Tableof Contents

 

 

 

**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-Q**

** **

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

 

**For the Quarterly Period Ended December 31,2009**

 

**OR**

 

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

 

**Commission file number 0-19972**

 

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**HF FINANCIAL CORP.**

(Exact name of registrant as specified 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 telephone number, including area code)

 

Indicate by check mark whether the Registrant (1) has filed allreports required to be filed by Section 13 or Section 15(d) ofthe Securities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the Registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days.  Yes x No o

 

Indicate by check mark whether the Registrant has submittedelectronically and posted on its corporate Web site, if any, every InteractiveData File required to be submitted and posted pursuant to Rule 405 ofRegulation S-T (Section 232.405 of this chapter) during the preceding 12months (or for such shorter period that the Registrant was required to submitand post such files).  Yes o No o

 

Indicate by check mark whether the registrant is a large acceleratedfiler, an accelerated filer, a non-accelerated filer, or a smaller reportingcompany. See the definitions of “large accelerated filer,” “accelerated filer”and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Checkone):

 

| 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 checkmark whether the registrant is a shell company (as defined in Rule 12b-2of the Exchange Act). Yes  o No x

 

As of February 2,2010, there were 6,938,538 shares of the registrant’s common stock outstanding.

 

 

 

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Tableof Contents

 

**Quarterly Report on Form 10-Q**

**Table of Contents**

 
| ** **                                    | ** **                                                                                            | **Page Number** |
|-----------------------------------------------|-------------------------------------------------------------------------------------------------------|----------------------|
| ** **                                    |                                                                                                  |                 |
| **PART I –  FINANCIAL INFORMATION** |
|                                          |                                                                                                  |                 |
| Item 1.                                       | Financial  Statements (Unaudited):                                                                    |                 |
|                                          |                                                                                                  |                 |
|                                          | Consolidated Statements of Financial Condition At  December 31, 2009 and June 30, 2009      | 1                    |
|                                          |                                                                                                  |                 |
|                                          | Consolidated Statements of Income for the Three and  Six Months Ended December 31, 2009 and 2008 | 2                    |
|                                          |                                                                                                  |                 |
|                                          | Consolidated Statements of Cash Flows for the Six  Months Ended December 31, 2009 and 2008       | 3                    |
|                                          |                                                                                                  |                 |
|                                          | Notes to Consolidated Financial Statements                                                            | 4                    |
|                                          |                                                                                                  |                 |
| Item 2.                                       | Management’s  Discussion and Analysis of Financial Condition and Results of Operations           | 19                   |
|                                          |                                                                                                  |                 |
| Item 3.                                       | Quantitative  and Qualitative Disclosures about Market Risk                                           | 41                   |
|                                          |                                                                                                  |                 |
| Item 4.                                       | Controls and  Procedures                                                                              | 42                   |
|                                          |                                                                                                  |                 |
| **PART II  – OTHER INFORMATION**    |
|                                          |                                                                                                  |                 |
| Item 1.                                       | Legal Proceedings                                                                                     | 43                   |
|                                          |                                                                                                  |                 |
| Item 1A.                                      | Risk  Factors                                                                                         | 43                   |
|                                          |                                                                                                  |                 |
| Item 2.                                       | Unregistered  Sales of Equity Securities and Use of Proceeds                                          | 45                   |
|                                          |                                                                                                  |                 |
| Item 3.                                       | Defaults  upon Senior Securities                                                                      | 45                   |
|                                          |                                                                                                  |                 |
| Item 4.                                       | Submission  of Matters to a Vote of Security Holders                                                  | 45                   |
|                                          |                                                                                                  |                 |
| Item 5.                                       | Other Information                                                                                     | 46                   |
|                                          |                                                                                                  |                 |
| Item 6.                                       | Exhibits                                                                                              | 46                   |
|                                          |                                                                                                  |                 |
| Form 10-Q                                | Signature Page                                                                                        | 47                   |

 

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Table ofContents

 

**PART I - FINANCIAL INFORMATION**

 

**Item 1.  *Financial Statements***

 

**HFFINANCIAL CORP.**

**CONSOLIDATED STATEMENTS OF FINANCIALCONDITION**

**(DOLLARSIN THOUSANDS, except share data)**

 
| ** **                                                                                                                                                         | ** ** | **December 31, 2009** | ** ** | **June 30, 2009** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|------------------------|------------|
| ** **                                                                                                                                                         | ** ** | **(Unaudited)**            | ** ** | **(Audited)**          | ** ** |
| **ASSETS**                                                                                                                                                         | ** ** | ** **                 | ** ** | ** **             | ** ** |
| Cash  and cash equivalents                                                                                                                                         |       | $                          | 38,706     |                   | $          | 18,511 |   |
| Securities  available for sale                                                                                                                                     |       | 221,840                    |       | 222,910                |       |
| Federal  Home Loan Bank stock                                                                                                                                      |       | 8,848                      |       | 12,476                 |       |
| Loans  held for sale                                                                                                                                               |       | 23,123                     |       | 14,881                 |       |
|                                                                                                                                                               |       |                       |       |                   |       |
| Loans  and leases receivable                                                                                                                                       |       | 819,034                    |       | 851,282                |       |
| Allowance  for loan and lease losses                                                                                                                               |       | (8,512                     | )          | (8,470                 | )          |
| Net  loans and leases receivable                                                                                                                                   |       | 810,522                    |       | 842,812                |       |
|                                                                                                                                                               |       |                       |       |                   |       |
| Accrued  interest receivable                                                                                                                                       |       | 9,384                      |       | 7,598                  |       |
| Office  properties and equipment, net of accumulated depreciation                                                                                                  |       | 17,638                     |       | 16,917                 |       |
| Foreclosed  real estate and other properties                                                                                                                       |       | 1,133                      |       | 1,085                  |       |
| Cash  value of life insurance                                                                                                                                      |       | 14,872                     |       | 14,594                 |       |
| Servicing  rights                                                                                                                                                  |       | 12,351                     |       | 11,768                 |       |
| Goodwill,  net                                                                                                                                                     |       | 4,951                      |       | 4,951                  |       |
| Other  assets                                                                                                                                                      |       | 12,080                     |       | 8,293                  |       |
| Total  assets                                                                                                                                                      |       | $                          | 1,175,448  |                   | $          | 1,176,796 |   |
|                                                                                                                                                               |       |                       |       |                   |       |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                                      |       |                       |       |                   |       |
|                                                                                                                                                               |       |                       |       |                   |       |
| LIABILITIES                                                                                                                                                        |       |                       |       |                   |       |
| Deposits                                                                                                                                                           |       | $                          | 863,388    |                   | $          | 837,868 |   |
| Advances  from Federal Home Loan Bank and other borrowings                                                                                                         |       | 166,041                    |       | 212,869                |       |
| Subordinated  debentures payable to trusts                                                                                                                         |       | 27,837                     |       | 27,837                 |       |
| Advances  by borrowers for taxes and insurance                                                                                                                     |       | 11,230                     |       | 11,899                 |       |
| Accrued  expenses and other liabilities                                                                                                                            |       | 14,650                     |       | 17,648                 |       |
| Total  liabilities                                                                                                                                                 |       | 1,083,146                  |       | 1,108,121              |       |
|                                                                                                                                                               |       |                       |       |                   |       |
| STOCKHOLDERS’  EQUITY                                                                                                                                         |       |                       |       |                   |       |
| Preferred  stock, $.01 par value, 500,000 shares authorized, none outstanding                                                                                      |       | —                     |       | —                 |       |
| Common  stock, $.01 par value, 10,000,000 shares authorized, 9,021,993 and 6,109,437  shares issued at December 31, 2009 and June 30, 2009, respectively |       | 90                         |       | 61                     |       |
| Common  stock subscribed for but not issued                                                                                                                        |       | —                     |       | 224                    |       |
| Additional  paid-in capital                                                                                                                                        |       | 44,142                     |       | 22,911                 |       |
| Retained  earnings, substantially restricted                                                                                                                       |       | 82,643                     |       | 80,735                 |       |
| Accumulated  other comprehensive (loss), net of related deferred tax effect                                                                                        |       | (3,676                     | )          | (4,359                 | )          |
| Less  cost of treasury stock, 2,083,455 and 2,083,455 shares at December 31,  2009 and June 30, 2009, respectively                                       |       | (30,897                    | )          | (30,897                | )          |
| Total  stockholders’ equity                                                                                                                                   |       | 92,302                     |       | 68,675                 |       |
| Total  liabilities and stockholders’ equity                                                                                                                   |       | $                          | 1,175,448  |                   | $          | 1,176,796 |   |

 

*Seeaccompanying notes to unaudited consolidated financial statements.*

 

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**HFFINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**(DOLLARSIN THOUSANDS, except share data)**

**(Unaudited)**

 
| ** **                                                                                     | ** ** | **Three Months Ended** | ** ** | **Six Months Ended**  | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| ** **                                                                                     | ** ** | **December 31,**  | ** ** | **December 31,** | ** ** |
| ** **                                                                                     | ** ** | **2009**               | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| Interest,  dividend and loan fee income:                                                       |       |                   |       |                  |       |   |   |   |   |
| Loans  and leases receivable                                                                   |       | $                      | 12,352     |                  | $          | 12,646 |   | $ | 24,695 |   | $ | 25,664 |   |
| Investment  securities and interest-earning deposits                                           |       | 1,995                  |       | 2,920                 |       | 4,285 |   | 5,733 |   |
|                                                                                           |       | 14,347                 |       | 15,566                |       | 28,980 |   | 31,397 |   |
| Interest  expense:                                                                             |       |                   |       |                  |       |   |   |   |   |
| Deposits                                                                                       |       | 3,332                  |       | 4,132                 |       | 6,856 |   | 8,709 |   |
| Advances  from Federal Home Loan Bank and other borrowings                                     |       | 2,157                  |       | 2,427                 |       | 4,515 |   | 4,992 |   |
|                                                                                           |       | 5,489                  |       | 6,559                 |       | 11,371 |   | 13,701 |   |
| Net  interest income                                                                           |       | 8,858                  |       | 9,007                 |       | 17,609 |   | 17,696 |   |
| Provision  for losses on loans and leases                                                      |       | 424                    |       | —                |       | 767 |   | 387 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Net  interest income after provision for losses on loans and leases                            |       | 8,434                  |       | 9,007                 |       | 16,842 |   | 17,309 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Noninterest  income:                                                                           |       |                   |       |                  |       |   |   |   |   |
| Fees  on deposits                                                                              |       | 1,403                  |       | 1,518                 |       | 2,849 |   | 3,069 |   |
| Loan  servicing income                                                                         |       | 488                    |       | 534                   |       | 979 |   | 1,091 |   |
| Gain  on sale of loans, net                                                                    |       | 537                    |       | 285                   |       | 1,033 |   | 536 |   |
| Trust  income                                                                                  |       | 207                    |       | 153                   |       | 464 |   | 375 |   |
| Gain  on sale of securities, net                                                               |       | 603                    |       | 45                    |       | 1,136 |   | 125 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Total  other-than-temporary impairment losses                                                  |       | (1,663                 | )          | —                |       | (2,081 | ) | — |   |
| Portion  of loss recognized in other comprehensive income comprehensive income (before  taxes) |       | 1,323                  |       | —                |       | (117 | ) | — |   |
| Net  impairment losses recognized in earnings                                                  |       | (340                   | )          | —                |       | (2,198 | ) | — |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Other                                                                                          |       | 355                    |       | 394                   |       | 688 |   | 782 |   |
|                                                                                           |       | 3,253                  |       | 2,929                 |       | 4,951 |   | 5,978 |   |
| Noninterest  expense:                                                                          |       |                   |       |                  |       |   |   |   |   |
| Compensation  and employee benefits                                                            |       | 5,139                  |       | 5,828                 |       | 10,302 |   | 10,949 |   |
| Occupancy  and equipment                                                                       |       | 1,100                  |       | 1,012                 |       | 2,184 |   | 1,989 |   |
| FDIC  insurance                                                                                |       | 335                    |       | 122                   |       | 660 |   | 263 |   |
| Check  and data processing expense                                                             |       | 677                    |       | 652                   |       | 1,375 |   | 1,274 |   |
| Professional  fees                                                                             |       | 337                    |       | 447                   |       | 937 |   | 955 |   |
| Marketing  and community development                                                           |       | 494                    |       | 475                   |       | 965 |   | 886 |   |
| Foreclosed  real estate and other properties, net                                              |       | 48                     |       | 96                    |       | 67 |   | 213 |   |
| Other                                                                                          |       | 649                    |       | 544                   |       | 1,238 |   | 1,050 |   |
|                                                                                           |       | 8,779                  |       | 9,176                 |       | 17,728 |   | 17,579 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Income  before income taxes                                                                    |       | 2,908                  |       | 2,760                 |       | 4,065 |   | 5,708 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Income  tax expense                                                                            |       | 947                    |       | 914                   |       | 1,249 |   | 1,887 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Net  income available to common shareholders                                                   |       | $                      | 1,961      |                  | $          | 1,846 |   | $ | 2,816 |   | $ | 3,821 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Comprehensive  income                                                                          |       | $                      | 1,401      |                  | $          | 1,031 |   | $ | 3,499 |   | $ | 2,574 |   |
|                                                                                           |       |                   |       |                  |       |   |   |   |   |
| Basic  earnings per common share:                                                              |       | $                      | 0.38       |                  | $          | 0.46 |   | $ | 0.61 |   | $ | 0.96 |   |
| Diluted  earnings per common share:                                                            |       | 0.38                   |       | 0.46                  |       | 0.61 |   | 0.95 |   |
| Dividends  declared per common share                                                           |       | 0.11                   |       | 0.11                  |       | 0.23 |   | 0.23 |   |

 

*See accompanying notes to unaudited consolidated financialstatements.*

 

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**HFFINANCIAL CORP.**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(DOLLARSIN THOUSANDS, except share data)**

**(Unaudited)**

** **
| ** **                                                                                             | ** ** | **Six Months Ended December 31,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|----------------------------------------|------------|
| ** **                                                                                             | ** ** | **2009**                               | ** ** | **2008** | ** ** |
| Cash  flows from operating activities                                                                  |       |                                   |       |   |   |
| Net  income                                                                                            |       | $                                      | 2,816      |   | $ | 3,821 |   |
| Adjustments  to reconcile net income to net cash (used in) operating activities                        |       |                                   |       |   |   |
| Provision  for losses on loans and leases                                                              |       | 767                                    |       | 387 |   |
| Depreciation                                                                                           |       | 1,005                                  |       | 842 |   |
| Amortization  of discounts and premiums on securities and other                                        |       | 1,451                                  |       | 955 |   |
| Stock  based compensation                                                                              |       | 369                                    |       | 194 |   |
| Net  change in loans held for resale                                                                   |       | (7,209                                 | )          | (4,695 | ) |
| (Gain)  on sale of loans, net                                                                          |       | (1,033                                 | )          | (536 | ) |
| Realized  (gain) on sale of securities, net                                                            |       | (1,136                                 | )          | (125 | ) |
| Other-than-temporary  impairments recognized in noninterest income                                     |       | 2,198                                  |       | — |   |
| (Gains)  losses and provision-for-losses on sales of foreclosed real estate and other  properties, net |       | 7                                      |       | 17 |   |
| Change  in other assets and liabilities                                                                |       | (9,255                                 | )          | (4,793 | ) |
| Net  cash (used in) operating activities                                                               |       | (10,020                                | )          | (3,933 | ) |
|                                                                                                   |       |                                   |       |   |   |
| Cash  flows from investing activities                                                                  |       |                                   |       |   |   |
| Loan  participations purchased                                                                         |       | (1,320                                 | )          | (969 | ) |
| Net  change in loans outstanding                                                                       |       | 32,329                                 |       | (25,209 | ) |
| Securities  available for sale                                                                         |       |                                   |       |   |   |
| Sales,  maturities, repayments and adjustments                                                         |       | 49,506                                 |       | 43,835 |   |
| Purchases                                                                                              |       | (49,432                                | )          | (74,342 | ) |
| Purchase  of Federal Home Loan Bank stock                                                              |       | (13                                    | )          | (5,565 | ) |
| Redemption  of Federal Home Loan Bank stock                                                            |       | 3,641                                  |       | 4,334 |   |
| Purchase  of office properties and equipment                                                           |       | (1,726                                 | )          | (1,046 | ) |
| Purchase  of servicing rights                                                                          |       | (817                                   | )          | (769 | ) |
| Proceeds  from sale of foreclosed real estate and other properties                                     |       | 265                                    |       | 405 |   |
| Net  cash provided by (used in) investing activities                                                   |       | 32,433                                 |       | (59,326 | ) |
|                                                                                                   |       |                                   |       |   |   |
| Cash  flows from financing activities                                                                  |       |                                   |       |   |   |
| Net  increase (decrease) in deposit accounts                                                           |       | 25,520                                 |       | (11,320 | ) |
| Proceeds  of advances from Federal Home Loan Bank and other borrowings                                 |       | 1,107,707                              |       | 1,408,730 |   |
| Payments  on advances from Federal Home Loan Bank and other borrowings                                 |       | (1,154,535                             | )          | (1,354,415 | ) |
| Increase  (decreases) in advances by borrowers                                                         |       | (669                                   | )          | 193 |   |
| Proceeds  from issuance of Preferred Stock                                                             |       | —                                 |       | 25,000 |   |
| Proceeds  from issuance of common stock                                                                |       | 20,667                                 |       | 694 |   |
| Cash  dividends paid                                                                                   |       | (908                                   | )          | (911 | ) |
| Net  cash provided by (used in) financing activities                                                   |       | (2,218                                 | )          | 67,971 |   |
|                                                                                                   |       |                                   |       |   |   |
| Increase  in cash and cash equivalents                                                                 |       | 20,195                                 |       | 4,712 |   |
| Cash  and cash equivalents                                                                             |       |                                   |       |   |   |
| Beginning                                                                                              |       | 18,511                                 |       | 21,170 |   |
| Ending                                                                                                 |       | $                                      | 38,706     |   | $ | 25,882 |   |
|                                                                                                   |       |                                   |       |   |   |
| Supplemental  Disclosures of Cash Flows Information                                                    |       |                                   |       |   |   |
| Cash  payments for interest                                                                            |       | $                                      | 12,449     |   | $ | 15,147 |   |
| Cash  payments for income and franchise taxes, net                                                     |       | 1,318                                  |       | 1,669 |   |

 

*See accompanying notes to unaudited consolidatedfinancial statements.*

 

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**HF FINANCIAL CORP.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**FORTHE SIX MONTHS ENDED DECEMBER 31, 2009 AND 2008**

**(Unaudited)**

 

**NOTE1—SELECTED ACCOUNTING POLICIES**

 

*Basis of Financial StatementPresentation*

 

The consolidatedfinancial information of HF Financial Corp. (the “Company”) and itswholly-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, 2009 (“fiscal 2009”), filed with theSecurities and Exchange Commission.  Theaccounting and reporting policies of the Company and its subsidiaries conformto accounting principles generally accepted in the United States of America (“GAAP”)and to general practice within the industry.

 

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

 

Management hasevaluated subsequent events for potential disclosure or recognition through February 5,2010, the date of the filing of the consolidated financial statements with theSecurities and Exchange Commission.

 

**NOTE 2—REGULATORY CAPITAL**

 

The followingtable sets forth the Bank’s compliance with its minimum capital requirementsfor a well-capitalized institution at December 31, 2009:

 
| ** **                                           | ** ** | **Amount**                 | ** ** | **Percent** | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|-------------|------------|
| ** **                                           | ** ** | **(Dollars in Thousands)** | ** ** |
| Tier  I (core) capital (to adjusted total assets):   |       |                       |       |        |       |
| Required                                             |       | $                          | 58,507     |        | 5.00       | % |
| Actual                                               |       | 103,645                    |       | 8.86        |       |
| Excess  over required                                |       | 45,138                     |       | 3.86        |       |
|                                                 |       |                       |       |        |       |
| Total  Risk-based capital (to risk-weighted assets): |       |                       |       |        |       |
| Required                                             |       | $                          | 94,513     |        | 10.00      | % |
| Actual                                               |       | 111,862                    |       | 11.84       |       |
| Excess  over required                                |       | 17,349                     |       | 1.84        |       |

 

**NOTE3—EARNINGS PER COMMON SHARE**

 

Basic earnings percommon share is computed by dividing income available to common stockholders(the numerator) by the weighted-average number of common shares outstanding(the denominator) during the period. Shares issued during the period and shares reacquired during the period areweighted for the portion of the period they were outstanding. The weightedaverage number of basic common shares outstanding for the three months ended December 31,

 

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2009 and 2008 was5,201,869 and 4,007,870, respectively. The weighted average number of basic common shares outstanding for thesix months ended December 31, 2009 and 2008 was 4,616,130 and 3,989,962,respectively.

