well-capitalized” OTS category in which the Company plans tooperate.  The Company historically hasbeen able to manage the size of its assets through secondary market loan salesof single-family mortgages and student loans.

 

Noninterest income was $3.8 million for the threemonths ended September 30, 2010, compared to $1.7 million for the sameperiod in the prior fiscal year, an increase of $2.1 million.  This increase is due primarily to netimpairment credit losses recognized in earnings of $1.9 million for the threemonths ended September 30, 2009, compared to the current quarter for whichno impairment credit losses were recorded.  Net gain on sale of loans and fees on deposits increased $251,000 and$163,000, respectively, while net gain on sale of securities and trust incomedecreased $136,000 and $103,000, respectively.

 

Noninterest expense was $9.4 million for the threemonths ended September 30, 2010, as compared to $8.9 million for the threemonths ended September 30, 2009, an increase of $478,000, or 5.3%.  The increase was attributed to an increase incompensation and employee benefits of $384,000 and partially offset by adecrease in marketing and community investment of $65,000.  Performance-based incentive pay and increasedpersonnel drove costs higher, while savings in healthcare costs partiallyoffset these increases.

 

TheBank is a member of the Deposit Insurance Fund (the “DIF”), which isadministered by the Federal Deposit Insurance Corporation (“FDIC”).  Deposits are insured up to the applicablelimits by the FDIC and such insurance is backed by the full faith and credit ofthe United States Government.  Under theDodd-Frank Act, deposits of the Bank are permanently insured up to $250,000 perdepositor for each account ownership category (prior to the legislation, theincreased insurance coverage from $100,000 to $250,000 was temporary untilDecember 31, 2013).  As insurer, the FDIC imposes deposit insurancepremiums and is authorized to conduct examinations of and to require reportingby FDIC-insured institutions.  On November 12, 2009, the FDIC Board approveda rule requiring prepayment of the quarterly assessments for the fourthquarter of calendar year 2009 and the entire calendar years of 2010, 2011, and2012.  On December 30, 2009, theCompany paid $4.9 million which was recorded as a prepaid asset and is beingproportionally expensed as each quarter elapses. At September 30, 2010,the remaining balance recorded as a prepaid asset was $3.4 million.  The FDIC may impose additional specialassessments, which would be recorded as they are incurred.  The FDIC also instituted the TransactionAccount Guarantee Program (“TAGP”).  TheTAGP extended the FDIC’s insurance to full coverage of non-interest bearingtransaction accounts for participating institutions through December 31,2010 at an annualized rate of 10 basis points on deposit balances in excess of the$250,000 insurance limit currently in place. The Bank is a participant in the TAGP, but does not expect this programto have a material impact on the FDIC assessment.

 

**General**

 

The Company is a financial services provider and, as such, has inherentrisks that must be managed in order to achieve net income.  Primary risks that affect net income includecredit risk, liquidity risk, operational risk, regulatory compliance risk andreputation risk.  The Company’s netincome is derived by managing net interest margin, the ability to collect feesfrom services provided, by controlling the costs of delivering services and themanagement of loan and lease losses.  Theprimary source of revenues comes from the net interest margin, which representsthe difference between 

 

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incomeon interest-earning assets (i.e. loans and investment securities) and expenseon interest-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 loan services.  Personnel costs are the primary expensesrequired to deliver the services to customers. Other costs include occupancy and equipment and general andadministrative expenses.

 

**FinancialCondition Data**

 

At September 30, 2010, the Company had total assets of $1.3billion, an increase of $7.5 million from the level at June 30, 2010.  The increase in assets in the three months offiscal 2011 was due primarily to an increases in net loans and leasesreceivable and securities available for sale of $5.0 million and $4.3 million,respectively.  Total liabilitiesincreased $8.5 million at September 30, 2010, as compared to June 30,2010.  This increase was primarily due toan increase in advances from the FHLB and other borrowings of $39.6 million andoffset by decreases in deposits of $36.6 million.  Stockholders’ equity decreased $1.1 millionto $93.4 million at September 30, 2010, due primarily to a decrease inaccumulated other comprehensive losses, net of deferred tax effect.

 

Netloans and leases receivable increased $5.0 million at September 30, 2010,as compared to June 30, 2010, due primarily to increases in balances of$7.7 million and partially offset by an increase in the allowance for loan andlease losses of $2.7 million.  Securitiesavailable for sale increased $4.3 million primarily as the result of netincreases of agency residential mortgage-backed securities of $3.4 millionduring the first quarter of fiscal 2011.

 

Cash and cash equivalents increased $1.0 million at September 30,2010 as compared to June 30, 2010. See the Consolidated Statement of Cash Flows for an in-depth analysis inthe change in cash and cash equivalents for the three months ended September 30,2010.

 

Deposits decreased $36.6 million at September 30, 2010 as comparedto June 30, 2010.  Money market andsavings accounts decreased $21.6 and $15.4 million, respectively, during thethree month period ended September 30, 2010, partially offset by anincrease in certificates of deposits of $10.8 million.  Public fund account balances, which areincluded in money markets, savings and certificates of deposits, decreased$37.1 million to $177.8 million at September 30, 2010 in part as a resultof seasonal fluctuations typical with these types of municipal deposits.  Advances from the FHLB and other borrowingsincreased $39.6 million at September 30, 2010 as compared to June 30,2010, due to the decrease in deposits during the three month period.

 

Stockholders’ equity decreased $1.0 million at September 30, 2010when compared to June 30, 2010. This decrease was due primarily to accumulated other comprehensivelosses from cash flow hedging activities of $968,000.

 

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

 

**Loan and Lease Portfolio Composition**

 
| ** **                            | ** ** | **September 30, 2010**     | ** ** | **June 30, 2010** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **Amount**                           | ** ** | **Percent**                 | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                            | ** ** | **(Dollars in Thousands)** | ** ** |
|                                  |       |                                 |       |                        |       |   |   |   |   |
| One-to four-family (1)                |       | $                                    | 73,024     |                        | 8.30       | % | $ | 72,392 |   | 8.30 | % |
| Commercial real estate                |       | 219,722                              |       | 24.96                       |       | 216,479 |   | 24.82 |   |
| Commercial business (2)               |       | 97,940                               |       | 11.13                       |       | 99,892 |   | 11.45 |   |
| Multi-family real estate              |       | 49,393                               |       | 5.61                        |       | 50,064 |   | 5.74 |   |
| Equipment finance leases              |       | 9,043                                |       | 1.03                        |       | 10,642 |   | 1.22 |   |
| Consumer direct (3)                   |       | 125,843                              |       | 14.30                       |       | 122,832 |   | 14.08 |   |
| Consumer indirect (4)                 |       | 6,121                                |       | 0.70                        |       | 8,186 |   | 0.94 |   |
| Agricultural                          |       | 277,415                              |       | 31.52                       |       | 270,568 |   | 31.02 |   |
| Construction                          |       | 21,566                               |       | 2.45                        |       | 21,225 |   | 2.43 |   |
| Total loans and leases receivable (5) |       | $                                    | 880,067    |                        | 100.00     | % | $ | 872,280 |   | 100.00 | % |

 

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(1) Excludes $16,830 and $20,394 loans held for sale at September 30,2010 and June 30, 2010, respectively.

(2) Includes $2,599 and $2,599 tax exempt leases at September 30,2010 and June 30, 2010, respectively.

(3) Excludes$1,290 and $4,893 student loans held for sale at September 30, 2010 andJune 30, 2010, respectively.

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

(5) Includes deferred loan fees and discounts.

