** **

**UNITED STATES**SECURITIES AND EXCHANGE COMMISSION

**Washington,D.C.  20549**

 

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**FORM 10-K**

 

**ý****        ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the FiscalYear Ended June 30, 2004**

 

**Commission FileNumber 0-19972**

 

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**HF FINANCIALCORP.**

(Exact name of registrant as specified in itscharter)

 
| **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)        |
|                                                              |
| Securities Registered  Pursuant to Section 12(b) of the Act: |
| **None**                                                          |
|                                                              |
| Securities Registered  Pursuant to Section 12(g) of the Act: |
|                                                              |
| **Common Stock, par value $.01 per share**                        |
| (Title of class)                                                  |

 

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

YES  ý  NO  o

 

Indicate by check mark if disclosure of delinquent filers pursuant toItem 405 of Regulation S-K is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. ý

 

Indicate by check mark whether the registrant is an accelerated filer(as defined in Rule 12b-2 of the Act.)

YES  o  NO  ý

 

As of September 22, 2004, there were 3,550,660 issued andoutstanding shares of the Registrant’s Common Stock.

 

The aggregate market value of the common equity held by non-affiliatesof the registrant, computed by reference to the average of the bid and askedprice of such common equity as of December 31, 2003, the last business dayof the registrant’s most recently completed second fiscal quarter, was $58.3million.  (The exclusion from suchamount of the market value of the common equity owned by any person shall notbe deemed an admission by the registrant that such person is an affiliate ofthe registrant.)

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Part III of Form 10-K - Portions of the Proxy Statement for 2004 AnnualMeeting of Stockholders.

 

 

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**Annual Report on Form 10-K**

**Table ofContents**

 
|     | **PART I**                                                                                                         |   |
|----------|--------------------------------------------------------------------------------------------------------------------|--------|
|     |                                                                                                               |   |
| Item 1.  | Business                                                                                                           |   |
|     |                                                                                                               |   |
| Item 2.  | Properties                                                                                                         |   |
|     |                                                                                                               |   |
| Item 3.  | Legal Proceedings                                                                                                  |   |
|     |                                                                                                               |   |
| Item 4.  | Submission of Matters to a Vote of Security  Holders                                                               |   |
|     |                                                                                                               |   |
|     | **PART II**                                                                                                        |   |
|     |                                                                                                               |   |
| Item 5.  | Market for Registrant’s Common Equity, Related  Stockholder Matters and Issuer Purchases of Equity Securities |   |
|     |                                                                                                               |   |
| Item 6.  | Selected Financial  Data                                                                                           |   |
|     |                                                                                                               |   |
| Item 7.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                        |   |
|     |                                                                                                               |   |
| Item 7A. | Quantitative and  Qualitative Disclosures About Market Risk                                                        |   |
|     |                                                                                                               |   |
| Item 8.  | Financial  Statements and Supplementary Data                                                                       |   |
|     |                                                                                                               |   |
| Item 9.  | Changes in and Disagreements with  Accountants on Accounting and Financial Disclosures                             |   |
|     |                                                                                                               |   |
| Item 9A. | Controls and Procedures                                                                                            |   |
|     |                                                                                                               |   |
|     | **PART III**                                                                                                       |   |
|     |                                                                                                               |   |
| Item 10. | Directors and  Executive Officers of the Registrant                                                                |   |
|     |                                                                                                               |   |
| Item 11. | Executive  Compensation                                                                                            |   |
|     |                                                                                                               |   |
| Item 12. | Security Ownership of Certain Beneficial  Owners and Management                                                    |   |
|     |                                                                                                               |   |
| Item 13. | Certain Relationships and Related  Transactions                                                                    |   |
|     |                                                                                                               |   |
| Item 14. | Principal Accounting Fees and Services                                                                             |   |
|     |                                                                                                               |   |
|     | **PART IV**                                                                                                        |   |
|     |                                                                                                               |   |
| Item 15. | Exhibits, Financial Statement Schedules,  and Reports on Form 8-K                                                  |   |

 

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**Forward-LookingStatements**

 

This Form 10-K and otherreports issued by HF Financial Corp. (the “Company”), including reports filedwith the Securities and Exchange Commission, contain “forward-lookingstatements” that deal with future results, expectations, plans and performance.  In addition, the Company’s management maymake forward-looking statements orally to the media, securities analysts,investors or others.  Theseforward-looking statements might include one or more of the following:

 

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

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

•                  Forecastsof future economic performance.

•                  Descriptionsof assumptions underlying or relating to such matters.

 

Forward-looking statements can be identifiedby the fact that they do not relate strictly to historical or currentfacts.  They often include words such as“optimism,” “look-forward,” “bright,” “believe,” “expect,” “anticipate,”“intend,” “plan,” “estimate” or words of similar meaning, or future orconditional verbs such as “will,” “would,” “should,” “could” or “may.”

 

Forward-lookingstatements about the Company’s expected financial results and other plans aresubject to certain risks, uncertainties and assumptions.  These include, but are not limited to thefollowing: possible legislative changes and adverse economic, business andcompetitive developments (such as shrinking interest margins); depositoutflows; reduced demand for financial services and loan products; changes inaccounting policies or guidelines, or in monetary and fiscal policies of the federalgovernment; changes in credit and other risks posed by the Company’s loanportfolios; unexpected claims against the Company’s self-insured health plan;the ability or inability of the Company to successfully enter into a definitiveagreement for and close anticipated transactions; technological,computer-related or operational difficulties; adverse changes in securitiesmarkets; results of litigation; or other significant uncertainties.

 

Forward-looking statements speak only as of the datethey are made.  The Company does notundertake to update forward-looking statements to reflect circumstances orevents that occur after the date the forward-looking statements are made.

 

**PART I**

 

**Item 1.****  Business**

 

This section should be readin conjunction with Part II, Item 7, “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations”, Part II, Item 7A, “Quantitativeand Qualitative Disclosures About Market Risk” and Part II, Item 8, “FinancialStatements and Supplementary Data”.

 

## **The Company**

 

HF Financial Corp., a unitary thrift holding company, was formed inNovember 1991, for the purpose of owning all of the outstanding stock ofHome Federal Bank (the “Bank”) issued in the mutual to stock conversion of theBank.  The Company acquired all of theoutstanding stock of the Bank on April 8, 1992.  The Company is incorporated under the laws of the State ofDelaware and generally is authorized to engage in any activity that ispermitted by the Delaware General Corporation Law.  Unless otherwise indicated, all matters discussed in this Form10-K relate to the Company, and its direct and indirect subsidiaries, includingwithout limitation, the Bank.  See“Subsidiary Activities” for further information on the subsidiary operations ofthe Company and the Bank.

 

The executive offices of the Company and its direct and indirectsubsidiaries are located at 225 South Main Avenue, Sioux Falls, South Dakota,57104.  The Company’s telephone numberis (605) 333-7556.

 

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**Websiteand Available Information**

 

The website forthe Company and the Bank is located at www.homefederal.com.  Information on this website does notconstitute part of this Form 10-K.

 

The Company makesavailable, free of charge, its Annual Report on Form 10-K, its quarterlyreports on Form 10-Q, its current reports on Form 8-K and amendments to suchreports filed or furnished pursuant to Section 13(a) or 15(d) of theExchange Act as soon as reasonably practicable after such forms are filed with orfurnished to the SEC.  Copies of thesedocuments are available to stockholders upon request addressed to the Secretaryof the Company at 225 South Main Avenue, Sioux Falls, SD  57104.

 

**The Bank**

 

The Bank was founded in 1929 and is a federally chartered stock savingsbank headquartered in Sioux Falls, South Dakota.  The Bank provides full-service consumer and commercial businessbanking, including an array of financial products, to meet the needs of itsmarket place.  The Bank attractsdeposits from the general public and uses such deposits, together withborrowings and other funds, to originate one- to four-family residential,commercial business, consumer, multi-family, commercial real estate,construction and agricultural loans. The Bank’s consumer loan portfolio includes, among other things,automobile loans, home equity loans, loans secured by deposit accounts andstudent loans.  The Bank also purchasesmortgage-backed securities and invests in U.S. Government and agencyobligations and other permissible investments. The Bank does not hold any non-investment grade bonds (i.e., “junkbonds”).  The Bank receives loanservicing income on loans serviced for others and commission income fromcredit-life insurance on consumer loans. The Bank, through its wholly-owned subsidiaries, offers annuities,mutual funds, life insurance and other financial products and equipment leasingservices.

 

The Bank’s deposits are insured up to applicable limits by the SavingsAssociation Insurance Fund (“SAIF”), administered by the Federal DepositInsurance Corporation (“FDIC”), and the Bank is subject to primary regulationand examination by the Office of Thrift Supervision (“OTS”).

 

## **Segments**

 

Operating segments are defined as components of an enterprise for whichseparate financial information is available that is evaluated regularly by thechief operating decision makers in deciding how to allocate resources and inassessing performance.  The Company’sreportable segments are “banking” (including leasing activities) and “other”.  The “banking” segment is conducted throughthe Bank and Mid America Capital Services, Inc. (“Mid America Leasing”) and the“other” segment is composed of smaller nonreportable segments, the Company andinter-segment eliminations.  Forfinancial information by segment see Note 1 of “Notes to Consolidated FinancialStatements”.

 

**Subsidiary Activities**

 

In addition to theBank, the Company had six other wholly-owned subsidiaries as of June 30,2004:  HF Financial Group, Inc. (“HFGroup”), HF Financial Capital Trust I (“Trust I”), HF Financial Capital TrustII (“Trust II”), HF Financial Capital Trust III (“Trust III”), HF FinancialCapital Trust IV (“Trust IV”) and HomeFirst Mortgage Corp. (the “MortgageCorp.”).

 

In August 2002, the Company formed HF Group, a South Dakotacorporation.  HF Group has the exclusiveright to market “Syben Services” for the Minneapolis-based corporation, SybenHoldings, Inc., to business customers within the seven-state territory that includesSouth Dakota, Minnesota, Iowa, Nebraska, Missouri, Kansas and NorthDakota.  Syben Services are internetbased services that utilize proprietary software developed to facilitateemployee benefits administration, payroll processing and management and governmentalreporting. Syben Services assists employers with the management of theiremployer sponsored compensation and benefit programs.  The Company anticipates that this marketing venture will provideexpanded opportunities to serve the Company’s existing business customers,develop new corporate relationships and increase the Company’s fee income.

 

InNovember 2001, the Company formed Trust I for the sole purpose of issuingtrust preferred securities and investing the proceeds in subordinateddebentures of the Company.  Thesesubordinated debentures constitute the

 

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sole asset of Trust I.

 

In July 2002,the Company formed Trust II for the sole purpose of issuing trust preferredsecurities and investing the proceeds in subordinated debentures of theCompany.  These subordinated debenturesconstitute the sole asset of Trust II.

 

InDecember 2002, the Company formed Trust III for the sole purpose ofissuing trust preferred securities and investing the proceeds in subordinateddebentures of the Company.  Thesesubordinated debentures constitute the sole asset of Trust III.

 

InSeptember 2003, the Company formed Trust IV for the sole purpose ofissuing trust preferred securities and investing the proceeds in subordinateddebentures of the Company.  Thesesubordinated debentures constitute the sole asset of Trust IV.

 

The MortgageCorp., a South Dakota corporation, in the past was engaged in the business oforiginating one- to four-family residential mortgage loans, which were soldinto the secondary market.  The MortgageCorp. had no activity during fiscal year 2004.

 

As a federallychartered thrift institution, the Bank is permitted by OTS regulations toinvest up to 2.00% of its assets in the stock of, or loans to, servicecorporation subsidiaries.  The Bank mayinvest an additional 1.00% of its assets in service corporations where suchadditional funds are used for inner-city or community developmentpurposes.  The Bank currently has lessthan 1.00% of its assets in investments in its subsidiary service corporationsas defined by the OTS.  In addition toinvestments in service corporations, the Bank is permitted to invest anunlimited amount in operating subsidiaries engaged solely in activities inwhich the Bank may engage directly.

 

The Bank has fivewholly-owned subsidiaries, Hometown Insurors, Inc. (“Hometown”), Mid AmericaLeasing, Home Federal Securitization Corp. (“HFSC”), Mid-America ServiceCorporation (“Mid-America”) and PMD, Inc. (“PMD”).

 

Hometown, a South Dakota corporation, provides financial and insuranceproducts to customers of the Bank and members of the general public in theBank’s market area.  Insurance productsoffered by Hometown primarily include annuities and life insurance products.  On August 8, 2003, the Company sold theproperty and casualty insurance book of business of Hometown to a third partyfor total proceeds of $375,000.  Thesales agreement includes a “Covenant Not to Compete” clause prohibitingHometown from directly or indirectly selling property or casualty insurance forthree years in the state of South Dakota. The transaction was effective as of July 31, 2003 and had animmaterial impact on the Company’s financial position and results ofoperations.  Hometown obtains itsfunding via a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to anoperating subsidiary.  As ofJune 30, 2004, the Bank had advanced no funds on an approved line ofcredit of $200,000.  Intercompanyinterest income and interest expense are eliminated in the preparation ofconsolidated financial statements.

 

Mid America Leasing, a South Dakota corporation, specializes inequipment finance leasing.  Mid AmericaLeasing Co. obtains its funding via a line of credit from the Bank.  Banking regulations do not limit the amountof funding provided to an operating subsidiary.  As of June 30, 2004, the Bank had advanced $22.2 million onan approved line of credit of $35.0 million. Intercompany interest income and interest expense are eliminated in thepreparation of consolidated financial statements.

 

HFSC, a Delawarecorporation, exists for the sole purpose of buying motor vehicle installmentloans from the Bank to be securitized. See Note 3 of “Notes to Consolidated Financial Statements” and Item 7,“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” for further discussion on consumer automobile loan securitization.

 

Mid-America, aSouth Dakota corporation, provided residential appraisal services to the Bankand other lenders in the Bank’s market area until the third quarter of fiscal2002.  The cessation of operations ofMid-America had no material effect on the consolidated financialstatements.  Mid-America had no activityduring fiscal year 2004.

 

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PMD, a SouthDakota corporation, in the past was engaged in the business of buying, sellingand managing repossessed real estate properties.  PMD had no activity during fiscal year 2004.

 

## **Market Area**

 

Based on total assets at June 30, 2004, the Bank is the largestthrift institution headquartered in South Dakota.  The Bank has a total of 34 banking centers in its market area and1 internet branch located at www.homefederal.com.  The Bank’s primary market area includes communities located ineastern and central South Dakota, including the cities of Sioux Falls, Brandon,Pierre, Winner, Freeman, Dell Rapids, Hartford, Canton, Parker, Lennox,Mitchell, Aberdeen, Mobridge, Brookings, Redfield, Dakota Dunes, Colman,Crooks, Watertown and Yankton.  The Bankalso has a branch in Marshall, Minnesota, which serves customers located insouthwestern Minnesota, and its banking center located in Dakota Dunes, SouthDakota which serves customers located in northwestern Iowa.  The Bank’s immediate market area features avariety of agri-business, banking, financial services, health care and lightmanufacturing firms.  The internetbranch allows access to customers nationwide.

 

Mid America Leasing provides services to customers primarily in a nine-statearea in the upper Midwest, but originations can and have expanded nationwide.

 

HF Group provides services to customers in the seven-state region ofSouth Dakota, Minnesota, Iowa, Nebraska, Missouri, Kansas and North Dakota.

 

## **Lending Activities**

 

*General*. The Bank originates a variety of loans including one- to four-familyresidential mortgages, commercial loans, agricultural loans, consumer loans forautomobile purchases, home equity and home improvement loans and student loans.

 

*One- to Four-Family ResidentialMortgage Lending*. One-to four-family residential mortgage loan originations are primarilygenerated by the Bank’s marketing efforts, its present customers, walk-incustomers and referrals from real estate brokers and builders.  The Bank has focused its lending effortsprimarily on the origination of loans secured by first mortgages onowner-occupied, one- to four-family residences.

 

The Bank currentlymakes 10-, 15- and 30-year fixed- and adjustable-rate (“ARM”) one- tofour-family residential mortgage loans in amounts up to 95.00% of the appraisedvalue of the collateral property provided that private mortgage insurance isobtained in an amount sufficient to reduce the Bank’s exposure at or below the80.00% level.  The Bank currently offersan ARM loan which has a fixed rate for the initial three to five years andconverts to a one-year ARM loan for the remainder of the life of the loan.  The Bank also offers a one-year ARM loanwith a rate below the Bank’s then current fixed-rate loan for a comparable 15-or 30-year term loan.  These loansprovide for an annual cap and a lifetime cap at a set percent over thefully-indexed rate.

 

The Bank alsooffers a 30-year balloon loan, which is sold on the secondary market and has afixed-rate for the first five or seven years of the loan term.  At the end of the five- or seven-yearperiod, the loan converts to a 23- or 25-year fixed-rate loan at the thencurrent market rate provided that the borrower qualifies at the new rate.  If the borrower fails to qualify at the newrate, the loan becomes payable in full. The Bank also offers a portfolio five- and seven-year balloon loan thatis underwritten to secondary market standards but is fully payable at the endof the balloon term.

 

To meet the needsof the Bank’s borrowers and financial needs of the communities it serves, theBank has developed two distinct types of loan programs.  The Integrity Mortgage Program is a limiteddocumentation program that is generally available to the upper creditcustomer.  The Olympic Plus Program is aprogram for individuals that do not meet secondary market standards but areeligible for Private Mortgage Insurance. The program underwriting guidelines match those as established by thePrivate Mortgage Insurance Company. Borrowers may choose from either an ARM or balloon product as afinancing option.

 

The Bank alsooffers fixed-rate 15- through 30-year mortgage loans that conform to secondarymarket standards. Interest rates charged on these fixed-rate loans arecompetitively priced on a daily basis according to market conditions.  Residential loans generally do not includeprepayment penalties.

 

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The Bank alsooriginates fixed-rate one- to four-family residential mortgage loans throughthe South Dakota Housing Development Authority (“SDHDA”) program.  These loans generally have terms not toexceed 30 years and are either insured by the Federal Housing Administration(“FHA”), Veterans Administration (“VA”) or private mortgage insuror and musthave no more than a 80.00% loan to value ratio.  The Bank receives an origination fee of 1.00% of the loan amountfrom the borrower and a servicing fee generally 0.38% from the SDHDA for theseservices.  The Bank is the largestservicer of loans for the SDHDA.  AtJune 30, 2004, the Bank serviced $416.1 million of mortgage loans for theSDHDA.  See Note 6 of “Notes toConsolidated Financial Statements” for information on loan servicing.

 

In underwritingone- to four-family residential mortgage loans, the Bank evaluates both theborrower’s ability to make monthly payments and the value of the propertysecuring the loan.  The property thatsecures the real estate loans made by the Bank is appraised by an appraiserapproved under the Bank’s appraisal policy. The Bank requires borrowers to obtain title, fire and casualty insurancein an amount not less than the amount of the loan.  Real estate loans originated by the Bank contain a “due-on-sale”clause allowing the Bank to declare the unpaid principal balance due andpayable upon the sale of the collateral property.

 

*Commercial Business Lending*.  In order to serve the needs of the localbusiness community and improve the interest rate sensitivity and yield of itsassets, the Bank originates adjustable- and fixed-rate commercial loans.  Interest rates on commercial business loansadjust or float with a designated national index plus a specified margin.  The Bank’s commercial business lendingactivities encompass loans with a variety of purposes and security, includingloans to finance accounts receivable, inventory and equipment and businessexpansion within the Bank’s market area. The Bank originates commercial business loans directly and throughprograms sponsored by the Small Business Administration (“SBA”) of which aportion of such loans are also guaranteed in part by the SBA.  The Bank generally originates commercialbusiness loans for its portfolio and retains the servicing with respect to suchloans.  In the future, the Bankanticipates continued expansion and emphasis of its commercial businesslending, subject to market conditions and the Home Owners’ Loan Act (“theHOLA”) restrictions.    See “Regulation–*Business Activities*” for HOLArestrictions.

 

Commercialbusiness loans typically are made on the basis of the borrower’s ability tomake repayment from the cash flow of the borrower’s business.  As a result, the availability of funds forthe repayment of commercial business loans may be substantially dependent onthe success of the business itself (which, in turn, may be dependent upon thegeneral economic environment).  TheBank’s commercial business loans are sometimes secured by the assets of thebusiness, such as accounts receivable, equipment and inventory.  However, the collateral securing the loansmay depreciate over time, may be difficult to appraise and may fluctuate invalue based on the success of the business. Whenever possible, the Bank’s commercial business loans include personalguarantees of the borrowers.  Inaddition, the loan officer may, on occasion, perform on-site visits, obtainfinancial statements and perform a financial review of the loan.

 

*Multi-Family and Commercial RealEstate Lending*.  TheBank engages in multi-family and commercial real estate lending primarily in SouthDakota and the adjoining Midwestern states. These lending activities may include existing property or newconstruction development or purchased loans.

 

Loans secured bymulti-family and commercial real estate properties are generally larger andinvolve a greater degree of credit risk than one- to four-family residentialmortgage loans. Because payments on loans secured by multi-family andcommercial real estate properties are often dependent on the successfuloperation or management of the properties, repayment of such loans may besubject to adverse conditions in the real estate market or the economy.  If the cash flow from the project is reduced(for example, if leases are not obtained or renewed), the borrower’s ability torepay the loan may be impaired. In addition, loans secured by property outsideof the Bank’s immediate market area may contain a higher degree of risk due tothe fact that the Bank may not be as familiar with market conditions where suchproperty is located.  The Bank does nothave a material concentration of multi-family or commercial real estate loansoutside of South Dakota and the adjoining Midwestern states.

 

The Bank presentlyoriginates adjustable-rate, short-term balloon payment, fixed-rate multi-familyand commercial real estate loans.  TheBank’s multi-family and commercial real estate loan portfolio is securedprimarily by apartment buildings and owner occupied and non-owner occupiedcommercial real estate.  The terms ofsuch loans are negotiated on a case by case basis.  Commercial real estate loans generally have terms that do notexceed 25 years.  The

 

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Bank has a variety ofrate adjustment features, call provisions and other terms in its multi-familyand commercial real estate loan portfolio. Generally, the loans are made in amounts up to 80.00% of the appraisedvalue of the collateral property and with debt service coverage ratios of115.00% or higher.  The debt servicecoverage is the ratio of net cash from operations before payment of debtservice.  However, these percentages mayvary depending on the type of security and the guarantor.  Such loans provide for a negotiated marginover a designated national index.  TheBank analyzes the financial condition of the borrower, the borrower’s credithistory, the borrower’s prior record for producing sufficient income fromsimilar loans, references and the reliability and predictability of the netincome generated by the property securing the loan.  The Bank generally requires personal guarantees ofborrowers.  Depending on thecircumstances of the security of the loan or the relationship with theborrower, the Bank may decide to sell participations in the loan.  The sale of participation interests in aloan are necessitated by the amount of the loan or the limitation of Loans toOne Borrower.  See “Regulation-*Loans to One Borrower*” for a discussion ofthe Loans to One Borrower rule.  Inreturn for servicing these loans for the participants, the Bank generallyreceives a fee of 0.25% to 0.38%.  Also,income is received at loan closing from loan fees and discount points.  Appraisals on properties securingmulti-family and commercial real estate loans originated by the Bank areperformed by appraisers approved pursuant to the Bank’s appraisal policy.

 

The HOLA includesa provision that limits the Bank’s non-residential real estate lending to nomore than four times its total capital. This maximum limitation, which at June 30, 2004 was $293.5 million,has not materially limited the Bank’s lending practices.

 

Under HOLA, themaximum amount which the Bank may lend to any one borrower is 15.00% of theBank’s unimpaired capital and surplus or $10.8 million at June 30,2004.  Loans in an amount equal to anadditional 10.00% of unimpaired capital and surplus may be made to the sameborrower if such loans are fully secured by readily marketable collateral.  The Bank may request a waiver from the OTSto exceed the 15.00% Loans to One Borrower limitation on a case by casebasis.  The Bank is in compliance withthe Loans to One Borrower limitation and had no borrowers in excess of theLoans to One Borrower requirements at June 30, 2004.  See “Regulation-*Loans to One Borrower*” for a discussion of the Loans to OneBorrower rule.

 

*Construction and Development Lending*.  The Bank makes construction loans toindividuals for the construction of their residences as well as to buildersand, to a lesser extent, developers for the construction of one- to four-familyresidences and condominiums and the development of one- to four-family lots inthe Bank’s primary market area.

 

Construction loansto individuals for their residences are structured to be converted to permanentloans at the end of the construction phase, which typically runs six to 12months.  These construction loans haverates and terms which match the one- to four-family permanent loans offered bythe Bank.  Residential constructionloans are generally underwritten pursuant to the same guidelines used fororiginating permanent residential loans.

 

The Bank alsomakes loans to developers for the purpose of developing one- to four-familylots.  These loans typically have termsof one year and carry floating interest rates based on a national designatedindex.  Loan commitment and partialrelease fees are charged.  These loansgenerally provide for the payment of interest and loan fees from loanproceeds.  The principal balance ofthese loans is typically paid down as lots are sold.  Builder construction and development loans are obtainedprincipally through continued business from developers and builders who havepreviously borrowed from the Bank as well as broker referrals and directsolicitations of developers and builders. The application process includes a submission to the Bank of plans,specifications and costs of the project to be constructed or developed.  These items are used as a basis to determinethe appraised value of the subject property. Loans are based on the lesser of current appraised value and/or the costof construction (land plus building).

 

The Bank makesloans for the construction of multi-family residential properties.  Such loans are generally made at adjustablerates, which adjust periodically based on the appropriate Treasury Notematurity.

 

Construction loansare generally originated with a maximum loan-to-value ratio of 80.00% and landdevelopment loans are generally originated with a maximum loan-to-value ratioof 60.00%, based upon an independent appraisal.  Because of the uncertainties inherent in estimating developmentand construction costs and the market for the project upon completion, it isrelatively difficult to evaluate accurately the total loan funds required tocomplete a project, the related loan-to-value ratios and the likelihood ofultimate success of the project. Construction and

 

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development loans toborrowers other than owner occupants also involve many of the same risksdiscussed above regarding multi-family and commercial real estate loans andtend to be more sensitive to general economic conditions than many other typesof loans.

 

Prior to making acommitment to fund a construction loan, the Bank requires an appraisal of theproperty, or, for larger projects, both an appraisal and a study of the feasibilityof the proposed project.  The Bank’sconstruction loan policy provides for the inspection of properties byindependent in-house and outside inspectors at the commencement of constructionand prior to disbursement of funds during the term of the construction loan.

 

*Consumer Lending*.  The Bank’s management considers its consumerloan products to be an important component of its lending strategy.  Specifically, consumer loans generally haveshorter terms to maturity and carry higher rates of interest than do one-tofour-family residential mortgage loans. In addition, the Bank’s management believes that the offering ofconsumer loan products helps to expand and create stronger ties to its existingcustomer base by increasing the number of customer relationships and providingcross-marketing opportunities.

 

The Bank currently purchases automobile conditionalsales contracts from selected dealers within its market area as well asoriginating automobile loans directly. The growth in indirect lending has provided securitization opportunitiesin the capital markets.  OnJanuary 31, 2003, the Bank sold approximately $40.1 million principal ofindirect and $9.9 million principal of direct automobile receivables in a securitizationtransaction.  The proceeds were used inpart to continue to service the demand of the Bank’s dealer network.  The securitization is a source of funds at arate lower than other sources of funds, and it reduces the Bank’s capitalrequirements and credit risk to the Bank from the loans sold.  See Note 3 of  “Notes to Consolidated Financial Statements” for details on theconsumer automobile loan securitization.

 

Loans secured bysecond mortgages, together with loans secured by all prior liens, are limitedto 100.00% or less of the appraised value of the property securing the loan andgenerally have maximum terms that do not exceed 10 to 15 years.

 

The student loansoriginated by the Bank are guaranteed as to principal and interest by the SouthDakota Education Assistance Corporation. The Bank sells such student loans with servicing rights releasedapproximately 120 days after funds have been disbursed to the student.

 

Consumer loan terms vary according to the type ofcollateral, length of contract and creditworthiness of the borrower.  The Bank offers both open- and closed-endcredit.  Overdraft lending is extendedthrough lines of credit that are tied to a checking account.  The credit lines generally bear interest at18.00% and are generally limited to no more than $2,000.  Loans secured by deposit accounts at theBank are currently originated for up to 90.00% of the account balance (althoughhistorically the Bank has loaned up to 100.00% of the account balance), with ahold placed on the account restricting the withdrawal of the account balance.  The interest rate on such loans is typicallyequal to 2.00% above the contract rate.

 

The underwritingstandards employed by the Bank for consumer loans, including mobile home loans,include an application, a determination of the applicant’s payment history onother debts, and an assessment of the ability to meet existing obligations andpayments on the proposed loan.  Althoughcreditworthiness of the applicant is a primary consideration, the underwritingprocess also includes a comparison of the value of the security, if any, inrelation to the proposed loan amount.

 

Consumer loans may entail greater credit risk than do residentialmortgage loans, particularly in the case of consumer loans which are unsecuredor are secured by rapidly depreciable assets, such as mobile homes, automobilesor boats.  In such cases, anyrepossessed collateral for a defaulted consumer loan may not provide anadequate source of repayment of the outstanding loan balance as a result of thegreater likelihood of damage, loss or depreciation.  In addition, consumer loan collections are dependent on theborrower’s continuing financial stability, and thus are more likely to beaffected by adverse personal circumstances. Furthermore, the application ofvarious federal and state laws, including bankruptcy and insolvency laws, maylimit the amount which can be recovered on such loans.

 

*Agricultural Loans.*  In order to serve the needs of the local business community andimprove the interest rate sensitivity and yield of its assets, the Bankoriginates agricultural loans through its agricultural division.  The

 

7

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agricultural division offers loans to its customers such as: (1)operating loans which are used to fund operating expenses which typically havea one year term and are indexed to the national prime rate; (2) term loans onmachinery, equipment and breeding stock that may have a term up to seven yearsand require annual payments; (3) agricultural farmland term loans which areused to fund land purchases or refinances; (4) specialized livestock loans tofund facilities and equipment for confinement enterprises; and (5) loans tofund ethanol plant development. Agriculture real estate loans typically will have personal guarantees ofthe borrowers, a first lien on the real estate, interest rates adjustable tothe national prime rate or Treasury Note rates, and annual, quarterly ormonthly payments.  Operating and termloans are secured by farm chattels (crops, livestock, machinery, etc.), whichare the operating assets of the borrower. The Bank also originates agricultural loans directly and throughprograms sponsored by the Farmers Service Agency (“FSA”) of which a portion ofsuch loans are also guaranteed in part by the FSA.

 

Loan customers are required to supply current financial statements, taxreturns for the past three to five years, and cash flow projections which areupdated on an annual basis.  Inaddition, on major loans, the loan officer will perform an annual farm visit,obtain financial statements and perform a financial review of the loan.