 

Dilutive earnings percommon share is similar to the computation of basic earnings per common shareexcept the denominator is increased to include the number of additional commonshares that would have been outstanding if the dilutive options outstanding hadbeen exercised. The weighted average number of common and dilutive potentialcommon shares outstanding for the three months ended December 31, 2009 and2008 was 5,204,102 and 4,023,791, respectively. The weighted average number of common and dilutive potential common sharesoutstanding for the six months ended December 31, 2009 and 2008 was4,622,984 and 4,019,280, respectively.

 

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

 

The amortized cost and fair values of investments in securities, all ofwhich are classified as available for sale according to management’s intent,are as follows:

 
| ** **                               | ** ** | **December 31, 2009** | ** ** | **December 31, 2008** | ** ** |
|------------------------------------------|------------|----------------------------|------------|----------------------------|------------|
| ** **                               | ** ** | ** **                 | ** ** | **Gross**                  | ** ** | ** ** | ** ** | ** ** | ** ** | **Gross** | ** ** | ** ** | ** ** |
| ** **                               | ** ** | **Amortized**              | ** ** | **Unrealized**             | ** ** | **Fair** | ** ** | **Amortized** | ** ** | **Unrealized** | ** ** | **Fair** | ** ** |
| ** **                               | ** ** | **Cost**                   | ** ** | **Gains**                  | ** ** | **(Losses)** | ** ** | **Value** | ** ** | **Cost** | ** ** | **Gains** | ** ** | **(Losses)** | ** ** | **Value** | ** ** |
| ** **                               | ** ** | **(Dollars in Thousands)** | ** ** |
|                                     |       |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Debt  securities:                        |       |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S.  government agencies                |       | $                          | 2,632      |                       | $          | 26 |   | $ | — |   | $ | 2,658 |   | $ | 6,373 |   | $ | 435 |   | $ | — |   | $ | 6,808 |   |
| Federal  Home Loan Bank                  |       | —                     |       | —                     |       | — |   | — |   | 1,500 |   | 23 |   | — |   | 1,523 |   |
| Municipal  bonds                         |       | 13,944                     |       | 373                        |       | (64 | ) | 14,253 |   | 13,862 |   | 145 |   | (255 | ) | 13,752 |   |
| Trust  preferred securities              |       | 9,701                      |       | —                     |       | (5,488 | ) | 4,213 |   | 12,310 |   | — |   | (5,336 | ) | 6,974 |   |
|                                     |       | 26,277                     |       | 399                        |       | (5,552 | ) | 21,124 |   | 34,045 |   | 603 |   | (5,591 | ) | 29,057 |   |
|                                     |       |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Equity  securities:                      |       |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| FNMA                                     |       | —                     |       | —                     |       | — |   | — |   | 8 |   | — |   | (8 | ) | — |   |
| Federal  Ag Mortgage                     |       | 7                          |       | —                     |       | (4 | ) | 3 |   | 7 |   | — |   | (5 | ) | 2 |   |
| Other  investments                       |       | 253                        |       | —                     |       | — |   | 253 |   | 253 |   | — |   | — |   | 253 |   |
|                                     |       | 260                        |       | —                     |       | (4 | ) | 256 |   | 268 |   | — |   | (13 | ) | 255 |   |
|                                     |       |                       |       |                       |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Residential  mortgage- backed securities |       | 197,559                    |       | 3,614                      |       | (713 | ) | 200,460 |   | 224,443 |   | 2,881 |   | (2,247 | ) | 225,077 |   |
|                                     |       | $                          | 224,096    |                       | $          | 4,013 |   | $ | (6,269 | ) | $ | 221,840 |   | $ | 258,756 |   | $ | 3,484 |   | $ | (7,851 | ) | $ | 254,389 |   |

 

Management has implemented a process to identify securities that couldpotentially have a credit impairment that is other-than-temporary.  This process involves evaluation of thelength of time and extent to which the fair value has been less than theamortized cost basis, review of available information regarding the financialposition of the issuer, monitoring the rating of the security, cash flowprojections, and the Company’s intent to sell a security or whether it is morelikely than not we will be required to sell the security before the recovery ofits amortized cost which, in some cases, may extend to maturity.  To the extent we determine that a security isdeemed to be other-than-temporarily impaired, an impairment loss is recognized.

 

For all securities that are considered temporarily impaired, the Companydoes not intend to sell these securities (has not made a decision to sell) andit is not more likely than not that the Company will be required to sell thesecurity before recovery of its amortized cost, which may occur atmaturity.  The Company believes that itwill collect all principal and interest due on all investments that haveamortized cost in excess of fair value that are considered only temporarilyimpaired.

 

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The following table presents the fair value and age of gross unrealizedlosses by investment category at December 31, 2009*:*

 
| ** **                              | ** ** | **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                        |       | $                          | 1,660      |                  | $          | (11        | )          | $ | 1,879 |   | $ | (53 | ) | $ | 3,539 |   | $ | (64 | ) |
| Trust  preferred securities             |       | —                     |       | —                |       | 4,213      |       | (5,488 | ) | 4,213 |   | (5,488 | ) |
|                                    |       | 1,660                      |       | (11                   | )          | 6,092      |       | (5,541 | ) | 7,752 |   | (5,552 | ) |
| Equity  securities:                     |       |                       |       |                  |       |       |       |   |   |   |   |   |   |
| Federal  Ag Mortgage                    |       | 3                          |       | (4                    | )          | —     |       | — |   | 3 |   | (4 | ) |
|                                    |       | 3                          |       | (4                    | )          | —     |       | — |   | 3 |   | (4 | ) |
| Residential  mortgage-backed securities |       | 36,782                     |       | (272                  | )          | 18,206     |       | (441 | ) | 54,988 |   | (713 | ) |
|                                    |       | $                          | 38,445     |                  | $          | (287       | )          | $ | 24,298 |   | $ | (5,982 | ) | $ | 62,743 |   | $ | (6,269 | ) |

 

For the three months ended December 31, 2009, gross proceedsfrom the securities sold at a gain were $13.1 million, resulting in a gain onsale of securities of $603,000.  Thiscompares to gross proceeds of $5.5 million, resulting in a gain on sale ofsecurities of $90,000 for the three months ended December 31, 2008.  There were no securities sold at a loss forthe three months ended December 31, 2009 as compared to $6.0 millionreceived in gross proceeds, which resulted in a net loss of $45,000 for thethree months ended December 31, 2008.

 

For the six months ended December 31, 2009, gross proceeds from thesecurities sold at a gain were $24.2 million, resulting in a gain on sale ofsecurities of $1.1 million.  Thiscompares to gross proceeds of $12.8 million, resulting in a gain on sale ofsecurities of $172,000 for the six months ended December 31, 2008.  There were no securities sold at a loss forthe six months ended December 31, 2009 as compared to $8.3 millionreceived in gross proceeds, which resulted in a net loss of $47,000 for the sixmonths ended December 31, 2008.

 

The unrealizedlosses reported for municipal bonds relate to 22 municipal general obligationor revenue bonds.  The unrealized lossesare primarily attributed to changes in credit spreads or market interest rateincreases since the securities were originally acquired, rather than due tocredit or other causes.  Management does not believe any individualunrealized losses as of December 31, 2009, represent another-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 residential mortgage-backed securitiesrelate to 49 securities issued by the Federal National Mortgage Association (“FNMA”),the Government National Mortgage Association (“GNMA”), or the Federal Home LoanMortgage Corporation (“FHLMC”).  Theseunrealized losses are primarily attributable to changes in interest rates andthe contractual cash flows of those investments which are guaranteed by anagency of the U.S. government. Residential mortgage-backed securities also include one “private-label”collateralized mortgage obligation with an amortized amount of $2.0 million,which has maintained its AAA rating as of December 31, 2009.  Management does not believe any of theseunrealized losses as of December 31, 2009, 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 losses reported for trust preferred securities areattributable to six rated pooled securities. Rating downgrades regarding theseinvestments have occurred placing each in a below investment grade rating. Thesecurities have an amortized cost of $1.9 million rated Caa3, $2.4 millionrated Caa1, and $5.4 million rated Ca. The market for these securities is currently inactive. The CUSIPs of thetrust preferred securities are 74042TAE1 rated Caa3, 740417AB6 and 74042CAE8rated Caa1, and 74041EAC9, 74041RAB2, and 55312HAE9 rated Ca. The Companyperformed assessments of available information for each security during thesecond quarter ended December 31, 2009, and also

 

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consideredfactors such as overall deal structure and its position within the structure,quality of underlying issuers within each pool, defaults and recoveries, lossseverities and prepayments. Based upon scenarios developed in regard to thisinformation, management compared the present value of best estimates of cashflows expected to be collected from each security at the security’s effectiveinterest rate to the amortized cost basis of each security. Managementdetermined that three trust preferred securities exhibited another-than-temporary impairment. The difference between the present value ofcash flows and the amortized cost basis for each of the three securities wasrecorded as credit loss impairment and recognized in earnings in the amount of$340,000. The amortized cost basis of the three securities was reduced by theamount of credit loss. The remaining impairment amount related to other factorsof $1.3 million was recognized in other comprehensive income, net of applicabletaxes. The unrealized losses on these trust preferred securities can primarilybe attributed to changes in credit spreads since the securities were acquired.See Note 13 “Financial Instruments” for additional information related to thedetermination of fair value. The Company does not have the intent to sell thesesix 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. Within this segment, fivesecurities with amortized cost of $7.9 million are quarterly variable-ratesecurities tied to 3-month LIBOR.

 

The following table presents the amounts recognized in the ConsolidatedStatements of Income for other-than-temporary impairments related to creditlosses charged to earnings:

 
| ** **                                                                                                                                                                             | ** ** | **Six Months Ended**       | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                                                                                             | ** ** | **December 31, 2009** | ** ** |
| ** **                                                                                                                                                                             | ** ** | **(Dollars in Thousands)** | ** ** |
| Beginning  balance of credit losses on securities held as of July 1, 2009 for which  a portion of other-than-temporary impairment was recognized in other  comprehensive income   |       | $                          | 405        |   |
|                                                                                                                                                                                   |       |                       |       |
| Credit  losses for which an other-than-temporary impairment was not previously  recognized                                                                                             |       | 50                         |       |
|                                                                                                                                                                                   |       |                       |       |
| Increases  to the amount related to the credit losses for which other-than-temporary was  previously recognized                                                                        |       | 2,148                      |       |
|                                                                                                                                                                                   |       |                       |       |
| Ending  balance of credit losses on securities held as of December 31, 2009 for  which a portion of other-than-temporary impairment was recognized in other  comprehensive income |       | $                          | 2,603      |   |

 

The compositionand maturities of the investment securities portfolio, excluding equitysecurities, are indicated in the following table:

 
| ** **                                   | ** ** | **At December 31, 2009** | ** ** |
|----------------------------------------------|------------|-------------------------------|------------|
| ** **                                   | ** ** | ** **                    | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | **TOTAL** | ** ** |
| ** **                                   | ** ** | **Less than**                 | ** ** | **1 to 5** | ** ** | **5 to 10** | ** ** | **Over 10** | ** ** | **Amortized** | ** ** | **Fair** | ** ** |
| ** **                                   | ** ** | **1 Year**                    | ** ** | **Years** | ** ** | **Years** | ** ** | **Years** | ** ** | **Cost** | ** ** | **Values** | ** ** |
| ** **                                   | ** ** | **(Dollars in Thousands)**    | ** ** |
| U.S.  government agencies & corporations |       | $                             | 1,128      |   | $ | 1,504 |   | $ | — |   | $ | — |   | $ | 2,632 |   | $ | 2,658 |   |
| Municipal  bonds                             |       | 730                           |       | 4,037 |   | 6,600 |   | 2,577 |   | 13,944 |   | 14,253 |   |
| Trust  preferred securities                  |       | —                        |       | — |   | — |   | 9,701 |   | 9,701 |   | 4,213 |   |
| Residential  mortgage- backed securities     |       | —                        |       | 3,775 |   | 20,789 |   | 172,995 |   | 197,559 |   | 200,460 |   |
| Total  investment securities                 |       | $                             | 1,858      |   | $ | 9,316 |   | $ | 27,389 |   | $ | 185,273 |   | $ | 223,836 |   | $ | 221,584 |   |

 

**NOTE5—LOAN SERVICING**

 

Mortgageloans serviced for others (primarily the South Dakota Housing DevelopmentAuthority) are not included in the accompanying consolidated statements offinancial condition.

 

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Thefollowing tables summarize the activity in, and the main assumptions used toestimate the amortization of servicing rights:

 
| ** **                     | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended**  | ** ** |
|--------------------------------|------------|----------------------------|------------|-----------------------|------------|
| ** **                     | ** ** | **December 31,**      | ** ** | **December 31,** | ** ** |
| ** **                     | ** ** | **2009**                   | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                     | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **                     | ** ** | ** **                 | ** ** | ** **            | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance,  beginning            |       | $                          | 11,998     |                  | $          | 11,426 |   | $ | 11,768 |   | $ | 11,189 |   |
| Additions                      |       | 775                        |       | 373                   |       | 1,429 |   | 958 |   |
| Amortization                   |       | (422                       | )          | (387                  | )          | (846 | ) | (735 | ) |
| Balance,  ending               |       | $                          | 12,351     |                  | $          | 11,412 |   | $ | 12,351 |   | $ | 11,412 |   |
|                           |       |                       |       |                  |       |   |   |   |   |
| Servicing  fees received       |       | $                          | 910        |                  | $          | 920 |   | $ | 1,825 |   | $ | 1,825 |   |
| Balance  of loans serviced at: |       |                       |       |                  |       |   |   |   |   |
| Beginning  of period           |       | 1,073,658                  |       | 1,016,293             |       | 1,046,600 |   | 994,065 |   |
| End  of period                 |       | 1,111,380                  |       | 1,033,884             |       | 1,111,380 |   | 1,033,884 |   |

 

Amortizationof servicing rights is adjusted each quarter as the result of the evaluation ofhistorical prepayment activity.  For thesecond quarter ended December 31, 2009 and 2008, the constant prepaymentrates (CPR) used to calculate the amortization was 10.57% and 10.09%,respectively.  Management utilized adiscount rate of 10.00% for valuation purposes for both periods.

 

**NOTE6—SEGMENT REPORTING**

 

Operating segmentsare defined as components of an enterprise for which discrete financialinformation is available that is evaluated regularly by the chief operatingdecision makers in deciding how to allocate resources and in assessingperformance.  The Company’s reportablesegments 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 approachis used as the conceptual basis for identifying reportable segments and isbased on the way that management organizes the segments within the enterprisefor making operating decisions, allocating resources and monitoringperformance, which is primarily based on products.

 
| ** **                                | ** ** | **Three Months Ended December 31,** | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|
| ** **                                | ** ** | **2009**                                 | ** ** | **2008** | ** ** |
| ** **                                | ** ** | **Banking**                              | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)**               | ** ** |
|                                      |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Net  interest income                      |       | $                                        | 9,349      |   | $ | (491 | ) | $ | 8,858 |   | $ | 9,460 |   | $ | (453 | ) | $ | 9,007 |   |
| Provision  for losses on loans and leases |       | (424                                     | )          | — |   | (424 | ) | — |   | — |   | — |   |
| Non-interest  income                      |       | 3,183                                    |       | 70 |   | 3,253 |   | 2,847 |   | 82 |   | 2,929 |   |
| Intersegment  non-interest income         |       | (24                                      | )          | (37 | ) | (61 | ) | (26 | ) | (35 | ) | (61 | ) |
| Non-interest  expense                     |       | (8,365                                   | )          | (414 | ) | (8,779 | ) | (8,723 | ) | (453 | ) | (9,176 | ) |
| Intersegment  non-interest expense        |       | —                                   |       | 61 |   | 61 |   | — |   | 61 |   | 61 |   |
| Income  (loss) before income taxes        |       | $                                        | 3,719      |   | $ | (811 | ) | $ | 2,908 |   | $ | 3,558 |   | $ | (798 | ) | $ | 2,760 |   |
|                                      |       |                                     |       |   |   |   |   |   |   |   |   |   |   |
| Total  assets at December 31         |       | $                                        | 1,158,655  |   | $ | 16,793 |   | $ | 1,175,448 |   | $ | 1,148,150 |   | $ | 25,002 |   | $ | 1,173,152 |   |

 

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| ** **                               | ** ** | **Six Months  Ended December 31,** | ** ** |
|------------------------------------------|------------|-----------------------------------------|------------|
| ** **                               | ** ** | **2009**                                | ** ** | **2008** | ** ** |
| ** **                               | ** ** | **Banking**                             | ** ** | **Other** | ** ** | **Total** | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
| ** **                               | ** ** | **(Dollars  in Thousands)**             | ** ** |
|                                     |       |                                    |       |   |   |   |   |   |   |   |   |   |   |
| Net  interest income                     |       | $                                       | 18,590     |   | $ | (981 | ) | $ | 17,609 |   | $ | 18,578 |   | $ | (882 | ) | $ | 17,696 |   |
| Provision for losses on loans and leases |       | (767                                    | )          | — |   | (767 | ) | (387 | ) | — |   | (387 | ) |
| Non-interest  income                     |       | 4,765                                   |       | 186 |   | 4,951 |   | 5,778 |   | 200 |   | 5,978 |   |
| Intersegment  non-interest income        |       | (48                                     | )          | (76 | ) | (124 | ) | (64 | ) | (57 | ) | (121 | ) |
| Non-interest  expense                    |       | (16,895                                 | )          | (833 | ) | (17,728 | ) | (16,773 | ) | (806 | ) | (17,579 | ) |
| Intersegment  non-interest expense       |       | —                                  |       | 124 |   | 124 |   | — |   | 121 |   | 121 |   |
| Income  (loss) before income taxes       |       | $                                       | 5,645      |   | $ | (1,580 | ) | $ | 4,065 |   | $ | 7,132 |   | $ | (1,424 | ) | $ | 5,708 |   |
|                                     |       |                                    |       |   |   |   |   |   |   |   |   |   |   |
| Total  assets at December 31        |       | $                                       | 1,158,655  |   | $ | 16,793 |   | $ | 1,175,448 |   | $ | 1,148,150 |   | $ | 25,002 |   | $ | 1,173,152 |   |

 

**NOTE7—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 in a plan year.  The benefits arebased on 6% of each eligible participant’s annual compensation, plus incomeearned in the accounts at a rate determined annually based on 30-year treasurynote rates.  The Company’s funding policyis to 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**     | ** ** | **Six Months  Ended** | ** ** |
|------------------------------------|------------|-----------------------------|------------|-----------------------|------------|
| ** **                         | ** ** | **December 31,**       | ** ** | **December 31,** | ** ** |
| ** **                         | ** ** | **2009**                    | ** ** | **2008**              | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                         | ** ** | **(Dollars  in Thousands)** | ** ** |
|                               |       |                        |       |                  |       |   |   |   |   |
| Service  cost                      |       | $                           | 142        |                  | $          | 118 |   | $ | 284 |   | $ | 237 |   |
| Interest  cost                     |       | 143                         |       | 120                   |       | 287 |   | 240 |   |
| Amortization  of prior losses      |       | 46                          |       | 16                    |       | 91 |   | 31 |   |
| Expected  return on plan assets    |       | (139                        | )          | (139                  | )          | (278 | ) | (253 | ) |
| Total  costs recognized in expense |       | $                           | 192        |                  | $          | 115 |   | $ | 384 |   | $ | 255 |   |

 

The Company previously disclosed in its consolidatedfinancial statements for fiscal 2009, which are included in Part II, Item8 “Financial Statements and Supplementary Data” of the Company’s Annual Reporton Form 10-K for fiscal 2009, that it contributed $2.35 million to fundits qualified pension plan.  During thesecond quarter of the fiscal 2010, the Company made contributions of $425,000to fund its qualified pension plan.  TheCompany anticipates no additional contributions will be made in fiscal 2010.

 

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

 

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

 

The Company assumes 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

 

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employee iseligible for coverage upon completion of 30 calendar days of regularemployment.  The plan, which is on acalendar year basis, is intended to comply with, and be governed by, theEmployee Retirement Income Security Act of 1974, as amended.