** **

**Deposit Composition**

 
| ** **                            | ** ** | **September 30, 2010**     | ** ** | **June 30, 2010** | ** ** |
|---------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                            | ** ** | **Amount**                           | ** ** | **Percent**                 | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                            | ** ** | **(Dollars in Thousands)** | ** ** |
|                                  |       |                                 |       |                        |       |   |   |   |   |
| Noninterest bearing checking accounts |       | $                                    | 107,037    |                        | 12.20      | % | $ | 117,139 |   | 12.81 | % |
| Interest bearing checking accounts    |       | 99,820                               |       | 11.37                       |       | 100,231 |   | 10.96 |   |
| Money market accounts                 |       | 168,198                              |       | 19.17                       |       | 189,821 |   | 20.76 |   |
| Savings accounts                      |       | 67,782                               |       | 7.72                        |       | 83,136 |   | 9.10 |   |
| In-market certificates of deposit     |       | 405,370                              |       | 46.19                       |       | 401,033 |   | 43.86 |   |
| Out-of-market certificates of deposit |       | 29,411                               |       | 3.35                        |       | 22,904 |   | 2.51 |   |
| Total deposits                        |       | $                                    | 877,618    |                        | 100.00     | % | $ | 914,264 |   | 100.00 | % |

 

**Analysisof Net Interest Income**

 

Net interest income represents the difference between income oninterest-earning assets and expense on interest-bearing liabilities.  Net interest income depends upon the volumeof interest-earning assets and interest-bearing liabilities and the interestrates earned or paid on them.

 

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

 

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| ** **                                    | ** ** | **Three Months Ended September 30,** | ** ** |
|-----------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                    | ** ** | **2010**                                                 | ** ** | **2009** | ** ** |
| ** **                                    | ** ** | **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)      |       | $                                                        | 892,630    |   | $ | 12,708 |   | 5.65 | % | $ | 851,419 |   | $ | 12,343 |   | 5.75 | % |
| Investment securities (2) (3)            |       | 258,379                                                  |       | 1,430 |   | 2.20 | % | 225,312 |   | 2,228 |   | 3.92 | % |
| FHLB stock                                    |       | 10,609                                                   |       | 53 |   | 1.98 | % | 12,476 |   | 62 |   | 1.97 | % |
|                                          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                 |       | 1,161,618                                                |       | $ | 14,191 |   | 4.85 | % | 1,089,207 |   | $ | 14,633 |   | 5.33 | % |
| Noninterest-earning assets                    |       | 79,949                                                   |       |   |   |   |   | 71,444 |   |   |   |   |   |
| Total assets                                  |       | $                                                        | 1,241,567  |   |   |   |   |   | $ | 1,160,651 |   |   |   |   |   |
|                                          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                 |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                     |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Checking and money market                     |       | $                                                        | 269,008    |   | $ | 381 |   | 0.56 | % | $ | 228,639 |   | $ | 324 |   | 0.56 | % |
| Savings                                       |       | 76,507                                                   |       | 65 |   | 0.34 | % | 66,592 |   | 62 |   | 0.37 | % |
| Certificates of deposit                       |       | 436,885                                                  |       | 2,166 |   | 1.97 | % | 432,573 |   | 3,138 |   | 2.88 | % |
| Total interest-bearing deposits               |       | 782,400                                                  |       | 2,612 |   | 1.32 | % | 727,804 |   | 3,524 |   | 1.92 | % |
| FHLB advances and other borrowings            |       | 195,220                                                  |       | 1,493 |   | 3.03 | % | 207,028 |   | 1,899 |   | 3.64 | % |
| Subordinated debentures payable to trusts     |       | 27,837                                                   |       | 461 |   | 6.57 | % | 27,837 |   | 459 |   | 6.54 | % |
|                                          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities            |       | 1,005,457                                                |       | 4,566 |   | 1.80 | % | 962,669 |   | 5,882 |   | 2.42 | % |
| Noninterest-bearing deposits                  |       | 104,727                                                  |       |   |   |   |   | 98,213 |   |   |   |   |   |
| Other liabilities                             |       | 37,184                                                   |       |   |   |   |   | 30,143 |   |   |   |   |   |
| Total liabilities                             |       | 1,147,368                                                |       |   |   |   |   | 1,091,025 |   |   |   |   |   |
| Equity                                        |       | 94,199                                                   |       |   |   |   |   | 69,626 |   |   |   |   |   |
| Total liabilities and equity                  |       | $                                                        | 1,241,567  |   |   |   |   |   | $ | 1,160,651 |   |   |   |   |   |
|                                          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Net interest income; interest rate spread (4) |       |                                                     |       | $ | 9,625 |   | 3.05 | % |   |   | $ | 8,751 |   | 2.91 | % |
|                                          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin (4) (5)              |       |                                                     |       |   |   | 3.29 | % |   |   |   |   | 3.19 | % |
|                                          |       |                                                     |       |   |   |   |   |   |   |   |   |   |   |
| Net interest margin, TE (6)                   |       |                                                     |       |   |   | 3.33 | % |   |   |   |   | 3.24 | % |

 

----

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

(2)          Includes federal funds sold.

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

(4)          Percentages for the three months ended September 30,2010 and September 30, 2009 have been annualized.

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

(6)          Net interest margin expressed on a fully taxableequivalent basis (“Net Interest Margin, TE”) is a non-GAAP financialmeasure.  The tax-equivalent adjustmentto net interest income recognizes the income tax savings when comparing taxableand tax-exempt assets and adjusting for federal and state exemption of interestincome and certain other permanent income tax differences.  We believe that it is a standard practice inthe banking industry to present net interest margin expressed on a fullytaxable equivalent basis, and accordingly believe the presentation of thisnon-GAAP financial measure may be useful for peer comparison purposes.  As a non-GAAP financial measure, Net InterestMargin, TE should be considered supplemental to and not a substitute for orsuperior to, financial measures calculated in accordance with GAAP.  As other companies may use differentcalculations for Net Interest Margin, TE, this presentation may not becomparable to similarly titled measures reported by other companies.

 

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The reconciliation of the net interest income (GAAP)to Net Interest Margin, TE (non-GAAP) is as follows:

** **
| ** **                      | ** ** | **Three Months Ended**     | ** ** |
|---------------------------------|------------|--------------------------------------|------------|
| ** **                      | ** ** | **September 30,**               | ** ** |
| ** **                      | ** ** | **2010**                             | ** ** | **2009** | ** ** |
| ** **                      | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **                      | ** ** | ** **                           | ** ** | ** ** | ** ** |
| Net interest income             |       | $                                    | 9,625      |   | $ | 8,751 |   |
| Taxable equivalent adjustment   |       | 129                                  |       | 145 |   |
| Adjusted net interest income    |       | 9,754                                |       | 8,896 |   |
| Average interest-earning assets |       | 1,161,618                            |       | 1,089,207 |   |
| Net interest margin, TE         |       | 3.33                                 | %          | 3.24 | % |
|                                 |            |                                      |            |  |  |  |  |

 

**Rate/Volume Analysis of Net Interest Income**

 

Thefollowing schedule presents the dollar amount of changes in interest income andinterest expense for major components of interest-earning assets and interest-bearingliabilities.  It distinguishes betweenthe increases and decreases due to fluctuating outstanding balances resultingfrom  the levels and volatility ofinterest rates.  For each category ofinterest-earning assets and interest-bearing liabilities, information isprovided on changes attributable to (i) changes in volume (i.e., changesin volume multiplied by old rate) and (ii) changes in rate (i.e., changesin rate multiplied by old volume).