 

# **Leasing Activities**

#  

*General.*Through its wholly-owned subsidiary,Mid America Leasing, the Bank originates commercial and municipal leases.  These products have a fixed interest ratefor the duration of the lease with terms typically ranging from 24 – 60months.  The leases generally are100.00% financed with usually only the first or first and last months’ paymentsdue at lease inception.  As a result ofthe 100.00% financing and fixed interest rate, the yield on leases is higherthan similar type lending products.

 

Leases are originated generally in a nine-state area in the upperMidwest.  All leases are secured by theequipment leased, with personal guarantees of the borrowers normally obtainedon commercial leases.

 

*Commercial Leases.*   In order to support the Bank and its customers and to improvethe yield of its assets,  Mid AmericaLeasing originates commercial leases to customers primarily in the upper Midwest.  The Bank offers three types of commercialleases: capital, tax and Terminal Rental Adjustment Clause leases(“TRAC”).  TRAC leases are generally formedium- to heavy-duty titled equipment, such as semi-tractors and trailers andmedium- to heavy-duty trucks.  Leasesmay be structured with a contracted residual of as little as $1.00 up to20.00-25.00% of the equipment cost. Leases encompass a wide variety of equipment for a variety of commercialuses.   The customer base tends to besmall- to medium-sized businesses that view leasing as another financing optionthat augments their overall operation. Repayment terms tend to be monthly in nature.

 

As with commercial loans, commercial leases typically are made on thebasis of the borrower’s ability to make repayment from the cash flow of theirbusiness.  As a result, the availabilityof funds for the repayment of commercial leases may be substantially dependenton the success of the business itself. The collateral securing the leases will generally depreciate over time,may be difficult to appraise and may fluctuate in value based on the success ofthe business.

 

*Municipal Leases.*   The Bank also originates leases to municipal entities such ascities, counties, and public schools. The lessee must be a political subdivision of the state in order toqualify as a municipal lease.   Becausethe interest income earned on this type of lease is exempt from federal incometaxes, the rate offered to the municipality is usually substantially lower thana comparable commercial lease. Repayment terms generally are on a monthly, semi-annual or annualbasis.  Residuals are $1.00 formunicipal leases.

 

Repayment is based on the municipality’s ability to levy and collecttaxes.  Assuming the municipality has abond rating, that bond rating, together with audited financial statements arethe basis for the lease.  On largerleases, bond ratings and financial statements will be reviewed annually.

 

8

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Loan and Lease Portfolio Composition.  The following table sets forth informationconcerning the composition of the Company’s loan and lease portfolio fromcontinuing operations in dollar amounts and in percentages (before deductionsfor the undisbursed portion of loans in process, deferred fees and discounts andallowance for losses) as of the dates indicated.  Balances related to discontinued credit card loan operations havebeen eliminated for all periods presented.

 
|                                    |   | **At  June 30,**       |    |
|-----------------------------------------|--------|-----------------------------|---------|
|                                    |   | **2004**                    |    | **2003** |   | **2002** |   | **2001** |   | **2000** |   |
|                                    |   | **Amount**                  |    | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   |
|                                    |   | **(Dollars  In Thousands)** |    |
| Real Estate Loans:                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One- to four-family (1)                 |   | $                           | 104,492 |   | 15.80 | % | $ | 100,065 |   | 16.18 | % | $ | 79,074 |   | 13.78 | % | $ | 124,951 |   | 21.71 | % | $ | 134,014 |   | 23.62 | % |
| Multi-family                            |   | 42,721                      |    | 6.46 |   | 49,364 |   | 7.98 |   | 56,952 |   | 9.92 |   | 44,378 |   | 7.71 |   | 44,793 |   | 7.89 |   |
| Commercial                              |   | 89,538                      |    | 13.54 |   | 93,405 |   | 15.10 |   | 89,111 |   | 15.53 |   | 73,720 |   | 12.81 |   | 68,556 |   | 12.08 |   |
| Agricultural                            |   | 20,449                      |    | 3.09 |   | 18,002 |   | 2.91 |   | 12,722 |   | 2.22 |   | 12,753 |   | 2.21 |   | 11,669 |   | 2.06 |   |
| Construction and development            |   | 15,044                      |    | 2.28 |   | 9,083 |   | 1.47 |   | 12,738 |   | 2.22 |   | 28,419 |   | 4.94 |   | 35,511 |   | 6.26 |   |
| Total real estate loans                 |   | 272,244                     |    | 41.17 |   | 269,919 |   | 43.64 |   | 250,597 |   | 43.67 |   | 284,221 |   | 49.38 |   | 294,543 |   | 51.91 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other Loans and Leases:                 |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer Loans:                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Mobile home                             |   | 848                         |    | 0.13 |   | 1,468 |   | 0.24 |   | 2,365 |   | 0.41 |   | 3,920 |   | 0.68 |   | 5,676 |   | 1.00 |   |
| Automobiles                             |   | 101,669                     |    | 15.38 |   | 74,066 |   | 11.98 |   | 84,782 |   | 14.77 |   | 78,082 |   | 13.57 |   | 81,092 |   | 14.29 |   |
| Deposit account                         |   | 1,489                       |    | 0.22 |   | 1,463 |   | 0.24 |   | 1,597 |   | 0.28 |   | 1,917 |   | 0.33 |   | 2,360 |   | 0.42 |   |
| Student (2)                             |   | 324                         |    | 0.05 |   | 7,745 |   | 1.25 |   | 7,340 |   | 1.28 |   | 6,831 |   | 1.19 |   | 7,146 |   | 1.26 |   |
| Junior liens on mortgages               |   | 85,684                      |    | 12.96 |   | 81,064 |   | 13.11 |   | 73,680 |   | 12.84 |   | 61,397 |   | 10.67 |   | 56,243 |   | 9.91 |   |
| Other                                   |   | 4,900                       |    | 0.74 |   | 6,035 |   | 0.98 |   | 8,529 |   | 1.49 |   | 10,939 |   | 1.90 |   | 11,570 |   | 2.04 |   |
| Total consumer loans                    |   | 194,914                     |    | 29.48 |   | 171,841 |   | 27.80 |   | 178,293 |   | 31.07 |   | 163,086 |   | 28.34 |   | 164,087 |   | 28.92 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial business                     |   | 124,158                     |    | 18.78 |   | 113,570 |   | 18.36 |   | 95,462 |   | 16.63 |   | 97,362 |   | 16.92 |   | 87,137 |   | 15.36 |   |
| Equipment finance leases                |   | 26,942                      |    | 4.07 |   | 23,016 |   | 3.72 |   | 22,834 |   | 3.98 |   | 10,509 |   | 1.82 |   | — |   | 0.00 |   |
| Agricultural                            |   | 42,953                      |    | 6.50 |   | 40,109 |   | 6.48 |   | 26,707 |   | 4.65 |   | 20,370 |   | 3.54 |   | 21,597 |   | 3.81 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total other loans and leases            |   | 388,967                     |    | 58.83 |   | 348,536 |   | 56.36 |   | 323,296 |   | 56.33 |   | 291,327 |   | 50.62 |   | 272,821 |   | 48.09 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total gross loans and leases            |   | $                           | 661,211 |   | 100.00 | % | $ | 618,455 |   | 100.00 | % | $ | 573,893 |   | 100.00 | % | $ | 575,548 |   | 100.00 | % | $ | 567,364 |   | 100.00 | % |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                   |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed portion of loans in process |   | (7,338                      | )       |   |   | (3,576 | ) |   |   | (4,678 | ) |   |   | (3,853 | ) |   |   | (17,374 | ) |   |   |
| Deferred fees and discounts             |   | 1,029                       |    |   |   | 364 |   |   |   | 504 |   |   |   | (133 | ) |   |   | (356 | ) |   |   |
| Allowance for losses                    |   | (3,605                      | )       |   |   | (3,842 | ) |   |   | (4,461 | ) |   |   | (5,509 | ) |   |   | (5,499 | ) |   |   |
| Total loans and leases receivable, net  |   | $                           | 651,297 |   |   |   | $ | 611,401 |   |   |   | $ | 565,258 |   |   |   | $ | 566,053 |   |   |   | $ | 544,135 |   |   |   |

 

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(1)          Includes one- to four-family loans held forsale.

(2)          Includes student loans held for sale.

 

9

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The following table sets forth the composition of the Company’s loanand lease portfolio from continuing operations by fixed- and adjustable-rate indollar amounts and in percentages (before deductions for the undisbursedportion of loans in process, deferred fees and discounts and allowance forlosses) as of the dates indicated. Balances related to discontinued credit card loan operations have beeneliminated for all periods presented.

 
|                                        |   | **At June 30,**        |    |
|---------------------------------------------|--------|-----------------------------|---------|
|                                        |   | **2004**                    |    | **2003** |   | **2002** |   | **2001** |   | **2000** |   |
|                                        |   | **Amount**                  |    | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   | **Amount** |   | **Percent  of Total** |   |
|                                        |   | **(Dollars  In Thousands)** |    |
| Fixed-Rate Loans and Leases:                |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Real Estate:                                |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
|                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One- to four-family (1)                     |   | $                           | 70,895  |   | 10.72 | % | $ | 72,472 |   | 11.72 | % | $ | 45,804 |   | 7.98 | % | $ | 78,350 |   | 13.61 | % | $ | 84,478 |   | 14.89 | % |
| Multi-family, commercial & construction |   | 44,065                      |    | 6.66 |   | 41,231 |   | 6.67 |   | 44,842 |   | 7.81 |   | 39,752 |   | 6.91 |   | 36,552 |   | 6.44 |   |
| Agricultural                                |   | 2,609                       |    | 0.39 |   | 4,760 |   | 0.77 |   | 1,305 |   | 0.23 |   | 3,433 |   | 0.60 |   | 2,843 |   | 0.50 |   |
| Total real estate loans                     |   | 117,569                     |    | 17.77 |   | 118,463 |   | 19.16 |   | 91,951 |   | 16.02 |   | 121,535 |   | 21.12 |   | 123,873 |   | 21.83 |   |
|                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer (2)                                |   | 133,012                     |    | 20.12 |   | 110,037 |   | 17.79 |   | 127,488 |   | 22.21 |   | 125,955 |   | 21.88 |   | 130,770 |   | 23.05 |   |
| Agricultural                                |   | 3,905                       |    | 0.59 |   | 5,285 |   | 0.85 |   | 5,596 |   | 0.98 |   | 6,007 |   | 1.04 |   | 7,632 |   | 1.35 |   |
| Equipment finance leases                    |   | 26,942                      |    | 4.07 |   | 23,016 |   | 3.72 |   | 22,834 |   | 3.98 |   | 10,509 |   | 1.82 |   | — |   | 0.00 |   |
| Commercial business                         |   | 26,631                      |    | 4.03 |   | 23,839 |   | 3.85 |   | 21,463 |   | 3.74 |   | 25,983 |   | 4.52 |   | 25,474 |   | 4.49 |   |
| Total fixed-rate loans and leases           |   | 308,059                     |    | 46.58 |   | 280,640 |   | 45.37 |   | 269,332 |   | 46.93 |   | 289,989 |   | 50.38 |   | 287,749 |   | 50.72 |   |
|                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Adjustable-Rate Loans:                      |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Real estate:                                |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One- to four-family(1)                      |   | 33,597                      |    | 5.08 |   | 27,593 |   | 4.46 |   | 33,270 |   | 5.80 |   | 46,601 |   | 8.10 |   | 49,536 |   | 8.73 |   |
| Multi-family, commercial & construction |   | 103,238                     |    | 15.61 |   | 110,621 |   | 17.89 |   | 113,959 |   | 19.86 |   | 106,765 |   | 18.55 |   | 112,308 |   | 19.80 |   |
| Agricultural                                |   | 17,840                      |    | 2.70 |   | 13,242 |   | 2.14 |   | 11,417 |   | 1.99 |   | 9,320 |   | 1.62 |   | 9,558 |   | 1.68 |   |
| Total real estate loans                     |   | 154,675                     |    | 23.39 |   | 151,456 |   | 24.49 |   | 158,646 |   | 27.65 |   | 162,686 |   | 28.27 |   | 171,402 |   | 30.21 |   |
|                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer (2) (3)                            |   | 61,902                      |    | 9.37 |   | 61,804 |   | 10.00 |   | 50,805 |   | 8.85 |   | 37,131 |   | 6.45 |   | 33,317 |   | 5.87 |   |
| Agricultural                                |   | 39,048                      |    | 5.91 |   | 34,824 |   | 5.63 |   | 21,111 |   | 3.68 |   | 14,363 |   | 2.50 |   | 13,233 |   | 2.33 |   |
| Commercial business                         |   | 97,527                      |    | 14.75 |   | 89,731 |   | 14.51 |   | 73,999 |   | 12.89 |   | 71,379 |   | 12.40 |   | 61,663 |   | 10.87 |   |
| Total adjustable-rate loans                 |   | 353,152                     |    | 53.42 |   | 337,815 |   | 54.63 |   | 304,561 |   | 53.07 |   | 285,559 |   | 49.62 |   | 279,615 |   | 49.28 |   |
|                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans and leases                      |   | $                           | 661,211 |   | 100.00 | % | $ | 618,455 |   | 100.00 | % | $ | 573,893 |   | 100.00 | % | $ | 575,548 |   | 100.00 | % | $ | 567,364 |   | 100.00 | % |
|                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                       |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed portion of loans in process     |   | (7,338                      | )       |   |   | (3,576 | ) |   |   | (4,678 | ) |   |   | (3,853 | ) |   |   | (17,374 | ) |   |   |
| Deferred fees and discounts                 |   | 1,029                       |    |   |   | 364 |   |   |   | 504 |   |   |   | (133 | ) |   |   | (356 | ) |   |   |
| Allowance for loan losses                   |   | (3,605                      | )       |   |   | (3,842 | ) |   |   | (4,461 | ) |   |   | (5,509 | ) |   |   | (5,499 | ) |   |   |
|                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans and leases receivable, net      |   | $                           | 651,297 |   |   |   | $ | 611,401 |   |   |   | $ | 565,258 |   |   |   | $ | 566,053 |   |   |   | $ | 544,135 |   |   |   |

 

----

(1)          Includes one- to four-family loans held forsale.

(2)          Includes mobile home loans

(3)          Includes student loans held for sale

 

10

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The following schedule illustrates the scheduled principalcontractual repayments of the Company’s loan and lease portfolio fromcontinuing operations at June 30, 2004. Mortgages which have adjustable or renegotiable interest rates are shownas maturing at the contractual maturity date. The schedule does not reflect the effects of possible prepaymentsor enforcement of due-on-sale clauses.

 
|                  |   | **Real  Estate**               |    | **Non-Real  Estate** |   |
|-----------------------|--------|--------------------------------|---------|----------------------|--------|
|                  |   | **One- to  Four-  Family (1)** |    | **Multi-  Family**   |   | **Commercial** |   | **Agricultural** |   | **Construction  &  Development** |   | **Consumer  (2)** |   | **Commercial  Business (3)** |   | **Agricultural** |   | **Total** |   |
|                  |   | **(Dollars  in Thousands)**    |    |
| Due in 1 year or less |   | $                              | 3,721   |                 | $      | 2,675 |   | $ | 7,534 |   | $ | 1,151 |   | $ | 7,349 |   | $ | 51,147 |   | $ | 81,213 |   | $ | 29,018 |   | $ | 183,808 |   |
| After 1 to 5 years    |   | 16,961                         |    | 12,403               |   | 34,589 |   | 5,379 |   | 7,695 |   | 143,767 |   | 61,366 |   | 12,452 |   | 294,612 |   |
| Greater than 5 years  |   | 83,810                         |    | 27,643               |   | 47,415 |   | 13,919 |   | — |   | — |   | 8,521 |   | 1,483 |   | 182,791 |   |
| Total                 |   | $                              | 104,492 |                 | $      | 42,721 |   | $ | 89,538 |   | $ | 20,449 |   | $ | 15,044 |   | $ | 194,914 |   | $ | 151,100 |   | $ | 42,953 |   | $ | 661,211 |   |

 

----

(1) Includes one- to four-family loans heldfor sale.

(2) Includes demand loans, loans having nostated maturity, student loans held for sale and overdraft loans.

(3) Includes equipment finance leases.

 

The total amountof loans due after June 30, 2005 which have predetermined interest ratesis $249.3 million, while the total amount of loans due after such date whichhave floating or adjustable interest rates is $228.1 million.

 

Scheduledcontractual principal repayments of loans do not reflect the actual life ofsuch assets.  The average life of loansis substantially less than their average contractual terms because ofprepayments.  In addition, due-on-saleclauses on loans generally give the Bank the right to declare a conventionalloan immediately due and payable in the event, among other things, that theborrower sells the real property subject to the mortgage and the loan is notrepaid.  The average life of mortgageloans tends to increase when current mortgage loan rates are substantiallyhigher than rates on existing mortgage loans and decrease when rates on existingmortgages are substantially higher than current mortgage loan rates.  One- to four-family residential mortgageloans have prepaid significantly and refinanced at lower rates due to theeffect of lower mortgage rates during the last year.

 

11

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**Potential Problem Loans**

 

*Nonperforming Assets. *See “Asset Quality” underManagement’s Discussion and Analysis for discussion.

 

*Classified Assets*.  Federal regulations provide for theclassification of loans, leases and other assets, such as debt and equitysecurities considered by the OTS to be of lesser quality, as “substandard,”“doubtful” or “loss.” An asset is considered “substandard” if it isinadequately protected by the current net worth and paying capacity of theobligor or of the collateral pledged, if any. “Substandard” assets include those characterized by the “distinctpossibility” that the Company will sustain “some loss” if the deficiencies arenot corrected.  Assets classified as“doubtful” have all of the weaknesses inherent in those classified“substandard,” with the added characteristic that the weaknesses present make“collection or liquidation in full,” on the basis of currently existing facts,conditions, and values, “highly questionable and improbable.”  Assets classified as “loss” are thoseconsidered “uncollectible” and of such little value that their continuance asassets without the establishment of a specific loss reserve is notwarranted.  Assets which do notcurrently expose the Company to sufficient risk to warrant classification inone of the aforementioned categories, but possess weaknesses, are required tobe designated “criticized” or “special mention” by management.

 

When the Companyclassifies problem assets as “loss, “ it is required either to establish aspecific allowance for losses equal to 100.00% of that portion of the asset soclassified or to charge-off such amount. The Company’s determination as to the classification of its assets andthe amount of its valuation allowances is subject to review by the Bank’sRegional Director at the regional OTS office, who may order the establishmentof additional general or specific loss allowances.

 

In connection withthe filing of its periodic reports with the OTS and in accordance with itsclassification of assets policy, the Company regularly reviews problem loansand leases in its portfolio to determine whether any loans or leases requireclassification in accordance with applicable regulations.  On the basis of management’s monthly reviewof its assets, at June 30, 2004, the Company had designated $15.2million of its assets as special mention and $3.9 million of its assets asclassified.  Other potential problemloans are included in criticized and classified assets.  See “Asset Quality” under Management’sDiscussion and Analysis for further discussion.

 

*Allowance for Loan and Lease Losses*.See “Application of Critical Accounting Policies” and “Asset Quality” underManagement’s Discussion and Analysis for discussion.

 

12

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**Investment Activities**

 

The Bank isrequired under OTS regulation to maintain a sufficient amount of liquidassets.  Liquidity may increase ordecrease depending upon the availability of funds and comparative yields oninvestments in relation to the return on loans.  Historically, the Bank has maintained its liquid assets above theminimum requirements imposed by the OTS regulations and at a level believed bymanagement adequate to meet requirements of normal daily activities, repaymentof maturing debt and potential deposit outflows.  As of June 30, 2004, the Bank’s liquidity ratio (liquidassets as a percentage of net withdrawable savings deposits and currentborrowings) was 4.28%. See “Regulation-*Liquidity*.”

 

Federallychartered savings institutions have the authority to invest in various types ofliquid assets, including United States Treasury obligations, securities ofvarious federal agencies, certain certificates of deposit of insured banks andsavings institutions, certain bankers’ acceptances, repurchase agreements andfederal funds.  Subject to variousrestrictions, federally chartered savings institutions may also invest theirassets in commercial paper, investment grade corporate debt securities andmutual funds whose assets conform to the investments that a federally charteredsavings institution is otherwise authorized to make directly.

 

Generally, theinvestment policy of the Bank is to invest funds among various categories ofinvestments and maturities based upon the Bank’s asset/liability management policies,investment quality and marketability, liquidity needs and performanceobjectives.

 

At June 30,2004, the Company’s investments in mortgage-backed securities totaled $105.0million, or 12.4% of its total assets. As of such date, the Bank also had a$5.5 million investment in the stock of the Federal Home Loan Bank of DesMoines (“FHLB” or “FHLB of Des Moines”) in order to satisfy the FHLB of DesMoines’ requirement for membership.

 

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

 
|                                        |   | **At  June 30, 2004**  |   |
|---------------------------------------------|--------|-----------------------------|--------|
|                                        |   | **Less Than  1 Year**       |   | **1 to 5  Years** |   | **5 to 10  Years** |   | **Over 10  Years** |   | **Total  Investment  Securities** |   |
|                                        |   | **Amortized  Cost**         |   | **Weighted  Average  Yield** |   | **Amortized  Cost** |   | **Weighted  Average  Yield** |   | **Amortized  Cost** |   | **Weighted  Average  Yield** |   | **Amortized  Cost** |   | **Weighted  Average  Yield** |   | **Amortized  Cost** |   | **Fair Value** |   |
|                                        |   | **(Dollars  in Thousands)** |   |
|                                        |   |                        |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies & corporations |   | $                           | — |   | — |   | $ | 2,999 |   | 2.76 | % | $ | — |   | — |   | $ | — |   | — |   | $ | 2,999 |   | $ | 2,985 |   |
| Federal Home Loan Bank                      |   | 1,000                       |   | 7.00 | % | — |   | — |   | — |   | — |   | — |   | — |   | 1,000 |   | 1,030 |   |
| Municipal bonds                             |   | 2,049                       |   | 2.41 | % | 2,569 |   | 2.21 | % | — |   | — |   | — |   | — |   | 4,618 |   | 4,613 |   |
| Preferred term securities                   |   | —                      |   | — |   | — |   | — |   | — |   | — |   | 9,000 |   | 2.91 | % | 9,000 |   | 9,034 |   |
| Mortgage-backed securities                  |   | 113                         |   | 6.14 | % | 49 |   | 7.03 | % | 9,818 |   | 4.62 | % | 97,287 |   | 4.05 | % | 107,267 |   | 105,015 |   |
| Total investment securities                 |   | $                           | 3,162  |   |   |   | $ | 5,617 |   |   |   | $ | 9,818 |   |   |   | $ | 106,287 |   |   |   | $ | 124,884 |   | $ | 122,677 |   |

 

The Company’sinvestment securities portfolio did not contain non-investment grade bonds(i.e., “junk bonds”) or other corporate debt securities.

 

The Bank’sinvestment security portfolio is managed in accordance with a writteninvestment policy adopted by the Board of Directors.  Investments may be made by the Bank’s officers within specifiedlimits and approved in advance by the Board of Directors for transactions overthese limits.  At the present time, theBank does not have any investments that are held for trading purposes.  At June 30, 2004, the Company had$122.7 million of securities available for sale, including mortgage-backedsecurities of $105.0 million.  See Note4 of “Notes to Consolidated Financial Statements” for further information onthe Company’s investment portfolio.

 

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**Sources of Funds**

 

*General*.  The Company’s primary sources of funds areearnings, in-market deposits, FHLB advances and other borrowings, amortizationand repayments of loan principal, mortgage-backed securities and callableagency securities.  Secondary sourcesinclude sales of mortgage loans, sales and/or maturities of securities,mortgage-backed securities, out-of-market deposits and short-term investments.

 

Borrowings of theBank are primarily from the FHLB of Des Moines, and may be used on a short-termbasis to compensate for seasonal reductions in deposits or deposit inflows atless than projected levels, and may be used on a longer-term basis to supportexpanded lending activities.  The Bankhas established collateral at the Federal Reserve Bank as a contingent sourceof funding.  The availability of fundsfrom loan sales is influenced by general interest rates.  See Note 9 of the “Notes to ConsolidatedFinancial Statements” for further detail of the Company’s borrowings.

 

*Deposits*.  The Bank offers a variety of depositaccounts having a wide range of interest rates and terms.  The Bank’s deposits consist of statementsavings accounts, checking accounts, money market and certificate accounts rangingin terms from 30 days to five years. The Bank primarily solicits deposits from its market area.  The Bank relies primarily on customerservice, competitive pricing policies and advertising to attract and retainthese deposits.  Based on liquidity needs,the Bank may, from time to time, acquire out-of-market deposits.

 

The flow ofdeposits is influenced by general economic conditions, changes in money marketand prevailing interest rates and competition.

 

The variety ofdeposit accounts offered by the Bank has allowed it to be competitive inobtaining funds and to respond with flexibility to changes in consumerdemand.  In recent years, the Bank hasbecome more susceptible to short-term fluctuations in deposit flows ascustomers have become more interest rate conscious.  The Bank manages the pricing of its deposits in keeping with itsasset/liability management and profitability objectives.  Based on its experience, the Bank believesthat its statement savings, money market, and checking accounts are stablesources of deposits.  However, theability of the Bank to attract and maintain certificates of deposit, and therates paid on these deposits, has been and will continue to be significantlyaffected by market conditions.

 

14

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The followingtable sets forth the dollar amount of deposits in the various types of depositaccounts offered by the Bank as of the dates indicated.

 
|                                                                                                                         |   | **At  June 30,**       |    |
|------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                         |   | **2004**                    |    | **2003** |   | **2002** |   |
|                                                                                                                         |   | **Amount**                  |    | **Percent of  Total** |   | **Amount** |   | **Percent of  Total** |   | **Amount** |   | **Percent of  Total** |   |
|                                                                                                                         |   | **(Dollars  in Thousands)** |    |
| Transaction Accounts:                                                                                                        |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest bearing accounts                                                                                                 |   | $                           | 75,251  |   | 11.42 | % | $ | 77,004 |   | 12.39 | % | $ | 61,355 |   | 10.91 | % |
| Interest bearing accounts weighted average  rates of 0.18%, 0.16%, and 0.39% at June 30, 2004, 2003 and 2002            |   | 45,738                      |    | 6.95 |   | 43,699 |   | 7.03 |   | 41,669 |   | 7.41 |   |
| Savings accounts weighted average rates of  0.72%, 0.68% and  1.13% at  June 30, 2004, 2003 and 2002               |   | 63,670                      |    | 9.67 |   | 54,462 |   | 8.77 |   | 50,387 |   | 8.95 |   |
| Money market accounts(1) weighted average  rates of 1.40%, 1.41% and 1.80% at June 30, 2004, 2003 and 2002              |   | 211,928                     |    | 32.17 |   | 178,113 |   | 28.66 |   | 157,770 |   | 28.04 |   |
|                                                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Total transaction accounts                                                                                                   |   | 396,587                     |    | 60.21 |   | 353,278 |   | 56.85 |   | 311,181 |   | 55.31 |   |
|                                                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| In-Market Certificates of Deposit:                                                                                           |   |                        |    |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| 0.00 - 3.99%                                                                                                                 |   | 206,552                     |    | 31.36 |   | 174,662 |   | 28.11 |   | 136,062 |   | 24.96 |   |
| 4.00 - 4.99%                                                                                                                 |   | 16,102                      |    | 2.44 |   | 21,112 |   | 3.40 |   | 29,089 |   | 5.17 |   |
| 5.00 - 5.99%                                                                                                                 |   | 10,312                      |    | 1.57 |   | 17,711 |   | 2.85 |   | 29,752 |   | 5.29 |   |
| 6.00 - 6.99%                                                                                                                 |   | 12,335                      |    | 1.87 |   | 18,040 |   | 2.90 |   | 34,167 |   | 6.07 |   |
| 7.00 - 7.99%                                                                                                                 |   | 1,006                       |    | 0.15 |   | 985 |   | 0.16 |   | 17,979 |   | 3.20 |   |
| Total in-market certificates of deposit                                                                                      |   | 246,307                     |    | 37.39 |   | 232,510 |   | 37.42 |   | 247,049 |   | 44.69 |   |
|                                                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Out-of-market certificates of deposit  weighted average rate of 2.23%, 2.11% and 2.90% at June 30, 2004, 2003  and 2002 |   | 15,825                      |    | 2.40 |   | 35,593 |   | 5.73 |   | 4,366 |   | — |   |
|                                                                                                                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |
| Total certificates of deposit                                                                                                |   | 262,132                     |    | 39.79 |   | 268,103 |   | 43.15 |   | 251,415 |   | 44.69 |   |
| Total deposits                                                                                                               |   | $                           | 658,719 |   | 100.00 | % | $ | 621,381 |   | 100.00 | % | $ | 562,596 |   | 100.00 | % |

 

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(1) Includesout-of-market money market accounts in the amount of $18.4 million, $14.1million and $0 for 2004, 2003 and 2002, respectively.

 

15

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The following table sets forth the amount of the Company’s certificatesof deposit and other deposits by time remaining until maturity as ofJune 30, 2004.

 
|                                           |   | **Maturity**                |   |               |   |
|------------------------------------------------|--------|-----------------------------|--------|--------------------|--------|
|                                           |   | **3 Months  or Less**       |   | **3 to 6  Months** |   | **6 to 12  Months** |   | **Over  12 Months** |   | **Total** |   |
|                                           |   | **(Dollars  in Thousands)** |   |
|                                           |   |                        |   |               |   |   |   |   |   |   |   |
| Certificates of deposit less than $100,000     |   | $                           | 28,350 |               | $      | 29,134 |   | $ | 45,780 |   | $ | 77,327 |   | $ | 180,591 |   |
|                                           |   |                        |   |               |   |   |   |   |   |   |   |
| Certificates of deposit of $100,000 or more    |   | 5,763                       |   | 6,415              |   | 12,794 |   | 13,751 |   | 38,723 |   |
|                                           |   |                        |   |               |   |   |   |   |   |   |   |
| Out-of-market certificates of deposit (1)  (2) |   | 1,677                       |   | 2,640              |   | 5,127 |   | 6,381 |   | 15,825 |   |
|                                           |   |                        |   |               |   |   |   |   |   |   |   |
| Public funds (3) (4)                           |   | 5,190                       |   | 12,491             |   | 7,358 |   | 1,954 |   | 26,993 |   |
|                                           |   |                        |   |               |   |   |   |   |   |   |   |
| Total certificates of deposit                  |   | $                           | 40,980 |               | $      | 50,680 |   | $ | 71,059 |   | $ | 99,413 |   | $ | 262,132 |   |

 

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(1)          Includesfunds from the Certificate of Deposit Account Registry Service (“CDARS”)certificate of deposit program of $3,668.

(2)          Includescertificates of deposit of $100,000 or greater of $1,352.

(3)          Includescertificates of deposit from governmental and other public entities, excludingout-of-market certificates of deposit.

(4)          Includescertificates of deposit of $100,000 or greater of $25,260.