 

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

 
| ** **                       | ** ** | **Fiscal  Years Ended June 30,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2010**                              | ** ** | **2009** | ** ** |
| ** **                       | ** ** | **(Dollars  in Thousands)**           | ** ** |
|                             |       |                                  |       |   |   |
| Quarter  ended September 30 |       | $                                     | 748        |   | $ | 358 |   |
| Quarter  ended December 31  |       | 311                                   |       | 945 |   |
| Quarter  ended March 31     |       | —                                |       | 704 |   |
| Quarter  ended June 30      |       | —                                |       | 555 |   |
| Net  healthcare costs            |       | $                                     | 1,059      |   | $ | 2,562 |   |

 

**NOTE9—STOCK-BASED COMPENSATION PLANS**

 

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

 
| ** **                | ** ** | **2009**   | ** ** | **2008**   | ** ** |
|---------------------------|------------|------------|------------|------------|------------|
| ** **                | ** ** | ** ** | ** ** | ** ** | ** ** |
| Expected  volatility      |       | 22.00      | %          | 19.00      | %          |
| Expected  dividend yield  |       | 3.61       | %          | 3.06       | %          |
| Risk-free  interest rate  |       | 2.35       | %          | 2.87       | %          |
| Expected  term (in years) |       | 5          |       | 5          |       |

 

Stock option activity forthe six months ended December 31, 2009 is as follows:

 
| ** **              | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|-------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **              | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **              | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **              | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **              | ** ** | **Shares** | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
| Beginning  balance      |       | 139,919    |       | $            | 12.89      |            |       |          |       |   |
| Granted                 |       | —     |       | —       |       |            |       |          |       |
| Forfeited               |       | —     |       | —       |       |            |       |          |       |
| Exercised               |       | —     |       | —       |       |            |       |          |       |
| Ending  balance         |       | 139,919    |       | $            | 12.89      |            | 3.52       |          | $          | 16,875 |   |
|                    |       |       |       |         |       |            |       |          |       |
| Vested  and exercisable |       | 139,919    |       | $            | 12.89      |            | 3.52       |          | $          | 16,875 |   |

 

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Stock appreciation rights activity for the six monthsended December 31, 2009 is as follows:

 
| ** **              | ** ** | ** ** | ** ** | ** **   | ** ** | **Weighted**    | ** ** | ** **    | ** ** |
|-------------------------|------------|------------|------------|--------------|------------|-----------------|------------|---------------|------------|
| ** **              | ** ** | ** ** | ** ** | **Weighted** | ** ** | **Average**     | ** ** | ** **    | ** ** |
| ** **              | ** ** | ** ** | ** ** | **Average**  | ** ** | **Remaining**   | ** ** | **Aggregate** | ** ** |
| ** **              | ** ** | ** ** | ** ** | **Exercise** | ** ** | **Contractual** | ** ** | **Intrinsic** | ** ** |
| ** **              | ** ** | **SARs**   | ** ** | **Price**    | ** ** | **Term**        | ** ** | **Value**     | ** ** |
|                    |       |       |       |         |       |            |       |          |       |
| Beginning  balance      |       | 87,650     |       | $            | 15.35      |            |       |          |       |   |
| Granted                 |       | 115,747    |       | 12.48        |       |            |       |          |       |
| Forfeited               |       | (2,084     | )          | 15.38        |       |            |       |          |       |
| Exercised               |       | —     |       | —       |       |            |       |          |       |
| Ending  balance         |       | 201,313    |       | $            | 13.70      |            | 9.00       |          | $          | — |   |
|                    | ** ** | ** ** |       |         |       |            |       |          |       |
| Vested  and exercisable |       | 35,463     |       | $            | 15.62      |            | 7.69       |          | $          | — |   |

 

The total intrinsic value of options exercised duringthe six months ended December 31, 2009 and 2008 was $0 and $174,000,respectively.  Cash received from theexercise of these options was $0 and $501,000, respectively, and the relatedtax benefit realized for the tax deductions from cashless option exercisestotaled $0 and $700, respectively.  Theweighted-average grant date fair value of stock appreciation rights (SARs)granted during the six months ended December 31, 2009 and 2008 was $1.75and $2.06, respectively.  The totalunrecognized compensation cost related to nonvested SARs awards at December 31,2009 was $303,000.  The unrecognized costat December 31, 2009 is expected to be recognized over a weighted averageperiod of 32 months.

 

Nonvested share activityfor the six months ended December 31 follows:

 
| ** **                    | ** ** | **2009**   | ** ** | **2008**       | ** ** |
|-------------------------------|------------|------------|------------|----------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Weighted**   | ** ** | ** ** | ** ** | **Weighted** | ** ** |
| ** **                    | ** ** | ** ** | ** ** | **Average**    | ** ** | ** ** | ** ** | **Average** | ** ** |
| ** **                    | ** ** | ** ** | ** ** | **Grant Date** | ** ** | ** ** | ** ** | **Grant Date** | ** ** |
| ** **                    | ** ** | **Shares** | ** ** | **Fair Value** | ** ** | **Shares** | ** ** | **Fair Value** | ** ** |
|                          |       |       |       |           |       |   |   |   |   |
| Nonvested  balance, beginning |       | 90,708     |       | $              | 15.81      |   | 121,746 |   | $ | 16.57 |   |
| Granted                       |       | 38,062     |       | 10.80          |       | 23,602 |   | 13.33 |   |
| Vested                        |       | (55,403    | )          | 15.30          |       | (48,982 | ) | 16.43 |   |
| Forfeited                     |       | (506       | )          | 16.53          |       | (1,305 | ) | 16.95 |   |
| ** **                    | ** ** | ** ** | ** ** | ** **     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Nonvested  balance, ending    |       | 72,861     |       | $              | 13.58      |   | 95,061 |   | $ | 15.83 |   |

 

Pretax compensation expense recognized for nonvested shares for the sixmonths ended December 31, 2009, and 2008 was $276,000 and $179,000, respectively.  The tax benefit for the six months ended December 31,2009, and 2008 was $94,000 and $61,000, respectively.  Annually, the expected forfeiture rate isconsidered and a cumulative amortization adjustment is recorded to compensationexpense if necessary.  During the secondquarter of fiscal 2010, the expected forfeiture rate was changed to 14%, downfrom 22% from the evaluation in the second quarter of fiscal 2009, based uponhistorical employee turnover and expectations about the future.  This resulted in a pretax cumulativeadjustment to increase compensation expense totaling $103,000.  This compares to a pretax adjustment todecrease compensation expense totaling $34,000 recognized in the second quarterof fiscal 2009, when the forfeiture rate increased from 19% to 22%.  As of December 31, 2009, there was$566,000 of total unrecognized compensation cost related to nonvested sharesgranted under the Company’s 2002 Stock Option and Incentive Plan, as amended (“thePlan”).  The cost is expected to berecognized over a weighted-average period of 21 months.  The total fair value of shares vested duringthe six months ended December 31, 2009 and 2008 was $673,000 and $805,000,respectively.

 

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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 2010,19,626 shares of nonvested stock were awarded. Nonvested shares vest on the first anniversary of the date ofgrant.  As of December 31, 2009,there was $181,000 of total unrecognized compensation cost related to nonvestedshares, which are expected to be recognized over the remaining 12 months.  For the six months ended December 31,2009, amortization expense was recorded in the amount of $60,000.

 

These stock option and incentive plans are described more fully in Part II,Item 8 “Financial Statements and Supplementary Data” of the Company’s AnnualReport on Form 10-K for fiscal 2009, under Note 16 of “Notes toConsolidated Financial 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 beyond January 7,2033. At the end of the deferral period, all accumulated and unpaiddistributions must be paid. The capital securities must be redeemed on January 7,2033; however, the Company has the option to shorten the maturity date as thecall option date has passed. Holders of the capital securities have no votingrights, are unsecured, and rank junior in priority of the payment to all of theCompany’s indebtedness and senior to the Company’s capital 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 beyond October 8,2033. At the end of the deferral period, all accumulated and unpaiddistributions must be paid. The capital securities must be redeemed on October 8,2033; however, the Company has the option to shorten the maturity date as thecall option date has passed. Holders of the capital securities have no votingrights, are unsecured, and rank junior in priority of the payment to all of theCompany’s indebtedness and senior to the Company’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 than March 1,2012. Holders of the capital securities have no voting rights, are unsecured,and rank junior in priority of the payment to all of the Company’s indebtednessand senior to the Company’s capital stock.

 

On July 5, 2007, the Company issued 5,000 shares totaling $5.0 millionof Company Obligated Mandatorily Redeemable Preferred Securities of Trust VI.Trust VI was established and exists for the sole purpose of issuing trustpreferred securities and investing the proceeds in subordinated debentures ofthe Company. These subordinated debentures constitute the sole asset of TrustVI. The securities provide for cumulative cash distributions calculated at arate based on three- month LIBOR plus 1.65% adjusted quarterly. The Companymay, at one or more times, defer interest payments on the capital securitiesfor up to 20 consecutive quarterly periods, but not beyond October 1,2037. At the end of the deferral period, all accumulated and unpaiddistributions must be paid. The capital securities must be redeemed on October 1,2037; however, the Company has the option to shorten the maturity date to adate not earlier than October 1, 2012. Holders of the capital securitieshave no voting rights, are unsecured, and rank junior in priority of thepayment to all of the Company’s indebtedness and senior to the Company’scapital stock.

 

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**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 counterparty.  TheCompany anticipates the counterparty will be able to fully satisfy itsobligations 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 derivative was a $491,000 unrealized loss at December 31,2009.

 

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 a $222,000 unrealized loss at December 31,2009.

 

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 also entered into an interestrate swap agreement with a $2.0 million notional amount to convert theremaining portion of variable rate Trust Preferred III security into a fixedrate instrument for a term of four years at a fixed rate of 6.91%.  The fair value of the $3.0 million notionalamount derivative was a $135,000 unrealized loss, while the fair value of the$2.0 million notional amount derivative was a $107,000 unrealized loss at December 31,2009.

 

During the second quarter of fiscal 2010, the Company entered intothree interest rate swap agreements with notional amounts totaling $22.0million to convert the variable-rate attributes of trust preferred debt intofixed-rate instruments through forward-starting swaps.  The $10.0 million notional amount fixed-rateinstrument has a term of five years at a fixed rate of 5.68%, effective December 1,2011 for Trust Preferred V.  The $7.0million notional amount fixed-rate instrument has a term of three years at afixed rate of 5.93%, effective January 8, 2011 for Trust Preferred IV. The$5.0 million notional amount fixed-rate instrument has a term of five years ata fixed rate of 5.95%, effective October 1, 2012 for Trust PreferredVI.  The fair value of the $10.0 million,$7.0 million and $5.0 million notional amount derivatives were unrealized gainsof $222,000, $91,000, and $98,000, respectively, at December 31, 2009.

 

No gain or loss was recognized in earnings for the six months ended December 31,2009, and 2008 related to interest rate swaps. No deferred net losses on interest rate swaps in other comprehensiveloss as of December 31, 2009, 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 $1.8 million in cash under collateral arrangementsas of December 31, 2009, to satisfy collateral requirements associatedwith our interest rate swap contracts.

 

The following table summarizes the derivative financial instrumentsutilized as of December 31, 2009:

 
|                          |       | **Balance**                          | ** ** | **Notional**               | ** ** | **Estimated  Fair Value** |       |
|-------------------------------|------------|--------------------------------------|------------|----------------------------|------------|---------------------------|------------|
| **Cash flow hedge**           | ** ** | **Sheet  Location**                  | ** ** | **Amount**                 | ** ** | **Gain**                  | ** ** | **Loss** | ** ** |
| ** **                    | ** ** | ** **                           | ** ** | **(Dollars in Thousands)** | ** ** |
|                          |       |                                 |       |                       |       |                      |       |   |   |
| Interest  rate swap contracts |       | Accumulated other comprehensive loss |       | $                          | 39,000     |                      | $          | 411 |   | $ | (954 | ) |
|                               |            |                                      |            |                            |            |                           |            |  |  |  |  |  |

 

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The followingtable details the derivative financial instruments, the average remainingmaturities and the weighted-average interest rates being paid and received asof December 31, 2009:

 
| ** **                     | ** ** | ** **                 | ** ** | **Average**  | ** ** | ** ** | ** ** | ** **                | ** ** | ** ** | ** ** |
|--------------------------------|------------|----------------------------|------------|--------------|------------|------------|------------|---------------------------|------------|------------|------------|
| ** **                     | ** ** | **Notional**               | ** ** | **Maturity** | ** ** | **Fair**   | ** ** | **Weighted Average Rate** | ** ** |
| **Liability conversion swaps** | ** ** | **Amount**                 | ** ** | **(years)**  | ** ** | **Value**  | ** ** | **Receive**               | ** ** | **Pay**    | ** ** |
| ** **                     | ** ** | **(Dollars in Thousands)** | ** ** |
|                           |       |                       |       |         |       |       |       |                      |       |       |       |
| Interest  rate swap contracts  |       | $                          | 39,000     |         | 4.3        |       | $          | (543                      | )          | 3.0        | %          | 6.1 | % |
|                                |            |                            |            |              |            |            |            |                           |            |            |            |  |  |

 

**NOTE 12****—****ACCUMULATED OTHER COMPREHENSIVELOSS**

 

The components ofaccumulated other comprehensive loss are as follows:

 
| ** **                                                                                                                                               | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                                                                                                                               | ** ** | **December 31,**           | ** ** | **December 31,**     | ** ** |
| ** **                                                                                                                                               | ** ** | **2009**                   | ** ** | **2008**             | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                                                                                                                                               | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **                                                                                                                                               |       |                       |       |                 |       |   |   |   |   |
| Net  income                                                                                                                                              |       | $                          | 1,961      |                 | $          | 1,846 |   | $ | 2,816 |   | $ | 3,821 |   |
| 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 |       | (1,663                     | )          | —               |       | (2,081 | ) | — |   |
| Change  in unrealized gain (losses) on other securities available for sale                                                                               |       | 482                        |       | (322                 | )          | 1,684 |   | (906 | ) |
| Reclassification  adjustment:                                                                                                                            |       |                       |       |                 |       |   |   |   |   |
| Net  impairment credit loss recognized in earnings                                                                                                       |       | 340                        |       | —               |       | 2,198 |   | — |   |
| Security  (gains) recognized in earnings                                                                                                                 |       | (603                       | )          | (45                  | )          | (1,136 | ) | (125 | ) |
| Net  unrealized gains (losses)                                                                                                                           |       | (1,444                     | )          | (367                 | )          | 665 |   | (1,031 | ) |
| Income  tax benefit (expense)                                                                                                                            |       | 550                        |       | 138                  |       | (252 | ) | 391 |   |
| Other  comprehensive income (loss) on securities available for sale                                                                                      |       | (894                       | )          | (229                 | )          | 413 |   | (640 | ) |
|                                                                                                                                                     |       |                       |       |                 |       |   |   |   |   |
| Defined  benefit plan:                                                                                                                                   |       |                       |       |                 |       |   |   |   |   |
| Other  comprehensive (loss) on defined benefit plan                                                                                                      |       | —                     |       | —               |       | — |   | — |   |
| Cash  flow hedging activities-interest rate swap contracts:                                                                                              |       |                       |       |                 |       |   |   |   |   |
| Net  unrealized gains (losses)                                                                                                                           |       | 505                        |       | (888                 | )          | 409 |   | (920 | ) |
| Income  tax benefit (expense)                                                                                                                            |       | (171                       | )          | 302                  |       | (139 | ) | 313 |   |
| Other  comprehensive income (loss) on cash flow hedging activities-interest rate  swap contracts                                                         |       | 334                        |       | (586                 | )          | 270 |   | (607 | ) |
| Total  other comprehensive income (loss)                                                                                                                 |       | (560                       | )          | (815                 | )          | 683 |   | (1,247 | ) |
| Comprehensive  income                                                                                                                                    |       | $                          | 1,401      |                 | $          | 1,031 |   | $ | 3,499 |   | $ | 2,574 |   |
|                                                                                                                                                     |       |                       |       |                 |       |   |   |   |   |
| Cumulative  other comprehensive (loss) balances were:                                                                                                    |       |                       |       |                 | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                                                                                                     |       |                       |       |                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Unrealized  loss on securities available for sale, net of related tax effect of $858 and  $1,659                                                         |       | $                          | (1,398     | )                    | $          | (2,707 | ) |
| Unrealized  loss on defined benefit plan, net of related tax effect of $1,177 and $523                                                                   |       | (1,920                     | )          | (853                 | )          |
| Unrealized  loss on cash flow hedging activities, net of related tax effect of $185 and  $354                                                            |       | (358                       | )          | (687                 | )          |
|                                                                                                                                                     |       | $                          | (3,676     | )                    | $          | (4,247 | ) |

 

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**NOTE 13****—****FINANCIAL INSTRUMENTS AND FAIRVALUE MEASUREMENT**

 

The Bank is aparty to financial instruments with off-balance-sheet risk in the normal courseof business to meet the financing needs of its customers. These financialinstruments include commitments to extend credit, standby letters of credit andfinancial guarantees. Those instruments involve, to varying degrees, elementsof credit and interest-rate risk in excess of amounts recognized in theconsolidated statements of financial condition. The contract or notionalamounts of those instruments reflect the extent of the Bank’s involvement inparticular classes of financial instruments.

 

The Bank’sexposure to credit loss in the event of nonperformance by the other party tothe financial instrument for commitments to extend credit, standby letters ofcredit, and financial guarantees written is represented by the 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 notedotherwise, the Bank does not require collateral or other security to supportfinancial instruments with credit risk.

 

The followingmethods and assumptions were used by the Company in estimating the fair valueof its financial instruments:

 

Cash and cashequivalents—The carrying amounts reported in the statements of financialcondition for cash and cash equivalents approximate their fair values.

 

Securities—Fairvalues for investment securities are based on quoted market prices or whosevalue is determined using discounted cash flow methodologies, except for stockin the Federal Home Loan Bank for which fair value is assumed to equal cost.

 

Loans and leases,net—The fair values for loans are estimated using discounted cash flowanalyses, using interest rates currently being offered for loans with similarterms and credit quality. Leases are stated at cost which equals fair value.

 

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

 

Servicingrights—Fair values are estimated using discounted cash flows based on currentmarket rates of interest.

 

Interest rate swapcontracts—Valuations of interest rate swap contracts are based on inputsobserved in active markets for similar instruments. Typical inputs include theLIBOR curve, option volatility and option skew.

 

Off-balance sheetinstruments - Loan commitments are negotiated at current market rates and arerelatively short-term in nature. Therefore, the estimated value of loan commitments approximates the faceamount.  Rates for these commitments areset at time of loan closing, such that no adjustment is necessary to reflectthese commitments at market value.

 

Deposits—The fairvalues for deposits with no defined maturities equal their carrying amounts,which represent the amount payable on demand. Fair values for fixed-ratecertificates of deposit are estimated using a discounted cash flow calculationthat applies interest rates currently being offered on a comparably termedwholesale funding alternative (i.e., FHLB borrowings).

 

Borrowed funds—Thecarrying amounts reported for variable rate advances approximate their fairvalues. Fair values for fixed-rate advances and other borrowings are estimatedusing a discounted cash flow calculation that applies interest rates currentlybeing offered on advances and borrowings with corresponding maturity dates.

 

Subordinateddebentures payable to trusts—Fair values for subordinated debentures areestimated using a discounted cash flow calculation that applies interest rateson comparable borrowing instruments with corresponding maturity dates.

 

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Accrued interestpayable and advances by borrowers for taxes and insurance—The carrying valuesof accrued interest payable and advances by borrowers for taxes and insuranceapproximate their fair values.

 

Estimated fairvalues of the Company’s financial instruments are as follows:

 
| ** **                                                                  | ** ** | **December 31, 2009**      | ** ** | **June 30, 2009** | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------------|------------|-------------------|------------|
| ** **                                                                  | ** ** | **Carrying**               | ** ** | **Fair**          | ** ** | **Carrying** | ** ** | **Fair** | ** ** |
| ** **                                                                  | ** ** | **Amount**                 | ** ** | **Value**         | ** ** | **Amount** | ** ** | **Value** | ** ** |
| ** **                                                                  | ** ** | **(Dollars in Thousands)** | ** ** |
| Financial  Assets                                                           |       |                       |       |              |       |   |   |   |   |
| Cash  and cash equivalents                                                  |       | $                          | 38,706     |              | $          | 38,706 |   | $ | 18,511 |   | $ | 18,511 |   |
| Securities                                                                  |       | 221,840                    |       | 221,840           |       | 222,910 |   | 222,910 |   |
| Federal  Home Loan Bank Stock                                               |       | 8,848                      |       | 8,848             |       | 12,476 |   | 12,476 |   |
| Loans  and leases                                                           |       | 833,645                    |       | 836,367           |       | 857,693 |   | 863,453 |   |
| Accrued  interest receivable                                                |       | 9,384                      |       | 9,384             |       | 7,598 |   | 7,598 |   |
| Servicing  rights                                                           |       | 12,351                     |       | 15,660            |       | 11,768 |   | 15,055 |   |
| Interest  rate swap contracts                                               |       | (543                       | )          | (543              | )          | (952 | ) | (952 | ) |
|                                                                        |       |                       |       |              |       |   |   |   |   |
| Financial  liabilities                                                      |       |                       |       |              |       |   |   |   |   |
| Deposits                                                                    |       | 863,388                    |       | 869,693           |       | 837,868 |   | 844,243 |   |
| Borrowed  funds                                                             |       | 166,041                    |       | 172,404           |       | 212,869 |   | 219,249 |   |
| Subordinated  debentures payable to trusts                                  |       | 27,837                     |       | 12,323            |       | 27,837 |   | 9,990 |   |
| Accrued  interest payable and advances by borrowers for taxes and insurance |       | 15,674                     |       | 15,674            |       | 17,421 |   | 17,421 |   |
|                                                                             |            |                            |            |                   |            |  |  |  |  |  |  |  |  |

 

*FairValue Measurement*

 

Effective July 1,2009, FASB Staff Position 157-2, *EffectiveDate of SFAS No. 157(ASC Topic 820)*, the Company applied theprovisions of this statement to non-financial assets and liabilities.  The Company early adopted FASB Staff Position157-4, in April 2009, *Determining Fair ValueWhen the Volume and Level of Activity for the Asset or Liability HaveSignificantly Decreased and Identifying Transactions That Are Not Orderly(ASC820-10-65)*.  ASC 820-10-65defines fair value and establishes a consistent framework for measuring fairvalue under GAAP and expands disclosure requirements for fair valuemeasurements. Fair values represent the estimated price that would be receivedfrom selling an asset or paid to transfer a liability in an orderly transactionbetween market participants at the measurement date under current marketconditions. The standard describes three levels of inputs that may be used to measurefair value:

 

Level 1:  Quoted prices (unadjusted) for identicalassets or liabilities in active markets that the entity has the ability toaccess as of the measurement date.