 

Forpurposes of this table, changes attributable to both rate and volume, whichcannot be segregated, have been allocated proportionately to the change due tovolume and the change due to rate.

 
| ** **                                | ** ** | **Three Months Ended September 30,** | ** ** |
|-------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                | ** ** | **2010 vs 2009**                               | ** ** |
| ** **                                | ** ** | **Increase**                                             | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **(Decrease)**                                           | ** ** | **(Decrease)** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **Due to**                                          | ** ** | **Due to** | ** ** | **Increase** | ** ** |
| ** **                                | ** ** | **Volume**                                               | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)**                     | ** ** |
| Interest-earning assets:                  |       |                                                     |       |   |   |   |   |
| Loans and leases receivable (1)           |       | $                                                        | 592        |   | $ | (227 | ) | $ | 365 |   |
| Investment securities (2)                 |       | 326                                                      |       | (1,124 | ) | (798 | ) |
| FHLB stock                                |       | (9                                                       | )          | — |   | (9 | ) |
|                                      |       |                                                     |       |   |   |   |   |
| Total interest-earning assets             |       | 909                                                      |       | (1,351 | ) | (442 | ) |
|                                      |       |                                                     |       |   |   |   |   |
| Interest-bearing liabilities:             |       |                                                     |       |   |   |   |   |
| Deposits:                                 |       |                                                     |       |   |   |   |   |
| Checking and money market                 |       | 57                                                       |       | — |   | 57 |   |
| Savings                                   |       | 9                                                        |       | (6 | ) | 3 |   |
| Certificates of deposit                   |       | 31                                                       |       | (1,003 | ) | (972 | ) |
| Total interest-bearing deposits           |       | 97                                                       |       | (1,009 | ) | (912 | ) |
| FHLB advances and other borrowings        |       | (107                                                     | )          | (299 | ) | (406 | ) |
| Subordinated debentures payable to trusts |       | —                                                   |       | 2 |   | 2 |   |
|                                      |       |                                                     |       |   |   |   |   |
| Total interest-bearing liabilities        |       | (10                                                      | )          | (1,306 | ) | (1,316 | ) |
|                                      |       |                                                     |       |   |   |   |   |
| Net interest income increase              |       | $                                                        | 919        |   | $ | (45 | ) | $ | 874 |   |

 

----

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

(2)  Includes federal funds sold.

 

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**Application of 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 requiresthe Company to set aside reserves or maintain an allowance against probableloan 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.

 

Theallowance is compiled by utilizing the Company’s loan and lease risk ratingsystem, which is structured to identify weaknesses in the loan and leaseportfolio.  The risk rating system hasevolved to a process whereby management believes the system will properlyidentify the credit 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 earningsbeing significantly affected if circumstances differ substantially from theassumptions used in making the final determinations.

 

*Mortgage Servicing Rights (“MSR”)*.  The Company records a servicing asset forcontractually separated servicing from the underlying mortgage loans.   The asset is initially recorded at fairvalue and represents an intangible asset backed by an income stream from theserviced assets.  The asset is amortizedin proportion to and over the period of estimated net servicing income.

 

Ateach balance sheet date, the MSRs are analyzed for impairment, which occurswhen the fair value of the MSRs is lower than the amortized book value. TheCompany’s MSRs 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.  Ifthe Company 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.

 

TheCompany has included MSRs as a critical accounting policy because the use ofestimates for determining fair value using present value concepts may produceresults which may significantly differ from other fair value analysis perhapseven to the point of recording impairment. The risk to earnings is when the underlying mortgages pay off significantlyfaster than 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 at September 30,2010.

 

*Security Impairment*.  Managementcontinually monitors the investment security portfolio for impairment on asecurity by security basis under the guidance of ASC Subtopic 320-10.  Management has a process in place to identifysecurities that could potentially have a credit impairment that isother-than-temporary.  This processinvolves the length of time and extent to which the fair value has been lessthan the amortized cost basis, review of available information regarding thefinancial position of the issuer, monitoring the rating of the security, cashflow projections, and the Company’s intent to sell a security or whether it ismore likely than not the Company will be required to sell the security beforethe recovery of its amortized cost which, in some cases, may extend tomaturity.  To the extent we determinethat a security is deemed to be other-than-temporarily impaired, an impairmentloss is recognized.  If the Companyintends to sell a security or it is more likely than not that the Company wouldbe required to sell a security before the recovery of its amortized cost, lessany current period credit loss, the Company recognizes an other-than-temporaryimpairment in earnings for the difference between amortized cost and fairvalue.  If we do not expect to recoverthe amortized cost basis, we do not plan to sell the security and if it is not morelikely than not that the Company would be required to sell a

 

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security before the recovery of it amortizedcost, less any current period credit loss, the recognition of theother-than-temporary impairment is bifurcated. For those securities, the Company separates the total impairment into acredit loss component recognized in earnings, and the amount of the lossrelated to other factors is recognized in other comprehensive income net oftaxes.

 

The amount of the credit loss component of a debtsecurity impairment is estimated as the difference between amortized cost andthe present value of the expected cash flows of the security.  The present value is determined using thebest estimate cash flows discounted at the effective interest rate implicit tothe security at the date of purchase or the current yield to accrete an asset-backedor floating rate security.  Cash flowestimates for trust preferred securities are derived from scenario-basedoutcomes of forecasted default rates, loss severity, prepayment speeds andstructural support.

 

*Level 3 Fair Value Measurement.*  GAAP requires the Company to measure the fairvalue of financial instruments under a standard which describes three levels ofinputs that may be used to measure fair value. Level 3 measurementincludes significant unobservable inputs that reflect the Company’s ownassumptions about the assumptions that market participants would use in pricingan asset or liability. Level 3 assets and liabilities include financialinstruments whose value is determined using pricing models, discounted cashflow methodologies, or similar techniques, as well as instruments for which thedetermination of fair value requires significant management judgment orestimation. Although management believes that it uses a best estimate ofinformation available to determine fair value, due to the uncertainty of futureevents, the approach includes a process that may differ significantly fromother methodologies and still produce an estimate that is in accordance withGAAP.

 

*Self-Insurance*.  The Company has a self-insured healthcareplan for its employees up to certain limits. To mitigate a portion of these risks, the Company has a stop-lossinsurance policy through a commercial insurance carrier for coverage in excessof $65,000 per individual occurrence with no maximum aggregate limitation.  The estimate of self-insurance liability isbased upon known claims and an estimate of incurred, but not reported (“IBNR”)claims.  IBNR claims are estimated usinghistorical claims lag information received by a third party claimsadministrator.  Due to the uncertainty ofhealth claims, the approach includes a process which may differ significantlyfrom other methodologies and still produce an estimate in accordance withGAAP.  Although management believes ituses the best information available to determine the accrual, unforeseen healthclaims could result in adjustments to the accrual.  These adjustments could significantly affectnet earnings if circumstances differ substantially from the assumptions used inestimating the accrual.

 

**Asset Quality and Potential Problem Loans and Leases**

 

Nonperformingassets (nonaccrual loans and leases, accruing loans and leases delinquent morethan 90 days and foreclosed assets) increased to $23.1 million at September 30,2010 from $9.2 million at June 30, 2010, an increase of $13.9million.  Nonaccruing loans and leasesincreased  $12.0 million from June 30,2010 to September 30, 2010, to a total of $18.0 million.  Accruing loans and leases delinquent morethan 90 days increased $2.0 million to $4.2 million at September 30, 2010from $2.2 million at June 30, 2010. Foreclosed assets decreased $4,000 to $942,000 at September 30,2010, from $946,000 at June 30, 2010. In addition, the ratio of nonperforming assets to total assets, which isone indicator of credit risk exposure, was 1.84% at September 30, 2010,which is an increase from 0.73% as reported at June 30, 2010.  The overall increase in nonperforming assetswas primarily attributed to the deterioration in certain dairy operations whichcaused three of our dairy loan relationships to be moved to nonaccrual statusthis quarter.  The deterioration in thesector is related to continued low commodity prices for milk combined withincreases in the cost of feed and operations.