 

The Bank solicitscertificates of deposit of $100,000 or greater from various state, county andlocal government units which carry rates which are negotiated at the time ofdeposit.  See Note 8 of “Notes toConsolidated Financial Statements.” Deposits at June 30, 2004 and 2003 included $53.0 million and $42.4million, respectively, of deposits from one local governmental entity, themajority of which are savings accounts.

 

*Borrowings*.  Although deposits are the Bank’s primarysource of funds, the Bank’s policy has been to utilize borrowings when they area less costly source of funds or can be invested at a positive rate of return.

 

The Bank’s borrowings consist primarily of advances from the FHLB ofDes Moines upon the security of its capital stock of the FHLB of Des Moines andcertain pledgable loans, including but not limited to, its mortgage relatedloans, mortgage-backed securities and U.S. Government and other agencysecurities.  Such advances can be madepursuant to several different credit programs, each of which has its owninterest rate and range of maturities. At June 30, 2004, the Bank’s FHLB advances totaled $93.0 million,representing 11.69% of total Company liabilities.  See Note 9 of  “Notes toConsolidated Financial Statements” for further detail of the Company’s borrowings.

 

16

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The following table sets forth the maximum month-end balances andaverage balances of FHLB and FRB advances and other borrowings at the datesindicated.

 

|                       |   | **Years  Ended June 30,** |   |
|----------------------------|--------|--------------------------------|--------|
|                       |   | **2004**                       |   | **2003** |   | **2002** |   |
|                       |   | **(Dollars  in Thousands)**    |   |
| Maximum Month-End Balance: |   |                           |   |   |   |   |   |
| FHLB and FRB advances      |   | $                              | 92,985 |   | $ | 134,503 |   | $ | 101,152 |   |
| Other borrowings           |   | 817                            |   | 5,321 |   | 922 |   |
|                       |   |                           |   |   |   |   |   |
| Average Balance:           |   |                           |   |   |   |   |   |
| FHLB and FRB advances      |   | $                              | 79,038 |   | $ | 99,064 |   | $ | 85,716 |   |
| Other borrowings           |   | 1,831                          |   | 1,201 |   | 896 |   |

 

The followingtable sets forth certain information as to the Bank’s FHLB and FRB advances andother borrowings of the Company at the dates indicated.

 

|                                                     |   | **June 30,**           |   |
|----------------------------------------------------------|--------|-----------------------------|--------|
|                                                     |   | **2004**                    |   | **2003** |   | **2002** |   |
|                                                     |   | **(Dollars  in Thousands)** |   |
|                                                     |   |                        |   |   |   |   |   |
| FHLB and FRB advances                                    |   | $                           | 92,985 |   | $ | 84,498 |   | $ | 83,434 |   |
| Other borrowings                                         |   | 765                         |   | 5,321 |   | 874 |   |
| Total borrowings                                         |   | $                           | 93,750 |   | $ | 89,819 |   | $ | 84,308 |   |
|                                                     |   |                        |   |   |   |   |   |
| Weighted average interest rate of FHLB and  FRB advances |   | 3.96                        | %      | 4.70 | % | 5.41 | % |

 

*Trust Preferred Securities. *Through an unconsolidatedtrust subsidiary, the Company issued trust preferred securities during fiscal2004 in order to provide funding to purchase treasury stock and repay otherborrowings.  See Note 10 of  “Notes to Consolidated FinancialStatements”.

 

*Consumer Automobile LoanSecuritization. *Thegrowth in indirect lending is providing securitization opportunities in thecapital markets.  On January 31,2003, the Bank sold approximately $40.1 million principal of indirect and $9.9million principal of direct automobile receivables in a securitizationtransaction.  See Note 3 of  “Notes to Consolidated Financial Statements”for details on the consumer automobile loan securitization.

 

**Competition**

 

The Bank facesstrong competition, both in originating real estate, commercial and consumerloans and in attracting deposits. Competition in originating real estate loanscomes primarily from other commercial banks, credit unions and mortgage bankersmaking loans secured by real estate located in the Bank’s market areas.Commercial banks and finance companies provide vigorous competition in consumerlending.  The Bank competes for realestate and other loans principally on the basis of the quality of services itprovides to borrowers, interest rates and loan fees it charges and the types ofloans it originates.

 

The Bank attractsthe majority of its deposits through its retail banking offices, primarily fromthe communities in which those retail banking offices are located; As such,competition for those deposits is principally from other commercial banks andcredit unions located in the same communities. The Bank competes for these deposits by offering a variety of depositaccounts at competitive rates, convenient business hours, and convenient branchlocations with interbranch deposit and withdrawal privileges at each.

 

**Employees**

 

At June 30,2004, the Bank had a total of 306 full-time equivalent employees (“FTEs”)including nine FTEs of the Bank’s service corporations.  The Bank’s employees are not represented byany collective bargaining group. Management considers its relations with its employees to be good.

 

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**Regulation**

 

*General*.  The Bank is a federally chartered thrift institution,the deposits of which are federally insured by the SAIF of the FDIC.  Accordingly, the Bank is subject to broadfederal regulation and oversight extending to all its operations, by itsprimary federal regulator, the OTS.  TheBank is a member of the FHLB of Des Moines and is subject to certain limitedregulation by the Federal Reserve Board (the “FRB”).  As the unitary thrift holding company of the Bank, the Companyalso is subject to federal regulation and oversight by the OTS.  The purpose of the regulation of the Companyand other holding companies is to protect subsidiary savings associations wheredeposits are federally insured.

 

Certain of theseregulatory requirements and restrictions are discussed below or elsewhere inthis document.  The following discussionis intended to be a summary of the material statutes, regulations and policiesapplicable to savings associations and their holding companies, and it does notpurport to be a complete discussion of all such statutes, regulations and policies.

 

*Regulation of Federal SavingsAssociations*.  The OTShas extensive authority over the operations of federal savings associations,such as the Bank.  Pursuant to thisauthority, the Bank is required to file periodic reports with the OTS and issubject to periodic examinations primarily by the OTS and to a lesser extent bythe FDIC.  The last examination of theBank by the OTS concluded on February 16, 2004.  Examiners may require a federal savings association to providefor higher general or specific loan loss-reserves.

 

*Assessments.*  The OTS has established a schedule forthe assessment of fees upon all savings associations to fund the operations ofthe OTS.  The general assessment, paidon a semiannual basis, is computed by totaling three components: the size ofthe association on which the basic assessment is based; the association’ssupervisory condition, which would result in an additional assessment based ona percentage of the basic assessment for any savings institution with acomposite rating of 3, 4 or 5 in its most recent safety and soundnessexamination; and the complexity of the association’s operations, which wouldresult in an additional assessment based on a percentage of the basicassessment for any savings association that managed over $1.0 billion in trustassets, serviced for others loans aggregating more than $1.0 billion, or hadcertain off-balance sheet assets aggregating more than $1.0 billion. ** **The Bank’s OTS assessment(standard assessment) for the fiscal year ended June 30, 2004 wasapproximately $164,000.

 

*Enforcement.* Under the Federal Deposit Insurance Act (the “FDI Act”), the OTS hasprimary enforcement responsibility over savings associations and has theauthority to bring enforcement action against all “institution-affiliatedparties,” including any controlling stockholder or any stockholder, attorney,appraiser or accountant who knowingly or recklessly participates in anyviolation of applicable law or regulation or breach of fiduciary duty orcertain other wrongful actions that causes or is likely to cause more than aminimal loss or other significant adverse effect on an insured savingsassociation.  Civil penalties cover awide range of violations and actions and range from $5,000 for each day duringwhich violations of law, regulations, orders and certain written agreements andconditions continue, to up to $1.0 million per day for such violations if theperson obtained a substantial pecuniary gain as a result of such violation orknowingly or recklessly caused a substantial loss to the institution.  Criminal penalties for certain financialinstitution crimes include fines of up to $1.0 million and imprisonment for upto 30 years.  In addition, regulatorshave substantial discretion to take enforcement action against an institutionthat fails to comply with its regulatory requirements, particularly withrespect to its capital requirements. Possible enforcement actions range from the imposition of a capital planand capital directive to receivership, conservatorship or the termination ofdeposit insurance.  Under the FDI Act,the FDIC has the authority to recommend to the Director of the OTS thatenforcement action be taken with respect to a particular savings association.  If action is not taken by the Director ofthe OTS, the FDIC has authority to take such action under certaincircumstances.

 

*Safety and Soundness Standards.*  Pursuant to the FDI Act, as amended by theFederal Deposit Insurance Corporation Improvement Act (“FDICIA”), and theRiegle Community Development and Regulatory Improvement Act of 1994, the OTSand the federal bank regulatory agencies adopted a set of guidelinesprescribing safety and soundness standards pursuant to FDICIA, as amended.  The guidelines establish general standardsrelating to internal controls, information systems, internal audit systems,loan documentation, credit underwriting, interest rate exposure, asset growth,asset quality, earnings and compensation, fees and benefits.  In general, the guidelines require, amongother things, appropriate systems and practices to identify and manage therisks and exposures specified in the

 

18

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guidelines.  The guidelinesprohibit excessive compensation as an unsafe and unsound practice and describecompensation as excessive when the amounts paid are unreasonable ordisproportionate to the services performed by an executive officer, employee,director or principal stockholder.  Inaddition, the OTS adopted regulations that authorize, but do not require, theOTS to order an institution that has been given notice by the OTS that it isnot satisfying any of such safety and soundness standards to submit acompliance plan.  If, after being sonotified, an institution fails to submit an acceptable compliance plan or failsin any material respect to implement an accepted compliance plan, the OTS mustissue an order directing action to correct the deficiency and may issue anorder directing corrective actions and other actions of the types to which anundercapitalized association is subject under the “prompt corrective action”provisions of FDICIA.  If an institutionfails to comply with such an order, the OTS may seek to enforce such order injudicial proceedings and to impose civil money penalties.

 

*Prompt Corrective Action Standards.*  The OTS and the FDIC are authorized and,under certain circumstances, required to take certain actions against anyassociation that fails to meet its capital requirements.  For this purpose, a savings bank is placedin one of the following four categories based on the associations capital:  (a) well-capitalized, (b) adequatelycapitalized, (c) undercapitalized or (d) critically undercapitalized.  The OTS is generally required to take actionto restrict the activities of an “undercapitalized association” (generallydefined to be one with less than a 4.00% core ratio or Tier 1 risked-basedcapital ratio or less than an 8.00% risk-based capital ratio).  Any such association must submit a capitalrestoration plan and until such plan is approved by the OTS may not increaseits assets, acquire another institution, establish a branch or engage in anynew activities, and generally may not make capital distributions.  The OTS is authorized to impose theadditional restrictions discussed below that are applicable to significantlyundercapitalized associations.

 

As a condition tothe approval of the capital restoration plan, any company controlling anundercapitalized association must agree that it will enter into a limitedcapital maintenance guarantee with respect to the institution’s achievement ofits capital requirements.

 

Any savingsassociation that fails to comply with its capital plan or is “significantlyundercapitalized” (i.e., Tier 1 risk-based or core capital ratios of less than3.00% or a risk-based capital ratio of less than 6.00%) must be subject to oneor more of the additional specified actions and operating restrictions mandatedby FDICIA.  These actions andrestrictions include requiring the issuance of additional voting securities,limitations on asset growth, mandated asset reduction, changes in seniormanagement, divestiture, merger or acquisition of the association, restrictionson executive compensation and any other action the OTS deems appropriate.

 

An associationthat becomes “critically undercapitalized” (i.e., a tangible capital ratio of2.00% or less) is subject to further restrictions on its activities in additionto those applicable to significantly undercapitalized associations.  The FDIC must restrict the activities of acritically undercapitalized association and, among other things, prohibit anymaterial transaction outside the ordinary course of business or engaging incertain transactions with affiliates, without the approval of the FDIC.  The OTS must appoint a receiver (orconservator with the concurrence of the FDIC) for a savings association, withcertain limited exceptions, within 90 days after it becomes criticallyundercapitalized.

 

Anyundercapitalized association is also subject to other possible enforcementactions by the OTS or the FDIC.  Suchactions could include a capital directive, a cease-and-desist order, civilmoney penalties, the establishment of restrictions on all aspects of theassociation’s operations or the appointment of a receiver or conservator or aforced merger into another institution. The grounds for appointment of a conservator or receiver includesubstantially insufficient capital and losses or likely losses that willdeplete substantially all capital with no reasonable prospect for replenishmentof capital without federal assistance.

 

If the OTSdetermines that an association is in an unsafe or unsound condition or isengaged in an unsafe or unsound practice it is authorized to reclassify awell-capitalized association as an adequately capitalized association and ifthe association is adequately capitalized, to impose the restrictionsapplicable to an undercapitalized association.

 

19

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The imposition by the OTS or the FDIC of any of these measures on theBank may have a substantial adverse effect on the Bank’s and the Company’soperations and profitability and the value of the Company’s Common Stock.  The Company’s stockholders do not have preemptiverights, and therefore, if the Company is directed by the OTS or the FDIC toissue additional shares of Common Stock, such issuance may result in thedilution in the percentage of ownership of the Company of those persons owningshares of the Company’s Common Stock.

 

At June 30, 2004, the Bank met the criteria for beingwell-capitalized.

 

*Business Activities.*  The Bank derives its lending and investment powers from the HOLA,and the regulations of the OTS thereunder. Under these laws and regulations, the Bank may invest in mortgage loanssecured by residential and commercial real estate, commercial and consumerloans, certain types of debt securities and certain other assets.  The Bank may also establish servicecorporations that may engage in activities not otherwise permissible for theBank, including certain real estate equity investments and securities andinsurance brokerage.  These investmentpowers are subject to various limitations, including (a) a prohibition againstthe acquisition of any corporate debt security that is not rated in one of thefour highest rating categories; (b) a limit of 400.00% of an association’scapital on the aggregate amount of loans secured by non-residential real estateproperty; (c) a limit of 20.00% of an association’s assets on the aggregateamount of commercial and agricultural loans and leases with the amount ofcommercial loans in excess of 10.00% of assets being limited to small businessloans; (d) a limit of 35.00% of an association’s assets on the aggregate amountof consumer loans and acquisitions of certain debt securities; (e) a limit of5.00% of assets on non-conforming loans (loans in excess of the specificlimitations of the HOLA); and (f) a limit of the greater of 5.00% of assets oran association’s capital on certain construction loans made for the purpose offinancing what is or is expected to become residential property.  In addition, the HOLA and the OTSregulations provide that a federal savings association may invest up to 10.00%of its assets in tangible personal property for leasing purposes.  Such general leases, however, do not have tobe aggregated with the institution’s loans for purposes of the HOLA’sinvestment and lending limitations. During the fiscal year ended June 30, 2004, the Bank reclassifiedcertain loans into other HOLA categories allowed by the regulations.  The result of the reclassification allowedthe Bank to meet the 20.00% limitation with 16.39% of total Bank assets atJune 30, 2004.

 

*Loans to One Borrower*.  Under the HOLA, savings associations aregenerally subject to the same limits on Loans to One Borrower as are imposed onnational banks.  Generally, under theselimits, a savings association may not make a loan or extend credit to a singleor related group of borrowers in excess of 15.00% of the association’s unimpairedcapital and surplus.  Additional amountsmay be loaned, not in excess of 10.00% of unimpaired capital and surplus, ifsuch loans or extensions of credit are fully secured by readily-marketablecollateral.  Such collateral is definedto include certain debt and equity securities and bullion, but generally doesnot include real estate.  The Bank mayrequest a waiver from the OTS to exceed the 15.00% Loans to One Borrowerlimitation on a case by case basis.  AtJune 30, 2004, the Bank’s lending limit under this restriction was $10.8million.  The Bank is in compliance withthe Loans to One Borrower limitation and had no borrowers in excess of theLoans to One Borrower requirements at June 30, 2004.

 

*Insurance of Accounts and Regulationby the FDIC*.  The Bankis a member of the SAIF, which is administered by the FDIC.  Savings deposits are insured up to $100,000per insured member (as defined by law and regulation) by the FDIC and suchinsurance is backed by the full faith and credit of the United States Government.  As insurer, the FDIC imposes depositinsurance premiums and is authorized to conduct examinations of and to requirereporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in anyactivity the FDIC determines by regulation or order to pose a serious risk tothe FDIC.  The FDIC also has theauthority to initiate enforcement actions against savings associations, aftergiving the OTS an opportunity to take such action, and may terminate thedeposit insurance if it determines that the institution has engaged or isengaging in unsafe or unsound practices, or is in an unsafe or unsoundcondition.

 

Pursuant to FDICIA, the FDIC established a risk based assessment systemfor determining the deposit insurance assessments to be paid by insureddepositary institutions.  Under theassessment system, the FDIC assigns an institution to one of three capitalcategories based on the institution’s financial information as of its mostrecent quarterly financial report filed with the applicable bank regulatoryagency prior to commencement of the assessment period.  The three capital categories consist of (a)well-capitalized, (b) adequately capitalized, or (c) undercapitalized.  The FDIC also assigns an institution to one ofthree supervisory subcategories within each capital

 

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group.  The supervisory subgroupto which an institution is assigned is based on a supervisory evaluationprovided to the FDIC by the institution’s primary federal regulator andinformation that the FDIC determines to be relevant to the institution’sfinancial condition and the risk posed to the deposit insurance funds.  An institution’s assessment rate depends onthe capital category and supervisory subcategory to which it is assigned.  Under the regulation, there are nineassessment risk classifications (i.e., combinations of capital groups andsupervisory subgroups) to which different assessment rates are applied.  Assessment rates currently range from 0.00%of deposits for an institution in the highest category (i.e., well capitalizedand financially sound, with no more than a few minor weaknesses) to 0.27% ofdeposits for an institution in the lowest category (i.e., undercapitalized andsubstantial supervisory concern).  TheFDIC is authorized to raise the assessment rates as necessary to maintain therequired reserve ratio of 1.25%.  As aresult of the Deposit Insurance Funds Act of 1996 (the “1996 Act”), both theBIF and the SAIF currently satisfy the reserve ratio requirement atJune 30, 2004.

 

The 1996 Act also provides that the FDIC cannot assess regularinsurance assessments for an insurance fund unless required to maintain or toachieve the designated reserve ratio of 1.25%, except on those of its memberinstitutions that are not classified as “well capitalized” or that have beenfound to have “moderately severe” or “unsatisfactory” financial, operational orcompliance weaknesses.  The Bank has notbeen so classified by the FDIC or the OTS.

 

In addition, the 1996 Act expanded the assessment base for the paymentson the bonds issued in the late 1980s by the Financing Corporation torecapitalize the now defunct FSLIC to include the deposits of both BIF- andSAIF-insured institutions beginning January 1, 1997.  Both BIF and SAIF-insured deposits areassessed the same FICO rates.

 

Under the FDI Act, insurance of deposits may be terminated by the FDICupon a finding that the institution has engaged in unsafe or unsound practices,is in an unsafe or unsound condition to continue operations or has violated anyapplicable law, regulation, rule, order or condition imposed by the FDIC or theOTS.  The management of the Bank doesnot know of any practice, condition or violation that might lead to terminationof deposit insurance.

 

*Regulatory Capital Requirements*.  Federally insured savings associations, suchas the Bank, are required to maintain a minimum level of regulatorycapital.  The OTS has establishedcapital standards, including a tangible capital requirement, a leverage ratio(or core capital) requirement and a risk-based capital requirement applicableto such savings associations.  Thesecapital requirements must be generally as stringent as the comparable capitalrequirements for national banks.  TheOTS is also authorized to impose capital requirements in excess of thesestandards on individual associations on a case-by-case basis.

 

The capitalregulations require tangible capital not less than 1.50% of adjusted totalassets (as defined by regulation). Tangible capital generally includes common stockholders’ equity andretained earnings, and certain noncumulative perpetual preferred stock andrelated earnings on withdrawable accounts and deposits that qualify as corecapital.  In addition, all intangibleassets, other than a limited amount of mortgage servicing rights and othercategories must be deducted from tangible capital.  At June 30, 2004, the Bank had $4.6 million of unamortizedloan servicing rights.  Included intotal unamortized loan servicing was $64,000 of nonmortgage servicing rightswhich was required to be deducted from tangible capital.

 

The OTSregulations establish special capitalization requirements for savingsassociations that own subsidiaries. Under these regulations certain subsidiaries are consolidated forcapital purposes and others are excluded from assets and capital.  In determining compliance with the capitalrequirements, all subsidiaries engaged solely in activities permissible fornational banks or engaged in certain other activities solely as agent for itscustomers such as mortgage banking activities are “includable” subsidiariesthat are consolidated for capital purposes in proportion to the association’slevel of ownership, including the assets of includable subsidiaries in whichthe association has a minority interest that is not consolidated for GAAPpurposes.  All subsidiaries of the Bankare includable subsidiaries.

 

The capitalstandards also require core capital equal to at least 4.00% of adjusted totalassets (as defined by regulation).  Corecapital generally consists of tangible capital plus certain intangible assets,and up to 25.00% of other intangibles which meet certain separate salabilityand market valuation tests.  AtJune 30, 2004, the Bank had $5.0 million in intangible assets which weresubject to these tests.  The amount ofservicing rights includable as core capital is limited to 50.00% of suchcapital.  At June 30, 2004, theBank had Tier I (core) capital equal to $69.8 million, or

 

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8.28% of adjusted totalassets, which is $36.1 million above the minimum leverage ratio requirement of4.00% as in effect on that date.

 

The OTS risk-basedcapital requirement requires savings associations to have total capital of atleast 8.00% of risk-weighted assets. Total capital consists of core capital, as defined above, andsupplementary capital.  Supplementarycapital consists of certain permanent and maturing capital instruments that donot qualify as core capital and general valuation loan and lease lossallowances up to a maximum of 1.25% of risk-weighted assets.  Supplementary capital may be used to satisfythe risk-based requirement only to the extent of core capital up to 100.00% ofcore capital.  At June 30, 2004,the Bank had no capital instruments that qualified as supplementary capital and$3.0 million of general loss reserves, which was not in excess of 1.25% ofrisk-weighted assets.

 

Certain exclusionsfrom capital and assets are required to be made for the purpose of calculatingtotal capital, in addition to the adjustments required for calculating corecapital.  Such exclusions consist ofequity investments (as defined by regulation) and that portion of land loansand nonresidential construction loans in excess of an 80.00% loan-to-valueratio, retained interest on securitizations and reciprocal holdings ofqualifying capital instruments.  TheBank had $1.9 million in dollar for dollar exclusions from capital and assetsat June 30, 2004 for the retained interest from securitized automobileloans.

 

In determining theamount of risk-weighted assets, all assets, including certain off-balance sheetitems, will be multiplied by the appropriate risk weight based on the risksinherent in the type of assets.  Therisk weights assigned by the OTS for principal categories of assets are: (a)0.00% for cash and securities issued by the United States Government orunconditionally backed by the full faith and credit of the United StatesGovernment, (b) 20.00% for securities (other than equity securities) issued byUnited States Government sponsored agencies, high quality mortgage-backedsecurities  and mortgage-backedsecurities issued by, or fully guaranteed as to principal and interest by, theFNMA or the FHLMC except for those classes with residual characteristics orstripped mortgaged-related securities, (c) 50.00% for prudently underwrittenpermanent one- to four-family first lien mortgage loans not more than 90 daysdelinquent and having a loan-to-value ratio of not more than 80.00% atorigination unless insured to such ratio by an insurer approved by FNMA orFHLMC and (d) 100.00% for all other loans and investments, including consumerloans, commercial loans, repossessed and loans more than 90 days past due andall other assets.

 

On June 30,2004, the Bank had total risk-based capital of $71.5 million (including $69.8million in core capital, $3.6 million in qualifying supplementary capital anddollar for dollar exclusions for the retained interest from securitizedautomobile loans of $1.9 million) and risk-weighted assets of $678.4 million(including $24.9 million in converted off-balance sheet assets), or totalcapital of 10.54% of risk-weighted assets. This amount was $17.2 million above the 8.00% requirement in effect onthat date.

 

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The following table setsforth the Bank’s compliance with its capital requirements at June 30,2004.

 
|                    |   | **Amount(2)**               |       | **Percent of  Applicable  Assets(1)** |       |
|-------------------------|--------|-----------------------------|------------|---------------------------------------|------------|
|                    |   | **(Dollars  in Thousands)** |       |
|                    |   |                        | ** ** |                                  | ** ** |
| GAAP capital            |   | $                           | 73,386     |                                  | 8.68       | % |
|                    |   |                        |       |                                  |       |
| Tier I (core) capital   |   | $                           | 69,762     |                                  | 8.28       | % |
| Required                |   | 33,689                      |       | 4.00                                  |       |
| Excess over requirement |   | $                           | 36,073     |                                  | 4.28       | % |
|                    |   |                        |       |                                  |       |
| Risk-based capital(3)   |   | $                           | 71,502     |                                  | 10.54      | % |
| Required                |   | 54,270                      |       | 8.00                                  |       |
| Excess over requirement |   | $                           | 17,232     |                                  | 2.54       | % |

 

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(1)                                  TierI (core) capital figures are determined as a percentage of total adjustedassets; risk-based capital figures are determined as a percentage ofrisk-weighted assets.

(2)                                  TheBank’s investment in its subsidiaries is included for purposes of calculatingregulatory capital.

(3)                                  Includesqualifying supplementary capital of $3.6 million and dollar for dollarexclusion for the retained interest from securitized automobile loans of $1.9million.

 

Under FDICIA allthe Federal banking agencies, including the OTS, must revise their risk-basedcapital requirements to ensure that such requirements account for interest raterisk, concentration of credit risk and the risks of non-traditional activities,and to further endure that they reflect the actual performance of and expectedloss on multi-family loans.  On May 10,2002, the OTS adopted an amendment to its capital regulations that eliminatedthe interest rate risk component of the risk-based capital requirement.

 

*Limitations on Dividends and OtherCapital Distributions*. The OTS regulations impose various restrictions or requirements onassociations with respect to their ability to pay dividends or make otherdistributions of capital.  The OTSregulations prohibit an association from declaring or paying any dividends orfrom repurchasing any of its stock if, as a result, the regulatory capital ofthe association would be reduced below the amount required to be maintained forthe liquidation account established in connection with its mutual to stockconversion.

 

The OTS imposesvarious restrictions or requirements on the Bank’s ability to make capitaldistributions, including cash dividends. A savings institution that is the subsidiary of a savings and loanholding company must file a notice with the OTS at least 30 days before makinga capital distribution.  The Bank mustfile an application for prior approval if the total amount of its capitaldistributions, including the proposed distribution, for the applicable calendaryear would exceed an amount equal to the Bank’s net income for that year plusretained net income for the previous two years.

 

The OTS maydisapprove of a notice or application if:

 

•                  the Bank would be undercapitalizedfollowing the distribution;

•                  the proposed capital distributionraises safety and soundness concerns; or

•                  the capital distribution wouldviolate a prohibition contained in any statute, regulation or agreement.

 

*Liquidity*.  All savings associations, including theBank, are required to maintain a sufficient amount of liquid assets to ensureits safe and sound operation.  For adiscussion of what the Bank includes in liquid assets, see “Management’sDiscussion and Analysis of Financial Condition and Results of Operations -Liquidity and Capital Resources.”  AtJune 30, 2004, the Bank’s overall liquid asset ratio was 4.28%.

 

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*Branching.*  Subject to certain limitations, the HOLA andthe OTS regulations permit federally chartered savings associations to establishbranches in any state of the United States. The authority to establish such branches is available (a) in states thatexpressly authorize branches of savings associations located in another stateor (b) to an association that qualifies as a “domestic building and loanassociation” under the Internal Revenue Code of 1986, as amended, which imposesqualification requirements similar to those for a “qualified thrift lender”under the HOLA.  See the section belowentitled “Qualified Thrift Lender Test.” The authority for a federal savings association to establish aninterstate branch network would facilitate a geographic diversification of theassociation’s activities.  Thisauthority under the HOLA and the OTS regulations preempts any state law purportingto regulate branching by federal savings associations.

 

*Community Reinvestment.*  Under the Community Reinvestment Act (the“CRA”), as implemented by the OTS regulations, a savings association has acontinuing and affirmative obligation consistent with its safe and soundoperation to help meet the credit needs of its entire community, including lowand moderate income neighborhoods.  TheCRA does not establish specific lending requirements or programs for financialinstitutions nor does it limit an institution’s discretion to develop the typesof products and services that it believes are best suited to its particularcommunity, consistent with the CRA.  TheCRA requires the OTS, in connection with its examination of a savingsassociation, to assess the association’s record of meeting the credit needs ofits community and to take such record into account in its evaluation of certainapplications by such association.  TheCRA also requires all institutions to make public disclosure of their CRAratings.  The Association receivedan  “Outstanding” CRA rating in its mostrecent examination.

 

The CRAregulations rate an institution based on its actual performance in meetingcommunity needs.  In particular, therating system focuses on three tests: (a) a lending test, to evaluate the institution’s record of making loansin its assessment areas; (b) an investment test, to evaluate the institution’srecord of investing in community development projects, affordable housing, andprograms benefiting low or moderate income individuals and businesses; and (c)a service test, to evaluate the institution’s delivery of services through itsbranches, ATMs and other offices.  Theamended CRA regulations also clarify how an institution’s CRA performance wouldbe considered in the application process.

 

*Qualified Thrift Lender Test*.  All savings associations, including theBank, are required to meet a qualified thrift lender (“QTL”) test to avoidcertain restrictions on their operations. This test requires a savings association to have at least 65.00% of itsportfolio assets (which consists of total assets less the sum of goodwill andother intangible assets, properties used to conduct the savings association’sbusiness and specified liquid assets not exceeding 20.00% of total assets) inqualified thrift investments on a monthly average for nine out of every 12months on a rolling basis.  AtJune 30, 2004 the Bank maintained 78.95% of its portfolio assets inqualified thrift investments, and thus met the test.  The Bank has met the QTL test since its inception.

 

Loans andmortgage-backed securities secured by domestic residential housing, FHLB stock,credit card loans, educational loans and certain small business loans as wellas certain obligations of the Federal Savings and Loan Insurance Corporation(“FSLIC”), the FDIC and certain other related entities may be included inqualifying thrift investments without limit. FHLMC and FNMA stock and certain other housing-related and non-residentialreal estate loans and investments, including loans to develop churches, nursinghomes, hospitals and schools, and consumer loans and investments insubsidiaries engaged in housing-related activities may also be included, invarying amounts, not to exceed 20.00% of portfolio assets.

 

Any savingsassociation that fails to meet the QTL test must either convert to a nationalbank charter or operate under certain restrictions on its activities, unless itrequalifies as a QTL and thereafter remains a QTL.  If any association that fails the QTL test is controlled by aholding company, then within one year after the failure, the holding companymust register as a bank holding company and become subject to all restrictionson bank holding companies.  See the section belowentitled “Holding Company Regulation.”