 

Level 2:  Significant other observable inputs otherthan Level 1 prices such as quoted prices for similar assets or liabilities;quoted prices in markets that are not active; or other inputs that areobservable or can be corroborated by observable market data.

 

Level 3:  Significant unobservable inputs that reflecta company’s own assumptions about the assumptions that market participantswould use in pricing an asset or liability. Level 3 assets and liabilitiesinclude financial instruments whose value is determined using pricing models,discounted cash flow methodologies, or similar techniques, as well asinstruments for which the determination of fair value requires significantmanagement judgment or estimation.

 

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The table belowpresents the Company’s assets and liabilities measured at fair value on arecurring basis by level within the hierarchy at December 31, 2009:

 
| ** **                     | ** ** | **Quoted Prices**          | ** ** | **Significant Other** | ** ** | **Significant**  | ** ** | ** **     | ** ** |
|--------------------------------|------------|----------------------------|------------|-----------------------|------------|------------------|------------|----------------|------------|
| ** **                     | ** ** | **In Active**              | ** ** | **Observable**        | ** ** | **Unobservable** | ** ** | ** **     | ** ** |
| ** **                     | ** ** | **Markets**                | ** ** | **Inputs**            | ** ** | **Inputs**       | ** ** | **Total at**   | ** ** |
| ** **                     | ** ** | **(Level 1)**              | ** ** | **(Level 2)**         | ** ** | **(Level 3)**    | ** ** | **Fair Value** | ** ** |
| ** **                     | ** ** | **(Dollars in Thousands)** | ** ** |
|                           |       |                       |       |                  |       |             |       |           |       |
| Securities  available for sale |       | $                          | 3          |                  | $          | 217,624          |       | $              | 4,213      |   | $ | 221,840 |   |
| Interest  rate swap contracts  |       | —                     |       | (543                  | )          | —           |       | (543           | )          |
| Total  assets                  |       | $                          | 3          |                  | $          | 217,081          |       | $              | 4,213      |   | $ | 221,297 |   |

 

The Company usedthe following methods and significant assumptions to estimate the fair value ofitems:

 

Securitiesavailable for sale: The fair values of securities available for sale are determinedby obtaining quoted prices on nationally recognized securities exchanges (Level1 inputs), 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 marketinformation.  This methodology includesbroker quotes, proprietary models, descriptive terms and conditions databases,as well as extensive quality control programs. As further valuation sources, the third party provider uses aproprietary valuation 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 securitiesshown in Level 3 relate to trust preferred securities which are currently partof an inactive market.  The inactivitywas evidenced first by a significant widening of the bid-ask spread in thebrokered markets in which these securities trade, and then by a significantdecrease in the volume of trades relative to historical levels.  The new issue market for pooled trustpreferred securities has been inactive since 2007.  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.

 

The results ofthird party valuation and valuation derived by management cash flow scenarioswere weighted each at 50% and used to measure fair value for each security. Theapproaches to determining fair value for the trust preferred securitiesincluded the following factors:

 

1.               The credit quality of the collateral is estimatedusing average probability of default values for each industry within the thirdpart valuation.

 

2.               The loss given default was assumed to be 100% (i.e. norecovery) for third party valuations. Management utilized a range of loss given default based upon a review ofthe financial condition of underlying issuers in each pool, under multiplescenarios for each security.

 

3.               The cash flows were forecasted for the underlyingcollateral and applied to each tranche to determine the resulting distributionamong the securities.

 

4.               For third party valuation, the expected cash flows foreach scenario are discounted at 3-month Libor plus 300 basis points.  Management scenarios of the best estimates ofexpected cash flows were discounted to calculate the present value of the security.  Management considered a range of discountrates based upon three factors:  (1) 3-MonthLibor or a risk-free rate based on the rate of return on government debtsecurities, 

 

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(2) the creditspread for BBB Bank Corporate Debt Indices, and (3) a liquidity or “riskpremium” of 200 basis points.

 

5.               The third party calculations were modeled in severalthousand scenarios and the average price was used for the third partyvaluations.  Management utilized anaverage price derived from various cash flow scenarios.

 

Interest rateswaps:  The fair values of interest rateswaps relate to cash flow hedges of trust preferred debt securities issued bythe Company.  The fair value is estimatedby a third party using inputs that are observable or that can be corroboratedby observable market data and, therefore, are classified within Level 2 of thevaluation hierarchy. These fair value estimations include primarily marketobservable inputs, such as yield curves, and include the value associated withcounterparty credit risk.

 

The followingtable reconciles the beginning and ending balances of securities available forsale that are measured at fair value on a recurring basis using significantunobservable inputs:

 
| ** **                                    | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|----------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **December 31, 2009**      | ** ** |
|                                          |       | **(Dollars in Thousands)** |       |
| Beginning  balance                            |       | $                          | 5,649      |                 | $          | 6,051 |   |
| Total  realized/unrealized gains (losses)     |       |                       |       |                 |       |
| Included  in earnings                         |       | (340                       | )          | (2,198               | )          |
| Included  in other comprehensive loss         |       | (1,113                     | )          | 336                  |       |
| Purchases,  issuances, (paydowns) and (sales) |       | 17                         |       | 24                   |       |
| Transfers  into or (out) of Level 3           |       | —                     |       | —               |       |
| Ending  balance                               |       | $                          | 4,213      |                 | $          | 4,213 |   |

 

The table belowpresents the Company’s assets subject to the nonrecurring fair valuemeasurements by level within the hierarchy at December 31, 2009:

 
| ** **                 | ** ** | **Quoted Prices**          | ** ** | **Significant Other** | ** ** | **Significant**  | ** ** | ** **      | ** ** |
|----------------------------|------------|----------------------------|------------|-----------------------|------------|------------------|------------|-----------------|------------|
| ** **                 | ** ** | **In Active**              | ** ** | **Observable**        | ** ** | **Unobservable** | ** ** | **Fiscal 2010** | ** ** |
| ** **                 | ** ** | **Markets**                | ** ** | **Inputs**            | ** ** | **Inputs**       | ** ** | **Incurred**    | ** ** |
| ** **                 | ** ** | **(Level 1)**              | ** ** | **(Level 2)**         | ** ** | **(Level 3)**    | ** ** | **Losses**      | ** ** |
| ** **                 | ** ** | **(Dollars in Thousands)** | ** ** |
|                       |       |                       |       |                  |       |             |       |            |       |
| Loans  held for sale       |       | $                          | —     |                  | $          | 23,123           |       | $               | —     |   | $ | — |   |
| Impaired  loans            |       | —                     |       | 7,691                 |       | 103              |       | —          |       |
| Mortgage  servicing rights |       | —                     |       | —                |       | 12,351           |       | —          |       |
| Foreclosed  assets         |       | —                     |       | —                |       | —           |       | 7               |       |
|                            |            |                            |            |                       |            |                  |            |                 |            |  |  |  |  |

 

Loans held forsale, which consist generally of current production of certain fixed-rate,first-lien residential mortgage loans and student loans, are carried at thelower of cost or estimated fair value. The estimated fair value is based onwhat secondary markets are currently offering for portfolios with similarcharacteristics, which the Company classifies as a Level 2 nonrecurring fairvalue measurement.

 

Impaired loans areevaluated and valued at the time the loan is identified as impaired, at thelower of cost or market value. Market value is measured based on the value ofthe collateral securing these loans.  Collateralis primarily real estate and its fair value is generally determined based onreal estate appraisals or other evaluations by qualified professionals andreported as Level 2 inputs. When no appraisal or external valuation can beobtained, the Company internally values these assets and reports these as Level3 inputs.  Impaired loans are reviewedand evaluated on at least a quarterly basis for additional impairment andadjusted accordingly, based on the same factors identified above. Impairedloans that are collateral dependent are written down to their fair value, lesscosts to sell, through the establishment of specific reserves or by recordingcharge-offs when the carrying value exceeds the fair value. Valuationtechniques

 

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consistent with themarket approach, income approach, and/or cost approach were used to measurefair value and primarily included observable inputs such as recent sales ofsimilar assets or observable market data for operational or carrying costs.

 

Foreclosed assets’values are originally derived from the estimated value of the collateral basedasset upon repossession by the Bank. During the period the foreclosed asset remains in the possession of theBank, the asset is evaluated periodically for any valuation adjustments. Thoseforeclosed assets, for which a reduction in asset value is needed, are adjustedand determined to be an impaired asset of the Company.  These assets will remain an impaired assetuntil ultimately sold or disposed.

 

Mortgage servicingrights do not trade in an active, open market with readily observable prices.While sales of mortgage servicing rights do occur, the precise terms andconditions typically are not readily available to allow for a “quoted price forsimilar assets” comparison. Accordingly, the Company relies on an internaldiscounted cash flow model to estimate the fair value of its mortgage servicingrights. The Company uses a valuation model to project mortgage servicing rightscash flows based on the current interest rate scenario, which is thendiscounted to estimate an expected fair value of the mortgage servicing rights.The valuation model considers portfolio characteristics of the underlyingmortgages, contractually specified servicing fees, prepayment assumptions,discount rate assumptions, other ancillary revenue, costs to service, and othereconomic factors. The Company reassesses and periodically adjusts theunderlying inputs and assumptions used in the model to reflect marketconditions and assumptions that a market participant would consider in valuingthe mortgage servicing rights asset. In addition, the Company compares its fairvalue estimates and assumptions to observable market data for mortgageservicing rights, where available, and to recent market activity and actualportfolio experience. Due to the nature of the valuation inputs, mortgageservicing rights are classified within Level 3 of the fair value hierarchy.The Company uses the amortization method (i.e., lower of amortized cost orestimated fair value measured on a nonrecurring basis), not fair valuemeasurement accounting, for its mortgage servicing rights assets.

 

**Item 2.   *Management’s Discussion and Analysis of Financial Condition and Resultsof Operations***

 

**Forward-LookingStatements**

 

This QuarterlyReport on Form 10-Q (“Form 10-Q”), as well as other reports issued byHF Financial Corp. (the “Company”) include “forward-looking statements” withinthe meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21Eof the Securities Exchange Act of 1934, as amended. In addition, the Company’smanagement may make forward-looking statements orally to the media, securitiesanalyst, investors and others from time to time. Forward-looking statements canbe identified by the fact that they do not relate strictly to historical orcurrent 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-looking statements.

 

Theseforward-looking statements might include one or more of the following:

 

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

 

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

 

·                  forecasts of future economic performance.

 

·                  use and descriptions of assumptions andestimates underlying or relating to such matters.

 

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Forward-lookingstatements are subject to certain risks and uncertainties that could causeactual results to differ materially from our historical experience and ourpresent expectations or projections. Factors that could cause actual results todiffer from those discussed in the forward-looking statements include, but arenot limited to:

 

·                  adverse economic and market conditions ofthe financial services industry in general, including, without limitation, thecredit markets;

 

·                  the effect of recent legislation to helpstabilize the financial markets or the effect of the phase-out of existingrecovery programs;

 

·                  future losses on our holdings of trustpreferred securities;

 

·                  increase of non-performing loans andadditional provisions for loan losses;

 

·                  the failure of assumptions underlying theestablishment of reserves for loan losses and other estimates;

 

·                  the failure to maintain our reputation inour market area;

 

·                  prevailing economic, political andbusiness conditions in South Dakota;

 

·                  the effects of competition from a widevariety of local, regional, national and other providers of financial services;

 

·                  compliance with existing and futurebanking laws and regulations, including, without limitation, regulatory capitalrequirements and FDIC insurance coverages and costs;

 

·                  changes in the availability and cost ofcredit and capital in the financial markets;

 

·                  the effects of FDIC deposit insurancepremiums and assessments;

 

·                  the risks of changes in market interestrates on the composition and costs of deposits, loan demand, net interestincome, and the values and liquidity of loan collateral, and our ability orinability to manage interest rate and other risks;

 

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

 

·                  an extended period of low commodityprices, significantly reduced yields on crops, reduced levels of governmentalassistance to the agricultural industry, and reduced farmland values;

 

·                  soundness of other financialinstitutions;

 

·                  the risks of future acquisitions andother expansion opportunities, including, without limitation, the related timeand costs of implementing such transactions, integrating operations as part ofthese transactions and possible failures to achieve expected gains, revenuegrowth and expense savings from such transactions;

 

·                  security and operations risks associatedwith the use of technology;

 

·                  the loss of one or more of our keypersonnel, or the failure to attract, assimilate and retain other highlyqualified personnel in the future;

 

·                  changes in or interpretations ofaccounting standards, rules or principles; and

 

·                  other factors and risks described under Part I,Item 2—“Management’s Discussion and Analysis of Financial Condition andResults of Operations” and Item 3—“Quantitative and Qualitative DisclosuresAbout Market Risk” in this Form 10-Q.

 

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Forward-lookingstatements speak only as of the date they are made. Forward-looking statementsare based upon management’s then-current beliefs and assumptions, butmanagement does not give any assurance that such beliefs and assumptions willprove to be correct. We undertake no obligation to publicly update or reviseany forward-looking statements included or incorporated by reference in this Form 10-Qor to update the reasons why actual results could differ from those containedin such statements, whether as a result of new information, future events orotherwise, except to the extent required by federal securities laws. Based uponchanging conditions, should any one or more of the above risks or uncertaintiesmaterialize, or should any of our underlying beliefs or assumptions proveincorrect, actual results may vary materially from those described in anyforward-looking statement.

 

References in thisForm 10-Q to “we,” “our,” “us” and other similar references are to theCompany, unless otherwise expressly stated or the context requires otherwise.

 

**ExecutiveSummary**

 

The Company’s netincome available to common shareholders for the second quarter of fiscal 2010was $2.0 million, or $0.38 in diluted earnings per common share, compared to$1.8 million, or $0.46 in diluted earnings per common share, for the secondquarter of fiscal 2009.  The Company’snet income available to common shareholders for the six months ended December 31,2009 was $2.8 million, or $0.61 in diluted earnings per common share, comparedto $3.8 million, or $0.95 in diluted earnings per common share, for the sixmonths ended December 31, 2008.

 

Net interest income forthe first six months of fiscal 2010 was $17.6 million, a decrease of $87,000,or 0.5%, compared to the same period a year ago.  For the six months ended December 31,2009, average interest-earning assets and average interest-bearing liabilitiesincreased 2.5% and 1.3%, respectively, compared to the same period a yearago.  Yields on earning assets decreasedto 5.29% in the first six months of fiscal 2010, compared to 5.88% a year ago,a decrease of 59 basis points.  For thesame period, interest-bearing cost of funds decreased to 2.35%, compared to2.87%, a decrease of 52 basis points.

 

The net interest marginon a fully taxable equivalent basis (“Net Interest Margin, TE”) for the sixmonths ended December 31, 2009 was 3.27%, compared to 3.37% for the same perioda year ago, a decrease of 10 basis points. A sustained overall decline in theinterest rate yield curve affected the yield for the interest-earning assetsand the interest-bearing liabilities, while the average balances for thesecategories increased 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.

 

The net interest marginratio may vary due to many factors, including Federal Reserve policies forshort-term interest rates, competitive and economic factors and customerpreferences for various products and services. In the second quarter of fiscal 2009, the Federal Reserve decreased theFed Funds Target Rate by a total of 175 basis points on three separateincrements, the first decrease in short-term interest rates since April 30,2008.

 

The allowance for loanand lease losses increased $42,000 to $8.5 million at December 31, 2009,compared to June 30, 2009.  Theratio of allowance for loan and lease losses to total loans and leases was1.01% as of December 31, 2009 compared to 0.98% at June 30, 2009.  Total nonperforming assets at December 31,2009 were $16.2 million as compared to $12.6 million at June 30, 2009, anincrease of $3.6 million.  The ratio ofnonperforming assets to total assets increased to 1.38% at December 31,2009, compared to 1.07% at June 30, 2009. The allowance for loan and lease losses is calculated based on loan andlease levels, loan and lease loss history over 12, 36, and 60 month timeperiods, credit quality of the loan and lease portfolio, and environmentalfactors such as economic health of the region and management experience.  This risk rating analysis is designed to givethe Company a consistent and systematic methodology to determine proper levelsfor the allowance at a given time. 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 non-performing assets inits loan portfolio and is working to resolve the credit issues related to theseassets to obtain the most favorable outcome for the Company.

 

The Company held$9.7 million in trust preferred securities at December 31, 2009 that arecurrently impaired under applicable accounting rules.  These are comprised of pooled securitiesissued primarily by banks throughout the United States, and were downgraded byMoody’s during the 2009 fiscal year.  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 Company recognizedtotal other-than-temporary impairment credit losses of $2.1 million for fourtrust preferred securities for the six months ended December 31,2009.  The difference between the present value of cash flows and the amortizedcost basis for each of the four securities was recorded as credit lossimpairment and recognized in earnings for a total of $2.2 million. Theamortized cost basis of the four securities was reduced by the amount of creditloss. The remaining amount of change in the fair value related to other factorswas an increase of $117,000 and is recognized in other comprehensive income,net of applicable taxes.

 

Total deposits at December 31,2009 were $863.4 million, an increase of $25.5 million, or 3.0%, from June 30,2009.  During the six month period,public fund account balances decreased $25.9 million which are categorized inmultiple categories of deposits. In-market certificates of deposit increased a total of $19.8 millionfrom $401.3 million to $421.1 million for the six month period, due in part tocustomer preference for higher yielding term deposit products.  The primary factor affecting interest expensewas the decrease in the average rates paid on total deposits for the six monthperiod ended December 31, 2009 of 1.86% compared to 2.52% for the sixmonth period ended December 31, 2008.

 

During the secondquarter of fiscal 2010, the Company issued 2.875 million shares of itscommon stock at a public offering price of $8.00 per share, for gross proceedsof $23.0 million. The net proceeds of the offering after deducting underwritingdiscounts and commissions and estimated offering expenses totaled approximately$20.7 million.  Per share earnings calculations were based on a dilutedweighted average shares outstanding of 5.20 million shares versus 4.02 millionshares in the comparable period in fiscal 2009.

 

On January 25,2010, the Company announced it will pay a quarterly cash dividend of 11.25cents per common share for the second quarter of fiscal 2010.  The dividend will be paid on February 12,2010 to stockholders of record on February 5, 2010.

 

The total risk-basedcapital ratio of 11.84% at December 31, 2009, increased by 79 basis pointsfrom 11.05% at June 30, 2009.  Thiscontinues to place the Bank in the “well-capitalized” category within OTSregulation at December 31, 2009 and is consistent with the “well-capitalized”OTS category in which the Company plans to operate.  The Company historically has been able tomanage the size of its assets through secondary market loan sales ofsingle-family mortgages and student loans.

 

Noninterestincome was $5.0 million for the six months ended December 31, 2009compared to $6.0 million for the same period in the prior fiscal year, adecrease of $1.0 million or 17.2%.  Thisdecrease is due primarily to net impairment credit losses recognized inearnings of $2.2 million for the six months ended December 31, 2009.   Net gain on sale of loans and net gain onsale of securities increased $497,000 and $1.0 million, respectively, topartially offset the decrease for the comparable period.

 

Noninterestexpense was $17.7 million for the six months ended December 31, 2009 ascompared to $17.6 million for the six months ended December 31, 2008, anincrease of $149,000, or 0.8%.  Theincrease was attributed to  an increasein FDIC insurance premiums and occupancy and equipment of $397,000 and$195,000, respectively.  The increase innoninterest expense was neutralized by a decrease in compensation and employeebenefits of $647,000, which was attributed primarily to performance-basedincentive pay and healthcare cost decreases.