 

Nonaccruingloans and leases increased $12.0 million to $18.0 million at September 30,2010 compared to $6.0 million at June 30, 2010.  The loans and leases included in nonaccruingloans and leases at September 30, 2010 were five loans totaling $275,000secured by one- to four-family real estate, 15 loans totaling $7.1 millionsecured by agricultural real estate, 25 loans totaling $7.7 million secured byagricultural business assets, nine loans totaling $1.3 million secured bycommercial real estate, 10 loans totaling $554,000 secured by commercialbusiness assets, 21 leases totaling $374,000 secured by equipment, and 24 loanstotaling $623,000 secured by consumer assets.

 

Accruingloans and leases delinquent more than 90 days increased $2.0 million, to $4.2million at September 30, 2010 compared to $2.2 million at June 30,2010.  Included in accruing loans andleases delinquent more than 90 days at September 30, 2010 were three loanstotaling $300,000 secured by commercial real estate, one loan for $120,000secured by one-to four-family real estate, four loans totaling $432,000 securedby agricultural real estate, nine loans totaling $446,000 secured by commercialbusiness assets, 16  loans totaling $2.7million secured by agricultural business assets,

 

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twoleases totaling $91,000 secured by equipment and eight loans totaling $143,000of unsecured overdraft and reserve accounts.

 

Therisk rating 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.

 

Asof September 30, 2010, foreclosed assets decreased by $4,000, or 0.4%, to$942,000 as compared to $946,000 at June 30, 2010.  The balance at September 30, 2010consisted of $229,000 of one- to four-family collateral owned, $55,000 ofcommercial business collateral owned, $205,000 of leased equipment owned,$42,000 of agricultural real estate owned, $404,000 of agricultural businesscollateral owned, and $7,000 of consumer collateral owned.

 

AtSeptember 30, 2010, the Company had designated $46.2 million of its loansas special mention and $48.4 million of its loans as classified, whichmanagement has determined need to be closely monitored because of possiblecredit problems of the borrowers or the cash flows of the securedproperties.  The Company also classified$9.3 million of trust preferred securities in accordance with OTS debt securityclassification guidelines.  At September 30,2010, the Company had $12.0 million in multi-family, commercial business,commercial real estate and agricultural participation loans purchased, of whichnone was classified.  These loans andleases were considered in determining the adequacy of the allowance for loanand lease losses.  The allowance for loanand lease losses is established based on management’s evaluation of the risksprobable in the loan and lease portfolio and changes in the nature and volumeof loan and lease activity.  Suchevaluation, which includes a review of all loans and leases for which fullcollectability may not be reasonably assured, considers the estimated fairmarket value of the underlying collateral, present value of expected principaland interest payments, economic conditions, historical loss experience and otherfactors that warrant recognition in providing for an adequate loan and leaseloss allowance.

 

Althoughthe Company’s management believes the September 30, 2010 recordedallowance for loan and lease losses was adequate to provide for probable losseson the related loans and leases, there can be no assurance the allowance willbe adequate in the future.  In addition,the Company’s determination as to the amount of our allowance for loan lossesis subject to review by the Bank’s principal federal regulator, the OTS. TheOTS will begin its periodic review in the second quarter of fiscal year2011.  As an integral part of itsexamination, the OTS will review our allowance for loan losses, and may requireus to recognize adjustments to the allowance based on its judgments after areview of the information available to it at the time of its examination.

 

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.

 

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Thefollowing table sets forth the amounts and categories of the Company’snonperforming assets for the periods indicated.

 
| ** **                                                                      | ** ** | **Nonperforming Assets**        | ** ** |
|---------------------------------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                                                      | ** ** | **September 30, 2010**     | ** ** | **June 30, 2010** | ** ** |
| ** **                                                                      | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccruing loans and leases:                                                   |       |                                 |       |   |   |
| One- to four-family                                                             |       | $                                    | 275        |   | $ | 159 |   |
| Commercial real estate                                                          |       | 1,307                                |       | 716 |   |
| Commercial business                                                             |       | 554                                  |       | 469 |   |
| Equipment finance leases                                                        |       | 374                                  |       | 862 |   |
| Consumer                                                                        |       | 623                                  |       | 649 |   |
| Agricultural                                                                    |       | 14,823                               |       | 3,181 |   |
| Total                                                                           |       | 17,956                               |       | 6,036 |   |
|                                                                            |       |                                 |       |   |   |
| Accruing loans and leases delinquent more than 90  days:                        |       |                                 |       |   |   |
| One- to four-family                                                             |       | 120                                  |       | — |   |
| Commercial real estate                                                          |       | 300                                  |       | 201 |   |
| Commercial business                                                             |       | 446                                  |       | 167 |   |
| Equipment finance leases                                                        |       | 91                                   |       | 334 |   |
| Consumer                                                                        |       | 143                                  |       | 22 |   |
| Agricultural                                                                    |       | 3,135                                |       | 1,472 |   |
| Total                                                                           |       | 4,235                                |       | 2,196 |   |
|                                                                            |       |                                 |       |   |   |
| Foreclosed assets:                                                              |       |                                 |       |   |   |
| One- to four-family                                                             |       | 229                                  |       | 212 |   |
| Equipment finance leases                                                        |       | 205                                  |       | 212 |   |
| Commercial business                                                             |       | 55                                   |       | 32 |   |
| Consumer                                                                        |       | 7                                    |       | 8 |   |
| Agricultural                                                                    |       | 446                                  |       | 482 |   |
| Total (1)                                                                       |       | 942                                  |       | 946 |   |
|                                                                            |       |                                 |       |   |   |
| Total nonperforming assets (2)                                                  |       | $                                    | 23,133     |   | $ | 9,178 |   |
|                                                                            |       |                                 |       |   |   |
| Ratio of nonperforming assets to total assets (3)                               |       | 1.84                                 | %          | 0.73 | % |
|                                                                            |       |                                 |       |   |   |
| Ratio of nonperforming loans and leases to total  loans and leases (4) (5) |       | 2.47                                 | %          | 0.92 | % |
|                                                                            |       |                                 |       |   |   |
| Accruing troubled debt restructures                                             |       | $                                    | 4,000      |   | $ | 4,000 |   |

 

----

(1)          Total foreclosed assets donot include land or other real estate owned held for sale.

(2)          Nonperforming assets includenonaccruing loans and leases, accruing loans and leases delinquent more than 90days and foreclosed assets.

(3)          Percentage is calculatedbased upon total assets of the Company and its direct and indirect subsidiarieson a consolidated basis.

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

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

 

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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,** | ** ** |
|------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------|------------|
| ** **                                                                                           | ** ** | **2010**                                                 | ** ** | **2009** | ** ** |
| ** **                                                                                           | ** ** | **(Dollars in Thousands)**                     | ** ** |
|                                                                                                 |       |                                                     |       |   |   |
| Balance at beginning of period                                                                       |       | $                                                        | 9,575      |   | $ | 8,470 |   |
| Charge-offs:                                                                                         |       |                                                     |       |   |   |
| One- to four-family                                                                                  |       | (15                                                      | )          | (83 | ) |
| Commercial real estate                                                                               |       | (4                                                       | )          | (4 | ) |
| Commercial business                                                                                  |       | (219                                                     | )          | (5 | ) |
| Equipment finance leases                                                                             |       | (148                                                     | )          | (113 | ) |
| Consumer                                                                                             |       | (296                                                     | )          | (150 | ) |
| Agricultural                                                                                         |       | (36                                                      | )          | — |   |
| Total charge-offs                                                                                    |       | (718                                                     | )          | (355 | ) |
|                                                                                                 |       |                                                     |       |   |   |
| Recoveries:                                                                                          |       |                                                     |       |   |   |
| One- to four-family                                                                                  |       | 1                                                        |       | 3 |   |
| Commercial business                                                                                  |       | 15                                                       |       | — |   |
| Consumer                                                                                             |       | 79                                                       |       | 42 |   |
| Total recoveries                                                                                     |       | 95                                                       |       | 45 |   |
|                                                                                                 |       |                                                     |       |   |   |
| Net recoveries (charge-offs)                                                                         |       | (623                                                     | )          | (310 | ) |
|                                                                                                 |       |                                                     |       |   |   |
| Additions charged to operations                                                                      |       | 3,367                                                    |       | 343 |   |
|                                                                                                 |       |                                                     |       |   |   |
| Balance at end of period                                                                             |       | $                                                        | 12,319     |   | $ | 8,503 |   |
|                                                                                                 |       |                                                     |       |   |   |
| Ratio of allowance for loan and lease losses to  total loans and leases at end of period (1)         |       | 1.37                                                     | %          | 0.99 | % |
|                                                                                                 |       |                                                     |       |   |   |
| Ratio of allowance for loan and lease losses to  nonperforming loans and leases at end of period (2) |       | 55.51                                                    | %          | 68.15 | % |
|                                                                                                 |       |                                                     |       |   |   |
| Ratio of net charge offs to average loans and  leases for the year-to-date period (3)                |       | 0.28                                                     | %          | 0.14 | % |