 

*Transactions with Affiliates*.  The Bank’s authority to engage intransactions with its “affiliates” is limited by the OTS regulations and bySections 23A and 23B of the Federal Reserve Act (the “FRA”).  In general, an affiliate of the Bank is any companythat controls the Bank or any other company that is controlled by a companythat controls the Bank, excluding the Bank’s subsidiaries other than those thatare insured depository institutions. The OTS regulations prohibit a savings association (a) from lending toany of its affiliates that is engaged in activities that are not

 

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permissible for bankholding companies under Section 4(c) of the BHC Act and (b) frompurchasing the securities of any affiliate other than a subsidiary.  Section 23A of the FRA limits theaggregate amount of transactions with any individual affiliate to 10.00% of thecapital and surplus of the savings association and also limits the aggregateamount of transactions with all affiliates to 20.00% of the savingsassociation’s capital and surplus. Extensions of credit to affiliates are required to be secured bycollateral in an amount and of a type described in Section 23A of the FRA,and the purchase of low quality assets from affiliates is generallyprohibited.  Section 23B of the FRAprovides that certain transactions with affiliates, including loans and assetpurchases, must be on terms and under circumstances, including credit standards,that are substantially the same or at least as favorable to the association asthose prevailing at the time for comparable transactions with non-affiliatedcompanies.  In the absence of comparabletransactions, such transactions may only occur under terms and circumstances,including credit standards, that in good faith would be offered to or wouldapply to non-affiliated companies.

 

Effective April 1, 2003, the FRB rescinded its interpretations ofSections 23A and 23B of the FRA and replaced these interpretations withRegulation W.  In addition, Regulation Wmakes various changes to existing law regarding Sections 23A and 23B of theFRA, including expanding the definition of what constitutes an affiliatesubject to Sections 23A and 23B of the FRA and exempting certain subsidiariesof state-chartered banks from the restrictions of Sections 23A and 23B of theFRA.

 

Under Regulation W, all transactions entered into on or beforeDecember 12, 2002, which either became subject to Sections 23A and 23B ofthe FRA solely because of Regulation W, and all transactions covered bySections 23A and 23B of the FRA, the treatment of which will change solelybecause of Regulation W, became subject to Regulation W on July 1,2003.  All other covered affiliatetransactions became subject to Regulation W on April 1, 2003.  The FRB expects each depository institutionthat is subject to Sections 23A and 23B of the FRA to implement policies andprocedures to ensure compliance with Regulation W.  Changes made by Regulation W did not have a material adverseeffect on the Company’s business.

 

The Bank’s authority to extend credit to its directors, executiveofficers and 10.00% stockholders, as well as to entities controlled by suchpersons, is currently governed by the requirements of Sections 22(g) and 22(h)of the FRA and Regulation O of the FRB thereunder.  Among other things, these provisions require that extensions ofcredit to insiders (a) be made on terms that are substantially the same as, andfollow credit underwriting procedures that are not less stringent than, thoseprevailing for comparable transactions with unaffiliated persons and that donot involve more than the normal risk of repayment or present other unfavorablefeatures and (b) not exceed certain limitations on the amount of theassociation’s capital.  In addition,extensions of credit in excess of certain limits must be approved by theassociation’s board of directors. Section 402 of the Sarbanes-Oxley Act of 2002 (the “Sarbanes-OxleyAct”) prohibits the extension of personal loans to directors and executiveofficers of issuers (as defined in the Sarbanes-Oxley Act).  The prohibition, however, does not apply tomortgages advanced by an insured depository institution, such as the Bank, thatare subject to the insider lending restrictions of Section 22(h) of theFRA.

 

Certaintransactions with directors, officers or controlling persons are also subjectto conflict of interest regulations enforced by the OTS.  These conflict of interest regulations andother statutes also impose restrictions on loans to such persons and theirrelated interests.  Among other things,such loans must be made on terms substantially the same as those for loans tounaffiliated individuals.

 

*Real Estate Lending Standards.*  The OTS and the other federal bankingagencies adopted regulations to prescribe standards for extensions of creditthat (a) are secured by real estate or (b) are made for the purpose offinancing the construction of improvements on real estate.  The OTS regulations require each savingsassociation to establish and maintain written internal real estate lendingstandards that are consistent with safe and sound banking practices andappropriate to the size of the association and the nature and scope of its realestate lending activities.  Thestandards also must be consistent with accompanying OTS guidelines, whichinclude loan-to-value ratios for the different types of real estate loans.  Associations are also permitted to make alimited amount of loans that do not conform to the proposed loan-to-valuelimitations so long as such exceptions are reviewed and justifiedappropriately.  The guidelines also lista number of lending situations in which exceptions to the loan-to-valuestandards are justified.

 

*Privacy Regulations.*  Under the OTS regulations adopted pursuant to the Gramm-Leach-BlileyAct of 1999 (“GLB Act”), the Bank is required to adopt proceduresto protect customers’ “nonpublic personal information.”  The new regulations generally require thatthe Bank disclose its privacy policy, including identifying with whom it

 

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shares a customer’s “nonpublic personal information,” to customers atthe time of establishing the customer relationship and annuallythereafter.  In addition, the Bank isrequired to provide its customers with the ability to “opt-out” of having itshare their personal information with unaffiliated third parties and not todisclose account numbers or access codes to nonaffiliated third parties formarketing purposes.  The Bank currentlyhas a privacy protection policy in place, which has been reviewed, forcompliance with the regulations.

 

*Federal Reserve System*.  Under FRB regulations, the Bank is requiredto maintain noninterest-earning reserves against its transaction accounts.  FRB regulations generally require that (a)reserves of 3.00% must be maintained against aggregate transaction accounts of$45.4 million or less, subject to adjustment by the FRB, and (b) a reserve of$1.2 million plus 10.00% (subject to adjustment by the FRB between 8.00% and14.00%) must be maintained against that portion of total transaction accountsin excess of $45.4 million.  The first$6.6 million of otherwise reservable balances are exempted from the reserverequirements.  The Bank is in compliancewith these reserve requirements at June 30, 2004.  Because required reserves must be maintainedin the form of either vault cash, a noninterest bearing account at a FRB, or apassthrough account as defined by the FRB, the effect of this reserverequirement is to reduce the Bank’s interest-earning assets to the extent thatthe requirement exceeds vault cash.

 

*Federal Home Loan Bank System*.  The Bank is a member of the FHLB of DesMoines, which is one of 12 regional FHLBs that administers the home financingcredit function of savings associations. Each FHLB serves as a reserve or central bank for its members within itsassigned region.  It is funded primarilyfrom proceeds derived from the sale of consolidated obligations of the FHLBSystem.  It makes loans to members (i.e.,advances) in accordance with policies and procedures established by the boardof directors of the FHLB.  Thesepolicies and procedures are subject to the regulation and oversight of theFederal Housing Finance Board.  Alladvances from the FHLB are required to be fully secured by sufficientcollateral as determined by the FHLB. On July 1, 2003 the FHLB of Des Moines implemented a new capitalplan converting from a subscription capital structure to a new permanentcapital structure mandated by the GLB Act. Under this new capital plan, the Bank, as a member of the FHLB of DesMoines, is required to acquire and hold shares of capital stock in the FHLB ofDes Moines equal to 0.12% of the total assets of the Bank at December 31annually.  The Bank is also required toown activity-based stock, which is based on 4.45% of the Bank’s outstandingadvances.  These percentages are subjectto change at the discretion of the FHLB Board of Directors.

 

At June 30, 2004, the Bank had $5.5 million in FHLB stock, whichwas in compliance with this requirement. The Bank receives dividends on its FHLB stock, subject to approval bythe FHLB.  For the fiscal year endedJune 30, 2004, dividends paid by the FHLB of Des Moines to the Banktotaled approximately $107,000, which constitutes a $97,000 decrease in theamount of dividends received in fiscal year 2003.  This decrease was primarily due to a decrease in the dividendrate approved by the FHLB Board of Directors.

 

*Trust Activities Regulation. ***The Bank derives its trust powersfrom Section 5(n) of the HOLA and the regulations and policies of theOTS.  Under these laws, regulations andpolicies, the trust activities of federal savings banks are governed by bothfederal and state laws.  Generally, thescope of trust activities that the Bank can provide will be governed by thelaws of the states in which the Bank is “located” (as such term is definedunder the regulations of the OTS), while other aspects of the trust operationsof the Bank are governed by federal laws and regulations.  If the trust activities of a federal savingsbank are located in more than one state, however, then the scope of fiduciaryservices the federal savings bank can provide will vary depending on the lawsof each state.**

 

**The Bank, throughits trust department, acts as trustee, executor, administrator, guardian,custodian, record keeper, agent, registrar, advisor and manager for variousaccounts.  As of June 30, 2004, thetrust department of the Bank maintained approximately $83.0 million in assetsunder management.**

 

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*USAPatriot Act*.  Inresponse to the events of September 11, 2001, President George W. Bushsigned into law the Uniting and Strengthening America by Providing AppropriateTools Required to Intercept and Obstruct Terrorism Act of 2001 (the “USAPATRIOT Act”) on October 26, 2001. The USA PATRIOT Act gives the federal government new powers to addressterrorist threats through enhanced domestic security measures, expandedsurveillance powers, increased information sharing, and broadened anti-moneylaundering requirements.  By way ofamendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takesmeasures intended to encourage information-sharing among bank regulatoryagencies and law enforcement bodies. Further, certain provisions of Title III of the USA PATRIOT Act imposeaffirmative obligations on a broad range of financial institutions, includingbanks, thrifts, brokers, dealers, credit unions, money transfer agents andparties registered under the Commodity Exchange Act.

 

Among other requirements, Title III of the USA PATRIOTAct imposes the following requirements with respect to financial institutions:

 

•                  Pursuant toSection 352, *all* financialinstitutions must establish anti-money laundering programs that include, atminimum: (a) internal policies, procedures, and controls, (b) specificdesignation of an anti-money laundering compliance officer, (c) ongoingemployee training programs, and (d) an independent audit function to test theanti-money laundering program.  Interimfinal rules implementing Section 352 were issued by the TreasuryDepartment on April 29, 2002, and were subsequently amended onNovember 6, 2002, and November 14, 2002.  Such rules state that a financial institution is in compliancewith Section 352 if it implements and maintains an anti-money launderingprogram that complies with the anti-money laundering regulations of its federalfunctional regulator.  The Bank is in compliancewith the OTS’s anti-money laundering regulations.

 

•                  Pursuant toSection 326, on May 9, 2003, the OTS, in conjunction with other bankregulators, issued a Joint Final Rule that provides for minimum standards withrespect to customer identification and verification.  This rule became effective October 1, 2003.

 

•                  Section 312requires financial institutions that establish, maintain, administer or manageprivate banking accounts or correspondent accounts in the United States fornon-United States persons or their representatives (including foreignindividuals visiting the United States) to establish appropriate, specific and,where necessary, enhanced due diligence policies, procedures and controlsdesigned to detect and report money laundering.

 

•                  EffectiveDecember 25, 2001, financial institutions are prohibited fromestablishing, maintaining, administering or managing correspondent accounts forforeign shell banks (foreign banks that do not have a physical presence in anycountry), and are be subject to certain recordkeeping obligations with respectto correspondent accounts of foreign banks.

 

•                  Bank regulatorsare directed to consider a holding company’s effectiveness in combating moneylaundering when ruling on FRA and Bank Merger Act applications.

 

*The Sarbanes-Oxley Act*.  OnJuly 30, 2002, President George W. Bush signed into law the Sarbanes-OxleyAct.  The Sarbanes-Oxley Act implementsa broad range of corporate governance and accounting measures for publiccompanies designed to promote honesty and transparency in corporate America andto better protect investors from the type of corporate wrongdoing that occurredin Enron, WorldCom and similar companies. The Sarbanes-Oxley Act generally applies to all companies, both U.S. andnon-U.S., that file or are required to file periodic reports with theSecurities and Exchange Commission (the “SEC”), under the Securities ExchangeAct of 1934, as amended (the “Exchange Act”).

 

The Sarbanes-Oxley Actincludes very specific additional disclosure requirements and new corporategovernance rules, requires the SEC and the securities exchanges to adoptextensive additional disclosure, corporate governance and other related rulesand mandates further studies of specified issues by the SEC and the ComptrollerGeneral.  The Sarbanes-Oxley Actrepresents significant federal involvement in matters traditionally left tostate regulatory systems, such as the regulation of the accounting profession,and to state corporate law, such as the relationship between a board ofdirectors and management and between a board of directors and its committees.

 

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The Sarbanes-Oxley Act’sprincipal legislation includes:

 

•                                    the creation of an independent accounting oversightboard;

 

•                                    auditor independence provisions which restrict non-auditservices that accountants may provide to their audit clients;

 

•                                    additional corporate governance and responsibilitymeasures, including the requirement that the chief executive officer and chieffinancial officer certify financial statements;

 

•                                    the forfeiture of bonuses or other incentive-basedcompensation and profits from the sale of an issuer’s securities by directorsand senior officers in the twelve month period following initial publication ofany financial statements that later require restatement;

 

•                                    an increase in the oversight of, and enhancement ofcertain requirements relating to audit committees of public companies and howthey interact with the Company’s independent auditors;

 

•                                    the requirement that audit committee members must beindependent and are absolutely barred from accepting consulting, advisory orother compensatory fees from the issuer;

 

•                                    the requirement that companies disclose whether atleast one member of the committee is an “audit committee financial expert” (assuch term is defined by the SEC) and if not, why not;

 

•                                    expanded disclosure requirements for corporateinsiders, including accelerated reporting of stock transactions by insiders anda prohibition  on insider  trading during pension blackout periods;

 

•                                    a prohibition on personal loans to directors andofficers, except certain loans made by insured financial institutions;

 

•                                    the disclosure of a code of ethics and filing aCurrent Report on Form 8-K for a change or waiver of such code;

 

•                                    the mandatory disclosure by analysts of potentialconflicts of interest; and

 

•                                    a range of enhanced penalties for fraud and otherviolations.

 

The SEC was delegated the task of enacting rules to implement variousprovisions with respect to, among other matters, disclosure in periodic filingspursuant to the Exchange Act.  Althoughthe SEC has implemented most of the provisions of the Sarbanes-Oxley Act, itdoes continue to issue final rules, reports and press releases.  As the SEC issues new rules, reports andpress releases, the Company reviews such requirements and complies as required.

 

Furthermore, the NASDAQ Stock Market (the “NASDAQ”) has alsoimplemented corporate governance rules which implement the mandates of theSarbanes-Oxley Act.  The material NASDAQrules include, among other things, ensuring that a majority of the board ofdirectors are independent of management, establishing and publishing a code ofconduct for directors, officers and employees, and requiring stockholderapproval of all new stock option plans and all material modifications.  These rules affect the Company because itscommon stock is listed on the NASDAQ under the symbol “HFFC.”

 

Although theCompany anticipates that it will incur additional expense in complying with theprovisions of the Sarbanes-Oxley Act and the resulting regulations, managementdoes not expect that such compliance will have a material impact on theCompany’s results of operations or financial condition.

 

*Holding Company Regulation*.  The Company is a unitary thrift holdingcompany subject to regulatory oversight by the OTS.  As such, the Company is registered with and files reports withthe OTS and is subject to regulation and examination by the OTS.  Under the GLB Act, any company which becomesa unitary savings and

 

28

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loan holding company pursuantto a charter application filed with the OTS after May 4, 1999, is prohibitedfrom engaging in non-financial activities or affiliating with non-financialcompanies.  All unitary savings and loanholding companies in existence prior to May 4, 1999, such as the Company, are“grandfathered” under the GLB Act and may continue to operate as a unitarysavings and loan holding company without any limitations in the types ofbusiness activities in which it can engage at the holding company level,provided the Bank continues to satisfy the QTL Test.  In addition, the OTS has enforcementauthority over the Company and its non-savings association subsidiaries whichalso permits the OTS to restrict or prohibit activities that are determined tobe a serious risk to the subsidiary savings association.

 

As a“grandfathered” unitary thrift holding company, the Company generally is notsubject to activity restrictions.  Ifthe Company acquires control of another savings association as a separatesubsidiary, it would become a multiple savings and loan holding company, andthe activities of the Company and any of its subsidiaries (other than the Bankor any other SAIF-insured savings association) would become subject to suchrestrictions unless such other associations each qualify as a QTL and wereacquired in a supervisory acquisition.

 

If the Bank failsthe QTL test, the Company must obtain the approval of the OTS prior tocontinuing after such failure, directly or through its other subsidiaries, anybusiness activity other than those approved for multiple savings and loanholding companies or their subsidiaries. In addition, within one year of such failure the Company must registeras, and will become subject to, the restrictions applicable to bank holdingcompanies.  The activities authorizedfor a bank holding company are more limited than are the activities authorizedfor a unitary or multiple savings and loan holding company.  See the section above entitled “QualifiedThrift Lender Test.”

 

Inaddition, for grandfathered savings and loan holding companies, such as theCompany, the GLB Act also prohibits the sale of such entities to nonfinancialcompanies.  This prohibition is intendedto restrict the transfer of grandfathered rights to other entities and,thereby, prevent evasion of the limitation on the creation of new unitarysavings and loan holding companies.

 

*Federal Securities Law*.  The common stock of the Company isregistered with the SEC under the Exchange Act.  The Company is subject to the information, proxy solicitation,insider trading restrictions and other requirements of the SEC under theExchange Act.

 

Company stock heldby persons who are affiliates (generally officers, directors and principalstockholders) of the Company may not be resold without registration or unlesssold in accordance with certain resale restrictions.  If the Company meets specified current public informationrequirements, each affiliate of the Company is able to sell in the publicmarket, without registration, a limited number of shares in any three-monthperiod.

 

**Federal and State Taxation**

 

The Company andits direct and indirect subsidiaries file a consolidated federal income taxreturn on a fiscal year basis.  Inaddition, each of Trust I, Trust II, Trust III, Trust IV and Home FederalAutomobile Securitization Trust 2003-A are required to file individual trustreturns on a calendar year basis.

 

In addition to theregular income tax, corporations, including savings associations such as theBank, generally are subject to a minimum tax. An alternative minimum tax is imposed at a minimum tax rate of 20.00% onalternative minimum taxable income, which is the sum of a corporation’s regulartaxable income (with certain adjustments) and tax preference items, less anyavailable exemption.  The alternativeminimum tax is imposed to the extent it exceeds the corporation’s regularincome tax and net operating losses can offset no more than 90.00% ofalternative minimum taxable income.

 

To the extentearnings appropriated to a savings association’s bad debt reserves for“qualifying real property loans” and deducted for federal income tax purposesexceed the allowable amount of such reserves computed under the experiencemethod and to the extent of the association’s supplemental reserves for losseson loans (“Excess”), such Excess may not, without adverse tax consequences, beutilized for the payment of cash dividends or other distributions to ashareholder (including distributions on redemption, dissolution or liquidation)or for any other purpose (except to absorb bad debt losses).  As of June 30, 2004, the Bank’s Excessfor tax purposes totaled approximately $4.8 million.

 

29

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*South Dakota Taxation*.  The Bank is subject to the South DakotaFranchise tax to the extent that such corporations are engaged in business inthe state of South Dakota. South Dakota does not have a corporate income tax.  The franchise tax will be imposed at a rateof 6.00% on franchise taxable income which is computed in the same manner asfederal taxable income with some minor variations to comply with South Dakotalaw, other than the carryover of net operating losses which is not permittedunder South Dakota law.  A South Dakotareturn of franchise tax must be filed annually.

 

*MinnesotaTaxation.*  The Bank issubject to the Minnesota Corporate Income tax to the extent that suchcorporations are engaged in business in the state of Minnesota.  The Corporate Income tax is imposed at arate of 9.8% on corporate taxable income, which is computed in the same manneras federal taxable income with some minor variations to comply with Minnesotalaw.  A Minnesota return of CorporateIncome tax must be filed annually.

 

*Delaware Taxation*.  As a Delaware holding company, the Companyis exempted from Delaware corporate income tax but is required to file anannual report with and pay an annual fee to the State of Delaware.  The Company is also subject to an annualfranchise tax imposed by the State of Delaware.

 

*Taxation in Other States.*  Mid America Leasing may be required to filestate income tax returns in those states which lessees have operations.  The total taxes paid in the year ended June30, 2004 were not material to the operation of Company.

 

**Executive Officers of the Company**

 

The followinginformation as to the business experience during the past five years issupplied with respect to executive officers of the Company and the Bank.

 

*Curtis L. Hage*- Mr. Hage, age 58, is Chairman, President and Chief Executive Officer of theCompany.  He was elected Chairman of theBoard of Directors of the Company in September 1996 and has held theposition of President and Chief Executive Officer sinceFebruary 1991.  Prior to such time,Mr. Hage served as Executive Vice President of the Bank since 1986.  Since joining the Bank in 1968, he served invarious capacities prior to being elected Executive Vice President.  Mr. Hage received his M.B.A. from theUniversity of South Dakota and attended the Graduate School of SavingsInstitution Management at the University of Texas.

 

*Darrel L. Posegate*– Mr. Posegate, age 46, is Executive Vice President/Chief Financial Officer andTreasurer of the Company and the Bank, a position he has held sinceJanuary 2002.  He was employed asChief Financial Officer for West Des Moines State Bank, Des Moines, IA, a statebanking institution, from 1998 until joining the Bank.  Prior to that time he was employed asPresident of Liberty Services, Inc., a bank services company, from 1994 to1998.  Mr. Posegate received his B.A.degree from Luther College, Decorah, IA, and is a Certified Public Accountant.

 

*David A. Brown*– Mr. Brown, age 42, is Senior Vice President/Business Banking, a position hehas held since November 1999. Prior to joining the Bank, Mr. Brown served as Vice President/ManagerCommercial Banking at Firstar Bank, Sioux City, Iowa, a national bankinginstitution, a position he held since December 1998.  Mr. Brown received his Masters of BusinessAdministration and a B.S. in Business Administration from University of SouthDakota.

 

*Mary F. Hitzemann*- Ms. Hitzemann, age 51, is Senior Vice President/Human Resources, a positionshe has held since October 1993. Ms. Hitzemann joined the Bank in January 1993.  Prior to that time, she was employed as VicePresident of Human Resources for Rapid City Regional Hospital from May 1989 toMay 1992.  Ms. Hitzemann received herB.A. degree from Augustana College.

 

*Mark S. Sivertson*- Mr. Sivertson, age 46, is Senior Vice President/Trust Officer, a positionhe has held since July 1996.  Hejoined the Bank in February 1995 as Vice President/Trust Officer.  Prior to joining the Bank, Mr. Sivertson wasVice President and Trust Officer in charge of the Investment Management and TrustDepartment at Western Bank.  He holds alaw degree from the University of North Dakota and the Certified TrustFinancial Advisor designation from the American Bankers Association.

 

30

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*Natalie A. Solberg –*Ms. Solberg, age 41, is Senior Vice President/Service and Support.  Since joining the Bank inFebruary 1994, she has been responsible for managing automated telephonebanking, deposit operations and retail support functions.  She was promoted to Vice President/In-TouchBanking in October 1995, and subsequently, held the position of VicePresident/Retail Support.  Prior tojoining the Bank, she was employed by the Bank of New York fromOctober 1989 to October 1993. Ms. Solberg received her B.S. from Northern State University.

 

*Raymond C. Wilson*– Mr. Wilson, age 46, is Vice President/Senior Controller for the Bank.  Mr. Wilson joined the Bank inSeptember 2003.  Prior to joiningthe Bank, he held senior financial and accounting management positions with twocommunity banks in Ohio.  Mr. Wilsonreceived his BBA and MAFIS from Cleveland State University, Cleveland, Ohio.

 

**Item 2****.  Properties**

 

The Company andits direct and indirect subsidiaries conduct their business at the main officelocated at 225 South Main Avenue, Sioux Falls, South Dakota, 57104.  Currently, the Bank also conducts businessfrom 33 other offices located in its primary market area.  Of such 34 total business offices, theCompany owns 20 and leases 14 others.

 

The total net bookvalue of the Company’s premises and equipment (including land, building,leasehold improvements and furniture, fixtures and equipment) at June 30,2004 was $12.6 million.  Managementbelieves that the Company’s existing properties are adequate for its currentneeds.

 

**Item 3****.  Legal Proceedings**

 

The Company, theBank and their subsidiaries are, from time to time, involved as plaintiff ordefendant in various legal actions arising in the normal course of theirbusinesses.  While the ultimate outcomeof any such proceedings cannot be predicted with certainty, it is generally theopinion of management, after consultation with counsel representing the Bankand the Company in any such proceedings, that the resolution of any suchproceedings should not have a material effect on the Company’s consolidatedfinancial position or results of operations. The Company, the Bank and their direct and indirect subsidiaries are notaware of any legal actions or other proceedings contemplated by governmentalauthorities outside of the normal course of business.

 

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

 

No matter wassubmitted to a vote of security holders, through the solicitation of proxies orotherwise, during the quarterly period ended June 30, 2004.

 

31

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**PART II**

 

**Item 5****.  Market for Registrant’s Common Equity,Related Stockholder Matters and Issuer Purchases of Equity Securities**

 

**Stock Listing**

 

The Company’s CommonStock is traded under the symbol “HFFC” on the NASDAQ National Market System.

 

The following table setsforth the range of high and low sale prices for the Company’s Common Stock foreach of the fiscal quarters of the two years ended June 30, 2004 and 2003.  Quotations for such periods are as reportedby the NASDAQ National Market System and have been retroactively adjusted forthe 10% stock dividend paid on December 31, 2003 to shareholders of record asof December 3, 2003.

 
| **FISCAL  2004** | ** ** | **HIGH** | ** ** | **LOW** | ** ** |
|------------------|------------|----------|------------|---------|------------|
| 1st Quarter      |       | $        | 17.32      |    | $          | 15.09 |   |
| 2nd Quarter      |       | $        | 17.04      |    | $          | 15.09 |   |
| 3rd Quarter      |       | $        | 18.25      |    | $          | 15.90 |   |
| 4th Quarter      |       | $        | 17.75      |    | $          | 14.28 |   |

 
| **FISCAL  2003** | ** ** | **HIGH** | ** ** | **LOW** | ** ** |
|------------------|------------|----------|------------|---------|------------|
| 1st Quarter      |       | $        | 11.81      |    | $          | 9.77 |   |
| 2nd Quarter      |       | $        | 13.64      |    | $          | 9.55 |   |
| 3rd Quarter      |       | $        | 15.46      |    | $          | 12.55 |   |
| 4th Quarter      |       | $        | 17.95      |    | $          | 14.54 |   |

 

As of September 22, 2004,the Company had 536 holders of record of its Common Stock.

 

The transfer agent forthe Company’s Common Stock is Mellon Investor Services, PO Box 3315, SouthHackensack, New Jersey, 07606-1915.

 

**Dividends**

 

On a quarterly basis, theCompany paid average cash dividends of $0.107 per share throughout fiscal 2004as compared to $0.105 per share throughout fiscal 2003.  The Board of Directors intends to continuethe payment of quarterly cash dividends, dependent on the results of operationsand financial condition of the Company, tax considerations, industry standards,economic conditions, general business practices and other factors the Board ofDirectors deems relevant.  On July 21,2004, the Board of Directors approved an increase in cash dividends to $0.108per share and the Company paid the respective cash dividends on August 18, 2004to shareholders of record on August 4, 2004. The Company’s ability to pay dividends is dependent on the dividendpayments it receives from its subsidiary, the Bank, which are subject to OTSregulations.  In addition, the Company’sability to pay dividends is subject to the terms of its line of credit withFirst Tennessee Bank, NA.  See Item 7,“Management’s Discussion and Analysis of Financial Condition and Results of Operations– Liquidity and Capital Resources.”

 

**Sales of Unregistered Stock**

 

The Company had no salesof unregistered stock during the fiscal year ended June 30, 2004.

 

32

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**Issuer Purchases of EquitySecurities**

 

The following table setsforth the purchases by the Company of its common stock during the quarterlyperiod ended June 30, 2004.

 
| **Period**         | ** ** | **Total  Number  of Shares  Purchased** | ** ** | **Average  Price Paid  per Share** | ** ** | **Total Number  of Shares Purchased  as Part of Publicly  Announced Programs** | ** ** | **Maximum Number of  Shares that May Yet  Be Purchased Under  the Current Program** | ** ** |
|--------------------|------------|-----------------------------------------|------------|------------------------------------|------------|--------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------------------|------------|
| April 1 - 30, 2004 |       | 0                                       |       | $                                  | 0.00       |                                                                           | 0          |                                                                                | 172,161    |   |
| May 1 - 31, 2004   |       | 0                                       |       | $                                  | 0.00       |                                                                           | 0          |                                                                                | 352,981    |   |
| June 1 - 30, 2004  |       | 0                                       |       | $                                  | 0.00       |                                                                           | 0          |                                                                                | 352,981    |   |
|               |       |                                    |       |                               |       |                                                                           |       |                                                                                |       |
| 4th Quarter Total  |       | 0                                       |       | $                                  | 0.00       |                                                                           | 0          |                                                                                |       |   |

 

The repurchases madeduring the fiscal year ended June 30, 2004 were made under the Company’s stockbuy back program which was publicly announced on April 28, 2003, in which theCompany was permitted to repurchase up to 10% of the common stock of theCompany that was outstanding on May 1, 2003. This stock buy back program expired on April 30, 2004.  A total of 154,300 shares of common stockwere purchased pursuant to the program with no shares purchased during April2004.  All of the 154,300 shares repurchasedduring the fiscal year ended June 30, 2004 were purchased in the open-market,except for 11,000 shares that were purchased at a price of $17.60 through aprivate transaction.

 

The Company approved anew stock buy back program which began on May 1, 2004 and was publiclyannounced on April 26, 2004.  Under thisprogram, the Company may repurchase up to 10% of the common stock of theCompany outstanding on May 1, 2004 through April 30, 2005.  No shares of common stock were purchasedpursuant to this program during May or June 2004.