 

The Bank is a member ofthe Deposit Insurance Fund (the “DIF”), which is administered by the FederalDeposit Insurance Corporation (“FDIC”). Deposits are insured up to the applicable limits by the FDIC and suchinsurance is backed by the full faith and credit of the United StatesGovernment.  As insurer, the FDIC imposesdeposit insurance premiums and is authorized to conduct examinations of and torequire reporting by FDIC-insured institutions. Recent bank failures have decreased the DIF to levels below its requiredreserve ratio.  In order to replenish theDIF, the FDIC has increased deposit insurance premiums to a level designed torestore the DIF to required levels within seven years, and the Company paid aone-time special assessment of $535,000 on September 30, 2009, based upondeposits at June 30, 2009.  Thisassessment was accrued in the fourth quarter of fiscal 2009.  In addition, on November 12, 2009, the FDIC Board approved a rule requiringprepayment of the quarterly assessments for the fourth quarter of calendar2009, and the entire calendar years of 2010, 2011, and 2012.  On December 30, 2009, the Company paid$4.9 million of which $4.3 million was recorded as a prepaid asset and will beproportionally expensed over the future periods.** **The FDIC may impose additionalspecial assessments 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 June 30, 2010at 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.  The Bank had previously paid 

 

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assessments under theSavings Association Insurance Fund (“SAIF”) and was eligible for certain creditagainst deposit insurance assessments when SAIF was merged into the DIF in2005.  This credit had offset themajority of the Bank’s FDIC premium expense in past fiscal years, but was fullyutilized during the second quarter of fiscal 2009.  As a result of these factors, the Bank isanticipating an increase in deposit insurance premiums in the first threequarters of fiscal 2010 as compared to the same period of fiscal 2009.

 

**General**

 

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

 

**Financial Condition Data**

 

At December 31,2009, the Company had total assets of $1.2 billion, and exhibited a decrease of$1.3 million from the level at June 30, 2009. The decrease in assets in the six months of fiscal 2010 was dueprimarily to a decrease in net loans and leases receivable of $32.3 million andwas partially offset by an increase of cash and cash equivalents and loans heldfor sale of $20.2 million and $8.2 million, respectively.  Total liabilities decreased $25.0 million at December 31,2009 as compared to June 30, 2009. This decrease was primarily due to decreases in advances from the FHLBand other borrowings of $46.8 million and was partially offset by an increasein deposits of $25.5 million. Stockholders’ equity increased $23.6 million to $92.3 million at December 31,2009 from $68.7 million at June 30, 2009, due primarily to the equityoffering in November 2009 and current earnings.

 

The decrease in net loansand leases receivable of $32.3 million at December 31, 2009 as compared toJune 30, 2009, was primarily the result of decreases in commercialbusiness and real estate loans of $27.7 million and one-to four-family loans of$9.7 million.  Commercial business linesavailable to customers continued to increase, though overall utilizationdecreased.  These decreases werepartially offset by an increase in agricultural loans of $3.8 million at December 31,2009 as compared to June 30, 2009. Loans held for sale increased $8.2 million at December 31, 2009, ascompared to June 30, 2009, due primarily to seasonal fluctuation ofstudent loan activity and increased single family loan production activity.

 

Cash and cashequivalents increased $20.2 million at December 31, 2009 as compared to June 30,2009.  See the Consolidated Statement ofCash Flows for an in-depth analysis in the change in cash and cash equivalentsfor the six months ended December 31, 2009.

 

Deposits increased $25.5 million at December 31,2009 as compared to June 30, 2009. Public fund account balances decreased $25.9 million to $156.6 millionat December 31, 2009 from $182.5 million at June 30, 2009, as aresult of seasonal fluctuations typical with these types of municipaldeposits.  In-market certificates ofdeposit increased $19.8 million to $421.1 million from $401.3 million for thefiscal year, while out-of-market certificates of deposit decreased $2.4 millionto $18.6 million at December 31, 2009.

 

Advances from theFHLB and other borrowings decreased $46.8 million at December 31, 2009 ascompared to June 30, 2009. This decrease was primarily the result of a netdecrease in net loans and leases receivable of $32.3 million combined with thenet proceeds from the equity offering of approximately $20.7 million.

 

Stockholders’equity increased $23.6 million at December 31, 2009 when compared to June 30,2009.  This increase was due primarily tothe underwritten public offering in November 2009, whereby the Companyissued 2.875 million shares of its common stock at a public offering of $8.00per share, for gross proceeds of $23.0 million. The net proceeds of theoffering after deducting underwriting discounts and commissions and estimatedoffering expenses totaled approximately $20.7 million.  The increase in stockholders’ equity was alsoattributed to the net income available to common shareholders for the sixmonths ended December 31, 2009 of $2.8 million.

 

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

 

**Loan and Lease Portfolio Composition**

 
| ** **                               | ** ** | **December 31, 2009**      | ** ** | **June 30, 2009** | ** ** |
|------------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                               | ** ** | **Amount**                           | ** ** | **Percent**                 | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                               | ** ** | **(Dollars in Thousands)** | ** ** |
|                                     |       |                                 |       |                        |       |   |   |   |   |
| One-to  four-family (1)                  |       | $                                    | 75,176     |                        | 9.18       | % | $ | 84,849 |   | 9.97 | % |
| Commercial  business and real estate (2) |       | 294,723                              |       | 35.98                       |       | 322,416 |   | 37.87 |   |
| Multi-family  real estate                |       | 47,800                               |       | 5.84                        |       | 48,342 |   | 5.68 |   |
| Equipment  finance leases                |       | 13,172                               |       | 1.61                        |       | 16,010 |   | 1.88 |   |
| Consumer  direct (3)                     |       | 118,856                              |       | 14.51                       |       | 116,777 |   | 13.72 |   |
| Consumer  indirect (4)                   |       | 13,912                               |       | 1.70                        |       | 21,394 |   | 2.51 |   |
| Agricultural                             |       | 235,140                              |       | 28.71                       |       | 231,315 |   | 27.17 |   |
| Construction                             |       | 20,255                               |       | 2.47                        |       | 10,179 |   | 1.20 |   |
| Total  loans and leases receivable (5)   |       | $                                    | 819,034    |                        | 100.00     | % | $ | 851,282 |   | 100.00 | % |

 

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(1)          Excludes $17,652 and$8,888 loans held for sale at December 31, 2009 and June 30, 2009,respectively.

(2)          Includes $2,706 and$2,810 tax exempt leases at December 31, 2009 and June 30, 2009,respectively.

(3)          Excludes $5,471 and$5,993 student loans held for sale at December 31, 2009 and June 30,2009, respectively.

(4)          The Company announcedConsumer Indirect originations ceased during the first quarter of Fiscal 2008.

(5)          Includes deferred loanfees and discounts.

 

**DepositComposition**

 
| ** **                             | ** ** | **December 31, 2009**      | ** ** | **June 30, 2009** | ** ** |
|----------------------------------------|------------|--------------------------------------|------------|-----------------------------|------------|
| ** **                             | ** ** | **Amount**                           | ** ** | **Percent**                 | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| ** **                             | ** ** | **(Dollars in Thousands)** | ** ** |
|                                   |       |                                 |       |                        |       |   |   |   |   |
| Noninterest  bearing checking accounts |       | $                                    | 93,254     |                        | 10.80      | % | $ | 94,067 |   | 11.23 | % |
| Interest  bearing checking accounts    |       | 99,921                               |       | 11.57                       |       | 94,846 |   | 11.32 |   |
| Money  market accounts                 |       | 147,734                              |       | 17.11                       |       | 145,214 |   | 17.33 |   |
| Savings  accounts                      |       | 82,816                               |       | 9.59                        |       | 81,417 |   | 9.72 |   |
| In-market  certificates of deposit     |       | 421,052                              |       | 48.77                       |       | 401,291 |   | 47.89 |   |
| Out-of-market  certificates of deposit |       | 18,611                               |       | 2.16                        |       | 21,033 |   | 2.51 |   |
| Total  deposits                        |       | $                                    | 863,388    |                        | 100.00     | % | $ | 837,868 |   | 100.00 | % |

 

**Analysis of Net Interest Income**

 

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

 

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

 

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| ** **                                     | ** ** | **Three Months Ended December 31,** |
|------------------------------------------------|------------|---------------------------------------------------------|
| ** **                                     | ** ** | **2009**                                                | ** ** | **2008** | ** ** |
| ** **                                     | ** ** | **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)      |       | $                                                       | 849,032 |   | $ | 12,352 |   | 5.77 | % | $ | 819,530 |   | $ | 12,646 |   | 6.12 | % |
| Investment  securities (2) (3)            |       | 221,444                                                 |   | 1,891 |   | 3.39 | % | 238,971 |   | 2,883 |   | 4.79 | % |
| FHLB  stock                                    |       | 11,922                                                  |   | 104 |   | 3.46 | % | 12,069 |   | 37 |   | 1.22 | % |
|                                           |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                 |       | 1,082,398                                               |   | $ | 14,347 |   | 5.26 | % | 1,070,570 |   | $ | 15,566 |   | 5.77 | % |
| Noninterest-earning  assets                    |       | 80,938                                                  |   |   |   |   |   | 67,481 |   |   |   |   |   |
| Total  assets                                  |       | $                                                       | 1,163,336 |   |   |   |   |   | $ | 1,138,051 |   |   |   |   |   |
|                                           |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                 |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                      |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Checking  and money market                     |       | $                                                       | 217,238 |   | $ | 291 |   | 0.53 | % | $ | 236,596 |   | $ | 559 |   | 0.94 | % |
| Savings                                        |       | 68,999                                                  |   | 63 |   | 0.36 | % | 64,029 |   | 127 |   | 0.79 | % |
| Certificates  of deposit                       |       | 447,988                                                 |   | 2,978 |   | 2.64 | % | 388,650 |   | 3,446 |   | 3.52 | % |
| Total  interest-bearing deposits               |       | 734,225                                                 |   | 3,332 |   | 1.80 | % | 689,275 |   | 4,132 |   | 2.38 | % |
| FHLB  advances and other borrowings            |       | 193,339                                                 |   | 1,697 |   | 3.48 | % | 233,474 |   | 1,947 |   | 3.31 | % |
| Subordinated  debentures payable to trusts     |       | 27,837                                                  |   | 460 |   | 6.56 | % | 27,837 |   | 480 |   | 6.84 | % |
|                                           |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities            |       | 955,401                                                 |   | 5,489 |   | 2.28 | % | 950,586 |   | 6,559 |   | 2.74 | % |
| Noninterest-bearing  deposits                  |       | 93,479                                                  |   |   |   |   |   | 72,626 |   |   |   |   |   |
| Other  liabilities                             |       | 32,891                                                  |   |   |   |   |   | 36,445 |   |   |   |   |   |
| Total  liabilities                             |       | 1,081,771                                               |   |   |   |   |   | 1,059,657 |   |   |   |   |   |
| Equity                                         |       | 81,565                                                  |   |   |   |   |   | 78,394 |   |   |   |   |   |
| Total  liabilities and equity                  |       | $                                                       | 1,163,336 |   |   |   |   |   | $ | 1,138,051 |   |   |   |   |   |
|                                           |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest income; interest rate spread (4) |       |                                                    |   | $ | 8,858 |   | 2.98 | % |   |   | $ | 9,007 |   | 3.03 | % |
|                                           |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest margin (4) (5)              |       |                                                    |   |   |   | 3.25 | % |   |   |   |   | 3.34 | % |
|                                           |       |                                                    |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest margin, TE (6)                   |       |                                                    |   |   |   | 3.30 | % |   |   |   |   | 3.40 | % |

 

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

(2)          Includes federal fundssold.

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

(4)          Percentages for thethree months ended December 31, 2009 and December 31, 2008 have beenannualized.

(5)          Net interest incomedivided by average interest-earning assets.

(6)          Net interest marginexpressed on a fully taxable equivalent basis (“Net Interest Margin, TE”) is anon-GAAP financial measure.  Thetax-equivalent adjustment to net interest income recognizes the income taxsavings when comparing taxable and tax-exempt assets and adjusting for federaland state exemption of interest income and certain other permanent income taxdifferences.  We believe that it is a standardpractice in the banking industry to present net interest margin expressed on afully taxable equivalent basis, and accordingly believe the presentation ofthis non-GAAP financial measure may be useful for peer comparisonpurposes.  As a non-GAAP financialmeasure, Net Interest Margin, TE should be considered supplemental to and not asubstitute for or superior to, financial measures calculated in accordance withGAAP.  As other companies may usedifferent calculations for Net Interest Margin, TE, this presentation may notbe comparable to similarly titled measures reported by other companies.

 

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| ** **                                     | ** ** | **Six Months Ended December 31,** |
|------------------------------------------------|------------|-------------------------------------------------------|
| ** **                                     | ** ** | **2009**                                              | ** ** | **2008** | ** ** |
| ** **                                     | ** ** | **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)      |       | $                                                     | 850,238 |   | $ | 24,695 |   | 5.76 | % | $ | 812,657 |   | $ | 25,664 |   | 6.26 | % |
| Investment  securities (2) (3)            |       | 223,378                                               |   | 4,119 |   | 3.66 | % | 234,450 |   | 5,575 |   | 4.72 | % |
| FHLB  stock                                    |       | 12,199                                                |   | 166 |   | 2.70 | % | 12,079 |   | 158 |   | 2.59 | % |
|                                           |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-earning assets                 |       | 1,085,815                                             |   | $ | 28,980 |   | 5.29 | % | 1,059,186 |   | $ | 31,397 |   | 5.88 | % |
| Noninterest-earning  assets                    |       | 76,074                                                |   |   |   |   |   | 66,864 |   |   |   |   |   |
| Total  assets                                  |       | $                                                     | 1,161,889 |   |   |   |   |   | $ | 1,126,050 |   |   |   |   |   |
|                                           |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:                 |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                      |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Checking  and money market                     |       | $                                                     | 222,467 |   | $ | 615 |   | 0.55 | % | $ | 241,027 |   | $ | 1,417 |   | 1.17 | % |
| Savings                                        |       | 67,796                                                |   | 125 |   | 0.37 | % | 67,284 |   | 388 |   | 1.14 | % |
| Certificates  of deposit                       |       | 440,276                                               |   | 6,116 |   | 2.76 | % | 376,546 |   | 6,904 |   | 3.64 | % |
| Total  interest-bearing deposits               |       | 730,539                                               |   | 6,856 |   | 1.86 | % | 684,857 |   | 8,709 |   | 2.52 | % |
| FHLB  advances and other borrowings            |       | 199,959                                               |   | 3,596 |   | 3.57 | % | 233,055 |   | 4,056 |   | 3.45 | % |
| Subordinated  debentures payable to trusts     |       | 27,837                                                |   | 919 |   | 6.55 | % | 27,837 |   | 936 |   | 6.67 | % |
|                                           |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities            |       | 958,335                                               |   | 11,371 |   | 2.35 | % | 945,749 |   | 13,701 |   | 2.87 | % |
| Noninterest-bearing  deposits                  |       | 95,846                                                |   |   |   |   |   | 75,263 |   |   |   |   |   |
| Other  liabilities                             |       | 31,381                                                |   |   |   |   |   | 32,706 |   |   |   |   |   |
| Total  liabilities                             |       | 1,085,562                                             |   |   |   |   |   | 1,053,718 |   |   |   |   |   |
| Equity                                         |       | 76,327                                                |   |   |   |   |   | 72,332 |   |   |   |   |   |
| Total  liabilities and equity                  |       | $                                                     | 1,161,889 |   |   |   |   |   | $ | 1,126,050 |   |   |   |   |   |
|                                           |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest income; interest rate spread (4) |       |                                                  |   | $ | 17,609 |   | 2.94 | % |   |   | $ | 17,696 |   | 3.01 | % |
|                                           |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest margin (4) (5)              |       |                                                  |   |   |   | 3.22 | % |   |   |   |   | 3.31 | % |
|                                           |       |                                                  |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest margin, TE (6)                   |       |                                                  |   |   |   | 3.27 | % |   |   |   |   | 3.37 | % |

 

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

(2)          Includes federal fundssold.

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

(4)          Percentages for the sixmonths ended December 31, 2009 and December 31, 2008 have beenannualized.

(5)          Net interest incomedivided by average interest-earning assets.

(6)          Netinterest margin expressed on a fully taxable equivalent basis (“Net InterestMargin, TE”) is a non-GAAP financial measure. The tax-equivalent adjustment to net interest income recognizes theincome tax savings when comparing taxable and tax-exempt assets and adjustingfor federal and state exemption of interest income and certain other permanentincome tax differences.  We believe thatit is a standard practice in the banking industry to present net interestmargin expressed on a fully taxable equivalent basis, and accordingly believe thepresentation of this non-GAAP financial measure may be useful for peercomparison purposes.  As a non-GAAPfinancial measure, Net Interest Margin, TE should be considered supplemental toand not a substitute for or superior to, financial measures calculated inaccordance with GAAP.  As other companiesmay use different calculations for Net Interest Margin, TE, this presentationmay not be comparable to similarly titled measures reported by other companies.

 

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

 
| ** **                       | ** ** | **Three Months Ended**     | ** ** | **Six Months Ended** | ** ** |
|----------------------------------|------------|--------------------------------------|------------|--------------------------------|------------|
| ** **                       | ** ** | **December 31,**                | ** ** | **December 31,**          | ** ** | **December 31,** | ** ** | **December 31,** | ** ** |
| ** **                       | ** ** | **2009**                             | ** ** | **2008**                       | ** ** | **2009** | ** ** | **2008** | ** ** |
| ** **                       | ** ** | **(Dollars in Thousands)** | ** ** |
| Net  interest income             |       | $                                    | 8,858      |                           | $          | 9,007 |   | $ | 17,609 |   | $ | 17,696 |   |
| Taxable  equivalent adjustment   |       | 144                                  |       | 167                            |       | 289 |   | 321 |   |
| Adjusted  net interest income    |       | 9,002                                |       | 9,174                          |       | 17,898 |   | 18,017 |   |
| Average  interest-earning assets |       | 1,082,398                            |       | 1,070,570                      |       | 1,085,815 |   | 1,059,186 |   |
| Net  interest margin, TE         |       | 3.30                                 | %          | 3.40                           | %          | 3.27 | % | 3.37 | % |
|                                  |            |                                      |            |                                |            |  |  |  |  |  |  |  |  |

 

**Rate/VolumeAnalysis of Net Interest Income**

 

The following schedulepresents the dollar amount of changes in interest income and interest expensefor major components of interest-earning assets and interest-bearingliabilities.  It distinguishes betweenthe increases and decreases due to fluctuating outstanding balances due to thelevels and volatility of interest rates. For each category of interest-earning assets and interest-bearingliabilities, information is provided on changes attributable to (i) changesin volume (i.e., changes in volume multiplied by old rate) and (ii) changesin rate (i.e., changes in rate multiplied by old volume).

 

For purposes of thistable, changes attributable to both rate and volume, which cannot besegregated, have been allocated proportionately to the change due to volume andthe change due to rate.

 
| ** **                                | ** ** | **Three Months Ended December 31,** | ** ** | **Six Months Ended December 31,** | ** ** |
|-------------------------------------------|------------|---------------------------------------------------------|------------|-------------------------------------------------------|------------|
| ** **                                | ** ** | **2009 vs 2008**                              | ** ** | **2009 vs 2008**                            | ** ** |
| ** **                                | ** ** | **Increase**                                            | ** ** | **Increase**                                          | ** ** | ** ** | ** ** | **Increase** | ** ** | **Increase** | ** ** | ** ** | ** ** |
| ** **                                | ** ** | **(Decrease)**                                          | ** ** | **(Decrease)**                                        | ** ** | **Total** | ** ** | **(Decrease)** | ** ** | **(Decrease)** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **Due to**                                         | ** ** | **Due to**                                       | ** ** | **Increase** | ** ** | **Due to** | ** ** | **Due to** | ** ** | **Increase** | ** ** |
| ** **                                | ** ** | **Volume**                                              | ** ** | **Rate**                                              | ** ** | **(Decrease)** | ** ** | **Volume** | ** ** | **Rate** | ** ** | **(Decrease)** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)**                    | ** ** |
| Interest-earning  assets:                 |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Loans  and leases receivable (1)          |       | $                                                       | 455        |                                                  | $          | (749 | ) | $ | (294 | ) | $ | 1,182 |   | $ | (2,151 | ) | $ | (969 | ) |
| Investment  securities (2)                |       | (212                                                    | )          | (780                                                  | )          | (992 | ) | (263 | ) | (1,193 | ) | (1,456 | ) |
| FHLB  stock                               |       | —                                                  |       | 67                                                    |       | 67 |   | 2 |   | 6 |   | 8 |   |
|                                      |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Total  interest-earning assets            |       | $                                                       | 243        |                                                  | $          | (1,462 | ) | $ | (1,219 | ) | $ | 921 |   | $ | (3,338 | ) | $ | (2,417 | ) |
|                                      |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:            |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Deposits:                                 |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Checking  and money market                |       | $                                                       | (46        | )                                                     | $          | (222 | ) | $ | (268 | ) | $ | (109 | ) | $ | (693 | ) | $ | (802 | ) |
| Savings                                   |       | 10                                                      |       | (74                                                   | )          | (64 | ) | 3 |   | (266 | ) | (263 | ) |
| Certificates  of deposit                  |       | 526                                                     |       | (994                                                  | )          | (468 | ) | 1,168 |   | (1,956 | ) | (788 | ) |
| Total  interest-bearing deposits          |       | 490                                                     |       | (1,290                                                | )          | (800 | ) | 1,062 |   | (2,915 | ) | (1,853 | ) |
| FHLB  advances and other borrowings       |       | (333                                                    | )          | 83                                                    |       | (250 | ) | (580 | ) | 120 |   | (460 | ) |
| Subordinated debentures payable to trusts |       | —                                                  |       | (20                                                   | )          | (20 | ) | — |   | (17 | ) | (17 | ) |
|                                      |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Total  interest-bearing liabilities       |       | $                                                       | 157        |                                                  | $          | (1,227 | ) | $ | (1,070 | ) | $ | 482 |   | $ | (2,812 | ) | $ | (2,330 | ) |
|                                      |       |                                                    |       |                                                  |       |   |   |   |   |   |   |   |   |
| Net  interest income increase             |       | $                                                       | 86         |                                                  | $          | (235 | ) | $ | (149 | ) | $ | 439 |   | $ | (526 | ) | $ | (87 | ) |

 

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

(2)          Includes federal fundssold.