 

----

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

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

(3) Percentages for the three months ended September 30, 2010 and September 30,2009 have been annualized.

 

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Thedistribution of the Company’s allowance for loan and lease losses and impairedloss summary as required by ASC Topic 310 (FASB Statement No. 114), “Accountingby Creditors for Impairment of a Loan” are summarized in the followingtables.  The combination of ASC Topic 450(FASB Statement No. 5) “Accounting for Contingencies” and FASB Statement No. 114calculations comprise the Company’s allowance for loan and lease losses.

 
| ** **               | ** ** | **FAS 5**                       | ** ** | **FAS 114**            | ** ** | **FAS 5**             | ** ** | **FAS 114**       | ** ** |
|--------------------------|------------|--------------------------------------|------------|-----------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **               | ** ** | **Allowance**                        | ** ** | **Impaired Loan**      | ** ** | **Allowance**              | ** ** | **Impaired Loan** | ** ** |
| ** **               | ** ** | **for Loan and**           | ** ** | **Valuation**               | ** ** | **for Loan and** | ** ** | **Valuation**          | ** ** |
| ** **               | ** ** | **Lease Losses**                | ** ** | **Allowance**               | ** ** | **Lease Losses**      | ** ** | **Allowance**          | ** ** |
| **Loan Type**       | ** ** | **September 30, 2010**     | ** ** | **June 30, 2010** | ** ** |
| ** **               | ** ** | **(Dollars in Thousands)** | ** ** |
|                     |       |                                 |       |                        |       |                       |       |                   |       |
| One- to four-family      |       | $                                    | 206        |                        | $          | —                     |       | $                      | 216        |   | $ | — |   |
| Commercial real estate   |       | 1,680                                |       | 229                         |       | 1,614                      |       | 165                    |       |
| Multi-family real estate |       | 26                                   |       | —                      |       | 105                        |       | —                 |       |
| Commercial business      |       | 1,937                                |       | 67                          |       | 1,923                      |       | 67                     |       |
| Equipment finance leases |       | 472                                  |       | —                      |       | 579                        |       | —                 |       |
| Consumer                 |       | 1,468                                |       | —                      |       | 1,273                      |       | —                 |       |
| Agricultural             |       | 3,616                                |       | 2,618                       |       | 3,540                      |       | 93                     |       |
| Total                    |       | $                                    | 9,405      |                        | $          | 2,914                      |       | $                      | 9,250      |   | $ | 325 |   |

 

**FAS 114Impaired Loan Summary**

** **
| ** **             | ** ** | ** **                           | ** ** | ** **                  | ** ** | **Impaired**  | ** ** | ** **       | ** ** | ** **  | ** ** | **Impaired**  | ** ** |
|------------------------|------------|--------------------------------------|------------|-----------------------------|------------|---------------|------------|------------------|------------|-------------|------------|---------------|------------|
| ** **             | ** ** | **Number**                           | ** ** | ** **                  | ** ** | **Loan**      | ** ** | **Number**       | ** ** | ** **  | ** ** | **Loan**      | ** ** |
| ** **             | ** ** | **of Loan**                     | ** ** | **Loan**                    | ** ** | **Valuation** | ** ** | **of Loan** | ** ** | **Loan**    | ** ** | **Valuation** | ** ** |
| ** **             | ** ** | **Customers**                        | ** ** | **Balance**                 | ** ** | **Allowance** | ** ** | **Customers**    | ** ** | **Balance** | ** ** | **Allowance** | ** ** |
| **Loan Type**     | ** ** | **September 30, 2010**     | ** ** | **June 30, 2010** | ** ** |
| ** **             | ** ** | **(Dollars in Thousands)** | ** ** |
|                   |       |                                 |       |                        |       |          |       |             |       |        |       |          |       |
| Commercial real estate |       | 2                                    |       | $                           | 795        |          | 229        |             | 4          |        | 731        |          | 165        |   |
| Commercial business    |       | 2                                    |       | 166                         |       | 67            |       | 5                |       | 362         |       | 67            |       |
| Agricultural           |       | 6                                    |       | 19,074                      |       | 2,618         |       | 5                |       | 7,728       |       | 93            |       |
| Total                  |       | 10                                   |       | $                           | 20,035     |          | $          | 2,914            |       | 14          |       | $             | 8,821      |   | $ | 325 |   |
|                        |            |                                      |            |                             |            |               |            |                  |            |             |            |               |            |  |  |  |  |

 

Theallowance for loan and lease losses was $12.3 million at September 30,2010, as compared to $8.5 million at September 30, 2009.  The ratio of the allowance for loan and leaselosses to total loans and leases was 1.37% at September 30, 2010, comparedto 0.99% at September 30, 2009.  TheCompany’s management has considered nonperforming loans and leases andpotential problem loans and leases in establishing the allowance for loan andlease losses.  The Company continues tomonitor its allowance for probable loan and lease losses and make futureadditions or reductions in light of the level of loans and leases in itsportfolio and as economic conditions dictate. The current level of the allowance for loan and lease losses is a resultof management’s assessment of the risks within the portfolio based on theinformation revealed in credit reporting processes. The Company utilizes arisk-rating system on all commercial business, agricultural, construction andmulti-family and commercial real estate loans, including purchased loans andleases.  A periodic credit review isperformed on all types of loans and leases to establish the necessary reservebased on the estimated risk within the portfolio. This assessment of risk takesinto account the composition of the loan and lease portfolio, historical lossexperience for each loan and lease category, previous loan and leaseexperience, concentrations of credit, current economic conditions and otherfactors that in management’s judgment deserve recognition.

 

Real estate properties acquired throughforeclosure are recorded at the lower of cost or fair value (less a deduction

 

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for disposition costs). Valuations are periodically updated by management and a specificprovision for losses on such properties is established by a charge tooperations if the carrying values of the properties exceed their estimated netrealizable values.

 

Although management believes it uses the bestinformation available to determine the allowances, unforeseen market conditionscould result in adjustments and net earnings being significantly affected ifcircumstances differ substantially from the assumptions used in making thefinal determinations.  Future additionsto the Company’s allowances may result from periodic loan, property orcollateral reviews which cannot be predicted in advance.

 

**Comparison of the Three Months Ended September 30, 2010 and September 30,2009**

 

*General*.  The Company’snet income was $490,000, or $0.07 in basic and diluted earnings per commonshare for the three months ended September 30, 2010, as compared to netincome of $855,000, or $0.21 in basic and diluted earnings per common share forthe same period in the prior fiscal year. For the first quarter of fiscal 2011, the return on average equity andthe return on average assets was 2.06% and 0.16%, respectively, compared to 4.87%and 0.29%, respectively, for the same period in the prior fiscal year.