 

33

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**Item 6****.  Selected Financial Data**

 

The following table setsforth selected financial data with respect to the Company for the periodsindicated.  This information should beread in conjunction with the Financial Statements and related notes appearingelsewhere in this Form 10-K and “Management’s Discussion and Analysis ofFinancial Condition and Results of Operations.” The Company’s selected financial statement and operations data for eachof the years set forth below have been derived from financial statements, whichhave been audited by McGladrey & Pullen, LLP, independent publicaccountants.

 
| ** **                                           | ** ** | **At June 30,**            | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                           | ** ** | **(Dollars in Thousands)** | ** ** |
| **Selected Statement of Financial Condition  Data:** |       |                       |       |   |   |   |   |   |   |   |   |
| Total assets                                         |       | $                          | 847,070    |   | $ | 801,103 |   | $ | 723,227 |   | $ | 784,002 |   | $ | 724,997 |   |
| Securities available for sale                        |       | 122,715                    |       | 88,527 |   | 82,804 |   | 87,387 |   | 107,316 |   |
| FHLB stock                                           |       | 5,469                      |       | 7,025 |   | 6,332 |   | 6,332 |   | 6,130 |   |
| Loans and leases receivable                          |       | 640,946                    |       | 595,417 |   | 559,814 |   | 563,836 |   | 542,494 |   |
| Loans held for sale                                  |       | 10,351                     |       | 15,984 |   | 6,559 |   | 7,270 |   | 8,257 |   |
| Deposits                                             |       | 658,719                    |       | 621,381 |   | 562,596 |   | 601,207 |   | 545,497 |   |
| Advances from FHLB and other borrowings              |       | 93,750                     |       | 89,819 |   | 84,308 |   | 108,376 |   | 113,020 |   |
| Subordinated debentures payable to trusts            |       | 27,837                     |       | 20,620 |   | 10,310 |   | — |   | — |   |
| Stockholders’ equity                            |       | 51,649                     |       | 49,358 |   | 48,536 |   | 52,525 |   | 46,943 |   |
|                                                      |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                                   | ** ** | **Years Ended June 30,**                          | ** ** |
|------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                   | ** ** | **2004**                                          | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                   | ** ** | **(Dollars in Thousands, Except Per Share Data)** | ** ** |
| **Selected Statement of Income Data:**                                       |       |                                              |       |   |   |   |   |   |   |   |   |
| Interest and dividend income                                                 |       | $                                                 | 40,260     |   | $ | 44,262 |   | $ | 48,185 |   | $ | 58,463 |   | $ | 52,134 |   |
| Interest expense                                                             |       | 15,188                                            |       | 17,997 |   | 23,573 |   | 35,051 |   | 29,141 |   |
| Net interest income                                                          |       | 25,072                                            |       | 26,265 |   | 24,612 |   | 23,412 |   | 22,993 |   |
| Provision for losses on loans and leases                                     |       | 2,020                                             |       | 3,173 |   | 1,905 |   | 1,482 |   | 1,682 |   |
| Net interest income after provision for  losses on loans and leases          |       | 23,052                                            |       | 23,092 |   | 22,707 |   | 21,930 |   | 21,311 |   |
| Loan servicing income                                                        |       | 1,578                                             |       | 1,610 |   | 1,858 |   | 1,567 |   | 1,381 |   |
| Gain on sale of loans, net                                                   |       | 1,311                                             |       | 1,629 |   | 1,464 |   | 745 |   | 627 |   |
| Gain on sale of securities, net                                              |       | 43                                                |       | 352 |   | 135 |   | — |   | 185 |   |
| Other noninterest income                                                     |       | 6,896                                             |       | 6,895 |   | 6,369 |   | 6,032 |   | 4,959 |   |
| Noninterest expense                                                          |       | (24,773                                           | )          | (26,048 | ) | (24,806 | ) | (22,750 | ) | (19,857 | ) |
| Income from continuing operations before  income taxes                       |       | 8,107                                             |       | 7,530 |   | 7,727 |   | 7,524 |   | 8,606 |   |
| Income tax expense                                                           |       | 2,891                                             |       | 2,584 |   | 2,856 |   | 2,929 |   | 3,077 |   |
| Income from continuing operations                                            |       | 5,216                                             |       | 4,946 |   | 4,871 |   | 4,595 |   | 5,529 |   |
| Discontinued Operations:                                                     |       |                                              |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations of  discontinued segment (net of income taxes) |       | —                                            |       | 253 |   | (246 | ) | 12 |   | (262 | ) |
| (Loss) on discontinued segment (net of  income taxes)                        |       | —                                            |       | (224 | ) | (1,440 | ) | — |   | — |   |
| Income (loss) from discontinued operations                                   |       | —                                            |       | 29 |   | (1,686 | ) | 12 |   | (262 | ) |
|                                                                         |       |                                              |       |   |   |   |   |   |   |   |   |
| Net income                                                                   |       | $                                                 | 5,216      |   | $ | 4,975 |   | $ | 3,185 |   | $ | 4,607 |   | $ | 5,267 |   |

 

34

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| ** **                                                                                                 | ** ** | **Years Ended June 30,**   | ** ** |
|------------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                                 | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                                                 | ** ** | **(Dollars in Thousands)** | ** ** |
| Basic earnings (loss) per share:                                                                           |       |                       |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                                                                          |       | $                          | 1.47       |   | $ | 1.36 |   | $ | 1.27 |   | $ | 1.14 |   | $ | 1.30 |   |
| Income (loss) from discontinued operations                                                                 |       | —                     |       | 0.01 |   | (0.44 | ) | — |   | (0.06 | ) |
| Net income                                                                                                 |       | 1.47                       |       | 1.37 |   | 0.83 |   | 1.14 |   | 1.24 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Diluted earnings (loss) per share:                                                                         |       |                       |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                                                                          |       | 1.43                       |       | 1.34 |   | 1.24 |   | 1.12 |   | 1.28 |   |
| Income (loss) from discontinued operations                                                                 |       | —                     |       | 0.01 |   | (0.43 | ) | — |   | (0.06 | ) |
| Net income                                                                                                 |       | 1.43                       |       | 1.35 |   | 0.81 |   | 1.12 |   | 1.22 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Dividends declared per share                                                                               |       | 0.43                       |       | 0.42 |   | 0.40 |   | 0.38 |   | 0.36 |   |
| Dividend payout ratio from continuing  operations (1)                                                      |       | 29.33                      | %          | 30.81 | % | 31.92 | % | 33.62 | % | 27.93 | % |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| **Other data from continuing operations: (2)**                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Interest rate spread (average during  period)                                                              |       | 3.18                       | %          | 3.42 | % | 3.25 | % | 2.83 | % | 3.20 | % |
| Net interest margin (3)                                                                                    |       | 3.41                       |       | 3.72 |   | 3.66 |   | 3.37 |   | 3.64 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Average interest-earning assets to average  interest-bearing liabilities                                   |       | 1.11                       |       | 1.12 |   | 1.12 |   | 1.11 |   | 1.10 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Equity to total assets (end of period)                                                                     |       | 6.10                       |       | 6.16 |   | 6.71 |   | 6.70 |   | 6.47 |   |
| Equity-to-assets ratio (ratio of average  equity to average total assets)                                  |       | 6.36                       |       | 6.52 |   | 7.17 |   | 6.77 |   | 6.85 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Nonperforming assets to total assets (end  of period)                                                      |       | 0.27                       |       | 0.77 |   | 1.59 |   | 0.76 |   | 0.33 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses to  nonperforming loans and leases (end of period) (4)                 |       | 174.75                     |       | 65.89 |   | 40.02 |   | 97.73 |   | 264.63 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses to  total loans and leases (end of period)                             |       | 0.55                       |       | 0.62 |   | 0.78 |   | 0.96 |   | 1.00 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Nonperforming loans and leases to total  loans and leases (end of period) (4)                              |       | 0.32                       |       | 0.95 |   | 1.96 |   | 0.99 |   | 0.38 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Noninterest expense to average total assets                                                                |       | 3.11                       |       | 3.42 |   | 3.42 |   | 3.06 |   | 2.91 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Net interest income after provision for  losses on loans and leases to noninterest expense (end of period) |       | 93.05                      |       | 88.65 |   | 91.54 |   | 96.40 |   | 107.32 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Return on assets  (ratio of income from continuing operations  to average total assets)               |       | 0.66                       |       | 0.65 |   | 0.67 |   | 0.62 |   | 0.81 |   |
| Return on assets  (ratio of net income to average total  assets)                                      |       | 0.66                       |       | 0.65 |   | 0.44 |   | 0.62 |   | 0.77 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Return on equity (ratio of income from  continuing operations to average equity)                           |       | 10.30                      |       | 9.96 |   | 9.37 |   | 9.14 |   | 11.83 |   |
| Return on equity (ratio of net income to  average equity)                                                  |       | 10.30                      |       | 10.02 |   | 6.13 |   | 9.16 |   | 11.27 |   |
|                                                                                                       |       |                       |       |   |   |   |   |   |   |   |   |
| Efficiency Ratio (5)                                                                                       |       | 70.98                      |       | 70.88 |   | 72.03 |   | 71.64 |   | 65.87 |   |
| Number of full-service offices                                                                             |       | 34                         |       | 34 |   | 33 |   | 31 |   | 27 |   |
|                                                                                                            |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Dividends declared per share divided bynet income per share from continuing operations.

(2) All periods presented have been restatedto eliminate effect of discontinued operations.

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

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

(5) Total noninterest expense divided by the sum of net interest incomeplus total noninterest income.

 

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**Item 7****.    Management’s Discussionand Analysis of Financial Condition and Results of Operations**

 

This sectionshould be read in conjunction with Item 8, “Financial Statements andSupplementary Data”, as well as Item 7A, “Quantitative and QualitativeDisclosures About Market Risk” and Part I, Item 1, “Business”.

 

**ExecutiveSummary**

 

The Company’s fiscal year 2004net income from continuing operations was $5.2 million, or $1.43 per dilutedshare, compared to $4.9 million, or $1.34 per diluted share for fiscal year2003.  Return on average equity was10.30% at June 30, 2004 compared with 9.96% at June 30, 2003.Mortgageoriginations were down by 29.0%, which followed the general trend of thenational economy.

 

Managementbelieves that the Company’s balance sheet has been diversified over the lastdecade to mitigate the variability of the traditional thrift lending activityof mortgage lending. The addition of business, agriculture and consumer lendinghas added stability to interest rate risk and is anticipated to continue to bea strength of the Company.

 

The nationallow rate environment over the last two years affected our net interest revenue,and accordingly, our net income from continuing operations, as net interestmargin was 3.41% for the year ended June 30, 2004 as compared to 3.72% for theprior fiscal year.  The length of thehistorically low interest rates and the response by competitors may lead thenet interest margin ratio to lower levels or they may tend to stabilize or riseover time.  The vulnerability of the netinterest margin ratio is affected by many aspects including Federal Reservepolicies for interest rates, competitive factors and customer preferences forvarious products and services.

 

The Company isactively involved in interest rate risk management of the balance sheet usingcomputer analysis to determine interest rate risk in the operation.  The analysis helps management determinepricing and funding strategies that will keep interest rate risk within theCompany’s adopted guidelines. The Company has not used off-balance sheethedging to manage interest rate risk but has opted to reduce the complexity byutilizing on-balance sheet techniques in the investment portfolio andout-of-market funding to balance out the interest rate risk to acceptablelevels.

 

The Companyhas set out to grow customer relationships within the markets it serves as aprimary method of growing assets and revenues. The growth in assets is accompanied by the need to provide capital forgrowth.  Capital is generated primarilyby retained earnings after paying out dividends.  The Company has used other sources such astrust preferred securities to fund growth. The use of trust preferred securities are limited by market underwritingconditions such as debt leverage.  TheCompany has reached a level of leverage and does not expect the use ofadditional trust preferred securities to continue over the near term.  Asset growth will be primarily correlated tothe retention of earnings for the immediate future.

 

The total riskbased capital ratio of 10.54% puts the Bank in the “well capitalized” categorywith the OTS and is consistent within the levels the Company plans tooperate.  The Company has been able tomanage the size of the assets by selling off loans through direct loan salesand through securitization of loans.

 

Credit qualityof the Company has improved over the last two years as a result of acombination of disciplined underwriting standards, good economic health of theregion and resolution of a few significant impaired loans.  These efforts supported a decrease in theallowance for loan and lease losses to $3.6 million at June 30, 2004 comparedto $3.8 million a year ago.  In addition,nonperforming assets at June 30, 2004 were $2.3 million in comparison to $6.2million a year ago.  The ratio ofnonperforming assets to total assets declined to 0.27% at June 30, 2004,compared to 0.77% at June 30, 2003.

 

The allowancefor loan and lease losses is calculated based on loan levels, loan losshistory, credit quality of the loan portfolio, and environmental factors suchas economic health of the region and management experience.  This analysis gives the Company a consistentand systematic methodology to determine proper levels for the allowance at agiven time.

 

36

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The Company’sliquidity structure is primarily based on providing reasonably priced depositsand obtaining FHLB advances to fund lending operations. This process issupplemented by access to contingent funding sources including FHLB and FRBadvances along with other borrowings. Through the process, the Company is able to manage the liquidity needsof the Company.

 

The Companyfocuses on balancing operating costs with operating revenue levels to providebetter efficiency ratios over time and continues to look at it’s operation forways to reduce it’s cost structure while continuing to support long-termrevenue enhancements.  Noninterestexpense was $24.8 million for the fiscal year ended June 30, 2004 compared to$26.0 million for the prior fiscal year, a decrease of 4.9%.

 

**General**

 

The Company isa financial 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 bymanagement of the net interest margin, the ability to collect fees fromservices provided, by controlling the costs of delivering services and themanagement of loan and lease losses.  Theprimary source of revenues comes from the net interest margin, which representsthe difference between income on interest-earning assets (i.e. loans andinvestment securities) and expense on interest-bearing liabilities (i.e.deposits and borrowed funding).  The netinterest margin is affected by regulatory, economic and competitive factorsthat influence interest rates, loan demand and deposit flows.  Fees earned include charges for depositservices, trust services and loan services. Personnel costs are the primary expenses required to deliver theservices to customers.  Other costsinclude occupancy and equipment and general and administrative expenses.

 

During thefourth quarter of fiscal 2002, management committed to a plan to sell thesubprime credit card operations which were previously reported in the creditcard segment of the Company.  At June 30,2002, the Company estimated the net realizable value based on estimates from athird party and reclassified the net realizable value of $1.1 million at thattime from loans receivable to loans held for sale.  The Bank ceased processing subprime creditcard applications in March 1999 and managed the portfolio from a balance of$18.1 million at June 30, 1999, to the sale of the receivables as of January31, 2003.  On December 31, 2002, theCompany, through the Bank, entered into an agreement to sell the discontinuedcredit card operations to an independent third party.  The sale of the receivables took place onJanuary 31, 2003, and the Company dissolved the operations of HF Card duringthe third quarter of fiscal 2003.  SeeNote 2 of “Notes to Consolidated Financial Statements” for further discussionon discontinued operations.

 

**FinancialCondition Data**

 

At June 30, 2004, the Company had total assets of $847.1 million, anincrease of $46.0 million from the level at June 30, 2003.  The increase in assets was due primarily toincreases in loans and leases receivable of $45.5 million and investmentsecurities available for sale of $34.2 million, offset by decreases in cash andcash equivalents of $23.7 million, loans held for sale of $5.6 million, andFHLB Stock of $1.6 million.  The increasein liabilities of $43.7 million was due to increases in deposits of $37.3million, the liability for subordinated debentures payable to trusts of $7.2million and advances from the FHLB and other borrowings of $3.9 million fromthe levels at June 30, 2003.  Inaddition, stockholders’ equity increased to $51.6 million at June 30, 2004 from$49.4 million at June 30, 2003 primarily due to net income of $5.2 millionoffset by the cost of treasury stock acquired of $1.9 million and cashdividends paid of $1.5 million.

 

The increase in net loans and leases receivable of $45.5 million wasdue primarily to an increase in purchases and originations over sales,amortization and repayments of principal. Automobile loans increased by $27.6 million over the levels at June 30,2003 reflecting an increase in new automobile dealership accounts together withvarious sales incentive and financing programs for the consumer.  In addition, commercial business loansincreased by $10.6 million and equipment lease financing increased by $3.9million.

 

The increase in securities available for sale of $34.2 million wasprimarily the result of purchases of $78.5 million exceeding sales, maturitiesand repayments of $41.0 million.  Thepurchases of $78.5 million included variable-rate,

 

37

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mortgage-backed securities of$73.3 million.  Included in the $41.0million of sales, maturities and repayments was approximately $29.7 million ofmortgage backed securities principal repayments.

 

The decrease in cash and cash equivalents of $23.7 million wasprimarily due to a decrease in Federal funds sold of $24.0 million in part dueto not renewing maturing advances with the FHLB and the use of funds to investin other interest-earning assets.  See“Liquidity and Capital Resources.”

 

The $5.6 million decrease in loans held for sale was primarily due to adecrease in mortgage loans held for sale of $6.0 million from $16.0 million atJune 30, 2003 to $10.0 million at June 30, 2004.  Offsetting the decrease in mortgage loansheld for sale was an increase in student loans held for sale in the amount of$324,000 at June 30, 2004.  During thesecond quarter of fiscal 2004, the Company began classifying its student loanportfolio as held for sale.

 

The net decrease in FHLB stock of $1.6 million was primarily the resultof the Company’s redemption of stock, through the Bank, due to a FHLB capitalstructure change effective July 1, 2003.

 

The $37.3 million increase in deposits was primarily due to increasesin money market accounts of $33.8 million, in-market certificates of deposit of$13.8 million and savings accounts of $9.2 million offset by a decrease inout-of-market certificates of deposit of $19.8 million

 

The liability forsubordinated debentures payable to trusts increased $7.2 million due to theCompany issuing additional trust preferred securities through Trust IV duringthe first quarter of fiscal 2004.

 

Advances fromthe FHLB and other borrowings increased $3.9 million for the year ended June30, 2004 primarily due to the Company increasing its overnight Fed Fundsadvances by $15.8 million offset by a net decrease in $7.3 million in short andlong-term advances and the Company’s repayment on two short-term notes withFirst Tennessee Bank, NA totaling $4.5 million during the fiscal year endedJune 30, 2004.

 

38

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**Analysisof Net Interest Income**

 

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

 

*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.  Average balances consist of daily averagebalances for the Bank with simple average balances for all othercompanies.  The average balances includenonaccruing loans and leases.  The yieldson loans and leases include origination fees, net of costs, which areconsidered adjustments to yield. Balances related to discontinued credit card loan operations have beenreclassified to noninterest-earning assets for all periods presented.

 
| ** **                                | ** ** | **Years Ended June 30,**          | ** ** |
|-------------------------------------------|------------|-----------------------------------|------------|
| ** **                                | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                | ** ** | **Average  Outstanding  Balance** | ** ** | **Interest  Earned/  Paid** | ** ** | **Yield/  Rate** | ** ** | **Average  Outstanding  Balance** | ** ** | **Interest  Earned/  Paid** | ** ** | **Yield/  Rate** | ** ** | **Average  Outstanding  Balance** | ** ** | **Interest  Earned/  Paid** | ** ** | **Yield/  Rate** | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)**        | ** ** |
| Interest-earning assets:                  |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans and leases receivable (1)           |       | $                                 | 621,548    |   | $ | 36,935 |   | 5.94 | % | $ | 594,873 |   | $ | 40,240 |   | 6.76 | % | $ | 546,055 |   | $ | 42,458 |   | 7.78 | % |
| Investment securities (2) (3)             |       | 107,942                           |       | 3,218 |   | 2.98 | % | 103,902 |   | 3,801 |   | 3.66 | % | 120,982 |   | 5,504 |   | 4.55 | % |
| FHLB stock                                |       | 4,726                             |       | 107 |   | 2.26 | % | 6,854 |   | 221 |   | 3.22 | % | 6,332 |   | 223 |   | 3.52 | % |
| Total interest-earning assets             |       | 734,216                           |       | $ | 40,260 |   | 5.49 | % | 705,629 |   | $ | 44,262 |   | 6.27 | % | 673,369 |   | $ | 48,185 |   | 7.16 | % |
| Noninterest-earning assets                |       | 61,381                            |       |   |   |   |   | 55,921 |   |   |   |   |   | 51,132 |   |   |   |   |   |
| Total assets                              |       | $                                 | 795,597    |   |   |   |   |   | $ | 761,550 |   |   |   |   |   | $ | 724,501 |   |   |   |   |   |
|                                      |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:             |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                 |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Checking and money market                 |       | $                                 | 238,774    |   | $ | 2,704 |   | 1.13 | % | $ | 195,394 |   | $ | 2,647 |   | 1.35 | % | $ | 189,705 |   | $ | 3,875 |   | 2.04 | % |
| Savings                                   |       | 50,791                            |       | 303 |   | 0.60 | % | 39,998 |   | 298 |   | 0.75 | % | 39,169 |   | 564 |   | 1.44 | % |
| Certificates of deposit                   |       | 261,982                           |       | 7,198 |   | 2.75 | % | 278,397 |   | 9,566 |   | 3.44 | % | 279,323 |   | 13,994 |   | 5.01 | % |
| Total interest-bearing deposits           |       | 551,547                           |       | 10,205 |   | 1.85 | % | 513,789 |   | 12,511 |   | 2.44 | % | 508,197 |   | 18,433 |   | 3.63 | % |
| FHLB advances and other borrowings        |       | 80,869                            |       | 3,753 |   | 4.64 | % | 100,200 |   | 4,565 |   | 4.56 | % | 87,512 |   | 4,766 |   | 5.45 | % |
| Subordinated debentures payable to trusts |       | 26,172                            |       | 1,230 |   | 4.70 | % | 17,844 |   | 921 |   | 5.16 | % | 6,744 |   | 374 |   | 5.55 | % |
| Total interest-bearing liabilities        |       | 658,588                           |       | $ | 15,188 |   | 2.31 | % | 631,833 |   | $ | 17,997 |   | 2.85 | % | 602,453 |   | $ | 23,573 |   | 3.91 | % |
| Noninterest-bearing deposits              |       | 66,807                            |       |   |   |   |   | 60,201 |   |   |   |   |   | 48,757 |   |   |   |   |   |
| Other liabilities                         |       | 19,586                            |       |   |   |   |   | 19,869 |   |   |   |   |   | 21,323 |   |   |   |   |   |
| Total liabilities                         |       | 744,981                           |       |   |   |   |   | 711,903 |   |   |   |   |   | 672,533 |   |   |   |   |   |
| Equity                                    |       | 50,616                            |       |   |   |   |   | 49,647 |   |   |   |   |   | 51,968 |   |   |   |   |   |
| Total liabilities and equity              |       | $                                 | 795,597    |   |   |   |   |   | $ | 761,550 |   |   |   |   |   | $ | 724,501 |   |   |   |   |   |
|                                      |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income; interest rate spread |       |                              |       | $ | 25,072 |   | 3.18 | % |   |   | $ | 26,265 |   | 3.42 | % |   |   | $ | 24,612 |   | 3.25 | % |
|                                      |       |                              |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin (4)                   |       |                              |       |   |   | 3.41 | % |   |   |   |   | 3.72 | % |   |   |   |   | 3.66 | % |

 

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

(2) Includes federal funds sold

(3) Yields do not reflect the tax-exemptnature of municipal securities.

(4) Net interest margin is net interestincome divided by average interest-earning assets.

 

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

 

The followingschedule presents the dollar amount of changes in interest income and interestexpense for major components of interest-earning assets and interest-bearingliabilities.  It distinguishes betweenthe increases and decreases due to fluctuating outstanding balances that aredue to the levels and volatility of interest rates.  For each category of interest-earning assetsand interest-bearing liabilities, information is provided on changesattributable to (i) changes in volume (i.e., changes in volume multiplied byold rate) and (ii) changes in rate (i.e., changes in rate multiplied by oldvolume).  For purposes of this table,changes attributable to both rate and volume, which cannot be segregated, havebeen allocated proportionately to the change due to volume and the change dueto rate.

 
| ** **                                | ** ** | **Years Ended June 30,**                 | ** ** | **Years Ended June 30,**               | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2004 vs. 2003**                        | ** ** | **2003 vs. 2002**                      | ** ** |
| ** **                                | ** ** | **(Dollars in Thousands)**               | ** ** |
| ** **                                | ** ** | **Increase  (Decrease)  Due to  Volume** | ** ** | **Increase  (Decrease  Due to  Rate)** | ** ** | **Total  Increase  (Decrease)** | ** ** | **Increase  (Decrease  Due to  Volume)** | ** ** | **Increase  (Decrease  Due to  Rate)** | ** ** | **Total  Increase  (Decrease)** | ** ** |
| Interest-earning assets:                  |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Loans and leases receivable (1)           |       | $                                        | 1,804      |                                   | $          | (5,109 | ) | $ | (3,305 | ) | $ | 3,796 |   | $ | (6,014 | ) | $ | (2,218 | ) |
| Investment securities (2)                 |       | 148                                      |       | (731                                   | )          | (583 | ) | (777 | ) | (926 | ) | (1,703 | ) |
| FHLB stock                                |       | (69                                      | )          | (45                                    | )          | (114 | ) | 18 |   | (20 | ) | (2 | ) |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Total interest-earning assets             |       | $                                        | 1,883      |                                   | $          | (5,885 | ) | $ | (4,002 | ) | $ | 3,037 |   | $ | (6,960 | ) | $ | (3,923 | ) |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:             |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Deposits:                                 |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Checking and money market                 |       | $                                        | 588        |                                   | $          | (531 | ) | $ | 57 |   | $ | 116 |   | $ | (1,344 | ) | $ | (1,228 | ) |
| Savings                                   |       | 80                                       |       | (75                                    | )          | 5 |   | 12 |   | (278 | ) | (266 | ) |
| Certificates of deposit                   |       | (564                                     | )          | (1,804                                 | )          | (2,368 | ) | (46 | ) | (4,382 | ) | (4,428 | ) |
| Total interest-bearing deposits           |       | 104                                      |       | (2,410                                 | )          | (2,306 | ) | 82 |   | (6,004 | ) | (5,922 | ) |
| FHLB advances and other borrowings        |       | (881                                     | )          | 69                                     |       | (812 | ) | 691 |   | (892 | ) | (201 | ) |
| Subordinated debentures payable to trusts |       | 430                                      |       | (121                                   | )          | 309 |   | 616 |   | (69 | ) | 547 |   |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities        |       | $                                        | (347       | )                                      | $          | (2,462 | ) | $ | (2,809 | ) | $ | 1,389 |   | $ | (6,965 | ) | $ | (5,576 | ) |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Net interest income increase (decrease)   |       |                                     |       |                                   |       | $ | (1,193 | ) |   |   |   |   | $ | 1,653 |   |

 

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

(2) Includes federal funds sold

 

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# **Application of Critical Accounting Policies**

#  

GAAP requires management to utilize estimates when reporting financialresults.  The Company has identified thepolicies discussed below as Critical Accounting Policies because the accountingestimates require management to make certain assumptions about matters that maybe uncertain at the time the estimate was made and a different method ofestimating could have been reasonably made that could have a material impact onthe presentation of the Company’s financial condition, changes in financialcondition or results of operations.

 

*Allowance for Loan and Lease Losses*– GAAP requires the Company to maintain an allowance for probable loan andlease losses in the loan and lease portfolio. Management must develop a consistent and systematic approach to estimatethe appropriate balances that will cover the probable losses.  Due to the uncertainty of future events, theapproach includes a process that may differ significantly from othermethodologies and still produce an estimate that is in accordance with GAAP.

 

The allowanceis compiled by utilizing the Company’s loan risk rating system which isstructured to identify weaknesses in the loan portfolio.  The risk rating system has evolved to aprocess whereby management believes the system will properly identify thecredit risk associated with the loan portfolio. Due to the segmenting of loans for the allowance calculation, theestimate of the allowance for loan and lease losses could change materially ifthe loan risk rating system would not properly identify the strength of a largeor a few large loan customers.  Althoughmanagement believes that it uses the best information available to determinethe allowance, unforeseen market or borrower conditions could result inadjustments and net earnings being significantly affected if circumstancesdiffer substantially from the assumptions used in making the finaldeterminations.

 

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

 

At eachbalance sheet date, the MSRs need to be analyzed for impairment which occurswhen the fair value of the MSRs is lower than the amortized book value. TheCompany’s MSRs are primarily servicing rights acquired on SDHDA first time homebuyers program.  Due to the lack ofquoted markets for the Company’s portfolio, the Company estimates the fairvalue of the MSRs using present value of future cash flow analysis.  If the analysis produces a fair value that isgreater than or equal to the amortized book value of the MSRs, no impairment isrecognized.  If the fair value is less thanthe book value, an expense for the difference is charged to earnings byinitiating a MSR valuation account.  Ifthe Company determines this impairment is temporary, any future changes  in 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.

 

Due to the substantial decline in interest rates over the last twoyears, the Company has included MSRs as a critical accounting policy becausethe use of estimates for determining fair value using present value conceptsmay produce results which may significantly differ from other fair valueanalysis perhaps even to the point of recording impairment.  The risk to earnings is when the underlyingmortgages payoff significantly faster than the previously recordedamortization.  Estimating future cashflows on the underlying mortgages is a difficult analysis and requires judgmentbased on the best information available. The Company looks at many reasonable and supportable assumptions andprojections in preparing the analysis. Based on the Company’s analysis of MSRs at quarter-end, there is noimpairment to the MSRs.

 

*RetainedInterest from Securitization* – The Company recorded an asset as a result of theautomobile securitization.  See Note 3 of“Notes to Consolidated Financial Statements.” This asset is recorded based on present value concepts of futureexpected cash flows.  The assumptionsused to calculate the initial retained interest value and subsequentassumptions are based the best information available.  The value of the retained interest may changesignificantly if actual cash flows differ from expected cash flows.

 

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**AssetQuality**

 

When a borrower fails tomake a required payment on a loan within 10 to 15 days after the payment isdue, the Bank generally institutes collection procedures by issuing a latenotice.  The customer is contacted againwhen the payment is between 17 and 40 days past due.  In most cases, delinquencies are curedpromptly; however, if a loan has been delinquent for more than 40 days, theBank attempts additional written as well as verbal contacts and, if necessary,personal contact with the borrower in order to determine the reason for thedelinquency and to effect a cure, and, where appropriate, reviews the conditionof the property and the financial circumstances of the borrower.  Based upon the results of any suchinvestigation, the Bank may: (i) accept a repayment program which underappropriate circumstances could involve an extension in the case of consumerloans for the arrearage from the borrower, (ii) seek evidence, in the form of alisting contract, of efforts by the borrower to sell the property if theborrower has stated that he is attempting to sell, or (iii) initiateforeclosure proceedings. When a loan payment is delinquent for 90 days, theBank generally will initiate foreclosure proceedings unless management is satisfiedthe credit problem is correctable.

 

Loans aregenerally classified as nonaccrual when there are reasonable doubts as to thecollectibility of principal and/or interest and/or when payment becomes 90 dayspast due, except loans which are well secured and in the process ofcollection.  Interest collections onnonaccrual loans, for which the ultimate collectibility of principal isuncertain, are applied as principal reductions.

 

Leases aregenerally classified as nonaccrual when there are reasonable doubts as to thecollectibility of principal and/or interest. Leases may be placed on nonaccrual when the lease has experienced eitherfour consecutive months with no payments or once the account is five months inarrears.  Interest collections onnonaccrual leases, for which the ultimate collectibility of principal isuncertain, are applied as principal reductions.

 

When a lesseefails to make a required lease payment within 10 days after the payment is due,Mid America Leasing generally institutes collection procedures.  The lessee may be contacted by telephone onthe 10th, but no later than the 30th day of delinquency.  A late notice is automatically issued by thesystem on the 11th day of delinquency and is sent to the lessee.  The lease may be referred to legal counselwhen the lease is past due beyond four payments and no positive response hasbeen received or when other considerations are present.

 

Nonperformingassets (nonaccrual loans and leases, accruing loans and leases delinquent morethan 90 days and foreclosed assets) decreased to $2.3 million at June 30, 2004from $6.2 million at June 30, 2003, a decrease of $3.9 million, or 63.1%.  In addition, the ratio of nonperformingassets to total assets, which is one indicator of credit risk exposure, decreasedto 0.27% at June 30, 2004 as compared to 0.77% at June 30, 2003.  The decrease in the ratio of nonperformingassets to total assets at June 30, 2004 compared to the prior year was due tothe decrease in nonperforming assets of $3.9 million and an increase in totalassets of $46.0 million.