 

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**Applicationof Critical Accounting Policies**

 

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

 

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

 

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

 

*MortgageServicing Rights (“MSR”)*. The Company records a servicing asset for contractually separatedservicing from the underlying mortgage loans.  The asset is initially recorded at fair value and represents anintangible asset backed by an income stream from the serviced assets.  The asset is amortized in proportion to andover the period of estimated net servicing income.

 

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

 

The Company has includedMSRs as a critical accounting policy because the use of estimates fordetermining fair value using present value concepts may produce results whichmay significantly differ from other fair value analysis perhaps even to thepoint of recording impairment.  The riskto earnings is when the underlying mortgages pay off significantly faster thanthe assumptions used in the previously recorded amortization.  Estimating future cash flows on theunderlying mortgages is a difficult analysis and requires judgment based on thebest information available.  The Companylooks at alternative assumptions and projections when preparing a reasonableand supportable analysis.  Based on theCompany’s quarterly analysis of MSRs, there was no impairment to the MSRs at December 31,2009.

 

*SecurityImpairment*.  Management continually monitors theinvestment security portfolio for impairment on a security by securitybasis.  During the third quarter offiscal 2009, the Company early adopted FASB Staff Position (“FSP”) No. FAS115-2(ASC Subtopic 320-10), *The Recognitionand Presentation of Other-Than-Temporary Impairments*, which changedthe recognition and presentation of other-than-temporary impairment forsecurities.  Management has a process inplace to identify securities that could potentially have a credit impairmentthat is other than temporary.  Thisprocess involves the length of time and extent to which the fair value has beenless than the amortized cost basis, review of available information regardingthe financial position of the issuer, monitoring the rating of the security,cash flow projections, and the Company’s intent to sell a security or whetherit is more likely than not the Company will be required to sell the securitybefore the 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

 

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required to sell a security before the recovery of its amortized cost,less any current period credit loss, the Company recognizes another-than-temporary impairment in earnings for the difference betweenamortized cost and fair value.  If we donot expect to recover the amortized cost basis, we do not plan to sell thesecurity and if it is not more likely than not that the Company would berequired to sell a security before the recovery of it amortized cost, less anycurrent period credit loss, the recognition of the other-than-temporaryimpairment is bifurcated.  For thosesecurities, the Company separates the total impairment into a credit losscomponent recognized in earnings, and the amount of the loss related to otherfactors is recognized in other comprehensive income net of taxes.

 

The amount of the credit loss component of a debt security impairment isestimated as the difference between amortized cost and the present value of theexpected cash flows of the security.  Thepresent value is determined using the best estimate cash flows discounted atthe effective interest rate implicit to the security at the date of purchase orthe current yield to accrete an asset-backed or floating rate security.  Cash flow estimates for trust preferredsecurities are derived from scenario-based outcomes of forecasted defaultrates, loss severity, prepayment speeds and structural support.

 

*Level 3 Fair Value Measurement.* GAAP requires the Company to measure the fair value of financialinstruments under a standard which describes three levels of inputs that may beused to measure fair value. Level 3 measurement includes significantunobservable inputs that reflect the 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. 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 healthcare plan for its employees up tocertain limits.  To mitigate a portion ofthese risks, the Company has a stop-loss insurance policy through a commercialinsurance carrier for coverage in excess of $65,000 per individual occurrence withno maximum aggregate limitation.  Theestimate of self-insurance liability is based upon known claims and an estimateof incurred, but not reported (“IBNR”) claims. IBNR claims are estimated using historical claims lag informationreceived by a third party claims administrator. Due to the uncertainty of health claims, the approach includes a processwhich may differ significantly from other methodologies and still produce anestimate in accordance with GAAP. Although management believes it uses the best information available todetermine the accrual, unforeseen health claims could result in adjustments tothe accrual.  These adjustments couldsignificantly affect net earnings if circumstances differ substantially fromthe assumptions used in estimating the accrual.

 

**AssetQuality and Potential Problem Loans and Leases**

 

Nonperformingassets (nonaccrual loans and leases, accruing loans and leases delinquent morethan 90 days and foreclosed assets) increased to $16.2 million at December 31,2009 from $12.6 million at June 30, 2009, an increase of $3.6 million, or29.0%.  Nonaccruing loans and leasesincreased $285,000 from June 30, 2009 to December 31, 2009, to atotal of $9.7 million.  Accruing loansand leases delinquent more than 90 days increased $3.3 million to $5.4 millionat December 31, 2009 from $2.1 million at June 30, 2009.  Foreclosed assets increased $48,000 to $1.1million at December 31, 2009, from $1.1 million at June 30,2009.  In addition, the ratio ofnonperforming assets to total assets, which is one indicator of credit risk exposure,was 1.38% at December 31, 2009, which is an increase from 1.07% asreported at June 30, 2009.

 

Nonaccruing loansand leases increased $285,000 to $9.7 million at December 31, 2009compared to $9.4 million at June 30, 2009. One agricultural relationship comprised most of the total nonaccruingloans and leases.  It consists of oneloan totaling $32,000 secured by one- to four-family real estate, one loantotaling $740,000 secured by agricultural real estate, and four loans totaling$6.5 million secured by agricultural business assets.  The remaining loans and leases included innonaccruing loans and leases at December 31, 2009 were 12 loans totaling$701,000 secured by one- to four-family real estate, one loan totaling $153,000secured by commercial real estate, seven loans totaling $352,000 secured bycommercial business assets, 26 leases totaling $742,000 secured by equipment,and 29 loans totaling $489,000 secured by consumer assets.

 

Accruing loans andleases delinquent more than 90 days increased $3.3 million, to $5.4 million at December 31,2009 compared to $2.1 million at June 30, 2009.  Included in accruing loans and leasesdelinquent more than 90 days at December 31, 2009 were two loans totaling$337,000 secured by commercial real estate, 11 loans totaling $2.4 million

 

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secured by agriculturalreal estate, nine loans totaling $1.8 million secured by commercial businessassets, 13  loans totaling $550,000secured by agricultural business assets, four leases totaling $232,000 securedby equipment and nine loans totaling $51,000 unsecured overdraft and reserve accounts.

 

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

 

As of December 31,2009, foreclosed assets increased by $48,000, or 4.42%, to $1.1 million ascompared to $1.1 million at June 30, 2009. The balance at December 31, 2009 consisted of $458,000 of one- tofour-family collateral owned, $99,000 of leased equipment owned, $482,000 ofagricultural collateral owned, and $94,000 of consumer collateral owned.

 

At December 31,2009, the Company had designated $25.6 million of its assets as special mentionand $24.0 million of its assets as classified that management has determinedneed to be closely monitored because of possible credit problems of theborrowers or the cash flows of the secured properties.  The Company also classified $9.7 million oftrust preferred securities in accordance with OTS debt security classificationguidelines.  At December 31, 2009the Company had $11.6 million in multi-family, commercial business, commercialreal estate and agricultural participation loans purchased, of which $1.5million were 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 full collectabilitymay not be reasonably assured, considers the estimated fair market value of theunderlying collateral, present value of expected principal and interestpayments, economic conditions, historical loss experience and other factorsthat warrant recognition in providing for an adequate loan and lease lossallowance.

 

Although the Company’s management believes the December 31, 2009recorded allowance for loan and lease losses was adequate to provide forprobable losses on the related loans and leases, there can be no assurance theallowance existing at December 31, 2009 will be adequate in the future.

 

In accordance with the Company’s internal classification of assetspolicy, 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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The following table sets forth the amounts and categories of theCompany’s nonperforming assets for the periods indicated.

 
| ** **                                                                      | ** ** | **Nonperforming  Assets**   | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                      | ** ** | **December 31,  2009** | ** ** | **June 30,  2009** | ** ** |
| ** **                                                                      | ** ** | **(Dollars  in Thousands)** | ** ** |
| Nonaccruing  loans and leases:                                                  |       |                        |       |   |   |
| One-  to four-family                                                            |       | $                           | 733        |   | $ | 977 |   |
| Commercial  real estate                                                         |       | 153                         |       | 177 |   |
| Commercial  business                                                            |       | 352                         |       | 405 |   |
| Equipment  finance leases                                                       |       | 741                         |       | 272 |   |
| Consumer                                                                        |       | 489                         |       | 355 |   |
| Agricultural                                                                    |       | 7,198                       |       | 7,195 |   |
| Total                                                                           |       | 9,666                       |       | 9,381 |   |
|                                                                            |       |                        |       |   |   |
| Accruing  loans and leases delinquent more than 90 days:                        |       |                        |       |   |   |
| Commercial  real estate                                                         |       | 337                         |       | 277 |   |
| Commercial  business                                                            |       | 1,829                       |       | 349 |   |
| Equipment  finance leases                                                       |       | 232                         |       | 264 |   |
| Consumer                                                                        |       | 51                          |       | 8 |   |
| Agricultural                                                                    |       | 2,958                       |       | 1,194 |   |
| Total                                                                           |       | 5,407                       |       | 2,092 |   |
|                                                                            |       |                        |       |   |   |
| Foreclosed  assets:                                                             |       |                        |       |   |   |
| One-  to four-family                                                            |       | 458                         |       | 406 |   |
| Equipment  finance leases                                                       |       | 99                          |       | 105 |   |
| Consumer                                                                        |       | 94                          |       | 92 |   |
| Agricultural                                                                    |       | 482                         |       | 482 |   |
| Total  (1)                                                                      |       | 1,133                       |       | 1,085 |   |
|                                                                            |       |                        |       |   |   |
| Total  nonperforming assets (2)                                                 |       | $                           | 16,206     |   | $ | 12,558 |   |
|                                                                            |       |                        |       |   |   |
| Ratio  of nonperforming assets to total assets (3)                              |       | 1.38                        | %          | 1.07 | % |
|                                                                            |       |                        |       |   |   |
| Ratio  of nonperforming loans and leases to total loans and leases (4) (5) |       | 1.79                        | %          | 1.32 | % |

 

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

(2)  Nonperforming assets include nonaccruingloans and leases, accruing loans and leases delinquent more than 90 days andforeclosed assets.

(3)  Percentage is calculated based upon totalassets of the Company and its direct and indirect subsidiaries on aconsolidated basis.

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

(5)  Total loans andleases include loans held for sale.

 

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

 
| ** **                                                                                                 | ** ** | **Six Months  Ended December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|-----------------------------------------|------------|
| ** **                                                                                                 | ** ** | **2009**                                | ** ** | **2008** | ** ** |
| ** **                                                                                                 | ** ** | **(Dollars  in Thousands)**             | ** ** |
|                                                                                                       |       |                                    |       |   |   |
| Balance  at beginning of period                                                                            |       | $                                       | 8,470      |   | $ | 5,933 |   |
| Charge-offs:                                                                                               |       |                                    |       |   |   |
| One-  to four-family                                                                                       |       | (90                                     | )          | (1 | ) |
| Commercial  real estate                                                                                    |       | (9                                      | )          | (9 | ) |
| Commercial  business                                                                                       |       | (215                                    | )          | (23 | ) |
| Equipment  finance leases                                                                                  |       | (113                                    | )          | (34 | ) |
| Consumer                                                                                                   |       | (376                                    | )          | (446 | ) |
| Construction                                                                                               |       | (11                                     | )          | — |   |
| Total  charge-offs                                                                                         |       | (814                                    | )          | (513 | ) |
|                                                                                                       |       |                                    |       |   |   |
| Recoveries:                                                                                                |       |                                    |       |   |   |
| One-  to four-family                                                                                       |       | 4                                       |       | 2 |   |
| Commercial  business                                                                                       |       | —                                  |       | 2,217 |   |
| Equipment  finance leases                                                                                  |       | 5                                       |       | — |   |
| Consumer                                                                                                   |       | 80                                      |       | 102 |   |
| Agricultural                                                                                               |       | —                                  |       | 5 |   |
| Total  recoveries                                                                                          |       | 89                                      |       | 2,326 |   |
|                                                                                                       |       |                                    |       |   |   |
| Net  recoveries (charge-offs)                                                                              |       | (725                                    | )          | 1,813 |   |
|                                                                                                       |       |                                    |       |   |   |
| Additions  charged to operations                                                                           |       | 767                                     |       | 387 |   |
|                                                                                                       |       |                                    |       |   |   |
| Balance  at end of period                                                                                  |       | $                                       | 8,512      |   | $ | 8,133 |   |
|                                                                                                       |       |                                    |       |   |   |
| Ratio  of allowance for loan and lease losses to total loans and leases at end of  period (1)         |       | 1.01                                    | %          | 0.99 | % |
|                                                                                                       |       |                                    |       |   |   |
| Ratio  of allowance for loan and lease losses to nonperforming loans and leases at  end of period (2) |       | 56.47                                   | %          | 198.17 | % |
|                                                                                                       |       |                                    |       |   |   |
| Ratio  of net charge offs to average loans and leases for the year-to-date period (3)                 |       | 0.17                                    | %          | (0.44 | )% |

 

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(1)  Total loans and leases include loans heldfor sale.

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

(3)  Percentages for the six months endedDecember 31, 2009 and December 31, 2008 have been annualized.

 

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The distribution of the Company’s allowance for loan and lease lossesand impaired loss summary as required by FASB Statement No. 114 (ASC Topic310), “Accounting by Creditors for Impairment of a Loan” are summarized in thefollowing tables.  The combination ofFASB Statement No. 5 (ASC Topic 450) “Accounting for Contingencies” andFASB Statement No. 114 calculations comprise the Company’s allowance forloan 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**             | ** ** | **December 31,  2009**          | ** ** | **June 30,  2009** | ** ** |
| ** **                | ** ** | **(Dollars in Thousands)** | ** ** |
|                      |       |                                 |       |                    |       |              |       |               |       |
| One-  to four-family      |       | $                                    | 343        |                    | $          | —            |       | $                  | 416        |   | $ | — |   |
| Commercial  real estate   |       | 1,399                                |       | 15                      |       | 1,110             |       | —             |       |
| Multi-family  real estate |       | 188                                  |       | —                  |       | 192               |       | —             |       |
| Commercial  business      |       | 1,671                                |       | 77                      |       | 2,136             |       | 153                |       |
| Equipment  finance leases |       | 389                                  |       | —                  |       | 409               |       | —             |       |
| Consumer                  |       | 1,268                                |       | —                  |       | 1,280             |       | —             |       |
| Agricultural              |       | 3,112                                |       | 50                      |       | 2,724             |       | 50                 |       |
| Total                     |       | $                                    | 8,370      |                    | $          | 142               |       | $                  | 8,267      |   | $ | 203 |   |

 

**FAS 114 Impaired Loan Summary**

** **
| ** **              | ** ** | ** **                  | ** ** | ** **              | ** ** | **Impaired**  | ** ** | ** **    | ** ** | ** **  | ** ** | **Impaired**  | ** ** |
|-------------------------|------------|-----------------------------|------------|-------------------------|------------|---------------|------------|---------------|------------|-------------|------------|---------------|------------|
| ** **              | ** ** | **Number**                  | ** ** | ** **              | ** ** | **Loan**      | ** ** | **Number**    | ** ** | ** **  | ** ** | **Loan**      | ** ** |
| ** **              | ** ** | **of Loan**                 | ** ** | **Loan**                | ** ** | **Valuation** | ** ** | **of Loan**   | ** ** | **Loan**    | ** ** | **Valuation** | ** ** |
| ** **              | ** ** | **Customers**               | ** ** | **Balance**             | ** ** | **Allowance** | ** ** | **Customers** | ** ** | **Balance** | ** ** | **Allowance** | ** ** |
| **Loan Type**           | ** ** | **December 31,  2009** | ** ** | **June 30,  2009** | ** ** |
| ** **              | ** ** | **(Dollars  in Thousands)** | ** ** |
|                    |       |                        |       |                    |       |          |       |          |       |        |       |          |       |
| Commercial  real estate |       | 2                           |       | $                       | 168        |          | 15         |          | 3          |        | 177        |          | $          | — |   |
| Commercial  business    |       | 4                           |       | 199                     |       | 77            |       | 4             |       | 453         |       | 153           |       |
| Agricultural            |       | 3                           |       | 7,569                   |       | 50            |       | 2             |       | 7,997       |       | 50            |       |
| Total                   |       | 9                           |       | $                       | 7,936      |          | $          | 142           |       | 9           |       | $             | 8,627      |   | $ | 203 |   |
|                         |            |                             |            |                         |            |               |            |               |            |             |            |               |            |  |  |  |  |

 

The allowance forloan and lease losses was $8.5 million at December 31, 2009, as comparedto $8.1 million at December 31, 2008. The ratio of the allowance for loan and lease losses to total loans andleases was 1.01% at December 31, 2009, compared to 0.99% at December 31,2008.  The Company’s management hasconsidered nonperforming loans and leases and potential problem loans andleases in establishing the allowance for loan and lease losses.  The Company continues to monitor itsallowance for probable loan and lease losses and make future additions orreductions in light of the level of loans and leases in its portfolio and aseconomic conditions dictate.  Thecurrent level of the allowance for loan and lease losses is a result ofmanagement’s assessment of the risks within the portfolio based on theinformation revealed in credit reporting processes. The Company utilizes arisk-rating system on all commercial business, agricultural, construction andmulti-family and commercial real estate loans, including purchased loans andleases.  A periodic credit review isperformed on all types of loans and leases to establish the necessary reservebased on the estimated risk within the portfolio. This assessment of risk takesinto account the composition of the loan and lease portfolio, historical lossexperience for each loan and lease category, previous loan and leaseexperience, concentrations of credit, current economic conditions and otherfactors that in management’s judgment deserve recognition.

 

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

 

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

 

**Comparison of the Three MonthsEnded December 31, 2009, and December 31, 2008**

 

*General*.  The Company’snet income available to common shareholders was $2.0 million, or $0.38 in basicand $0.38 in diluted earnings per common share for the three months ended December 31,2009, a $115,000 increase in earnings available to common shareholders comparedto $1.8 million, or $0.46 in basic and $0.46 in diluted earnings per commonshare for the same period in the prior fiscal year.  For the three months ended December 31,2009, the return on average equity and the return on average assets was 9.54%and 0.67%, respectively, compared to 9.34% and 0.64%, respectively, for thesame period in the prior fiscal year.

 

*Interest, Dividend and Loan Fee Income.* Interest, dividend and loan fee income was $14.3 million for the threemonths ended December 31, 2009 as compared to $15.6 million for the sameperiod in the prior fiscal year, a decrease of $1.2 million or 7.8%.  This decrease was primarily the result ofdeclining average yields on the interest-earning assets.  Loans and leases receivable had an averageyield of 5.77% for the three months ended December 31, 2009, which is 35basis points less than the average yield of 6.12% for the three months ended December 31,2008.  Investment securities also had adecline in average yield of 140 basis points when comparing the second quarterof fiscal 2010 against the same period of the prior year.  The average interest-earning assets for loansand leases receivables increased $29.5 million, or 3.6% to $849.0 million forthe three months ended December 31, 2009, when compared to the threemonths ended December 31, 2008. Investment securities decreased in average balance $17.5 million, or7.3% to $221.4 million for the second quarter of fiscal 2010, when compared tothe average balance of the same quarter of the prior fiscal year.  The revenue decrease attributable to theoverall declining yield for loans and leases was $749,000, which was partiallyoffset by the revenue increase due to an increase in average volume of$455,000.  The net revenue decreaseattributable to the overall declining yield and average volume for investmentsecurities was $780,000 and $212,000, respectively.

 

*InterestExpense.*  Interest expense was $5.5 million for thethree months ended December 31, 2009 as compared to $6.6 million for thesame period in the prior fiscal year, a decrease of $1.1 million or 16.3%.  A $1.3 million decrease in interest expensewas the result of a decrease in the average rate paid of 1.80% oninterest-bearing deposits for the three months ended December 31, 2009compared to an average rate paid of 2.38% for the three months ended December 31,2008.  Average balance ofinterest-bearing deposits increased by $45.0 million, or 6.5%, while averagebalance of FHLB advances and other borrowings decreased by $40.1 million, or17.2% for the three month period ended December 31, 2009, as compared tothe three month period ended December 31, 2008.  The decrease in interest expense due to adecrease in the overall rate of interest-bearing liabilities was $1.2 million,while the increase in average volume of interest-bearing liabilities partiallyoffset this decrease by $157,000 for the quarter.  The average rate paid on totalinterest-bearing liabilities was 2.28% for the three months ended December 31,2009 as compared to 2.74% for the same period in fiscal 2009.