 

*Interest, Dividend and Loan Fee Income.*  Interest, dividend and loan fee income was$14.2 million for the three months ended September 30, 2010, as comparedto $14.6 million for the same period in the prior fiscal year, a decrease of$442,000 or 3.0%.  This decrease wasprimarily the result of declining average yields on the investmentsecurities.  Loans and leases receivablehad an average yield of 5.65% for the three months ended September 30,2010, which is 10 basis points less than the average yield of 5.75% for thethree months ended September 30, 2009. Investment securities had a decline in average yield of 172 basis pointswhen comparing the first quarter of fiscal 2011 against the same period of theprior year.  The average balance forloans and leases receivables for the first quarter of fiscal 2011 increased$41.2 million, or 4.8% to $892.6 million when compared to the average balanceof the first quarter of fiscal 2010.  Theaverage balance of investment securities increased $33.1 million, or 14.7% to$258.4 million for the first quarter of fiscal 2011, when compared to theaverage balance of the same quarter of the prior fiscal year.  The revenue decrease attributable to theoverall declining yield for interest-earning assets was $1.4 million, which waspartially offset by the revenue increase due to an increase in averageinterest-earning assets balances of $909,000.

 

*Interest Expense.* Interest expense was $4.6 million for the three months ended September 30,2010, as compared to $5.9 million for the same period in the prior fiscal year,a decrease of $1.3 million or 22.4%.  A$1.0 million decrease in interest expense was the result of a decrease in theaverage rate paid of 1.32% on interest-bearing deposits for the three monthsended September 30, 2010, compared to an average rate paid of 1.92% forthe three months ended September 30, 2009. The average balance of interest-bearing deposits increased by $54.6million, or 7.5%, which increased interest expense by $97,000 for the threemonths ended September 30, 2010, as compared to the same period of fiscal2010.  The net effect of interest-bearingdeposits on interest expense due to rate and volume was a decrease of $912,000for the first quarter of fiscal 2011 as compared to the first quarter of2010.  FHLB advances and other borrowingsdecreased by $11.8 million, or 5.7% for the three month period ended September 30,2010, as compared to the three month period ended September 30, 2009,while the rate decreased to 3.03% from 3.64% for the periods.  The resulting reduction in volume and ratedecreased interest expense by $406,000 due to these liabilities.  The average rate paid on totalinterest-bearing liabilities, which include interest-bearing deposits andliabilities, was 1.80% for the three months ended September 30, 2010 ascompared to 2.42% for the same period in fiscal 2010.

 

*Net Interest Income.* The Company’s net interest income for the three months ended September 30,2010, increased $874,000 or 10.0%, to $9.6 million compared to $8.8 million forthe same period in the prior fiscal year. The net increase in volumes of interest-earning assets in excess ofincreased volumes of interest-bearing liabilities resulted in a net increase innet interest income of $919,000.  Thiswas partially offset by the net effect of the reduction of rates earned forinterest-earning assets in excess of the reduction of rates paid forinterest-bearing liabilities and resulted in a net decrease in net interestincome of $45,000.  The Company’s NetInterest Margin, TE was 3.33% for the three months ended September 30,2010, as compared to 3.24% for the three months ended September 30,2009.  Net Interest Margin, TE is anon-GAAP financial measure.  See “Analysisof Net Interest Income” for a calculation of this non-GAAP financial measureand for further discussion as to the reasons we believe this non-GAAP financialmeasure is useful.

 

*Provision for Losses on Loans andLeases.*The allowance for loan and lease losses is maintained at a level which isconsidered by management to be adequate to absorb probable losses on existingloans and leases that may become uncollectible, based on an evaluation of thecollectability of loans and leases and prior loan and lease loss

 

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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 the three months ended September 30,2010, the Company recorded a provision for losses on loans and leases of $3.4million compared to $343,000 for the three months ended September 30,2009.  See “Asset Quality and PotentiallyProblem Loans and Leases” for further discussion.

 

*Noninterest Income.*  Noninterest income was $3.8million for the quarter ended September 30, 2010, compared to $1.7 millionfor the quarter ended September 30, 2009, an increase of $2.1million.  This increase is due primarilyto a decrease in net impairment losses recognized in earnings of $1.9million.  Fees on deposits and net gainon sale of loans increased $163,000 and $251,000, respectively, which added tothe increase over the prior year’s amount. Trust fees and net gain on the sale of securities decreased by $103,000and $136,000, respectively, which partially offset the increase in noninterestincome when comparing the two periods.

 

There were no net impairment credit lossesrecognized in earnings for the quarter ended September 30, 2010, comparedto a net credit loss of $1.9 million recognized in earnings for the firstquarter of fiscal 2010.  Fees ondeposits increased by $163,000 to $1.6 million forthe quarter ended September 30, 2010, compared to $1.4 million for thequarter ended September 30, 2009, primarily due to a $107,000increase in net fees from insufficient funds and depositor overdrafts, and a$28,000 net increase in income from point-of-sale purchases by customers andATM service fees.  Net gain on sale of loans increased $251,000, primarily due to anincrease in mortgage loan activity and the related loan sales when comparingthe quarter-over-quarter activity.  Netgain on the sale of securities totaled $397,000, a decrease of $136,000 for thethree months ended September 30, 2010, as compared to the same period infiscal 2010.  Trust income decreased$103,000 from $257,000 to $154,000 when comparing the first quarter of fiscal2010 to fiscal 2011.  The prior year’squarter activity included a one-time estate fee of $79,000, which was notpresent in the current quarter’s activity.

 

*Noninterest Expense.*  Noninterest expense was $9.4million for the three months ended September 30, 2010 as compared to $8.9million for the three months ended September 30, 2009, an increase of$478,000, or 5.3%.  Compensation andemployee benefits increased $384,000 and was the primary factor in the overallincrease.  Marketing and community investmentdecreased $65,000 to partially offset the overall increase for the firstquarter of fiscal 2011 compared to the same period of fiscal 2010.

 

Compensation andemployee benefits were $5.5 million for the three months ended September 30,2010, an increase of $384,000 or 7.4% when compared to the three months ended September 30,2009.  Employee compensation increased$326,000, or 8.8% when compared to the prior year’s quarter due to increasedstaffing needs for local and new market expansion.  Of the total increase, annual salaryincreases to existing staff accounted for approximately half of thistotal.  Performance-based incentives andcommissions increased $163,000 due to an increase in performance outcomes forthe first quarter of fiscal 2011 as compared to the prior year’s quarter.  Net healthcare costs, whichare included in the total for compensation and employee benefits, decreased$161,000, or 21.5% to $587,000 when comparing the three month period ended September 30,2010 to the same quarter in the prior year. This decrease is due to the overall utilization decreases and employeereimbursement increases anticipated from the plan modifications initiated on January 1,2010.  Management currently believes theself-insured structure is a reasonable alternative to traditional healthcareplans over the long term.  The level ofhealthcare costs which the Company incurs may vary from year to year.

 

Marketing and community investment decreased$65,000, or 13.8% to $406,000 for the first quarter of fiscal 2011, compared tothe first quarter of fiscal 2010.  Theancillary rewards program and community investment were the primary factors inthe decrease as compared to the prior year’s quarter.  The ancillary rewards program was initiatedin the beginning of fiscal 2010 and higher costs were associated with the bonusrewards to customers.  The prior year’squarter costs included bulk rewards costs, which were not present in thecurrent quarter.  Community investmentsalso decreased for the current quarter as compared to the prior year’s quarterdue to the timing of larger contributions in the prior fiscal year.  These decreases were partially offset by anincrease in advertising costs for the first quarter of fiscal 2011 as comparedto the first quarter of fiscal 2010.