 

Nonaccruingloans and leases decreased 64.2%, or $2.8 million to $1.6 million at June 30,2004 compared to $4.4 million at June 30, 2003. Included in nonaccruing loans and leases at June 30, 2004 were threeloans totaling $86,000 secured by one- to four-family real estate, one loan inthe amount of $75,000 secured by commercial real estate, eight commercialbusiness loans totaling $795,000, two agricultural loans totaling $20,000, fiveequipment finance leases totaling $21,000 and 31 consumer loans totaling$564,000.  During the first quarter offiscal 2003, the Bank modified a $2.4 million agricultural participation loanas a troubled debt restructuring with specific reserve allowance and placed theloan on nonaccrual.  The Bank took anadditional fourth quarter fiscal 2003 charge to provision in the amount of$893,000 and charged off $1.4 million upon significant deterioration of theborrower’s credit from levels previously estimated.  See Note 5 of “Notes to ConsolidatedFinancial Statements” for information concerning interest income recognized onimpaired loans.

 

The Company’snonperforming loans and leases, which represent nonaccrual and past due 90 daysand still accruing, have decreased $3.8 million, or 64.6%, from the levels atJune 30, 2003.  The risk rating system inplace is designed to identify and manage the nonperforming loans andleases.  Commercial and agriculturalloans and equipment finance leases will have specific reserve allocations basedon collateral values or based on the present value of expected cash flows ifthe loans or leases are deemed impaired. Loans and leases that are not performing do not necessarily result in aloss.

 

42

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As of June 30,2004, the Company had $212,000 of foreclosed assets.  The balance of foreclosed assets at June 30,2004 consisted of $112,000 in consumer collateral and $100,000 in single-familyresidences.  The Company did not have anyforeclosed assets secured by mobile homes at June 30, 2004.

 

At June 30,2004, the Company had designated $15.2 million of its assets as special mentionand classified $3.9 million of its assets that management has determined needto be closely monitored because of possible credit problems of the borrowers orthe cash flows of the secured properties. At June 30, 2004, the Company had $37.5 million in multi-family,commercial real estate and agricultural participation loans purchased, of whichnone were classified at June 30, 2004. These loans and leases were considered in determining the adequacy ofthe allowance for loan and lease losses. The allowance for loan and lease losses is established based onmanagement’s evaluation of the risks probable in the loan and lease portfolioand changes in the nature and volume of loan and lease activity.  Such evaluation, which includes a review ofall loans and leases for which full collectability may not be reasonablyassured, considers the estimated fair market value of the underlyingcollateral, present value of expected principal and interest payments, economicconditions, historical loss experience and other factors that warrantrecognition in providing for an adequate loan and lease loss allowance.

 

Although theCompany’s management believes that the June 30, 2004 recorded allowance forloan and lease losses was adequate to provide for probable losses on therelated loans and leases, there can be no assurance that the allowance existingat June 30, 2004 will be adequate in the future.

 

In accordancewith the Company’s internal classification of assets policy, managementevaluates the loan and lease portfolio on a monthly basis to identify losspotential and determines the adequacy of the allowance for loan and leaselosses quarterly.  Loans are placed onnonaccrual status when the collection of principal and/or interest becomedoubtful.  Foreclosed assets includeassets acquired in settlement of loans. The following table sets forth the amounts and categories of theCompany’s nonperforming assets from continuing operations for the periodsindicated.  Balances related todiscontinued credit card loan operations have been eliminated for all periodspresented.

 

43

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| ** **                                                            | ** ** | **At June 30,**            | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                            | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                            | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccruing loans and leases:                                         |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                   |       | $                          | 86         |   | $ | 103 |   | $ | 886 |   | $ | 723 |   | $ | 551 |   |
| Commercial real estate                                                |       | 75                         |       | 310 |   | 3,678 |   | 385 |   | 165 |   |
| Multi-family                                                          |       | —                     |       | — |   | 290 |   | — |   | — |   |
| Commercial business                                                   |       | 795                        |       | 472 |   | 1,872 |   | 3,223 |   | 971 |   |
| Equipment finance leases                                              |       | 21                         |       | 30 |   | — |   | — |   | — |   |
| Consumer(1)                                                           |       | 564                        |       | 875 |   | 690 |   | 518 |   | 317 |   |
| Agricultural                                                          |       | 20                         |       | 2,541 |   | 2,801 |   | 373 |   | 31 |   |
| Mobile homes                                                          |       | —                     |       | 34 |   | 25 |   | 88 |   | 43 |   |
| Total                                                                 |       | 1,561                      |       | 4,365 |   | 10,242 |   | 5,310 |   | 2,078 |   |
|                                                                  |       |                       |       |   |   |   |   |   |   |   |   |
| Accruing loans and leases delinquent more  than 90 days               |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                   |       | —                     |       | 330 |   | — |   | — |   | — |   |
| Commercial real estate                                                |       | —                     |       | 42 |   | — |   | — |   | — |   |
| Multi-family                                                          |       | —                     |       | — |   | — |   | 304 |   | — |   |
| Commercial business                                                   |       | 221                        |       | 779 |   | 512 |   | — |   | — |   |
| Equipment finance leases                                              |       | 281                        |       | 313 |   | 229 |   | — |   | — |   |
| Consumer(1)                                                           |       | —                     |       | 2 |   | — |   | — |   | — |   |
| Agricultural                                                          |       | —                     |       | — |   | 165 |   | 23 |   | — |   |
| Total                                                                 |       | 502                        |       | 1,466 |   | 906 |   | 327 |   | — |   |
|                                                                  |       |                       |       |   |   |   |   |   |   |   |   |
| Foreclosed assets:                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                   |       | 100                        |       | 258 |   | 239 |   | 203 |   | 214 |   |
| Consumer(1)                                                           |       | 112                        |       | 77 |   | 132 |   | 105 |   | 67 |   |
| Mobile homes                                                          |       | —                     |       | — |   | 3 |   | 2 |   | 15 |   |
| Total (2)                                                             |       | 212                        |       | 335 |   | 374 |   | 310 |   | 296 |   |
|                                                                  |       |                       |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets(3)                                         |       | $                          | 2,275      |   | $ | 6,166 |   | $ | 11,522 |   | $ | 5,947 |   | $ | 2,374 |   |
| Ratio of nonperforming assets to total  assets(4)                     |       | 0.27                       | %          | 0.77 | % | 1.59 | % | 0.76 | % | 0.33 | % |
| Ratio of nonperforming loans and leases to  total loans and leases(5) |       | 0.32                       | %          | 0.95 | % | 1.96 | % | 0.99 | % | 0.38 | % |

 

----

(1)             Consists ofnonperforming consumer loans exclusive of mobile home loans and credit cardloans.

(2)             Total foreclosedassets do not include land or other real estate owned held for sale.

(3)             Nonperforming assetsinclude nonaccruing loans and leases, accruing loans and leases delinquent morethan 90 days and foreclosed assets.

(4)             Percentage iscalculated based upon total assets of the Company and its direct and indirectsubsidiaries on a consolidated basis.

(5)             Nonperforming loansand leases include both nonaccruing and accruing loans and leases delinquentmore than 90 days.

 

44

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The followingtable sets forth information with respect to activity in the Company’sallowance for loan and lease losses from continuing operations during theperiods indicated.  Balances related todiscontinued credit card loan operations have been eliminated for all periodspresented.

 
| ** **                                                                                              | ** ** | **Years Ended June 30,**   | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                                              | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                                              | ** ** | **(Dollars in Thousands)** | ** ** |
| Balance at beginning of period                                                                          |       | $                          | 3,842      |   | $ | 4,461 |   | $ | 5,509 |   | $ | 5,499 |   | $ | 4,518 |   |
|                                                                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Charge-offs:                                                                                            |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                                                     |       | (7                         | )          | (9 | ) | (38 | ) | (21 | ) | (92 | ) |
| Commercial real estate                                                                                  |       | (92                        | )          | — |   | (76 | ) | (361 | ) | — |   |
| Commercial business                                                                                     |       | (457                       | )          | (1,234 | ) | (1,484 | ) | (253 | ) | (54 | ) |
| Equipment finance leases                                                                                |       | (30                        | )          | (124 | ) | (323 | ) | (131 | ) | — |   |
| Consumer                                                                                                |       | (1,143                     | )          | (1,164 | ) | (1,323 | ) | (1,106 | ) | (827 | ) |
| Agricultural                                                                                            |       | (835                       | )          | (1,429 | ) | (108 | ) | — |   | (11 | ) |
| Mobile homes                                                                                            |       | —                     |       | (41 | ) | (55 | ) | (51 | ) | (56 | ) |
| Total charge-offs                                                                                       |       | (2,564                     | )          | (4,001 | ) | (3,407 | ) | (1,923 | ) | (1,040 | ) |
| Recoveries:                                                                                             |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                                                     |       | 4                          |       | 3 |   | 2 |   | — |   | 12 |   |
| Commercial real estate                                                                                  |       | 1                          |       | — |   | 2 |   | — |   | 6 |   |
| Commercial business                                                                                     |       | 3                          |       | 5 |   | 59 |   | — |   | — |   |
| Equipment finance leases                                                                                |       | 64                         |       | 41 |   | 45 |   | 16 |   | — |   |
| Consumer                                                                                                |       | 232                        |       | 319 |   | 296 |   | 325 |   | 282 |   |
| Agricultural                                                                                            |       | 3                          |       | 100 |   | 28 |   | — |   | — |   |
| Mobile homes                                                                                            |       | —                     |       | 5 |   | 22 |   | 13 |   | 39 |   |
| Total recoveries                                                                                        |       | 307                        |       | 473 |   | 454 |   | 354 |   | 339 |   |
|                                                                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Net (charge-offs)                                                                                       |       | (2,257                     | )          | (3,528 | ) | (2,953 | ) | (1,569 | ) | (701 | ) |
|                                                                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Additions charged to operations                                                                         |       | 2,020                      |       | 3,173 |   | 1,905 |   | 1,482 |   | 1,682 |   |
| Allowance related to assets acquired  (sold), net                                                       |       | —                     |       | (264 | ) | — |   | 97 |   | — |   |
| Balance at end of period                                                                                |       | 3,605                      |       | 3,842 |   | $ | 4,461 |   | $ | 5,509 |   | $ | 5,499 |   |
|                                                                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Ratio of net (charge-offs) during the  period to average loans and leases outstanding during the period |       | (0.36                      | )%         | (0.59 | )% | (0.54 | )% | (0.28 | )% | (0.14 | )% |
|                                                                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Ratio of allowance for loan and lease  losses to total loans and leases at end of period                |       | 0.55                       | %          | 0.62 | % | 0.78 | % | 0.96 | % | 1.00 | % |
|                                                                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| Ratio of allowance for loan and lease  losses to nonperforming loans and leases at end of period(1)     |       | 174.75                     | %          | 65.89 | % | 40.02 | % | 97.73 | % | 264.63 | % |
|                                                                                                         |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)             Nonperforming loansand leases include both nonaccruing and accruing loans and leases delinquentmore than 90 days.

 

45

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The distribution of theCompany’s allowance for loan and lease losses and impaired loss summary asrequired by the Financial Accounting Standards Board, (“FASB”) Statement No.114, “Accounting by Creditors for Impairment of a Loan” are summarized in thefollowing tables.  Balances related todiscontinued credit card loan operations have been eliminated for all periodspresented.

 
| ** **                                 | ** ** | **At June 30,**            | ** ** |
|--------------------------------------------|------------|----------------------------|------------|
| ** **                                 | ** ** | **2004**                   | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                 | ** ** | **Amount (3)**             | ** ** | **Percent of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount (3)** | ** ** | **Percent of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount(3)** | ** ** | **Percent of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount** | ** ** | **Percent of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount** | ** ** | **Percent of  Loans in  Each  Category to  Total Loans** | ** ** |
| ** **                                 | ** ** | ** **                 | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **(Dollars in Thousands)** | ** ** |
| One-to four-family(1)                      |       | $                          | 15         |   | 17.51 | % | $ | 28 |   | 17.39 | % | $ | 81 |   | 16.00 | % | $ | 1,196 |   | 26.65 | % | $ | 1,299 |   | 29.88 | % |
| Commercial and multi-family real estate(1) |       | 220                        |       | 20.57 |   | 241 |   | 23.34 |   | 606 |   | 25.45 |   | 1,402 |   | 20.52 |   | 1,442 |   | 19.97 |   |
| Commercial business(2)                     |       | 1,270                      |       | 22.85 |   | 1,033 |   | 22.09 |   | 1,460 |   | 20.61 |   | 1,033 |   | 18.74 |   | 844 |   | 15.36 |   |
| Consumer                                   |       | 1,736                      |       | 29.48 |   | 1,538 |   | 27.55 |   | 1,889 |   | 30.66 |   | 1,524 |   | 27.66 |   | 1,536 |   | 27.92 |   |
| Agricultural                               |       | 364                        |       | 9.59 |   | 945 |   | 9.39 |   | 375 |   | 6.87 |   | 317 |   | 5.75 |   | 323 |   | 5.87 |   |
| Mobile homes                               |       | —                     |       | — |   | 57 |   | 0.24 |   | 50 |   | 0.41 |   | 37 |   | 0.68 |   | 55 |   | 1.00 |   |
| Total                                      |       | $                          | 3,605      |   | 100.00 | % | $ | 3,842 |   | 100.00 | % | $ | 4,461 |   | 100.00 | % | $ | 5,509 |   | 100.00 | % | $ | 5,499 |   | 100.00 | % |

 

----

(1) Includes construction and development loans.

(2) Includes equipment finance leases.

(3) The Company migrated its allocation methodology ofallowances by type in 2002 to reflect a more systematic method based in part onthe Company’s historical charge-offs by each loan type as compared to primarilya pro rata allocation based on loan balances in prior years.

 
| ** **               | ** ** | **FASB 5  Allowance  for loan and  lease losses** | ** ** | **FASB 114  Impaired Loan  Valuation  Allowance** | ** ** | **FASB 5  Allowance  for loan and  lease losses** | ** ** | **FASB 114  Impaired Loan  Valuation  Allowance** | ** ** |
|--------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|---------------------------------------------------|------------|
| **Loan Type**            | ** ** | **At June 30, 2004**                              | ** ** | **At June 30, 2003**                              | ** ** |
| ** **               | ** ** | **(Dollars in Thousands)**                        | ** ** |
|                     |       |                                              |       |                                              |       |                                              |       |                                              |       |
| One- to four-family      |       | $                                                 | 15         |                                              | $          | —                                            |       | $                                                 | 28         |   | $ | — |   |
| Commercial real estate   |       | 135                                               |       | —                                            |       | 130                                               |       | —                                            |       |
| Multi-family real estate |       | 85                                                |       | —                                            |       | 111                                               |       | —                                            |       |
| Commercial business      |       | 970                                               |       | —                                            |       | 652                                               |       | 132                                               |       |
| Equipment finance leases |       | 296                                               |       | 4                                                 |       | 250                                               |       | —                                            |       |
| Consumer (1)             |       | 1,736                                             |       | —                                            |       | 1,595                                             |       | —                                            |       |
| Agricultural             |       | 364                                               |       | —                                            |       | 230                                               |       | 714                                               |       |
| Total                    |       | $                                                 | 3,601      |                                              | $          | 4                                                 |       | $                                                 | 2,996      |   | $ | 846 |   |

 

----

(1) Includes mobile home loans.

 

46

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FASB 114 Impaired Loan Summary

 
| ** **               | ** ** | **Number  of Loan  Customers** | ** ** | **Loan  Balance**          | ** ** | **Impaired Loan  Valuation  Allowance** | ** ** | **Number  of Loan  Customers** | ** ** | **Loan  Balance** | ** ** | **Impaired Loan  Valuation  Allowance** | ** ** |
|--------------------------|------------|--------------------------------|------------|----------------------------|------------|-----------------------------------------|------------|--------------------------------|------------|-------------------|------------|-----------------------------------------|------------|
| **Loan  Type**           | ** ** | **At June 30, 2004**           | ** ** | **At June 30, 2003**       | ** ** |
| ** **               | ** ** | **(Dollars in Thousands)**     | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **               | ** ** | ** **                     | ** ** | ** **                 | ** ** |
| Equipment finance leases |       | 1                              |       | $                          | 4          |                                    | $          | 4                              |       | —            |       | $                                       | —     |   | $ | — |   |
| Commercial real estate   |       | 1                              |       | 73                         |       | —                                  |       | 8                              |       | 354               |       | 132                                     |       |
| Commercial business      |       | 5                              |       | 175                        |       | —                                  |       | —                         |       | —            |       | —                                  |       |
| Agriculture real estate  |       | —                         |       | —                     |       | —                                  |       | 1                              |       | 27                |       | —                                  |       |
| Other agricultural loans |       | —                         |       | —                     |       | —                                  |       | 3                              |       | 2,293             |       | 714                                     |       |
| Total                    |       | 7                              |       | $                          | 252        |                                    | $          | 4                              |       | 12                |       | $                                       | 2,674      |   | $ | 846 |   |

 

The allowancefor loan and lease losses was $3.6 million at June 30, 2004 as compared to $3.8million at June 30, 2003.    The ratio ofthe allowance for loan and lease losses to total loans and leases was 0.55% atJune 30, 2004 compared to 0.62% at June 30, 2003, a decrease of 11.3%.  The Company’s management has considerednonperforming assets and other assets of concern in establishing the allowancefor loan and lease losses.  The Companycontinues to monitor its allowance for possible loan and lease losses and makefuture additions or reductions in light of the level of loans and leases in itsportfolio and as economic conditions dictate. The current level ofthe allowance for loan and lease losses is a result of management’s assessmentof the risks within the portfolio based on the information revealed in creditreporting processes. The Company utilizes a risk-rating system on allcommercial business, agricultural, construction, multi-family and commercialreal estate loans, including purchased loans. A periodic credit review is performed on all types of loans and leasesto establish the necessary reserve based on the estimated risk within the portfolio.This assessment of risk takes into account the composition of the loan andlease portfolio, historical loss experience for each loan and lease category,previous loan and lease experience, concentrations of credit, current economicconditions and other factors that in management’s judgment deserve recognition.OTS regulators have reviewed the Company’s methodology for determiningallowance requirements on the Company’s loan and lease portfolio and have madeno required recommendations for increases in the allowances during the threeyear period ended June 30, 2004.

 

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

 

Although managementbelieves that 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 allowancesresult from periodic loan, property and collateral reviews and thus cannot bepredicted in advance.  See Note 1 of“Notes to Consolidated Financial Statements” for a description of the Company’spolicy regarding the provision for losses on loans and leases.

 

47

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**Comparisonof the Years Ended June 30, 2004 and June 30, 2003**

 

**ContinuingOperations**

 

*General*.  The Company’s income from continuingoperations was $5.2 million or $1.47 and $1.43 for basic and diluted earningsper share, respectively, for the year ended June 30, 2004, a $270,000 increasein earnings compared to $4.9 million or $1.36 and $1.34 for basic and dilutedearnings per share, respectively, for the prior year.  Basic and diluted earnings per shareincreased 8.1% and 6.7%, respectively, for the year ended June 30, 2004 ascompared to the prior year due to an increase in earnings offset by a netdecrease in shares outstanding as a result of Company stock repurchases.  For the year ended June 30, 2004, the returnon average equity from continuing operations was 10.30%, a 3.5% increasecompared to 9.96% in the prior year.  Forthe year ended June 30, 2004, the return on average assets from continuingoperations was 0.66%, a 1.5% increase compared to 0.65% in the prior year.  As discussed in more detail below, theincreases were due to a variety of key factors, including decreases innoninterest expense of $1.3 million and provision for losses on loans andleases of $1.2 million offset by decreases in net interest income of $1.2million and noninterest income of $658,000 and an increase in income taxexpense of $272,000.

 

*Interestand Dividend Income.* Interest and dividend income was $40.3 million for the year ended June30, 2004 as compared to $44.3 million for the prior year, a decrease of $4.0million, or 9.0%.  A $5.9 milliondecrease in interest and dividend income was the result of a 12.4% decrease inthe average yield on interest-earning assets. The average yield on interest-earning assets was 5.49% for the yearended June 30, 2004 as compared to 6.27% for the prior year.  For the year ended June 30, 2004, the averageyield on loans and leases receivable was 5.94%, a decrease of 12.1% from 6.76%in the prior year.  The Company continuesto manage yields by changing the types of loans that comprise the portfolio toloans that have a higher yield than single-family real estate loans.  Commercial business loans, agriculturalbusiness loans and equipment finance leases comprise 29.3% of the total loanand lease portfolio at June 30, 2004 as compared to 28.6% at June 30,2003.  The percentages of business loansare expected to remain stable at these levels due to restrictions imposed byHOLA at 20.00% of total Bank assets.  Asof June 30, 2004, the Bank met the 20.00% limitation at 16.39% of total Bankassets.  The overall decrease in interestand dividend income was primarily due to repricing of loans and investmentsthat generally reflected the decline in national interest rates.  From June 30, 2001 to June 30, 2004, theprime rate dropped from 6.75% to 4.00%.

 

*InterestExpense.* Interest expense was $15.2 million for the year ended June 30, 2004 ascompared to $18.0 million for the prior year, a decrease of $2.8 million or 15.6%.  A $2.5 million decrease was the result of a18.9% decrease in the average rate paid on interest-bearing liabilities.  The average rate on interest-bearingliabilities was 2.31% for the year ended June 30, 2004 as compared to 2.85% forthe prior year.  For the year ended June30, 2004, the average rate paid on interest-bearing deposits was 1.85%, adecrease of 24.2% from 2.44% in the prior year. The average rate paid on FHLB advances and other borrowings increased1.8% to 4.64% at June 30, 2004 from 4.56% at June 30, 2003.  An average volume decrease of $19.3 millionfor FHLB advances and other borrowings contributed to a decrease in interestexpense of $881,000 for the for the year ended June 30, 2004 as compared to theprior year.

 

*NetInterest Income.* The Company’s net interest incomefrom continuing operations for the year ended June 30, 2004 decreased $1.2million, or 4.5%, to $25.1 million compared to $26.3 million for the prioryear.  The decrease in net interestincome was due primarily to declining asset yields and a slower decrease in thecost of funds throughout fiscal years 2003 and 2004.  The Company’s net interest margin decreasedto 3.41% for the year ended June 30, 2004 as compared to 3.72% for the prioryear.  In addition, the Company hasincreased its investment portfolio composition in high quality GNMA adjustablerate securities in order to enhance its net interest margin.

 

*Provisionfor Losses on Loans and Leases.* The allowance for loanand lease losses is maintained at a level which is considered by management tobe adequate to absorb probable losses on existing loans and leases that maybecome uncollectible, based on an evaluation of the collectability of the loansand leases and 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.

 

48

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Provision forlosses on loans and leases decreased $1.2 million, or 36.3%, to $2.0 millionfor the year ended June 30, 2004 as compared to $3.2 million in the prioryear.  The decrease was due tocharge-offs decreasing from $4.5 million during fiscal year 2003 to $2.5million during fiscal year 2004.  In thefourth quarter of fiscal 2003, a $1.4 million agriculture real estateparticipation loan was modified as a troubled debt restructuring with specificreserve allowance which resulted in a fiscal 2003 charge to provision in theamount of $893,000.  In addition,recoveries fell from $473,000 during fiscal year 2003 compared to $307,000during fiscal year 2004.   See “AssetQuality” for further discussion.

 

The allowancefor loan and lease losses at June 30, 2004 was $3.6 million.  The allowance decreased from the June 30,2003 balance of $3.8 million primarily as a result of charge-offs exceedingrecoveries by $2.3 million offset by the provision for losses on loans andleases of $2.0 million.  The ratio ofallowance for loan and lease losses to nonperforming loans and leases at June30, 2004 was 174.75% compared to 65.89% at June 30, 2003.  The allowance for loan and lease losses tototal loans and leases at June 30, 2004 was 0.55% compared to 0.62% at June 30,2003.  The Bank’s management believesthat the June 30, 2004 recorded allowance for loan and lease losses wasadequate to provide for probable losses on the related loans and leases, basedon its evaluation of the collectability of loans and leases and prior lossexperience.

 

*NoninterestIncome.* Noninterest income was $9.8 million for the year ended June 30, 2004 ascompared to $10.5 million for the year ended June 30, 2003, a decrease of$658,000, or 6.3%.  The decrease innoninterest income was due primarily to decreases in commission and insuranceincome of $525,000, net gain on sale of loans of $318,000 and net gain on saleof securities of $309,000 offset by increases in earnings on cash value of lifeinsurance of $188,000, trust income of $97,000 and other noninterest income of$309,000.

 

Commission andinsurance income was $507,000 for the year ended June 30, 2004 compared to $1.1million in the prior year, a decrease of 50.9%. Hometown’s personal and commercial insurance lines are down compared tothe prior year primarily due to the sale of the property and casualty book ofbusiness in August 2003.  See Note 1 of“Notes to Consolidated Financial Statements”. The decrease in commission and insurance income was offset by anincrease in income from financial products of $59,000 for the year ending June30, 2004 as compared to the prior year.

 

Net gain onsale of loans decreased $318,000 for the year ended June 30, 2004 as comparedto the prior year.  The decrease wasprimarily due to a decrease in the amount of residential mortgage loans soldinto the secondary market during the fiscal year ended June 30, 2004 ascompared to the prior fiscal year. During the fiscal year ended June 30, 2004, the total number of singlefamily loans sold was 1,288 with principal balances of $127.4 million.  This compares to 1,609 loans sold withprincipal balances of $161.1 million for the prior fiscal year.  As is the case with the industry, residentialmortgage loan pipelines decreased back to more historical levels and wasreflected in fiscal year earnings.

 

Net gain onsale of securities decreased $309,000 for the year ended June 30, 2004 ascompared to the prior year due to a $8.9 million decrease in proceeds from thesale of securities to $6.3 million for the year ended June 30, 2004 compared to$15.2 million for the year ended June 30, 2003. Sales of securities for the year ended June 30, 2004 consisted primarilyof variable mortgage-backed securities.

 

The Bankrecorded an increase of 43.6%, or $188,000, to $619,000 for the year ended June30, 2004 compared to $431,000 in the prior year for earnings on cash value ofbank owned life insurance (“BOLI”), which is tax-exempt.

 

Trust incomeincreased by $97,000 to $568,000 during the fiscal year ended June 30, 2004 ascompared to the prior year primarily due to assets under management increasingfrom $63 million to $83 million.

 

Othernoninterest income increased 46.3% to $976,000 for the year ended June 30, 2004compared to $667,000 in the prior year primarily due to an increase of $135,000recorded on the retained interest obtained through the securitization ofautomobile loans.  See Note 3 of  “Notes to Consolidated Financial Statements.”

 

*NoninterestExpense.* Noninterest expense was $24.8 million for the year ended June 30, 2004as compared to $26.0 million for the prior year, an decrease of $1.3 million,or 4.9%.  The decrease in noninterestexpense was due primarily to decreases in occupancy and equipment of $338,000,compensation and employee benefits of $334,000, advertising of $168,000 and othernoninterest expenses of $438,000.

 

Occupancy and equipmentdecreased 9.5% to $3.2 million for the year ended June 30, 2004 as compared to$3.5 million for the prior year.  Thedecrease was primarily due to recording a valuation impairment of $200,000 duringthe year ended June 30, 2003.

 

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Compensationand employee benefits decreased 2.1% to $15.5 million for the year ended June30, 2004 as compared to $15.9 million for the prior year.  This decrease was primarily due to areduction in variable compensation (performance incentives) to $579,000 for thefiscal year ended June 30, 2004 from $970,000 during the prior fiscalyear.  In addition, annual employeebonuses decreased $265,000 and pension plan costs decreased $245,000.   Employee staffing levels decreased from 329at June 30, 2003 to 306 at June 30, 2004 due in part to the sale of Hometown’sproperty and casualty book of business. The Company has had a self-insured health plan for ten years.  Although health claims expense net of thestop loss receivable increased to $1.7 million for the year ended June 30, 2004as compared to $1.6 million for the prior fiscal year, the Company does notbelieve the claim level will continue at the current rate.  Management believes the current structure isa reasonable alternative to traditional health care plans over the longrun.  This is a challenging area for allcompanies and the Company continues to review its health care plans in aneffort to provide its employees with affordable health care.

 

Advertising expensedecreased 18.3% to $749,000 for the year ended June 30, 2004 as compared to$917,000 for the prior year primarily due to a reduction in extensiveadvertising campaigns and more emphasis on existing programs to strengthen ourposition in the marketplace.

 

*Income taxexpense.*  TheCompany’s income tax expense increased $307,000, or 11.9%, for the year endedJune 30, 2004 to $2.9 million compared to $2.6 million for the prior year.  The increase was primarily due to theincrease in the Company’s effective tax rate due to changes in permanent taxdifferences.  The effective rate was35.66% and 34.32% for the years ended June 30, 2004 and June 30, 2003,respectively.

 

**Comparisonof the Years Ended June 30, 2003 and June 30, 2002**

 

**ContinuingOperations**

 

*General*.  The Company’s income from continuingoperations was $4.9 million or $1.36 and $1.34 for basic and diluted earningsper share, respectively, for the year ended June 30, 2003, a $75,000 increasein earnings compared to $4.9 million or $1.27 and $1.24 for basic and dilutedearnings per share, respectively, for the prior year.  Basic and diluted earnings per shareincreased 7.1% and 8.1%, respectively, for the year ended June 30, 2003 ascompared to the prior year primarily due to the decrease in shares outstandingas a result of Company stock repurchases. For the year ended June 30, 2003, the return on average equity fromcontinuing operations was 9.96%, a 6.3% increase compared to 9.37% in the prioryear.  For the year ended June 30, 2003,the return on average assets from continuing operations was 0.65%, a 3.0%decrease compared to 0.67% in the prior year. As discussed in more detail below, the increases were due to a varietyof key factors, including increases in net interest income of $1.7 million andnoninterest income of $660,000 and a decrease in income tax expense of $272,000offset by increases in provision for losses on loans and leases of $1.3million, noninterest expense of $1.2 million.