 

*Net Interest Income.* The Company’s net interestincome for the three months ended December 31, 2009 decreased $149,000 or1.7%, to $8.9 million compared to $9.0 million for the same period in the priorfiscal year.  The net increase in volumesof interest-earning assets in excess of increased volumes of interest-bearingliabilities resulted in a net increase in net interest income of $86,000.  This was offset by the net effect of thereduction of rates earned for interest-earning assets in excess of thereduction of rates paid for interest-bearing liabilities and resulted in a netdecrease in net interest income of $235,000. The Company’s Net Interest Margin, TE was 3.30% for the three monthsended December 31, 2009 as compared to 3.40% for the three months ended December 31,2008.  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 and Leases.*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

 

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becomeuncollectible, based on an evaluation of the collectability of loans and leasesand prior loan and lease loss experience. The evaluation takes into consideration such factors as changes in thenature and volume of the loan and lease portfolio, overall portfolio quality,review of specific problem loans and leases, and current economic conditionsthat may affect the borrower’s ability to pay. The allowance for loan and lease losses is established through aprovision for losses on loans and leases charged to expense.

 

Duringthe three months ended December 31, 2009, the Company recorded a provisionfor losses on loans and leases of $424,000 compared to $0 for the three monthsended December 31, 2008.  See “AssetQuality and Potentially Problem Loans and Leases” for further discussion.

 

*Noninterest Income.*  Noninterest income was $3.3 million for thequarter ended December 31, 2009 compared to $2.9 million for the quarterended December 31, 2008, an increase of $324,000 or 11.1%.  This increase is due primarily to net gain onsale of loans and net gain on sale of securities of $252,000 and $558,000,respectively.  Net impairment creditlosses on trust preferred securities recognized in earnings of $340,000 for thequarter ended December 31, 2009, partially offset the increase innoninterest income.

 

Feeson deposits decreased $115,000 to $1.4 million for the three months ended December 31,2009 as compared to the three months ended December 31, 2008, due largelyto a decrease in NSF and overdraft fees of $187,000 and partially offset by anincrease in point-of-sale interchange and ATM fee income of $95,000.  Loan servicing income decreased by $46,000 to$488,000 for the second quarter fiscal 2010 due primarily to increasedservicing rights amortization expense recorded during the period based upon theCompany’s quarterly analysis of portfolio prepayment experience.  Net gain on sale of loans increased $252,000to $537,000 for the three months ended December 31, 2009 from $285,000 forthe three months ended December 31, 2008, primarily due to an increase inmortgage loan activity and the related loan sales.  Net gain on the sale of securities totaled$603,000, an increase of $558,000 for the three months ended December 31,2009 as compared to the same period in fiscal 2009.  The Company took advantage of elevatedfixed-rate mortgage-backed securities prices which were influenced by U.S.government participation in the mortgage-backed securities market, while alsorestructuring the portfolio for a higher rate environment.  Net impairment credit losses on trustpreferred securities recognized in earnings were $340,000 for the quarter endedDecember 31, 2009.  The Companydetermined that a total of $1.7 million of losses due to other-than temporaryimpairments were incurred, of which $1.3 million were recognized in othercomprehensive income.  The resulting netcredit loss of $340,000 was recognized as a reduction of other noninterestincome.

 

*Noninterest Expense.*  Noninterest expense was $8.8 million for thethree months ended December 31, 2009 as compared to $9.2 million for thethree months ended December 31, 2008, a decrease of $397,000, or4.3%.  For the second quarter of fiscal2010, compensation and employee benefits decreased $689,000, or 11.8 percent,compared to the second quarter of fiscal 2009. Net healthcare costs, also a component of compensation and employeebenefits, decreased $634,000, to $311,000, the result of a reduction inspecific high dollar claims from the prior year.  FDIC insurance premiums increased $213,000,to $335,000 for the second quarter of fiscal 2010, versus fiscal 2009.

 

Compensation and employee benefits were $5.1million for the three months ended December 31, 2009, a decrease of$689,000 or 11.8% when compared to the three months ended December 31,2008.  Performance-based incentivesdecreased $206,000, or 13.7%, due to a reduction in performance outcomesthrough the second quarter of fiscal 2010. Net healthcarecosts, which are included in the total for compensation and employee benefits,decreased $634,000, or 67.1% to $311,000 due to a reduction in specific highdollar claims and general overall utilization. Management currently believes the self-insured structure is a reasonablealternative to traditional healthcare plans over the long term.  The level of healthcare costs which theCompany incurs may vary from year to year.

 

Occupancyand equipment increased $88,000, or 8.7% to $1.1 million for the three monthsended December 31, 2009 as compared to the same period ended December 31,2008.  During fiscal 2009, a new facilityin Watertown, South Dakota was built and placed in service in July 2009.  The depreciation and expenses related to thisnew facility as well as other increases related to information technologyequipment accounted for an increase of $83,000 when compared to the secondquarter of fiscal 2009.

 

FDIC insurance premiums increased $213,000, to$335,000 for the second quarter of fiscal 2010, compared to the same period offiscal 2009.  FDIC rate increasestotaling 8 basis points were added during the last twelve months, which increasedthe total expense for the current quarter versus the comparable quarter of theprior fiscal year.  The Bank also appliedthe remaining unused credits in the second quarter of fiscal 2009, whichreduced the amount when compared to the current quarter where no credits wereapplied.

 

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Professionalfees decreased $110,000, or 24.6% to $337,000 for the second quarter of fiscal2010, compared to the second quarter of fiscal 2009.  This decrease is primarily attributed to theincrease in services needed in fiscal 2009 for the Company’s involvement in theissuance of preferred stock under the CPP program in November of 2008.

 

*Incometax expense.*  The Company’s income tax expensefor the three months ended December 31, 2009 increased to $947,000compared to $914,000 for the same period in the prior fiscal year.  The effective tax rate was 32.6% and 33.1%for the three months ended December 31, 2009 and 2008, respectively.

 

**Comparisonof the Six Months Ended December 31, 2009, and December 31, 2008**

* *

*General*.  The Company’snet income available to common shareholders was $2.8 million, or $0.61 in basicand $0.61 in diluted earnings per common share for the six months ended December 31,2009, a $1.0 million decrease in earnings available to common shareholderscompared to $3.8 million, or $0.96 in basic and $0.95 in diluted earnings percommon share for the same period in the prior fiscal year.  For the six months ended December 31,2009, the return on average equity and the return on average assets was 7.32%and 0.48%, respectively, compared to 10.48% and 0.67%, respectively, for thesame period in the prior fiscal year.  Asdiscussed in more detail below, the decrease to earnings was due primarily tothe recording of net impairment credit losses of $2.2 million for the first sixmonths of fiscal 2010.

 

*Interest, Dividend and Loan Fee Income.* Interest, dividend and loan fee income was $29.0 million for the six monthsended December 31, 2009 as compared to $31.4 million for the same periodin the prior fiscal year, a decrease of $2.4 million or 7.7%.  This decrease was primarily the result ofdeclining average yields on the interest-earning assets.  Loans and leases receivable had an averageyield of 5.76% for the six months ended December 31, 2009, which is 50basis points less than the average yield of 6.26% for the six months ended December 31,2008.  Investment securities also had adecline in average yield of 106 basis points when comparing the second quarterof fiscal 2010 against the same period of the prior year.  The average interest-earning assets for loansand leases receivables increased $37.6 million, or 4.6% to $850.2 million forthe six months ended December 31, 2009, when compared to the six monthsended December 31, 2008.  Investmentsecurities decreased in average balance $11.1 million, or 4.7% to $223.4million for the first six months of fiscal 2010, when compared to the averagebalance of the comparable period of fiscal 2009.  The net revenue decrease from loans andleases receivable attributable to the overall declining yield and partiallyoffset by the increasing average volume was $2.2 million and $1.2 million,respectively, which netted to a decrease of $1.0 million.  The net revenue decrease from investmentsecurities attributable to the overall declining yield and average volume was$1.2 million and $263,000, respectively.

 

*InterestExpense.*  Interest expense was $11.4 million for thesix months ended December 31, 2009 as compared to $13.7 million for thesame period in the prior fiscal year, a decrease of $2.3 million or 17.0%.  A $2.9 million decrease in interest expensewas the result of a decrease in the average rate paid of 1.86% on interest-bearingdeposits for the six months ended December 31, 2009 compared to an averagerate paid of 2.52% for the six months ended December 31, 2008.  The average balance of interest-bearingdeposits increased by $45.7 million, or 6.7%, resulting in an increase of $1.1million in interest expense.  The averagebalance of FHLB advances and other borrowings decreased by $33.1 million, or14.2% for the six month period ended December 31, 2009, as compared to thesix month period ended December 31, 2008. This net decrease in volume accounted for a reduction in interestexpense of $580,000.  The average ratepaid on total interest-bearing liabilities was 2.35% for the six months ended December 31,2009 as compared to 2.87% for the same period in fiscal 2009.

 

*Net Interest Income.* The Company’s net interestincome for the six months ended December 31, 2009 decreased $87,000 or0.5%, to $17.6 million compared to $17.7 million for the same period in theprior fiscal year.  The net effect of thereduction of rates earned for interest-earning assets in excess of thereduction of rates paid for interest-bearing liabilities resulted in a netdecrease in net interest income of $526,000. This was offset by the net increase in volumes of interest-earningassets in excess of the increased volumes of interest-bearing liabilities andresulted in a net increase in net interest income of $439,000.  The Company’s Net Interest Margin, TE was3.27% for the six months ended December 31, 2009 as compared to 3.37% forthe six months ended December 31, 2008. Net Interest Margin, TE is a non-GAAP financial measure.  See “Analysis of Net Interest Income” for acalculation of this non-GAAP financial measure and for further discussion as tothe reasons we believe this non-GAAP financial measure is useful.

 

*Provision for Losses on Loans and Leases.*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

 

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becomeuncollectible, based on an evaluation of the collectability of loans and leasesand prior loan and lease loss experience.  The evaluation takes into consideration suchfactors as changes in the nature and volume of the loan and lease portfolio,overall portfolio quality, review of specific problem loans and leases, andcurrent economic conditions that may affect the borrower’s ability to pay.  The allowance for loan and lease losses isestablished through a provision for losses on loans and leases charged toexpense.

 

Duringthe six months ended December 31, 2009, the Company recorded a provisionfor losses on loans and leases of $767,000 compared to $387,000 for the sixmonths ended December 31, 2008.  See“Asset Quality and Potentially Problem Loans and Leases” for furtherdiscussion.

 

*Noninterest Income.*  Noninterest income was $5.0 million for thesix months ended December 31, 2009 compared to $6.0 million for the sixmonths ended December 31, 2008, a decrease of $1.0 million or 17.2%.  This decrease is due primarily to netimpairment credit losses on trust preferred securities recognized in earningsof $2.2 million for the six months ended December 31, 2009.   Net gain on sale of loans and net gain onsale of securities increased $497,000 and $1.1 million, respectively, topartially offset the decrease caused by the net impairment losses.

 

Netimpairment credit losses on trust preferred securities recognized in earningswere $2.2 million for the six months ended December 31, 2009.  The Company determined that a total of $2.1million of losses due to market value changes were incurred, but $117,000 ofmarket value increases not related to credit impairment were recognized inother comprehensive income.  Theresulting net $2.2 million of credit loss was recognized as a reduction ofother noninterest income.  Fees ondeposits decreased $220,000 to $2.8 million for the six months ended December 31,2009 as compared to the six months ended December 31, 2008, due largely toa decrease in NSF and overdraft fees of $412,000 and partially offset by anincrease in point-of-sale interchange and ATM fee income of $234,000.  Loan servicing income decreased by $112,000to $979,000 for the six months of fiscal 2010 due primarily to increasedservicing rights amortization expense recorded during the period based upon theCompany’s quarterly analysis of portfolio prepayment experience.  Net gain on sale of loans increased $497,000to $1.0 million for the six months ended December 31, 2009 as compared to$536,000 for the six months ended December 31, 2008, primarily due to anincrease in mortgage loan activity and the related loan sales.  Net gain on the sale of securities totaled$1.1 million, an increase of $1.0 million for the six months ended December 31,2009 as compared to the same period in fiscal 2009.  The Company took advantage of elevatedfixed-rate mortgage-backed securities prices which were influenced by U.S.government participation in the mortgage-backed securities market, while alsorestructuring the portfolio for a higher rate environment.

 

*Noninterest Expense.*  Noninterest expense was $17.7 million for thesix months ended December 31, 2009 as compared to $17.6 million for thesix months ended December 31, 2008, an increase of $149,000, or 0.8%.  The increase was attributed to increases inFDIC insurance premiums of $397,000 and occupancy and equipment of$195,000.  The increases in noninterestexpense were neutralized primarily by a decrease in performance-based incentivepay and healthcare costs of $933,000 and $244,000, respectively.

 

Compensation and employee benefits were$10.3 million for the six months ended December 31, 2009, a decrease of$647,000 or 5.9% when compared to the six months ended December 31,2008.  Net healthcare costs, which are included in the totalfor compensation and employee benefits, decreased $244,000, or 18.7% to $1.1million due to a reduction of specific high dollar claims and general overallutilization for the six month period of fiscal 2010 compared to the same periodof the prior fiscal year.  Managementcurrently believes the self-insured structure is a reasonable alternative totraditional healthcare plans over the long term.  The level of healthcare costs which theCompany incurs may vary from year to year. Performance-based incentive pay decreased $933,000, or 62.2% due to areduction in performance outcomes through the second quarter of fiscal 2010.

 

Occupancyand equipment increased $195,000, or 9.8% to $2.2 million for the six monthsended December 31, 2009 as compared to the same period ended December 31,2008.  During fiscal 2009, a new facilityin Watertown, South Dakota was built and placed in service in July 2009.  The depreciation and expenses related to thisnew facility as well as other increases in information technology equipmentaccounted for an increase of $159,000 when compared to the six months of fiscal2009.

 

FDIC insurance premiums increased $397,000, to$660,000 for the six months of fiscal 2010, compared to the same period offiscal 2009.  In the first quarter offiscal 2009, the Bank applied previously unused credits in the payment of itsinsurance premiums.  The credits werefully utilized in the second quarter of fiscal 2009.  FDIC rate increases totaling 8 basis pointswere also added during the last twelve months, which increased the totalexpense for the six months of fiscal 2010 versus fiscal 2009.

 

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*Incometax expense.*  The Company’s income tax expensefor the six months ended December 31, 2009 decreased to $1.2 millioncompared to $1.9 million for the same period in the prior fiscal year.  The effective tax rate was 30.7% and 33.1%for the six months ended December 31, 2009 and 2008, respectively.  Permanent tax differences were relativelyconstant when comparing the six month periods of fiscal 2010 and 2009, but thetaxable income was lower in the six months of fiscal 2010, which created alesser tax effective rate than anticipated.

 

**Liquidityand Capital Resources**

 

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

 

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

 

Although in-marketdeposits is one of the Bank’s primary source of funds, the Bank’s policy hasbeen to utilize borrowings where the funds can be invested in either loans orsecurities at a positive rate of return or to use the funds for short-termliquidity purposes. As of December 31, 2009, the Bank had the followingsources of additional borrowings:

 

·                  $15.0 million in an uncommitted, unsecured line of federal fundswith First Tennessee Bank, NA;

 

·                  $10.0 million in an uncommitted, unsecured line of federal fundswith Zions Bank;

 

·                  $53.1 million of available credit from the Federal Reserve Bank(after deducting outstanding borrowings with the Federal Reserve Bank); and

 

·                  $102.9 million of available credit from FHLB of Des Moines (afterdeducting outstanding borrowings with FHLB of Des Moines).

 

The Bank may alsoseek other sources of contingent liquidity including additional federal fundspurchased lines with correspondent banks and lines of credit with the FederalReserve Bank. There were no funds drawn on the uncommitted, unsecured lines offederal funds with First Tennessee Bank, NA and Zions Bank at December 31,2009. The Bank, as a member of the FHLB of Des Moines, is required to acquireand hold shares of capital stock in the FHLB of Des Moines equal to 0.12% ofthe total assets of the Bank at December 31 annually. The Bank is alsorequired to own activity-based stock, which is based on 4.45% of the Bank’soutstanding advances. These percentages are subject to change at the discretionof the FHLB Board of Directors.

 

In addition to theabove sources of additional borrowings, the Bank has implemented arrangementsto acquire out-of-market certificates of deposit as an additional source offunding. As of December 31, 2009, the Bank had $18.6 million inout-of-market certificates of deposit.

 

On September 30,2009, the Company entered into a Loan Agreement (the “Loan Agreement”) withUnited Bankers’ Bank (the “Lender”) in order to refinance its outstandingborrowings of $5.966 million under its line of credit with First TennesseeBank, NA (the “FTB Line of Credit”) that matured. Under the Loan Agreement, theLender committed to lend to the Company an aggregate principal amount not toexceed $6.0 million. On November 25, 2009, the Company repaid itsoutstanding borrowings of $6.044 million (principal plus accrued interest)under the Loan Agreement.  The loan is evidencedby a promissory note, accrues interest at the United Bankers’ Bank Rate with a

 

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minimum interest rate of4.75% per annum, and the principal balance (plus any accrued and unpaidinterest) is due and payable in full on October 1, 2010.

 

In connection withentering into the Loan Agreement, the Company also entered into a CommercialPledge Agreement with the Lender, granting the Lender a first security interestin all of the stock of the Bank.  TheLoan Agreement contains customary events of default and affirmative covenantswith which the Company and Bank were in compliance at December 31, 2009.

 

The Bank anticipatesthat it will have sufficient funds available to meet current loan commitments.At December 31, 2009, the Bank had outstanding commitments to originateand purchase mortgage and commercial loans of $43.2 million and to sellmortgage loans of $30.5 million. Commitments by the Bank to originateloans are not necessarily executed by the customer. The Bank monitors the ratioof commitments to funding for use in liquidity management. At December 31,2009, the Bank had no commitments to purchase or to sell investment securitiesavailable for sale.

 

The Company uses itscapital resources to pay dividends to its stockholders, to support organicgrowth, to make acquisitions, to service its debt obligations and to providefunding for investment into the Bank of Tier 1 (core) capital.

 

Savings institutionsinsured by the Federal Deposit Insurance Corporation are required by theFinancial Institutions Reform, Recovery and Enforcement Act of 1989 to meetthree regulatory capital requirements. If a requirement is not met, regulatory authorities may take legal oradministrative actions, including restrictions on growth or operations or, inextreme cases, seizure.  Institutions notin compliance may apply for an exemption from the requirements and submit arecapitalization plan.  At December 31,2009, the Bank met all current regulatory capital requirements.

 

The minimum OTSTier 1 (core) capital requirement for well-capitalized institutions is 5.00% oftotal adjusted assets for thrifts.  TheBank had Tier 1 (core) capital of 8.86% at December 31, 2009.  The minimum OTS total risk-based capitalrequirement for well-capitalized institutions is 10.00% of risk-weightedassets.  The Bank had total risk-basedcapital of 11.84% at December 31, 2009.

 

**Impact of Inflation and ChangingPrices**

 

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

 

**RecentAccounting Pronouncements**

** **

**FASBEstablishes Accounting Standards Codification**TM

 

In June 2009,the FASB issued Accounting Standards Update No. 2009-01, “GenerallyAccepted Accounting Principles” (ASC Topic 105) which establishes the FASBAccounting Standards Codification (“the Codification” or “ASC”) as the officialsingle source of authoritative U.S. generally accepted accounting principles (“GAAP”).All existing accounting standards are superseded. All other accounting guidancenot included in the Codification will be considered non-authoritative. TheCodification also includes all relevant Securities and Exchange Commission (“SEC”)guidance organized using the same topical structure in separate sections withinthe Codification.

 

Following theCodification, the Board will not issue new standards in the form of Statements,FASB Staff Positions or Emerging Issues Task Force Abstracts. Instead, it willissue Accounting Standards Updates (“ASU”) which will serve to update theCodification, provide background information about the guidance and provide thebasis for conclusions on the changes to the Codification.

 

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The Codificationis not intended to change GAAP, but it will change the way GAAP is organizedand presented. The Codification was effective for our first quarter fiscal 2010financial statements and the principal impact on our financial statements islimited to disclosures as all future references to authoritative accountingliterature will be referenced in accordance with the Codification. In order toease the transition to the Codification, we are providing the Codificationcross-reference alongside the references to the standards issued and adoptedprior to the adoption of the Codification.

 

**FairValue Accounting**

 

In 2006, the FASBissued SFAS No. 157, “Fair Value Measurements” (ASC Topic 820) whichdefines fair value, establishes a market-based framework or hierarchy formeasuring fair value and expands disclosures about fair value measurements.This guidance is applicable whenever another accounting pronouncement requiresor permits assets and liabilities to be measured at fair value. It does notexpand or require any new fair value measures; however the application of thisstatement may change current practice. The Company adopted this guidance forfinancial assets and liabilities effective July 1, 2008 and for nonfinancial assets and liabilities effective July 1, 2009.  The adoption did not have a material effecton the Company’s consolidated financial condition, results of operations orcash flow.