 

*Income tax expense.*  The Company’sincome tax expense for the three months ended September 30, 2010 decreasedto $123,000 compared to $302,000 for the same period in the prior fiscalyear.  The effective tax rate was 20.1%and 26.1% for the three months ended September 30, 2010 and 2009,respectively.  The amount of permanenttax

 

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difference as a net deduction was a higherpercentage to income before income taxes in the first quarters of fiscal 2011and fiscal 2010 than anticipated, which reduces the overall effective tax rate.

 

**Liquidity and Capital Resources**

 

TheBank’s primary sources of funds are earnings, in-market deposits, FHLB advancesand other borrowings, repayments of loan principal, agency residentialmortgage-backed securities and callable agency securities and, to a lesserextent, sales of mortgage loans, sales and maturities of securities,out-of-market deposits and short-term investments.  While scheduled loan payments and maturingsecurities are relatively predictable, deposit flows and loan and securityprepayments are more influenced by interest rates, general economic conditionsand competition. The Bank attempts to price its deposits to meet itsasset/liability objectives consistent with local market conditions.  Excess balances are invested in overnightfunds.

 

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) projectedloan sales, (iii) expected deposit flows, (iv) yields available oninterest-bearing deposits, and (v) the objectives of its asset/liabilitymanagement program.  Excess liquidity isinvested generally in interest-bearing overnight deposits and other short-termgovernment and agency obligations.

 

Although in-market deposits is one of the Bank’s primary source offunds, the Bank’s policy has been to utilize borrowings where the funds can beinvested in either loans or securities at a positive rate of return or to usethe funds for short-term liquidity purposes. As of September 30, 2010, theBank had the following sources of additional borrowings:

 

·                  $15.0 million in anuncommitted, unsecured line of federal funds with First Tennessee Bank, NA;

 

·                  $10.0 million in anuncommitted, unsecured line of federal funds with Zions Bank;

 

·                  $66.3 million ofavailable credit from the Federal Reserve Bank; and

 

·                  $47.3 million ofavailable credit from FHLB of Des Moines (after deducting outstandingborrowings with FHLB of Des Moines).

 

The Bank may also seek other sources of contingent liquidity includingadditional federal funds purchased lines with correspondent banks and lines ofcredit with the Federal Reserve Bank. There were no funds drawn on the uncommitted,unsecured lines of federal funds with First Tennessee Bank, NA and Zions Bankat September 30, 2010. The Bank, as a member of the FHLB of Des Moines, isrequired to acquire and hold shares of capital stock in the FHLB of Des Moinesequal to 0.12% of the total assets of the Bank at December 31 annually.The Bank is also required to own activity-based stock, which is based on 4.45%of the Bank’s outstanding advances. These percentages are subject to change atthe discretion of the FHLB Board of Directors.

 

TheCompany has a line of credit for $4.0 million with United Bankers’ Bankfor liquidity needs, which was renewed and amended on Ocotober 1, 2010 toreduce the line of credit from $6.0 million to $4.0 million.  The Company pledged 100% of the stock of theBank as collateral on the line of credit. At September 30, 2010, there areno outstanding advances under this Loan Agreement and the note has a maturityof October 1, 2011.  In connectionwith entering into the Loan Agreement, the Company also entered into aCommercial Pledge Agreement with the Lender, granting the Lender a firstsecurity interest in all of the stock of the Bank.  The Loan Agreement contains customary eventsof default and affirmative covenants with which the Company and Bank were in complianceat September 30, 2010.

 

In addition to the above sources of additional borrowings, the Bank hasimplemented arrangements to acquire out-of-market certificates of deposit as anadditional source of funding. As of September 30, 2010, the Bank had $29.4 millionin out-of-market certificates of deposit.

 

The Bank anticipates that it will have sufficient funds available tomeet current loan commitments. At September 30, 2010, the Bank hadoutstanding commitments to originate and purchase mortgage and commercial loansof $18.2 million and to sell mortgage loans of $28.1 million.Commitments by the Bank to originate loans are not necessarily executed by thecustomer. The Bank monitors the ratio of commitments to funding for use inliquidity

 

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management.At September 30, 2010, the Bank had outstanding commitments to purchase$195,000 of investment securities available for sale.

 

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

 

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 a recapitalizationplan.  At September 30, 2010, theBank met all current regulatory capital requirements.

 

The minimum OTS Tier 1 (core) capital requirement for well-capitalizedinstitutions is 5.00% of total adjusted assets for thrifts.  The Bank had Tier 1 (core) capital of 8.73%at September 30, 2010.  The minimumOTS total risk-based capital requirement for well-capitalized institutions is10.00% of risk-weighted assets.  The Bankhad total risk-based capital of 11.71% at September 30, 2010.

 

**Impactof Inflation 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,which require the measurement of financial position and operating results interms of historical dollars without considering the change in the relativepurchasing power of money over time due to inflation.  The impact of inflation is reflected in theincreased cost of the Bank’s operations. Unlike most industrial companies, nearly all the assets and liabilitiesof the Bank are monetary in nature.  As aresult, interest rates have a greater impact on the Bank’s performance than dothe effects of general levels of inflation. Interest rates do not necessarily move in the same direction or to thesame extent as the prices of goods and services.

 

**RecentAccounting Pronouncements**

 

On June 12, 2009, theFASB issued SFAS No. 166, “Accounting for Transfers of Financial Assets”(ASC Topic 860). This updated guidance removed the concept of a qualifyingspecial-purpose entity and removed the exception from applying consolidationguidance to these entities. This update also clarified the requirements forisolation and limitations on portions of financial assets that are eligible forsale accounting. ASC Topic 860 is reportable for interim and annual reports andeffective for the Company on reporting periods beginning July 1,2010.  The Company adopted this guidanceeffective in the first quarter of fiscal 2011 and the adoption did not have amaterial effect on the Company’s consolidated financial condition, results ofoperations or cash flow.

 

In April 2010, the FASBissued ASU No. 2010-18,”Effect of a Loan Modification When the Loan Is Part ofa Pool That Is Accounted for as a Single Asset”.  As a result of this update, modifications ofloans that are accounted for within a pool under Subtopic 310-30 do not resultin the removal of those loans from the pool even if the modification of thoseloans would otherwise be considered a troubled debt restructuring.  An entity will continue to be required toconsider whether the pool of assets in which the loan is included is impairedif expected cash flows for the pool change. The Company adopted this update effective in the first quarter of fiscal2011 and the adoption did not have a material effect on the Company’sconsolidated financial condition, results of operations or cash flow.

 

In July 2010, FASBissued ASU 2010-20, “Disclosures about the Credit Quality of FinancingReceivables and the Allowance for Credit Losses” (ASC Topic 310). This guidancewill require significant new disclosures about the allowance for credit lossesand the credit quality of financing receivables. The requirements are intendedto enhance transparency regarding credit losses and the credit quality of loan andlease receivables. Under this statement, allowance for credit losses and fairvalue are to be disclosed by portfolio segment, while credit qualityinformation, impaired financing receivables and nonaccrual status are to bepresented by class of financing receivable.  Disclosure of the nature andextent, the financial impact and segment information of restructured loans willalso be required.  The disclosures are to be presented at the level ofdisaggregation that management uses when assessing and monitoring the portfolio’srisk and performance. ASU 2010-20 is effective for the Company for interim andannual reporting periods ending after

 

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December 15, 2010 andthe Company does not expect the adoption to have a material effect on theCompany’s consolidated financial condition, results of operations or cash flow.

 

During the first quarter offiscal 2011, the FASB issued several ASUs: ASU No. 2010-20 through ASUNo. 2010-26.  Except for ASU No. 2010-20,mentioned above, the other ASUs issued have minimal, if any, impact on theCompany.