 

*Interestand Dividend Income.* Interest and dividend income was $44.3 million for the year ended June30, 2003 as compared to $48.0 million for the prior year, a decrease of $3.7million, or 8.1%.  A $7.0 milliondecrease in interest and dividend income was the result of a 12.4% decrease inthe average yield on interest-earning assets. The average yield on interest-earning assets was 6.27% for the yearended June 30, 2003 as compared to 7.16% for the prior year.  For the year ended June 30, 2003, the averageyield on loans and leases receivable was 6.76%, a decrease of 13.1% from 7.78%in the prior year.  The Company continuesto manage yields by changing the types of loans that comprise the portfolio toloans that have a higher yield than single-family real estate loans.  Commercial business loans, agriculturalbusiness loans and equipment finance leases comprise 31.5% of the total loanand lease portfolio at June 30, 2003 as compared to 25.26% at June 30,2002.  The percentages of business loansare expected to remain stable at these levels due to restrictions imposed byHOLA at 20.00% of total Bank assets.  Asof June 30, 2003, the Bank exceeded the 20.00% limitation by 0.92%.  The Bank informed the OTS and submitted aplan to reduce the percentage within the 20.00% limit.  Potential solutions include selling loans inthis category, increasing the total assets of the Bank or changing Bankcharters.  The overall decrease ininterest and dividend income was primarily due to repricing of loans andinvestments that generally reflected the decline in national interestrates.  From June 30, 2001 to June 30,2003, the prime rate dropped from 6.75% to 4.00%.

 

*InterestExpense.* Interest expense was $18.0 million for the year ended June 30, 2003 ascompared to $23.6 million for the prior year, a decrease of $5.6 million or23.7%.  A $7.0 million decrease was theresult of a 27.1% decrease in the average rate paid on interest-bearingliabilities.  The average rate oninterest-bearing liabilities was 2.85% for the year ended June 30, 2003 ascompared to 3.91% for the prior year. For the year ended June 30, 2003, the average rate paid oninterest-bearing deposits was 2.44%, a decrease of 32.8% from 3.63% in theprior year.  The average rate paid onFHLB advances and other borrowings decreased 16.3% to 4.56% at June 30, 2003from 5.45% at June 30, 2002 and contributed to a $892,000

 

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decrease in interestexpense.  Average volume increases of$12.7 million and $11.1 million for FHLB advances and other borrowings and subordinateddebentures payable to trusts, respectively, contributed to an increase ininterest expense of $691,000 and $616,000, respectively, for the year endedJune 30, 2003 as compared to the prior year.

 

*NetInterest Income.* The Company’s net interest incomefrom continuing operations for the year ended June 30, 2003 increased $1.7million, or 6.7%, to $26.3 million compared to $24.6 million for the prioryear.  The increase in net interestincome was due primarily to an increasing net interest margin during the firstquarter of fiscal 2003 as national interest rates were declining.  The net interest margin then began todecrease over the last three quarters of fiscal 2003 as interest ratescontinued to remain low over the prior year. As a result, the Company’s net interest margin remained constant at3.72% for the year ended June 30, 2003 as compared to 3.66% for the prior year.

 

*Provisionfor Losses on Loans and Leases.* The allowance for loanand lease losses is maintained at a level which is considered by management tobe adequate to absorb probable losses on existing loans and leases that maybecome uncollectible, based on an evaluation of the collectability of the loansand leases and 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.

 

Provision forlosses on loans and leases increased $1.3 million, or 66.6%, to $3.2 millionfor the year ended June 30, 2003 as compared to $1.9 million in the prioryear.  The increase was primarily due toa $1.4 million participation loan charge-off in the fourth quarter of fiscal2003.  The Company modified this loan asa troubled debt restructuring with specific reserve allowance during the firstquarter of fiscal 2003 and took an additional fourth quarter fiscal 2003 chargeto provision in the amount of $893,000 upon significant deterioration of theborrower’s credit from levels previously estimated.

 

The allowancefor loan and lease losses at June 30, 2003 was $3.8 million.  The allowance decreased from the June 30,2002 balance of $4.5 million primarily as a result of charge-offs exceedingrecoveries by $3.5 million offset by the provision for losses on loans andleases of $3.2 million.  The ratio ofallowance for loan and lease losses to nonperforming loans and leases at June30, 2003 was 65.89% compared to 40.02% at June 30, 2002.  The allowance for loan and lease losses tototal loans and leases at June 30, 2003 was 0.62% compared to 0.78% at June 30,2002.  The Bank’s management believesthat the June 30, 2003 recorded allowance for loan and lease losses wasadequate to provide for probable losses on the related loans and leases, basedon its evaluation of the collectability of loans and leases and prior lossexperience.

 

*NoninterestIncome.* Noninterest income was $10.5 million for the year ended June 30, 2003 ascompared to $9.8 million for the year ended June 30, 2002, an increase of$660,000, or 6.7%.  The increase innoninterest income was due primarily to increases in earnings on cash value oflife insurance of $431,000, fees on deposits of $363,000 and net gain on saleof securities of $217,000 offset by decreases in commission and insuranceincome of $256,000 and loan servicing income of $248,000.

 

Earnings oncash value of life insurance was $431,000 due to the purchase of BOLI duringthe fiscal year ended June 30, 2003.

 

Fees ondeposits increased 9.2% to $4.3 million for the year ended June 30, 2003compared to $3.9 million in the prior year primarily due to a $17.7 million and$4.1 million increase in demand deposit and savings account balances,respectively, at June 30, 2003 compared to balances at June 30, 2002 and anincrease in monthly fees charged on savings accounts.

 

Net gain onsale of securities increased $217,000 for the year ended June 30, 2003 ascompared to the prior year.    Long-termfixed-rate mortgage-backed securities were sold to reduce the potential marketvalue loss of rising interest rates.

 

Othernoninterest income decreased 6.7% to $667,000 for the year ended June 30, 2003compared to $715,000 in the prior year primarily due to a decrease of $163,000in appraisal income due to the cessation of operations of Mid America Appraisalduring the third quarter of fiscal 2002 offset by an increase in the amount of$237,000 recorded on the retained interest obtained through the securitizationof automobile loans during the last half of fiscal 2003.  See Note 3 of “Notes to Consolidated Financial Statements.

 

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Commission andinsurance income was $1.0 million for the year ended June 30, 2003 compared to$1.3 million in the prior year, a decrease of 19.9%.  Hometown’s personal and commercial insurancelines are down compared to the prior year primarily due to less emphasis on theproperty and casualty line of business. The Company sold the property and casualty book of business in August2003.

 

Loan servicingincome was $1.6 million for the year ended June 30, 2003 compared to $1.9million in the prior year, a decrease of 13.3%. The decrease was primarily due to the package sale of $23.1 million ofone- to four- family, 15- and 30-year fixed-rate loans during the first quarterof fiscal 2002.

 

*NoninterestExpense.*  Noninterestexpense was $26.0 million for the year ended June 30, 2003 as compared to $24.8for the prior year, an increase of $1.2 million, or 5.0%.  The increase in noninterest expense was dueprimarily to increases in compensation and employee benefits of $640,00 andoccupancy and equipment of $188,000.

 

Compensationand employee benefits increased to $15.9 million for the year ended June 30,2003 as compared to $15.2 million for the prior year in part due to increasedemployee base compensation and variable compensation (performance incentives)of $592,000 and health insurance claim accruals of $747,000 offset by areduction of $257,000 in compensation for deferred loan origination costs.  The Company has had a self-insured healthplan for nine years.  Although healthclaims were significantly higher for the year ended June 30, 2003 as comparedto the prior year, the Company does not believe the claim level will continueat the current rate.  Management believesthe current structure is a reasonable alternative to traditional health careplans over the long run.  Five newin-store locations opened since September 30, 2001 attributed to an increase inemployee compensation, related benefits and payroll taxes of approximately$451,000 for the year ended June 30, 2003 as compared to the prior year.

 

Occupancy and equipmentincreased 5.6% to $3.5 million for the year ended June 30, 2003 as compared to$3.4 million for the prior year.  Theincrease was primarily due to an increase in rent expense of $99,000 for newbranch locations and furniture and fixture expense of $169,000, including avaluation impairment of $200,000 recorded in the third quarter of fiscal 2003as a result of a significant change in market value of property that theCompany no longer uses in its banking operations.  The Company reclassed the property as heldfor sale during the fourth quarter of fiscal 2003.

 

*Income taxexpense.*  TheCompany’s income tax expense decreased $272,000, or 9.5%, for the year endedJune 30, 2003 to $2.6 million compared to $2.9 million for the prior year.  The decrease was primarily due to thedecrease in the Company’s effective tax rate due to changes in permanent taxdifferences.  The effective rate was34.32% and 36.96% for the years ended June 30, 2003 and June 30, 2002,respectively.

 

**DiscontinuedOperations**

 

*Income (loss) from discontinuedoperations. *Incomefrom discontinued operations increased $1.7 million, or 101.7%, for the yearended June 30, 2003 compared to the prior year primarily due to the sale of thecredit card portfolio on January 31, 2003. A contingent legal liability arising from the normal course of businessof $100,000 was recorded during the fourth quarter of fiscal 2002 and reversedduring the third quarter of fiscal 2003.  See Note 2 of “Notes to Consolidated Financial Statements” for furtherdiscussion on discontinued operations.

 

**Liquidity andCapital Resources**

** **

The Company’sliquidity is comprised of three primary classifications:  cash flows from operating activities, cashflows from investing activities and cash flows from financing activities.  Net cash provided by operating activities was$17.1 million for the fiscal year ended June 30, 2004, which was primarily dueto proceeds from the sale of loans of $131.6 million offset by loans originatedfor resale of $124.6 million.  For thefiscal year ended June 30, 2003, net cash used in operating activities was$966,000 primarily due to loans originated for resale of $219.7 offset byproceeds from the sale of loans of $211.5 million.  Net cash used in investing activities was$84.9 million for the fiscal year ended June 30, 2004 primarily due to loansand leases originated and held of $266.5 million offset by principal collectedon loans and leases of $221.2 million. For the fiscal year ended June 30, 2004, net cash used in investingactivities was $54.0 primarily due to loans and leases originated and held of$203.6 million offset by principal collected on loans and leases of $164.9million.  Net cash provided by financingactivities for the fiscal year ended June 30, 2004 was $44.0 million primarilydue to a net increase in deposit accounts of $37.3 million.  This compares to net cash provided byfinancing activities in the prior fiscal year of $71.7 million primarily due toa net increase in deposit accounts of $58.8 million.

 

The Bank’sprimary sources of funds are earnings, in-market deposits, FHLB advances andother borrowings, repayments of loan principal, mortgage-backed securities andcallable agency securities and, to a lesser extent, sales of

 

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mortgage loans, sales andmaturities of securities, mortgage-backed securities, out-of-market depositsand short-term investments.  Whilescheduled loan payments and maturing securities are relatively predictable,deposit flows and loan prepayments are more influenced by interest rates,general economic conditions and competition. The Bank attempts to price itsdeposits to meet its asset/liability objectives consistent with local marketconditions.  Excess balances are investedin overnight funds.

 

Liquiditymanagement is both a daily and long-term responsibility of management.  The Bank adjusts its investments in liquidassets based upon management’s assessment of (i) expected loan demand, (ii) projectedloan sales, (iii) expected deposit flows, (iv) yields available oninterest-bearing deposits and (v) the objectives of its asset/liabilitymanagement program. Excess liquidity is invested generally in interest-bearingovernight deposits and other short-term government and agency obligations.  At June 30, 2004, the Bank had no fundsinvested in federal funds sold. During the year ended June 30, 2004, the Bankincreased its borrowings with the FHLB and FRB by $8.5 million.

 

The Bankanticipates that it will have sufficient funds available to meet current loancommitments.  At June 30, 2004, the Bankhad outstanding commitments to originate and purchase mortgage and commercialloans of $55.8 million and to sell mortgage loans of $17.0 million.  Commitments by the Bank to originate loansare not necessarily executed by the customer. The Bank monitors the ratio ofcommitments to funding for use in liquidity management. At June 30, 2004, theBank had no outstanding commitments to purchase investment securities availablefor sale or commitments to sell investment securities available for sale.

 

The growth in indirect lending has provided securitizationopportunities in the capital markets.  OnJanuary 31, 2003, the Bank sold approximately $40.1 million principal ofindirect and $9.9 million principal of direct automobile receivables in asecuritization transaction.  The proceedswere used in part to continue to service the demand of the Bank’s dealernetwork.  The securitization is a sourceof funds at a rate lower than other sources of funds, which reduces the Bank’scapital requirements and the credit risk from the loans sold.  See Note 3 of “Notes to Consolidated Financial Statements” for details on the consumerautomobile securitization.

 

Althoughin-market deposits are the Bank’s primary source of funds, the Bank’s policyhas been to utilize borrowings where the funds can be invested in either loansor securities at a positive rate of return or to use the funds for short-termliquidity purposes.  During fiscal 2002,the Bank increased the amount of pledgeable loans at the FHLB in order toincrease its contingent liquidity sources. The Bank currently has two $10.0 million unsecured lines of federalfunds with correspondent banks. There were no funds drawn on either line ofcredit at June 30, 2004.  Also, the Bankhas implemented arrangements to acquire out-of-market certificates of depositand money market accounts as an additional source of funding.  As of June 30, 2004, the Bank had $15.8million in out-of-market certificates of deposit and $18.4 million inout-of-market money market accounts. The Bank may also seek other sources ofcontingent liquidity including additional federal funds purchased lines withcorrespondent banks and lines of credit with the Federal Reserve Bank.

 

The Companyexecuted a renewal of a line of credit for $3.0 million with First TennesseeBank, NA for liquidity needs in the Company. The note is short-term in duration and is subject to annual review.  In case of default on the notes, theCompany’s ability to pay cash dividends may be restricted.  At June 30, 2004 no funds were advanced onthe line of credit.  See Note 9 of  “Notes to Consolidated Financial Statements”and “Financial Condition Data” and Exhibits 10.19 to 10.21 for further details.

 

Through anunconsolidated subsidiary, the Company issued trust preferred securities duringfiscal 2004 in order to provide funding for treasury stock purchases and torepay other borrowings.  See Note 10 of  “Notes to Consolidated Financial Statements”.

 

The Companyuses its capital resources to pay dividends to its stockholders, to repurchaseCompany stock in the market pursuant to Board of Directors’ approved plans, tosupport organic growth, to make acquisitions, to service its debt obligationsand to provide funding for investment into the Bank of Tier 1 (core) capital.

 

The Company’s stock repurchases made during the year ended June 30,2004 were made under the Company’s stock buy back program which was publiclyannounced on April 28, 2003 in which the Company was permitted to repurchase upto 10% of the common stock of the Company that was outstanding on May 1,2003.  This stock buy back programexpired on April 30, 2004.  A total of154,300 shares of common stock were purchased pursuant to the program with noshares purchased during the three months ended June 30, 2004.  All of the 154,300 shares repurchased duringthe fiscal year ended June 30, 2004 were purchased in the open-market, exceptfor 11,000 shares that were purchased at a price of $17.60 through a privatetransaction.

 

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The Company approved anew stock buy back program which began on May 1, 2004 and was publiclyannounced on April 26, 2004.  Under thisprogram, the Company may repurchase up to 10% of the common stock of theCompany outstanding on May 1, 2004 through April 30, 2005.  No shares of common stock were purchasedpursuant to this program during the fiscal year ended June 30, 2004.

 

Savings institutions insured by the FDIC are required to meet threeregulatory capital requirements.  If arequirement is not met, regulatory authorities may take legal or administrativeactions, including restrictions on growth or operations or, in extreme cases,seizure.  Institutions not in compliancemay apply for an exemption from the requirements and submit a recapitalizationplan.  Under these capital requirements,at June 30, 2004, the Bank met all current capital requirements.

 

The OTS hasadopted capital requirements for savings institutions comparable to therequirement for national banks.  Theminimum OTS core capital requirement for well capitalized institutions is 5.00%of total adjusted assets for thrifts. The Bank had tier 1 (core) capital of 8.28% at June 30, 2004.  The minimum OTS risk-based capitalrequirement for well capitalized institutions is 10.00% of risk-weightedassets.  The Bank had risk-based capitalof 10.54% at June 30, 2004.

 

**Off-BalanceSheet Financing Arrangements**

 

During fiscal 2003, the Bank securitized andsold consumer automobile loans in the amount of $50.0 million through HFSC andHome Federal Automobile Securitization Trust 2003-A.  As a result of this securitizationtransaction, the Bank had off-balance sheet automobile loans in the amount of$35.5 million at June 30, 2003.  At June30, 2004, the outstanding balance was $17.2 million.  As part of the sales transaction, the Bankretains servicing responsibilities and a retained interest in the interestpayments from the receivables, which is subordinated to third party investors’interests.  The receivables were soldwithout legal recourse to third party conduits. The sale provided the Bank with an additional source of liquidity atinterest rates more favorable than it could receive through other forms offinancing.  It also assisted in reducingcapital requirements and credit risk to the Bank, in addition to giving theBank access to the national capital markets. The Bank has the option to execute a clean-up call when the remainingbalance of the loans outstanding is at 10% of the original balance.  See Notes 1 and 3 of “Notes to ConsolidatedFinancial Statements” and “Comparison of the Years Ended June 30, 2003 and June30, 2002” for further detail.

 

**Impact ofInflation and Changing Prices**

 

The ConsolidatedFinancial Statements and Notes thereto presented in this Form 10-K have beenprepared in accordance with GAAP, which require the measurement of financialposition and operating results in terms of historical dollars withoutconsidering the change in the relative purchasing power of money over time dueto inflation.  The impact of inflation isreflected in the increased cost of the Bank’s operations.  Unlike most industrial companies, nearly allthe assets and liabilities of the Bank are monetary in nature.  As a result, interest rates have a greaterimpact on the Bank’s performance than do the effects of general levels ofinflation.  Interest rates do notnecessarily move in the same direction or to the same extent as the prices ofgoods and services.

 

**Effect ofNew Accounting Standards**

 

In March 2003, the FASBstarted a project to address issues related to stock-based compensation(“SBC”). The objective of the project is to cooperate with the InternationalAccounting Standards Board to achieve convergence to one single, high-qualityglobal accounting standard on SBC.   TheFASB has discussed several issues relating to SBC arrangements, but continuesto deliberate on other SBC issues.

 

The Company accounts forstock-based compensation in accordance with Accounting Principles Board (“APB”)Opinion No. 25., *Accounting for Stock Issuedto Employees*, and related interpretations. No stock-based employeecompensation cost has been recognized for grants under the Company’s fixedstock option plans, as all options granted under those plans had an exerciseprice equal to the market value of the underlying common stock on the date ofgrant.

 

The Companycontinues to monitor the progress of the FASB regarding its SBC project andwill continue applying the guidance of APB Opinion No. 25.  The Company will reevaluate its accountingpolicy on SBC upon the FASB’s issuance of the final accounting standardregarding SBC as a result of its current SBC project.

 

FASB Interpretation No. 46 (Revised December 2003), *Consolidation of Variable Interest Entities*(FIN 46R) replaces in its entirety FASB Interpretation No. 46, *Consolidation of Variable Interest Entities*,that was issued by the FASB in January 2003. Fin 46R provides guidance related to identifying variable interest entities(previously known generally as special purpose entities or SPEs) anddetermining whether such entities should be consolidated. Key to theconsolidation

 

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determination is whether suchentities disperse risks among the parties involved. If those risks are notdispersed, and therefore an enterprise bears the majority of the risks orrewards related to the variable interest entity, it would consolidate thatvariable interest entity.

 

The subordinated trustentities of the Company were deconsolidated during the fiscal year ended June30, 2004 and the June 30, 2003 balance sheet was restated at that time asallowed by FIN 46R.  As a result, the 2004 and 2003 balance sheets include$27.8 and  $20.6 million, respectively,of subordinated debt, which was previously included on the balance sheet atJune 30, 2003 as $20.0 million in trust preferred securities after aconsolidation elimination of $620,000. The overall effect on the Company’sfinancial position and operating results of the deconsolidation was notmaterial, and did not affect reported equity or net income. The consolidatedfinancial statements reflect the deconsolidation of the subsidiary trusts ofthe Company, HF Financial Capital Trust I, HF Financial Capital Trust II, HFFinancial Capital Trust III and HF Financial Capital Trust IV.

 

In April 2003,FASB issued SFAS Statement No. 149, *“Amendmentof Statement 133 on Derivative Instruments and Hedging Activities.”*  This Statement improves financial reportingby requiring that contracts with comparable characteristics be accounted forsimilarly.  In particular, this Statement(i) clarifies under what circumstances a contract with an initial netinvestment meets the characteristics of a derivative discussed in paragraph6(b) of Statement 133, (ii) clarifies when a derivative contains a financingcomponent, (iii) amends the definition of an underlying to conform it tolanguage used in FASB Interpretation No. 45, *“Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others”* and (iv) amends certain otherexisting pronouncements.  The changeswill result in more consistent reporting on contracts and hedging relationshipsentered into or modified after June 30, 2003.  The above pronouncement did not have a material effect on the Company’sfinancial position, liquidity or results of operations.

 

In May 2003, FASBissued SFAS Statement No. 150, *“Accountingfor Certain Financial Instruments with Characteristics of both Liabilities andEquity”*.  This Statementestablishes standards for how an issuer classifies and measures certainfinancial instruments with characteristics of both liabilities and equity. Itrequires that an issuer classify a financial instrument that is within itsscope as a liability (or an asset in some circumstances). This Statement iseffective for financial instruments entered into or modified after May 31,2003, and otherwise is effective at the beginning of the first interim periodbeginning after June 15, 2003, except for mandatorily redeemable financialinstruments of nonpublic entities.  Theabove pronouncements did not have a material effect on the Company’s financialposition, liquidity or results of operations, however, management continues toreview guidance from the FASB and Federal Reserve.

 

**Asset/Liabilityand Risk Management**

 

Interest rate risk is the most significant market risk affecting theCompany.  Other types of market risk,such as foreign currency exchange rate risk and commodity price risk, do notarise in the normal course of the Company’s business activities.  The Bank, like other financial institutions,is subject to interest rate risk to the extent that its interest-bearingliabilities with short- and medium-term maturities mature or reprice morerapidly than its interest-earning assets. The Company does not currently engagein trading activities or use derivative instruments to control interest raterisk although it may in the future, if necessary, to manage interest rate risk.

 

As acontinuing part of its financial strategy, the Bank considers methods ofmanaging this asset/liability mismatch consistent with maintaining acceptablelevels of net interest income.  In orderto properly monitor interest rate risk, the Board of Directors has created anAsset/Liability Committee whose principal responsibilities are to assess theBank’s asset/liability mix and recommend strategies to the Board that willenhance income while managing the Bank’s vulnerability to changes in interestrates.

 

In managingmarket risk and the asset/liability mix, the Bank has placed its emphasis ondeveloping a portfolio in which, to the extent practicable, assets andliabilities reprice within similar periods. The goal of this policy is toprovide a relatively consistent level of net interest income in varyinginterest rate cycles and to minimize the potential for significant fluctuationsfrom period to period.

 

One approachused to quantify interest rate risk is the net portfolio value (“NPV”)analysis.  In essence, this analysiscalculates the difference between the present value of the liabilities and thepresent value of expected cash flows from assets and off-balance sheetcontracts.  The following table setsforth, at June 30, 2004 and June 30, 2003, an analysis of the Company’sinterest rate risk as measured by the estimated changes in NPV resulting frominstantaneous and sustained parallel shifts in the yield curve (+ 300 or –100basis points, measured in 100 basis point increments).  Due to the abnormally low prevailing interestrate environment, -200 and –300 NPV were not estimated by the OTS.

 

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The data in the following tables is based on assumptions utilized bythe OTS in assessing interest rate risk of thrift institutions and published in“Selected Asset and Liability Price Tables as of June 30, 2004” and “SelectedAsset and Liability Price Tables as of June 30, 2003”.  Even if interest rates change in thedesignated amounts, there can be no assurance that the Company’s assets andliabilities would perform as set forth below. In addition, a change in U.S. Treasury rates in the designated amountsaccompanied by a change in the shape of the Treasury yield curve would causesignificantly different changes to the NPV than indicated below.

 
| **June 30, 2004**             | ** ** |
|-------------------------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Estimated Increase  (Decrease) in NPV** | ** ** |
| **Change in  Interest Rates** | ** ** | **Estimated  NPV  Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Basis Points**              | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
|                          |       |   |   |   |   |   |   |
| +300                          |       |   | $ | 101,515 |   | $ | (9,951 | ) | (9 | )% |
| +200                          |       |   | 106,605 |   | (4,861 | ) | (4 | ) |
| +100                          |       |   | 110,164 |   | (1,301 | ) | (1 | ) |
| —                        |       |   | 111,465 |   | — |   | — |   |
| -100                          |       |   | 108,310 |   | (3,156 | ) | (3 | ) |
|                               |            |  |  |  |  |  |  |  |  |  |

 
| **June 30, 2003**             | ** ** |
|-------------------------------|------------|
| ** **                    | ** ** | ** ** | ** ** | **Estimated Increase  (Decrease) in NPV** | ** ** |
| **Change in  Interest Rates** | ** ** | **Estimated  NPV  Amount** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| **Basis Points**              | ** ** | **(Dollars in Thousands)** | ** ** | ** ** | ** ** |
|                          |       |   |   |   |   |   |   |
| +300                          |       |   | $ | 80,157 |   | $ | 2,306 |   | 3 | % |
| +200                          |       |   | 80,555 |   | 2,703 |   | 3 |   |
| +100                          |       |   | 79,200 |   | 1,348 |   | 2 |   |
| —                        |       |   | 77,852 |   | — |   | — |   |
| -100                          |       |   | 76,488 |   | (1,364 | ) | (2 | ) |
|                               |            |  |  |  |  |  |  |  |  |  |

 

56

----

 

**ContractualObligations**

 

The following table setsforth information with respect to the Company’s contractual obligations as ofJune 30, 2004.    Long-term debtobligations are primarily made up of FHLB advances and subordinated debenturespayable to trusts.  Operating leaseobligations are primarily related to the lease of certain branch offices andpurchase obligations are primarily related to various smaller purchases, whichthe Company has committed to as of June 30, 2004.

 
| ** **                    | ** ** | **Payments due by period** | ** ** |
|-------------------------------|------------|----------------------------|------------|
| ** **                    | ** ** | **1 Year  or Less**        | ** ** | **1 to 3 Years** | ** ** | **3 to 5 Years** | ** ** | **Greater than  5 Years** | ** ** | **Total** | ** ** |
|                          |       |                       |       |   |   |   |   |   |   |   |   |
| Long-Term Debt Obligations    |       | $                          | 15,969     |   | $ | 211 |   | $ | 15,154 |   | $ | 90,254 |   | $ | 121,588 |   |
|                          |       |                       |       |   |   |   |   |   |   |   |   |
| Operating Lease Obligations   |       | 441                        |       | 513 |   | 238 |   | 19 |   | 1,211 |   |
|                          |       |                       |       |   |   |   |   |   |   |   |   |
| Purchase Obligations          |       | 1,033                      |       | — |   | – |   | — |   | 1,033 |   |
|                          |       |                       |       |   |   |   |   |   |   |   |   |
| Total Contractual Obligations |       | $                          | 17,443     |   | $ | 724 |   | $ | 15,392 |   | $ | 90,273 |   | $ | 123,832 |   |

 

57

----

 

**Item 7A****. Quantitative and QualitativeDisclosures About Market Risk**

 

*Interest Rate Risk Management*

 

The Company’snet income is largely dependent on its net interest income. Net interest incomeis susceptible to interest rate risk to the degree that interest-bearingliabilities mature or reprice on a different basis than interest-earningassets. When interest-bearing liabilities mature or reprice more quickly thaninterest-earning assets in a given period, a significant increase in marketrates of interest could adversely affect net interest income. Similarly, wheninterest-earning assets mature or reprice more quickly than interest-bearingliabilities, falling interest rates could result in a decrease in net income.

 

In an attemptto manage its exposure to change in interest rates, management monitors theCompany’s interest rate risk. Management’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 the Bank’s securities portfolio, formulatesinvestment strategies, and oversees the timing and implementation oftransactions to assure attainment of the Board ‘s objectives in the mosteffective manner. Notwithstanding the Company’s interest rate risk managementactivities, the potential for changing interest rates is an uncertainty thatcan have an adverse effect on net income.

 

In adjustingthe Company’s asset/liability position, management attempts to manage theCompany’s interest rate risk while enhancing net interest margins. At times,depending on the level of general interest rates, the relationship between longand short-term interest rates, market conditions and competitive factors,management may determine to increase the Company’s interest rate risk positionsomewhat in order to increase its net interest margin. The Company’s results ofoperations and net portfolio values remain vulnerable to increases in interestrates and to fluctuations in the difference between long- and short-terminterest rates.

 

Consistentwith the asset/liability management philosophy described above, the Company hastaken several steps to manage its interest rate risk. First, the Company hasstructured the security portfolio to shorten the repricing of its interest-earningassets. The Company’s recent purchases of mortgage-backed securities andsecurities available for sale have had either short or medium terms to maturityor adjustable interest rates. At June 30, 2004, the Company had investmentsecurities available for sale of $8.8 million with contractual maturities offive years or less.  Variable-ratemortgage-backed securities totaled $95.0 million at June 30, 2004.Mortgage-backed securities amortize and experience prepayments ofprincipal.  The Company has receivedaverage cash flows from principal paydowns, maturities, sales and calls of allsecurities available for sale of $61.6 million annually over the past threefiscal years. The Company also controls interest rate risk reduction byutilizing non-certificate depositor accounts for certain liquidity purposes.The Board and management believe that such accounts carry a lower cost thancertificate accounts, and that a material portion of such accounts may be moreresistant to changes in interest rates than are certificate accounts. At June30, 2004, the Company had $63.7 million of savings accounts, $211.9 million ofmoney market accounts and $121.0 million of checking accounts, representing60.2% of total depositor accounts.

 

One approachused to quantify interest rate risk is the NPV analysis. In essence, thisanalysis calculates the difference between the present value of liabilities andthe present value of expected cash flows from assets and off-balance sheetcontracts.  See Item 7, “Management’s Discussionand Analysis of Financial Condition and Results of Operations – Asset/Liabilityand Risk Management” for further discussion.

 

58

----

**Item 8****.  FinancialStatements and Supplementary Data**

 

**Contents**

 
| Independent  Registered Public Accounting Firm’s  Report on the Financial Statements |   |
|-------------------------------------------------------------------------------------------|--------|
|                                                                                      |   |
| Consolidated  Financial Statements                                                        |   |
|                                                                                      |   |
| Statements  of financial condition                                                        |   |
|                                                                                      |   |
| Statements of income                                                                      |   |
|                                                                                      |   |
| Statements  of stockholders’ equity                                                  |   |
|                                                                                      |   |
| Statements of  cash flows                                                                 |   |
|                                                                                      |   |
| Notes to  consolidated financial statements                                               |   |

 

59

----

 

 

 

**Report of IndependentRegistered Public Accounting Firm**

 

To the Boardof Directors and Stockholders

HF FinancialCorp.

Sioux Falls,South Dakota

 

We haveaudited the consolidated statements of financial condition of HF FinancialCorp. and subsidiaries as of June 30, 2004 and 2003, and the relatedconsolidated statements of income, stockholders’ equity and cash flows for eachof the three years in the period ended June 30, 2004.  These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conductedour audits in accordance with the standards of the Public Company AccountingOversight Board (United States).  Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement.  An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements.  An audit alsoincludes assessing the accounting principles used and significant estimatesmade by management, as well as evaluating the overall financial statementpresentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In ouropinion, the consolidated financial statements referred to above presentfairly, in all material respects, the financial position of HF Financial Corp.and subsidiaries as of June 30, 2004 and 2003, and the results of theiroperations and their cash flows for each of the three years in the period endedJune 30, 2004, in conformity with U.S. generally accepted accounting principles.