 

FSP FAS 107-1 andAPB 28-1, “Interim Disclosures about Fair Value of Financial Instruments” (ASCTopic 320-10-65). This update requires fair value disclosures for financialinstruments that are not currently reflected on the balance sheet at fair valueon a quarterly basis.  The Companyadopted this update effective June 30, 2009 and the adoption did not havea material effect on the Company’s consolidated financial condition or resultsof operations or cash flow.

 

In August 2009,FASB issued ASU No. 2009-05 which amends Fair Value Measurements andDisclosures — Overall (ASC Topic 820-10) to provide guidance on the fair valuemeasurement of liabilities. This update requires clarification for circumstancesin which a quoted price in an active market for the identical liability is notavailable, a reporting entity is required to measure fair value using one ormore of the following techniques: 1) a valuation technique that uses either thequoted price of the identical liability when traded as an asset or quotedprices for similar liabilities or similar liabilities when traded as an asset;or 2) another valuation technique that is consistent with the principles in ASCTopic 820 such as the income and market approach to valuation. The amendmentsin this update also clarify that when estimating the fair value of a liability,a reporting entity is not required to include a separate input or adjustment toother inputs relating to the existence of a restriction that prevents thetransfer of the liability. This update further clarifies that if the fair valueof a liability is determined by reference to a quoted price in an active marketfor an identical liability, that price would be considered a Level 1 measurementin the fair value hierarchy. Similarly, if the identical liability has a quotedprice when traded as an asset in an active market, it is also a Level 1 fairvalue measurement if no adjustments to the quoted price of the asset arerequired. The Company adopted this update effective in the second quarter offiscal 2010 and the adoption did not have a material effect on the Company’sconsolidated financial condition or results of operations or cash flow.

 

**BusinessCombinations and Noncontrolling Interests**

 

In 2007, the FASBissued SFAS No. 141 (revised 2007), “Business Combinations” (ASC Topic805). This guidance requires the acquiring entity in a business combination torecognize the full fair value of assets acquired and liabilities assumed in thetransaction (whether a full or partial acquisition); establishes theacquisition date fair value as the measurement objective for all assetsacquired and liabilities assumed; requires expensing of most transaction andrestructuring costs; and requires the acquirer to disclose the informationnecessary to evaluate and understand the nature and financial effect of thebusiness combination. The Company adopted this guidance effective July 1,2009 and the adoption did not have a material effect on the Company’sconsolidated financial condition, results of operations or cash flow.

 

In April 2009,the FASB issued Staff Position No. FSP FAS 141(R)-1, “Accounting forAssets Acquired and Liabilities Assumed in a Business Combination That Arisefrom Contingencies” (ASC Topic 805-20). This updated guidance amended theaccounting treatment for assets and liabilities arising from contingencies in abusiness combination and requires that pre-acquisition contingencies berecognized at fair value, if fair value can be reasonably determined. If fairvalue cannot be reasonably determined, measurement should be based on the bestestimate in accordance with SFAS No. 5, “Accounting for Contingencies”(ASC Topic 405). This updated guidance was effective July 1, 2009 and theadoption did not have a material effect on the Company’s consolidated financialcondition, results of operations or cash flow.

 

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**OtherAccounting Changes**

 

On June 12,2009, the FASB issued SFAS No. 166, “Accounting for Transfers of FinancialAssets”, (ASC Topic 860). This updated guidance removed the concept of aqualifying special-purpose entity and removed the exception from applyingconsolidation guidance to these entities. This update also clarified therequirements for isolation and limitations on portions of financial assets thatare eligible for sale accounting. ASC Topic 860 is reportable for interim andannual reports and effective for the Company on reporting periods beginning July 1, 2010.  Management is currently evaluating the impactof adopting this update on the Company’s consolidated financial condition,results of operations and cash flow.

 

On June 122009, the FASB issued SFAS No. 167, “Amendments to FASB Interpretation No. 46(R),Consolidation of Variable Interest Entities” (ASC Topic 810-10). This updatedguidance requires an analysis to determine whether a variable interest givesthe entity a controlling financial interest in a variable interest entity. Italso requires an ongoing reassessment and eliminates the quantitative approachpreviously required for determining whether an entity is the primarybeneficiary.  This update is effectivefor the Company for interim and annual reporting periods beginning January 1,2010 and management is currently evaluating the impact of adopting this updateon the Company’s consolidated financial condition, results of operations andcash flow.

 

In 2008, the FASBissued Staff Position No. FAS 132(R)-1, “Employers’ Disclosures aboutPostretirement Benefit Plan Assets” (ASC Topic 715-20-65). This guidance willexpand disclosure by requiring the following new disclosures: 1) how investmentallocation decisions are made by management; 2) major categories of planassets; and 3) significant concentrations of risk. Additionally, ASC 715-20-65will require an employer to disclose information about the valuation of planassets similar to that required in ASC Topic 820 Fair Value Measurements andDisclosures. ASC 715-20-65 is effective for the Company for annual reportingperiods beginning July 1, 2010 and the Company does not expect theadoption to have a material effect on the Company’s consolidated financialcondition, results of operations or cash flow.

 

During the secondquarter of fiscal 2010, the FASB issued several ASU’s — ASU No. 2009-16through ASU No. 2010-07. Except for ASU No. 2010-06, which modifiesdisclosure requirements related to ASC Topic 820 discussed above, and 2009-16,which modifies guidance related to ASC Topic 860 discussed above, the ASU’sentail technical corrections to existing guidance or affect guidance related tospecialized industries or entities and therefore have minimal, if any, impacton the Company.

 

**Item 3.   *Quantitative and Qualitative Disclosures About Market Risk***

 

**InterestRate Risk Management**

 

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

 

In an attempt to manage its exposure to change ininterest rates, management monitors the Company’s interest rate risk.  The Company’s Asset/Liability Committee meetsperiodically to review the Company’s interest rate risk position andprofitability, and to recommend adjustments for consideration by executivemanagement.  Management also reviews theBank’s securities portfolio, formulates investment strategies, and oversees thetiming and implementation of transactions to assure attainment of the Board’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.

 

The Company adjusts itsasset/liability position to mitigate the Company’s interest rate risk.  At times, depending on the level of generalinterest rates, the relationship between long- and short-term interest rates,market conditions and competitive factors, management may increase the Company’sinterest rate risk position in order to increase its net interest margin.  The Company’s results of operations and netportfolio values remain vulnerable to increases in interest rates and tofluctuations in the difference between long- and short-term interest rates.

 

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Asset forth below, the volatility of a rate change, the change in asset orliability mix of the Company or other factors may produce a decrease in netinterest margin in an upward moving rate environment even as the net portfoliovalue (“NPV”) estimate indicates an increase in net value.  The inverse situation may also occur.  One approach used by the Company to quantify interest rate risk is an NPVanalysis.  This analysis calculates thedifference between the present value of the liabilities and the present valueof expected cash flows from assets and off-balance sheet contracts.  The following tables set forth, at December 31,2009 and 2008, respectively, an analysis of the Company’s interest rate risk asmeasured by the estimated changes in NPV resulting from instantaneous andsustained parallel shifts in the yield curve. Management does not believe that the Company has experienced any materialchanges in its market risk position from that disclosed in the Company’s AnnualReport on Form 10-K for fiscal 2009 or that the Company’s primary marketrisk exposures and how those exposures were managed during the six months endedDecember 31, 2009 changed significantly when compared to June 30,2009.

 

Even if interest rates change in the designatedamounts, there can be no assurance that the Company’s assets and liabilitieswould perform as set forth below.  Inaddition, a change in U.S. Treasury rates in the designated amounts accompaniedby a change in the shape of the Treasury yield curve would cause significantlydifferent changes to the NPV than indicated below.

 
| **December 31, 2009** | ** ** |
|----------------------------|------------|
| ** **                 | ** ** | ** ** | ** ** | **Estimated Increase** | ** ** |
| **Change in**              | ** ** | **Estimated** | ** ** | **(Decrease) in NPV** | ** ** |
| **Interest Rates**         | ** ** | **NPV Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Basis Points**      | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
| ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| +300                       |       | $ | 117,289 |   | $ | 11,193 |   | 11 | % |
| +200                       |       | 115,155 |   | 9,059 |   | 9 |   |
| +100                       |       | 111,573 |   | 5,477 |   | 5 |   |
| —                     |       | 106,096 |   | — |   | — |   |
| -100                       |       | 96,576 |   | (9,520 | ) | (9 | ) |
|                            |            |  |  |  |  |  |  |  |  |

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

 

In managing market riskand the asset/liability mix, the Bank has placed an emphasis on developing aportfolio in which, to the extent practicable, assets and liabilities repricewithin similar periods.  The goal of thispolicy is to provide a relatively consistent level of net interest income invarying interest rate cycles and to minimize the potential for significantfluctuations from period to period.

 

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

 

As of December 31,2009, an evaluation was performed by the Company’s management, including theCompany’s Chairman, President and Chief Executive Officer and the Company’sExecutive Vice President, Chief Financial Officer and Treasurer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Securities Exchange Act of 1934, as amended) to provide reasonableassurance that information required to be disclosed in the reports the Companyfiles and submits under the Securities Exchange Act of 1934, as amended, isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. Based uponthat evaluation, the

 

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Company’s Chairman,President and Chief Executive Officer and the Company’s Executive VicePresident, Chief Financial Officer and Treasurer concluded that the Company’sdisclosure controls and procedures were effective as of December 31,2009.  There were no changes in theCompany’s internal control over financial reporting that occurred during thesecond quarter ended December 31, 2009, that have materially affected, orare reasonably likely to materially affect, the Company’s internal control overfinancial reporting.

 

**PART II - OTHER INFORMATION**

 

**Item 1.  *Legal Proceedings***

 

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

 

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

 

The discussion of our businessand operations should be read together with the risk factors contained in Part I,Item 1A of our Annual Report on Form 10-K for the fiscal year ended June 30,2009, and our Quarterly Report on Form 10-Q for the fiscal quarter ended September 30,2009, 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 December 31, 2009.

*** ***

***We recorded other-than-temporary impairment (“OTTI”) charges in ourtrust preferred securities (“TRUPS”) portfolio in the third and fourth quartersof 2009 and in the first and second quarters of 2010, and we could recordadditional losses in the future.***

 

We determine the fair value of our investment securities based on GAAPand three levels of informational inputs that may be used to measure fairvalue. The price at which a security may be sold in a market transaction couldbe significantly lower than the quoted market price for the security,particularly if the quoted market price is based on infrequent trading history,the market for the security is illiquid, or a significant amount of securitiesare being sold.

 

We held six TRUPS pools with an adjusted cost basis of $11.9 millionand a fair value of $6.1 million at June 30, 2009. Rating downgradeson these investments occurred during fiscal year 2009, placing each in a belowinvestment grade rating. Due to an inactive market for these securities,management utilized a “Level 3” fair value input according to Statement ofFinancial Accounting Standard No. 157, utilizing discounted cash flowmethodologies to determine fair value and OTTI. During fiscal 2009, wedetermined that three debt securities exhibited OTTI. The aggregate OTTI lossesrecorded for the three securities for the fiscal year 2009 were $3.9 million,of which $3.5 million was recognized on the balance sheet in othercomprehensive income, with the balance being $397,000 of credit loss recognizedthrough earnings. The remaining difference between amortized cost basis andfair value of $2.3 million recognized in other comprehensive income isprimarily attributable to the three TRUPS for which OTTI was not recognized forthe fiscal year 2009.

 

At December 31, 2009, we carried the six TRUPS pools at an adjustedcost basis of $9.7 million and a fair value of $4.2 million. We determinedthat four debt securities exhibited OTTI of $2.1 million, of which$2.2 million of credit loss was recognized through earnings for the sixmonths ended December 31, 2009, with the balance of $117,000 of net changerecognized on the balance sheet in other comprehensive income since June 30,2009.

 

The valuation of our TRUPS will continue to be influenced by externalmarket and other factors, including implementation of Securities and ExchangeCommission and Financial Accounting Standards Board guidance on fair valueaccounting, the financial condition of specific issuers within our pooledsecurities (including any credit deterioration thereof), deferral and default ratesof specific issuer financial institutions, rating agency actions, and theprices at which

 

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observablemarket transactions occur. If we are required to record additional OTTI chargeson our TRUPS portfolio, we could experience potentially significant earningslosses as well as an adverse impact to our capital position.

 

***Liquidity risks could affect operations and jeopardize our financialcondition.***

 

Liquidity is essential to our business. An inability to raise fundsthrough deposits, borrowings, the sale of loans and other sources toaccommodate our existing and future lending and investment activities couldhave a substantial negative effect on our liquidity and severely constrain ourfinancial flexibility. Our primary source of funding is retail depositsgathered through our network of branch offices. Our alternative funding sourcesinclude, without limitation, brokered certificates of deposit, federal fundspurchased, Federal Reserve Discount Window borrowings, Federal Home Loan Bankof Des Moines (FHLB) advances and short- and long-term debt.

 

Until recently, the Bank has historically obtained funds principallythrough local deposits and it has a base of lower cost transaction deposits.Generally, we believe local deposits are a cheaper and more stable source offunds than other borrowings, because interest rates paid for local deposits aretypically lower than interest rates charged for borrowings from otherinstitutional lenders and reflect a mix of transaction and time deposits,whereas brokered deposits typically are higher cost time deposits.

 

Our costs of funds, profitability and liquidity will be adverselyaffected to the extent we have to rely upon higher cost borrowings from otherinstitutional lenders or brokers to fund loan demand or liquidity needs, andchanges in our deposit mix and growth could adversely affect our profitabilityand the ability to expand our loan portfolio.

 

On September 30, 2009, we entered into a Loan Agreement (the “LoanAgreement”) with United Bankers’ Bank (the “Lender”) in order to refinance ouroutstanding borrowings of $5.966 million under our line of credit withFirst Tennessee Bank, NA (the “FTB Line of Credit”). Our borrowings under theFTB Line of Credit were scheduled to mature on September 30, 2009. Underthe Loan Agreement, the Lender committed to lend to us an aggregate principalamount not to exceed $6 million. As of November 25, 2009, we repaidthe outstanding borrowings of $6.044 million (principal plus accrued interest)under the Loan Agreement. The loan is evidenced by a promissory note, accruesinterest at the United Bankers’ Bank Rate with a minimum interest rate of 4.75%per annum, and the principal balance (plus any accrued and unpaid interest) isdue and payable in full on October 1, 2010. To the extent we have toborrow funds from other institutional lenders to repay this indebtedness, ourcosts of funds, profitability and liquidity may be adversely affected.

 

We may look to sell production assets, such as mortgage loans, into thesecondary market as a means to manage the size of our balance sheet and managethe use of our capital. The demand for these products in the capital markets isnot driven by us and may not benefit us at the time we look to sell the loans.

 

Our liquidity, on a parent only basis, may be adversely affected bycertain restrictions on receiving dividends from the Bank without priorregulatory approval.

 

***Higher FDIC deposit insurance premiums and assessments could adverselyaffect our financial condition.***

 

FDIC insurance premiums have increased substantially in 2009 and weexpect to pay significantly higher FDIC premiums in the future. Marketdevelopments have significantly depleted the DIF and reduced the ratio ofreserves to insured deposits. The FDIC adopted a revised risk-based depositinsurance assessment schedule on February 27, 2009, which raised depositinsurance premiums. On May 22, 2009, the FDIC also implemented a fivebasis point special assessment of each insured depository institution’s assetsminus Tier 1 capital as of June 30, 2009, but no more than 10 basis pointstimes the institution’s assessment base for the second quarter of 2009, thatwas collected on September 30, 2009. In imposing the special assessment,the FDIC noted that additional special assessments may be imposed by the FDICfor future periods.

 

On November 12, 2009, the FDIC adopted a final rule thatrequires insured depository institutions to prepay their quarterly risk-basedassessments for the fourth quarter of 2009, and for all of 2010, 2011, and2012, on December 30, 2009, along with each institution’s risk-baseddeposit insurance assessment for the third quarter of 2009. For purposes ofcalculating the prepaid amount, the base assessment rate in effect at September 30,2009 would be used for 2010. That rate would be increased by an annualized 3basis points for 2011 and 2012 assessments. The prepayment calculation wouldalso assume a 5 percent annual growth rate, increased quarterly, through theend of 2012. Under the final rule, an institution will account for theprepayment by recording the entire amount of its prepaid assessment as aprepaid expense (an asset) as of 

 

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December 30,2009. Subsequently, each institution will record an expense (charge toearnings) for its regular quarterly assessment and an offsetting credit to theprepaid assessment until the asset is exhausted. Once the asset is exhausted,the institution would resume paying and accounting for quarterly depositinsurance assessments as they do currently. Under the final rule, the FDICstated that its requirement for prepaid assessments does not preclude the FDICfrom changing assessment rates or from further revising the risk-basedassessment system during 2009, 2010, 2011, 2012, or thereafter, pursuant tonotice-and-comment rulemaking procedures provided by statute, and therefore,continued actions by the FDIC could significantly increase the Bank’snoninterest expense in fiscal 2010 and for the foreseeable future.  On December 30, 2009, the Company paid$4.9 million for its quarterly risk-based assessments for the fourth quarter of2009 and for all of 2010, 2011, and 2012, of which $4.3 million was recorded asa prepaid asset and will be proportionally expensed over the future periods.

 

The Bank participates in the FDIC’s Temporary Liquidity GuaranteeProgram, or TLGP, for noninterest-bearing transaction deposit accounts. Banksthat participate in the TLGP’s noninterest-bearing transaction accountguarantee program pay the FDIC an annual assessment of 10 basis points on theamounts in such accounts above the amounts covered by FDIC deposit insurance.The general termination date for the transaction account guarantee portion ofthe TLGP is December 31, 2009. To promote an orderly phase-out of theprogram, on August 26, 2009, the FDIC adopted a final rule extendingthe program for six months, through June 30, 2010. For institutions thatchoose to remain in the program, the fee will be raised and adjusted to reflectthe institution’s risk profile. The Bank has decided to remain in the program,and therefore will be subject to additional fees for the extended portion ofthe program. Continued actions by the FDIC could significantly increase theBank’s noninterest expense in fiscal 2010 and for the foreseeable future.

 

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

 

None

 

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

 

None

 

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

 

At the Company’sAnnual Meeting of Stockholders held on November 18, 2009, (the “AnnualMeeting”), the stockholders elected the two individuals nominated to serve as Class Idirectors until 2012 or until their respective successors are elected andqualified, as set forth in Proposal 1 in the Company’s Proxy Statement relatingto the Annual Meeting.  The twoindividuals elected, and the number of votes cast for, or withheld, withrespected to each of them, is as follows:

 
| David J. Horazdovsky |   | For: 3,046,458 |   | Vote Withheld: 666,444 |
|----------------------|--------|----------------|--------|------------------------|
| William G. Pederson  |   | For: 3,039,619 |   | Vote Withheld: 666,444 |

 

The followingdirectors continue to serve on the Board of Directors following the AnnualMeeting:  Charles T. Day, Curtis L. Hage,Christine E. Hamilton, Robert L. Hanson and Thomas L. Van Wyhe.

 

The Company alsovoted and approved the ratification of the re-appointment of Eide Bailly, LLPas the Company’s auditors for fiscal year ending June 30, 2010.  The number of votes for ratification and therelated percentage of votes actually cast are as follows:

 
| For:     | 3,582,711 |   | Actually Cast: | 96.49 | % |
|----------|-----------|--------|----------------|-------|---|
| Against: | 99,316    |   | Actually Cast: | 2.68  | % |
| Abstain: | 30,875    |   | Actually Cast: | 0.83  | % |

 

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**Item 5.  *Other Information***

 

None

 

**Item 6.  *Exhibits***

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

 

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**SIGNATURES**

 

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

 

 
|   |                  |   |   | HF  Financial Corp.                                  |
|--------|-----------------------|--------|--------|------------------------------------------------------|
|   |                  |   |   | (Registrant)                                         |
|   |                  |   |   |                                                 |
|   |                  |   |   |                                                 |
| Date:  | February 5, 2010 |   | By:    | /s/ Curtis L. Hage                                   |
|   |                  |   |   | Curtis L. Hage, Chairman,  President                 |
|   |                  |   |   | and Chief Executive  Officer                         |
|   |                  |   |   | (Principal Executive  Officer)                       |
|   |                  |   |   |                                                 |
| Date:  | February 5, 2010 |   | By:    | /s/ Darrel L. Posegate                               |
|   |                  |   |   |  Darrel L. Posegate, Executive Vice  President, |
|   |                  |   |   | Chief Financial Officer  and Treasurer               |
|   |                  |   |   | (Principal Financial  and Accounting Officer)        |

 

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**Exhibit Index**

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

 

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