 

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

 

**Interest Rate Risk Management**

 

TheCompany’s net 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 thaninterest-earning assets in a given period, a significant increase in marketrates of interest could adversely affect net interest income.  Similarly, when interest-earning assets matureor reprice more quickly than interest-bearing liabilities, falling interestrates could result in a decrease 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 reviews the Bank’s securitiesportfolio, formulates investment strategies, and oversees the timing andimplementation of transactions to assure attainment of the Board’s objectivesin the most effective manner.  Inmanaging market risk and the asset/liability mix, the Bank has placed itsemphasis on developing a portfolio in which, to the extent practicable, assetsand liabilities reprice within similar periods. Notwithstanding the Company’s interest rate risk management activities,the potential for changing interest rates is an uncertainty which may have anadverse effect on net income.

 

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

 

As set forth below, the volatility of a rate change,the change in asset or liability mix of the Company or other factors mayproduce a decrease in net interest margin in an upward moving rate environmenteven as the net portfolio value (“NPV”) estimate indicates an increase in netvalue.  The inverse situation may alsooccur.  One approach used by the Companyto quantify interest 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 September 30, 2010 and 2009, respectively,an analysis of the Company’s interest rate risk as measured by the estimatedchanges in NPV resulting from instantaneous and sustained parallel shifts inthe yield curve.  Management does notbelieve that the Company has experienced any material changes in its marketrisk position from that disclosed in the Company’s Annual Report on Form 10-Kfor fiscal 2010 or that the Company’s primary market risk exposures and howthose exposures were managed during the three months ended September 30,2010 changed significantly when compared to June 30, 2010.

 

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Evenif interest rates change in the designated amounts, there can be no assurancethat the Company’s assets and liabilities would perform as set forthbelow.  In addition, a change in U.S.Treasury rates in the designated amounts accompanied by a change in the shapeof the Treasury yield curve would cause significantly different changes to theNPV than indicated below.

 
| **September 30, 2010** | ** ** |
|----------------------------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Estimated Increase** | ** ** |
| **Change in**               | ** ** | **Estimated** | ** ** | **(Decrease) in NPV** | ** ** |
| **Interest Rates**          | ** ** | **NPV Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Basis Points**            | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
|                             |       |   |   |   |   |   |   |
| +300                             |       | $ | 136,425 |   | $ | 21,075 |   | 18 | % |
| +200                             |       | 132,959 |   | 17,609 |   | 15 |   |
| +100                             |       | 125,646 |   | 10,296 |   | 9 |   |
| —                           |       | 115,350 |   | — |   | — |   |
| -100                             |       | 103,819 |   | (11,531 | ) | (10 | ) |
|                                  |            |  |  |  |  |  |  |  |  |

 
| **September 30, 2009** | ** ** |
|----------------------------------|------------|
| ** **                       | ** ** | ** ** | ** ** | **Estimated Increase** | ** ** |
| **Change in**               | ** ** | **Estimated** | ** ** | **(Decrease) in NPV** | ** ** |
| **Interest Rates**          | ** ** | **NPV Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Basis Points**            | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
|                             |       |   |   |   |   |   |   |
| +300                             |       | $ | 130,136 |   | $ | 10,102 |   | 8 | % |
| +200                             |       | 129,045 |   | 9,011 |   | 8 |   |
| +100                             |       | 125,825 |   | 5,791 |   | 5 |   |
| —                           |       | 120,034 |   | — |   | — |   |
| -100                             |       | 112,835 |   | (7,199 | ) | (6 | ) |
|                                  |            |  |  |  |  |  |  |  |  |

 

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

 

**Item 4.  *Controls and Procedures***

 

As of September 30, 2010, an evaluation was performed by theCompany’s management, including the Company’s Chairman, President and ChiefExecutive Officer and the Company’s Executive Vice President, Chief FinancialOfficer and Treasurer, of the effectiveness of the design and operation of theCompany’s disclosure controls and procedures (as defined in Rules 13a-15(e) and15d-15(e) under the Securities Exchange Act of 1934, as amended) toprovide reasonable assurance that information required to be disclosed in thereports the Company files and submits under the Securities Exchange Act of1934, as amended, is recorded, processed, summarized and reported within thetime periods specified in the Securities and Exchange Commission’s rules andforms. Based upon that evaluation, the Company’s Chairman, President and ChiefExecutive Officer and the Company’s Executive Vice President, Chief FinancialOfficer and Treasurer concluded that the Company’s disclosure controls andprocedures were effective as of September 30, 2010.  There were no changes in the Company’sinternal control over financial reporting that occurred during the firstquarter ended September 30, 2010, that have materially affected, or arereasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

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**PART II - OTHER INFORMATION**

 

**Item 1.  *Legal Proceedings***

 

The Company, the Bank and each of theirsubsidiaries are, from time to time, involved as plaintiff or defendant invarious legal actions arising in the normal course of their businesses.  While the ultimate outcome of any suchproceedings cannot be predicted with certainty, it is generally the opinion ofmanagement, after consultation with counsel representing the Bank and theCompany in any such proceedings, the resolution of any such proceedings shouldnot have a material effect on the Company’s consolidated financial position orresults of operations.  The Company, theBank and each of their subsidiaries are not aware of any legal actions or otherproceedings contemplated by governmental authorities outside of the normalcourse of business.

 

**Item 1A.  *Risk Factors***

 

The discussion of our business and operations should beread together with the risk factors contained in Part I, Item 1Aof our Annual Report on Form 10-K for the fiscal year ended June 30,2010, which describe various risks and uncertainties to which we are or maybecome subject.  These risks anduncertainties have the potential to affect our business, financial condition,results of operations, cash flows, strategies or prospects in a material and adversemanner.  Other than as set forth below,there have been no material changes to the risk factors set forth in theabove-referenced filing as of September 30, 2010.

 

**Item 2.  *Unregistered Sales ofEquity Securities and Use of Proceeds***

 

None.

 

**Item 3.  *Defaults upon SeniorSecurities***

 

None.

 

**Item 4.  *[Removed and Reserved]***

 

**Item 5.  *Other Information***

 

None.

 

**Item 6.  *Exhibits***

 

See “Exhibit Index.”

 

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**SIGNATURES**

 

Pursuantto the 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 12,  2010 |   | By:    | /s/  Curtis L. Hage                            |
|   |                    |   |   | Curtis  L. Hage, Chairman, President           |
|   |                    |   |   | and  Chief Executive Officer                   |
|   |                    |   |   | (Principal  Executive Officer)                 |
|   |                    |   |   |                                           |
| Date:  | November 12,  2010 |   | By:    | /s/  Darrel L. Posegate                        |
|   |                    |   |   | Darrel  L. Posegate, Executive Vice President, |
|   |                    |   |   | Chief  Financial Officer and Treasurer         |
|   |                    |   |   | (Principal Financial and  Accounting Officer)  |

 

41

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Table of Contents

 

**Exhibit Index**

 
| **Exhibit Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                     |
|-------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                    |       |                                                                                                                                                                                                                                                                                                                                                                |
| 10.1                    |       | Form of Restated Employment Agreement, made and  entered into as of April 26, 2010, between Home Federal Bank and Stephen  M. Bianchi (incorporated herein by reference to Exhibit 10.2 from the  Company’s Current Report on Form 8-K dated December 31, 2008, and  filed with the SEC on January 7, 2009, file no. 033-44383). |
| 10.2                    |       | Revised Employment Agreement by and among Home Federal  Bank and Curtis L. Hage (incorporated herein by reference to  Exhibit 10.1 from the Company’s Current Report on 8-K dated  July 22, 2010 and filed with the SEC on July 22, 2010, file no.  033-44383).                                                                                 |
| 10.3                    |       | Amendment No. 1 to Loan Agreement, dated  October 01, 2010, by and between the Company and United Bankers’ Bank.                                                                                                                                                                                                                                     |
| 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                                                                                                                                                                                                                   |

 

Index

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