 

 
|                       | /s/  McGladrey & Pullen, LLP |
|----------------------------|----------------------------------|
|                       |
| Sioux Falls,  South Dakota |
| July 30,  2004             |

 

60

----

 

**HFFinancial Corp. and Subsidiaries**

 

**ConsolidatedStatements of Financial Condition**

**June 30,2004 and 2003**

**(Dollars inThousands)**

 
| ** **                                                                                                                                  | ** ** | **2004**    | ** **  | **2003**   | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|------------|------------|
| **Assets**                                                                                                                                  |       | ** **  | ** **  |       |       |
| Cash and cash equivalents                                                                                                                   |       | **$**       | **20,474**  | ** ** | $          | 44,214 |   |
| Securities available for sale (Note 4)                                                                                                      |       | **122,715** | ** **  | 88,527     |       |
| Federal Home Loan Bank stock (Note 9)                                                                                                       |       | **5,469**   | ** **  | 7,025      |       |
| Loans held for sale (Note 5)                                                                                                                |       | **10,351**  | ** **  | 15,984     |       |
| Loans and leases receivable (Notes 5 and 9)                                                                                                 |       | **640,946** | ** **  | 595,417    |       |
| Accrued interest receivable                                                                                                                 |       | **4,056**   | ** **  | 4,298      |       |
| Office properties and equipment, net of  accumulated depreciation (Note 7)                                                                  |       | **12,555**  | ** **  | 13,138     |       |
| Foreclosed real estate and other properties                                                                                                 |       | **1,689**   | ** **  | 1,812      |       |
| Cash value of life insurance                                                                                                                |       | **12,051**  | ** **  | 11,432     |       |
| Servicing rights (Note 6)                                                                                                                   |       | **4,620**   | ** **  | 4,003      |       |
| Goodwill, net                                                                                                                               |       | **4,951**   | ** **  | 5,020      |       |
| Intangible asset                                                                                                                            |       | **—**  | ** **  | 175        |       |
| Other assets (Notes 3 and 11)                                                                                                               |       | **7,193**   | ** **  | 10,058     |       |
|                                                                                                                                        |       | **$**       | **847,070** | ** ** | $          | 801,103 |   |
|                                                                                                                                        |       | ** **  | ** **  |       |       |
| **Liabilities and Stockholders’ Equity**                                                                                               |       | ** **  | ** **  |       |       |
| Liabilities                                                                                                                                 |       | ** **  | ** **  |       |       |
| Deposits (Note 8)                                                                                                                           |       | **$**       | **658,719** | ** ** | $          | 621,381 |   |
| Advances from Federal Home Loan Bank and  other borrowings (Note 9)                                                                         |       | **93,750**  | ** **  | 89,819     |       |
| Subordinated debentures payable to trusts  (Note 10)                                                                                        |       | **27,837**  | ** **  | 20,620     |       |
| Advances by borrowers for taxes and  insurance                                                                                              |       | **6,391**   | ** **  | 7,901      |       |
| Accrued expenses and other liabilities  (Note 15)                                                                                           |       | **8,724**   | ** **  | 12,024     |       |
| **Total liabilities**                                                                                                                       |       | **795,421** | ** **  | 751,745    |       |
|                                                                                                                                        |       | ** **  | ** **  |       |       |
| Commitments and Contingencies (Notes 7 and  20)                                                                                             |       | ** **  | ** **  |       |       |
|                                                                                                                                        |       | ** **  | ** **  |       |       |
| Stockholders’ Equity (Notes 11, 12 and 13)                                                                                             |       | ** **  | ** **  |       |       |
| Preferred stock, $.01 par value, 500,000  shares authorized, none outstanding                                                               |       | **—**  | ** **  | —     |       |
| Series A Junior Participating Preferred  Stock, $1.00 stated value, 50,000 shares authorized, none outstanding                              |       | **—**  | ** **  | —     |       |
| Common stock, $.01 par value, 10,000,000  shares authorized, 5,347,686 and 5,252,535 shares issued at June 30, 2004 and  2003, respectively |       | **53**      | ** **  | 49         |       |
| Common stock subscribed for but not issued  shares , 40,244 and 23,535 at June 30, 2004 and 2003, respectively                              |       | **698**     | ** **  | 382        |       |
| Additional paid-in capital                                                                                                                  |       | **17,680**  | ** **  | 16,527     |       |
| Retained earnings, substantially restricted                                                                                                 |       | **61,653**  | ** **  | 57,967     |       |
| Deferred compensation (Note 17)                                                                                                             |       | **(1,147**  | **)**       | (733       | )          |
| Accumulated other comprehensive (loss), net  of related deferred tax effect (Note 18)                                                       |       | **(1,327**  | **)**       | (735       | )          |
| Less cost of treasury stock, 1,815,036 and  1,708,946 shares at June 30, 2004 and 2003, respectively                                        |       | **(25,961** | **)**       | (24,099    | )          |
|                                                                                                                                        |       | **51,649**  | ** **  | 49,358     |       |
|                                                                                                                                        |       | **$**       | **847,070** | ** ** | $          | 801,103 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

61

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**HFFinancial Corp. and Subsidiaries**

 

**ConsolidatedStatements of Income**

**Years EndedJune 30, 2004, 2003 and 2002**

**(Dollars inThousands, Except Per Share Data)**

 
| ** **                                                                                     | ** ** | **2004**   | ** ** | **2003**   | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------|------------|
| Interest and dividend income:                                                                  |       | ** ** | ** ** |       |       |     |       |
| Loans and leases receivable                                                                    |       | **$**      | **36,935** | ** ** | $          | 40,240   |       | $ | 42,458 |   |
| Investment securities and interest-bearing  deposits                                           |       | **3,325**  | ** ** | 4,022      |       | 5,727    |       |
|                                                                                           |       | **40,260** | ** ** | 44,262     |       | 48,185   |       |
| Interest expense:                                                                              |       | ** ** | ** ** |       |       |     |       |
| Deposits                                                                                       |       | **10,205** | ** ** | 12,511     |       | 18,433   |       |
| Advances from Federal Home Loan Bank and  other borrowings                                     |       | **4,983**  | ** ** | 5,486      |       | 5,140    |       |
|                                                                                           |       | **15,188** | ** ** | 17,997     |       | 23,573   |       |
| **Net interest income**                                                                        |       | **25,072** | ** ** | 26,265     |       | 24,612   |       |
| Provision for losses on loans and leases                                                       |       | **2,020**  | ** ** | 3,173      |       | 1,905    |       |
| **Net interest income after provision for  losses on loans and leases**                        |       | **23,052** | ** ** | 23,092     |       | 22,707   |       |
| Noninterest income:                                                                            |       | ** ** | ** ** |       |       |     |       |
| Fees on deposits                                                                               |       | **4,226**  | ** ** | 4,294      |       | 3,931    |       |
| Loan servicing income                                                                          |       | **1,578**  | ** ** | 1,610      |       | 1,858    |       |
| Gain on sale of loans, net                                                                     |       | **1,311**  | ** ** | 1,629      |       | 1,464    |       |
| Earnings on cash value of life insurance                                                       |       | **619**    | ** ** | 431        |       | —   |       |
| Trust income                                                                                   |       | **568**    | ** ** | 471        |       | 435      |       |
| Commission and insurance income                                                                |       | **507**    | ** ** | 1,032      |       | 1,288    |       |
| Gain on sale of securities, net                                                                |       | **43**     | ** ** | 352        |       | 135      |       |
| Other                                                                                          |       | **976**    | ** ** | 667        |       | 715      |       |
|                                                                                           |       | **9,828**  | ** ** | 10,486     |       | 9,826    |       |
| Noninterest expense:                                                                           |       | ** ** | ** ** |       |       |     |       |
| Compensation and employee benefits                                                             |       | **15,542** | ** ** | 15,876     |       | 15,236   |       |
| Occupancy and equipment                                                                        |       | **3,209**  | ** ** | 3,547      |       | 3,359    |       |
| Check and data processing expense                                                              |       | **1,819**  | ** ** | 1,741      |       | 1,263    |       |
| Advertising                                                                                    |       | **749**    | ** ** | 917        |       | 1,042    |       |
| Foreclosed real estate and other  properties, net                                              |       | **296**    | ** ** | 371        |       | 263      |       |
| Other                                                                                          |       | **3,158**  | ** ** | 3,596      |       | 3,643    |       |
|                                                                                           |       | **24,773** | ** ** | 26,048     |       | 24,806   |       |
| **Income from continuing operations before  income taxes**                                     |       | **8,107**  | ** ** | 7,530      |       | 7,727    |       |
| Income tax expense (Note 11)                                                                   |       | **2,891**  | ** ** | 2,584      |       | 2,856    |       |
| **Income from continuing operations**                                                          |       | **5,216**  | ** ** | 4,946      |       | 4,871    |       |
| Discontinued operations (Note 2):                                                              |       | ** ** | ** ** |       |       |     |       |
| Income (loss) from operations of  discontinued segment, net of income taxes of $131 and $(127) |       | **—** | ** ** | 253        |       | (246     | )          |
| (Loss) on discontinued segment, net of  income taxes of $(116) and $(741)                      |       | **—** | ** ** | (224       | )          | (1,440   | )          |
| **Income (loss) from discontinued operations**                                                 |       | **—** | ** ** | 29         |       | (1,686   | )          |
| **Net income**                                                                                 |       | **$**      | **5,216**  | ** ** | $          | 4,975    |       | $ | 3,185 |   |
|                                                                                           |       | ** ** | ** ** |       |       |     |       |
| Basic earnings (loss) per share (Note 14):                                                     |       | ** ** | ** ** |       |       |     |       |
| Income from continuing operations                                                              |       | **$**      | **1.47**   | ** ** | $          | 1.36     |       | $ | 1.27 |   |
| Income (loss) from discontinued operations                                                     |       | **—** | ** ** | 0.01       |       | (0.44    | )          |
| Net income                                                                                     |       | **1.47**   | ** ** | 1.37       |       | 0.83     |       |
|                                                                                           |       | ** ** | ** ** |       |       |     |       |
| Diluted earnings (loss) per share (Note  14):                                                  |       | ** ** | ** ** |       |       |     |       |
| Income from continuing operations                                                              |       | **1.43**   | ** ** | 1.34       |       | 1.24     |       |
| Income (loss) from discontinued operations                                                     |       | **—** | ** ** | 0.01       |       | (0.43    | )          |
| Net income                                                                                     |       | **1.43**   | ** ** | 1.35       |       | 0.81     |       |
|                                                                                           |       | ** ** | ** ** |       |       |     |       |
| Dividend declared per share                                                                    |       | **0.43**   | ** ** | 0.42       |       | 0.40     |       |

 

See Notes to ConsolidatedFinancial Statements.

 

62

----

 

**HF Financial Corp. and Subsidiaries**

 

**ConsolidatedStatements of Stockholders’ Equity**

**Years Ended June 30, 2004, 2003 and 2002**

**(Dollars in Thousands)**

 
| ** **                                                                                    | ** ** | **Common  Stock** | ** ** | **Common  Stock  Subscribed** | ** ** | **Additional  Paid-In  Capital** | ** ** | **Retained  Earnings** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Other  Comprehensive  (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------|------------|-----------------------------------------------|------------|---------------------|------------|-----------|------------|
|                                                                                          |       |              |       |                          |       |                             |       |                   |       |                       |       |                                          |       |                |       |      |       |
| Balance, June 30, 2001                                                                        |       | $                 | 48         |                          | $          | —                           |       | $                      | 15,378     |                       | $          | 52,886                                        |       | $                   | —     |      | $          | 338 |   | $ | (16,125 | ) | $ | 52,525 |   |
| Comprehensive income:                                                                         |       |              |       |                          |       |                             |       |                   |       |                       |       |                                          |       |                |       |      |       |
| Net income                                                                                    |       | —            |       | —                        |       | —                           |       | 3,185                  |       | —                     |       | —                                        |       | —              |       |      |       |
| Net change in unrealized gain on securities available for sale, net  of deferred taxes        |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 160                                           |       | —              |       |      |       |
| Net change in unrecognized pension costs, net of deferred taxes                               |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | (704                                          | )          | —              |       |      |       |
| Comprehensive income                                                                          |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | —              |       | 2,641     |       |
| Issuance of restricted stock and exercise of stock options                                    |       | 1                 |       | —                        |       | 636                              |       | —                 |       | (169                       | )          | —                                        |       | —              |       | 468       |       |
| Cash dividends paid on common stock                                                           |       | —            |       | —                        |       | —                           |       | (1,555                 | )          | —                     |       | —                                        |       | —              |       | (1,555    | )          |
| Purchase of treasury stock                                                                    |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | (5,571              | )          | (5,571    | )          |
| Amortization of deferred compensation                                                         |       | —            |       | —                        |       | —                           |       | —                 |       | 28                         |       | —                                        |       | —              |       | 28        |       |
| Balance, June 30, 2002                                                                        |       | 49                |       | —                        |       | 16,014                           |       | 54,516                 |       | (141                       | )          | (206                                          | )          | (21,696             | )          | 48,536    |       |
| Comprehensive income:                                                                         |       |              |       |                          |       |                             |       |                   |       |                       |       |                                          |       |                |       |      |       |
| Net income                                                                                    |       | —            |       | —                        |       | —                           |       | 4,975                  |       | —                     |       | —                                        |       | —              |       |      |       |
| Net change in unrealized gain (loss) on securities available for  sale, net of deferred taxes |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | (554                                          | )          | —              |       |      |       |
| Net change in retained interest, net of deferred taxes                                        |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 5                                             |       | —              |       |      |       |
| Net change in unrecognized pension costs, net of deferred taxes                               |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 20                                            |       | —              |       |      |       |
| Comprehensive income                                                                          |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | —              |       | 4,446     |       |
| Issuance of restricted stock and exercise of stock options (Note 17)                          |       | —            |       | —                        |       | 513                              |       | —                 |       | (287                       | )          | —                                        |       | —              |       | 226       |       |
| Common stock subscribed for but not issued                                                    |       | —            |       | 382                           |       | —                           |       | —                 |       | (382                       | )          | —                                        |       | —              |       | —    |       |
| Cash dividends paid on common stock                                                           |       | —            |       | —                        |       | —                           |       | (1,524                 | )          | —                     |       | —                                        |       | —              |       | (1,524    | )          |
| Purchase of treasury stock                                                                    |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | (2,403              | )          | (2,403    | )          |
| Amortization of deferred compensation                                                         |       | —            |       | —                        |       | —                           |       | —                 |       | 77                         |       | —                                        |       | —              |       | 77        |       |
| Balance, June 30, 2003                                                                        |       | 49                |       | 382                           |       | 16,527                           |       | 57,967                 |       | (733                       | )          | (735                                          | )          | (24,099             | )          | 49,358    |       |
| Comprehensive income:                                                                         |       |              |       |                          |       |                             |       |                   |       |                       |       |                                          |       |                |       |      |       |
| Net income                                                                                    |       | —            |       | —                        |       | —                           |       | 5,216                  |       | —                     |       | —                                        |       | —              |       |      |       |
| Net change in unrealized gain (loss) on securities available for  sale, net of deferred taxes |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | (1,298                                        | )          | —              |       |      |       |
| Net change in retained interest, net of deferred taxes                                        |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 22                                            |       | —              |       |      |       |
| Net change in unrecognized pension costs, net of deferred taxes                               |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 684                                           |       | —              |       |      |       |
| Comprehensive income                                                                          |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | —              |       | 4,624     |       |
| Issuance of stock and exercise of stock options (Note 17)                                     |       | 4                 |       | (382                          | )          | 1,153                            |       | —                 |       | 166                        |       | —                                        |       | —              |       | 941       |       |
| Common stock subscribed for but not issued                                                    |       | —            |       | 698                           |       | —                           |       | —                 |       | (698                       | )          | —                                        |       | —              |       | —    |       |
| Cash dividends paid on common stock                                                           |       | —            |       | —                        |       | —                           |       | (1,530                 | )          | —                     |       | —                                        |       | —              |       | (1,530    | )          |
| Purchase of treasury stock                                                                    |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | (1,862              | )          | (1,862    | )          |
| Amortization of deferred compensation                                                         |       | —            |       | —                        |       | —                           |       | —                 |       | 118                        |       | —                                        |       | —              |       | 118       |       |
| Balance, June 30, 2004                                                                        | ** ** | **$**             | **53**     | ** **                    | **$**      | **698**                          | ** ** | **$**                  | **17,680** | ** **                 | **$**      | **61,653**                                    | ** ** | **$**               | **(1,147** | **)**     | **$**      | **(1,327** | **)** | **$** | **(25,961** | **)** | **$** | **51,649** | ** ** |

 

SeeNotes to Consolidated Financial Statements.

 

63

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**HF Financial Corp. and Subsidiaries**

 

**ConsolidatedStatements of Cash Flows**

**Years Ended June 30, 2004, 2003 and 2002**

**(Dollars in Thousands)**

 
| ** **                                                                                    | ** ** | **2004**     | ** ** | **2003**   | ** ** | **2002**   | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------|------------|------------|------------|------------|------------|
| Cash Flows From Operating Activities                                                          |       | ** **   | ** ** |       |       |       |       |
| Net income                                                                                    |       | **$**        | **5,216**  | ** ** | $          | 4,975      |       | $ | 3,185 |   |
| Adjustments to reconcile net income to net  cash provided by (used in) operating activities:  |       | ** **   | ** ** |       |       |       |       |
| Provision for losses on loans and leases                                                      |       | **2,020**    | ** ** | 3,173      |       | 2,543      |       |
| Depreciation                                                                                  |       | **1,518**    | ** ** | 1,659      |       | 1,683      |       |
| Amortization of discounts and premiums on  securities and other                               |       | **1,616**    | ** ** | 1,549      |       | 994        |       |
| Stock based compensation                                                                      |       | **234**      | ** ** | 166        |       | 117        |       |
| Deferred income taxes (credits)                                                               |       | **976**      | ** ** | 2,629      |       | (267       | )          |
| Loans originated for resale                                                                   |       | **(124,615** | **)**      | (219,671   | )          | (158,329   | )          |
| Proceeds from the sale of loans                                                               |       | **131,559**  | ** ** | 211,461    |       | 161,234    |       |
| Gain on sale of loans, net                                                                    |       | **(1,311**   | **)**      | (1,664     | )          | (1,518     | )          |
| Realized gain on sale of securities, net                                                      |       | **(43**      | **)**      | (352       | )          | (135       | )          |
| Losses and provision for losses on sales of  foreclosed real estate and other properties, net |       | **114**      | ** ** | 150        |       | 129        |       |
| Loss on disposal of office properties and  equipment, net                                     |       | **1**        | ** ** | 243        |       | 8          |       |
| Change in other assets and liabilities  (Note 21)                                             |       | **(175**     | **)**      | (5,284     | )          | (4,729     | )          |
| **Net cash provided by (used in) operating  activities**                                      |       | **17,110**   | ** ** | (966       | )          | 4,915      |       |
|                                                                                          |       | ** **   | ** ** |       |       |       |       |
| Cash Flows From Investing Activities                                                          |       | ** **   | ** ** |       |       |       |       |
| Loans and leases purchased                                                                    |       | **(2,212**   | **)**      | (1,466     | )          | (33,340    | )          |
| Loans and leases originated and held                                                          |       | **(266,519** | **)**      | (203,562   | )          | (249,705   | )          |
| Principal collected on loans and leases                                                       |       | **221,173**  | ** ** | 164,911    |       | 282,495    |       |
| Securities available for sale:                                                                |       | ** **   | ** ** |       |       |       |       |
| Sales, maturities and repayments                                                              |       | **41,010**   | ** ** | 54,398     |       | 89,410     |       |
| Purchases                                                                                     |       | **(78,508**  | **)**      | (61,641    | )          | (84,574    | )          |
| Purchase of other assets                                                                      |       | **(240**     | **)**      | —     |       | —     |       |
| Purchase of Federal Home Loan Bank stock                                                      |       | **(3,458**   | **)**      | (693       | )          | —     |       |
| Redemption of Federal Home Loan Bank stock                                                    |       | **5,014**    | ** ** | —     |       | —     |       |
| Purchase cash value of life insurance                                                         |       | **—**   | ** ** | (5,000     | )          | (5,000     | )          |
| Proceeds from sale of office properties and  equipment                                        |       | **—**   | ** ** | 14         |       | 13         |       |
| Purchase of office properties and equipment                                                   |       | **(936**     | **)**      | (1,531     | )          | (1,662     | )          |
| Purchase of servicing rights                                                                  |       | **(892**     | **)**      | (569       | )          | (600       | )          |
| Proceeds from sale of foreclosed real estate  and other properties                            |       | **684**      | ** ** | 1,102      |       | 1,358      |       |
| **Net cash used in investing activities**                                                     |       | **(84,884**  | **)**      | (54,037    | )          | (1,605     | )          |
| ** **                                                                                    | ** ** | ** **   | ** ** | ** ** | ** ** | ** ** | ** ** |
|                                                                                               |            |              |            |            |            |            |            |  |  |  |

 

SeeNotes to Consolidated Financial Statements.

 

64

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| Cash Flows From Financing Activities                                         |   | ** **   | ** ** |       |   |     |   |
|------------------------------------------------------------------------------|--------|--------------|------------|------------|--------|----------|--------|
| Net increase (decrease) in deposit accounts                                  |   | **$**        | **37,338** | ** ** | $      | 58,785   |   | $ | (38,611 | ) |
| Proceeds of advances from Federal Home Loan  Bank and other borrowings       |   | **277,211**  | ** ** | 565,250    |   | 89,900   |   |
| Payments on advances from Federal Home Loan  Bank and other borrowings       |   | **(273,280** | **)**      | (559,739   | )      | (113,968 | )      |
| Payment of debt issue costs                                                  |   | **(158**     | **)**      | (300       | )      | (350     | )      |
| Proceeds from issuance of subordinated  debentures                           |   | **7,000**    | ** ** | 10,000     |   | 10,000   |   |
| Increase (decrease) in advances by  borrowers                                |   | **(1,510**   | **)**      | 1,465      |   | (901     | )      |
| Purchase of treasury stock                                                   |   | **(1,862**   | **)**      | (2,403     | )      | (5,571   | )      |
| Proceeds from issuance of common stock                                       |   | **825**      | ** ** | 137        |   | 379      |   |
| Cash dividends paid                                                          |   | **(1,530**   | **)**      | (1,524     | )      | (1,555   | )      |
| **Net cash provided by (used in) financing  activities**                     |   | **44,034**   | ** ** | 71,671     |   | (60,677  | )      |
| **Increase (decrease) in cash and cash  equivalents**                        |   | **(23,740**  | **)**      | 16,668     |   | (57,367  | )      |
|                                                                         |   | ** **   | ** ** |       |   |     |   |
| Cash and Cash Equivalents                                                    |   | ** **   | ** ** |       |   |     |   |
| Beginning                                                                    |   | **44,214**   | ** ** | 27,546     |   | 84,913   |   |
| Ending                                                                       |   | **$**        | **20,474** | ** ** | $      | 44,214   |   | $ | 27,546 |   |
|                                                                         |   | ** **   | ** ** |       |   |     |   |
| Supplemental Disclosures of Cash Flows  Information                          |   | ** **   | ** ** |       |   |     |   |
| Cash payments for interest                                                   |   | **$**        | **15,441** | ** ** | $      | 18,650   |   | $ | 27,890 |   |
| Cash payments (receipts) for income and  franchise taxes, net                |   | **(159**     | **)**      | 2,487      |   | 2,715    |   |
|                                                                         |   | ** **   | ** ** |       |   |     |   |
| Supplemental Schedule of Noncash Investing  and Financing Activities         |   | ** **   | ** ** |       |   |     |   |
| Foreclosed real estate and other properties  acquired in settlement of loans |   | **$**        | **713**    | ** ** | $      | 1,201    |   | $ | 379 |   |
| Loans receivable reclassified as held for  sale                              |   | **—**   | ** ** | —     |   | 1,115    |   |
| Office property reclassified as held for  sale                               |   | **—**   | ** ** | 191        |   | —   |   |

 

 

65

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**HFFinancial Corp. and Subsidiaries**

** **

**Notesto Consolidated Financial Statements**

**(Dollarsin Thousands)**

** **

**Note 1.**                                  Summary ofSignificant Accounting Policies

** **

The accountingand reporting policies of HF Financial Corp. and subsidiaries (the Company)conform to accounting principles generally accepted in the United States ofAmerica and to general practice within the industry.  The following is a description of the moresignificant of those policies that the Company follows in preparing and presentingits consolidated financial statements.

 

Principles ofconsolidation: The accompanying consolidated financial statements include the accountsof the Company, the Company’s wholly-owned subsidiaries, HomeFirst MortgageCorp. (the Mortgage Corp.), HF Card Services, LLC (HF Card), HF FinancialGroup, Inc. (HF Group), and Home Federal Bank (the Bank) and the Bank’swholly-owned subsidiaries, Hometown Insurors, Inc. (Hometown), Mid AmericaCapital Services, Inc. (Mid America Leasing), Home Federal Securitization Corp.(HFSC), Mid-America Service Corporation and PMD, Inc. HF Card was dissolvedduring fiscal year 2003 (Note 2).  Allintercompany balances and transactions have been eliminated in consolidation.

 

Basis offinancial statement presentation:  In preparing the financial statements, managementis required to make estimates and assumptions that affect the reported amountsof assets and liabilities as of the date of the statement of financialcondition and revenues and expenses for the year.  Actual results could differ significantly fromthose estimates.  Material estimates thatare particularly susceptible to significant change in the near-term relate tothe determination of the allowance for loan and lease losses, the retainedinterest asset and servicing rights.

 

Cash and cashequivalents: For purposes of reporting the statements of cash flows, the Companyincludes as cash equivalents all cash accounts which are not subject towithdrawal restrictions or penalties and time deposits with original maturitiesof 90 days or less.

 

Trust assets:  Assets of the trust department, other thantrust cash on deposit at the Bank, are not included in these financialstatements because they are not assets of the Bank.

 

Securities:  Management determines the appropriateclassification of securities at the date individual securities are acquired andevaluates the appropriateness of such classifications at each statement offinancial condition date.

 

Securitiesavailable for sale are those debt securities that the Company intends to holdfor an indefinite period of time, but not necessarily to maturity, and allequity securities.  Any decision to sella security classified as available for sale would be based on various factors,including significant movements in interest rates, changes in the maturity mixof the Company’s assets and liabilities, liquidity needs, regulatory capitalconsiderations, and other similar factors. Securities available for sale are carried at fair value and unrealizedgains or losses are reported as increases or decreases in other comprehensiveincome, net of the related deferred tax effect.

 

Premiums anddiscounts on securities are amortized over the contractual lives of thosesecurities, except for mortgage-backed securities, for which prepayments areprobable and predictable, which are amortized over the estimated expectedrepayment terms of the underlying mortgages. The method of amortization results in a constant effective yield onthose securities (the interest method). Interest on debt securities is recognized in income as accrued.  Realized gains and losses on the sale ofsecurities are determined using the specific identification method.

 

66

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Retainedinterest asset: When the Bank sells receivables in securitizations of automobile loans,it retains an interest-only strip and a cash reserve account, which is combinedand included in other assets.  Theretained interest asset is initially recognized based upon an allocation of thecarrying value of the assets which are securitized in proportion to therelative fair values of the assets sold and interests retained.  After the securitization, these interests aretreated as available for sale and are adjusted to fair value with theadjustment reflected as an unrealized gain or loss in the accumulated othercomprehensive income category in stockholders’ equity, unless a decline in fairvalue is determined to be other than temporary, in which case the loss ischarged to expense.

 

The retained interest asset isinitially recorded as an asset at fair value. Fair value is based upon estimating future cash flows paid to the Bankfrom the Home Federal Automobile Securitization Trust 2003-A (“AutomobileSecuritization Trust”) sometimes called the “cash-out” method.  The cash flows are modeled to reflect certainassumptions for prepayment speeds, discount rates and chargeoff rates as wellas cash reserve balances reflecting the required credit enhancements.

 

The value of the retainedinterest asset will fluctuate over the life of the securitization to reflectincome recorded on the amortized balance of the retained interest, cashreceived from the trust and changes in assumptions.  The amortized balance is comprised of theinitial allocated retained interest plus the interest accrued on the outstandingamortized balance less excess cash payments received from the AutomobileSecuritization Trust  and less anyrecognized impairment on the securitization asset.  The income recorded on the retained interestasset is classified as noninterest income and not interest income, which isconsistent with the Office of Thrift Supervision (“OTS”) guidelines.

 

Impairmentusually occurs whenever the current fair value of the retained interest islower than its current amortized cost. If this occurs, a test must take place to see if an impairment chargefor the deficiency is required to be taken through current earnings.  If there has been an adverse change inestimated cash flows considering both the timing and amount of flows, theretained interest must be written down to fair value, which becomes the newamortized cost basis for future amortization. No impairment losses were recorded during fiscal year 2004.

 

Loans held forsale:  Loansreceivable which the Bank may sell or intends to sell prior to maturity arecarried at the lower of net book value or fair value on an aggregatebasis.  Such loans held for sale includeloans receivable that management intends to use as part of its asset/liabilitystrategy, or that may be sold in response to changes in interest rates, changesin prepayment risk or other similar factors.

 

Loans andleases receivable: Loans receivable are stated at unpaid principal balances, less theallowance for loan losses, and net of deferred loan origination fees, costs anddiscounts.

 

Discounts andpremiums on loans are amortized to income using the interest method over theremaining period to contractual maturity, adjusted for prepayments.

 

67

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Loans andleases are generally classified as nonaccrual when there are reasonable doubtsas to the collectibility of principal and/or interest and/or when paymentbecomes 90 days past due, except loans which are well secured and in theprocess of collection.  Uncollectibleinterest on loans and leases that are impaired or contractually past due is chargedoff based on management’s periodic evaluation. The charge to interest income is equal to all interest previouslyaccrued, and income is subsequently recognized only to the extent cash paymentsare received until, in management’s judgment, the borrower’s ability to makeperiodic interest and principal payments is no longer in doubt, in which casethe loan is returned to accrual status.

 

The Company’sleases receivable are classified as direct finance leases. Under the directfinancing method of accounting for leases, the total net payments receivableunder the lease contracts and the residual value of the leased equipment, netof unearned income, are recorded as a net investment in direct financing leasesand the unearned income is recognized each month on a basis which approximatesthe interest method.

 

The allowancefor loan and lease losses is established as losses are estimated to haveoccurred through a provision for loan losses charged to earnings.  Loan losses are charged against the allowancewhen management believes the uncollectibility of a loan balance isconfirmed.  Subsequent recoveries, ifany, are credited to the allowance.

 

The allowancefor loan losses is evaluated on a regular basis by management and is based uponmanagement’s periodic review of the collectibility of the loans in light ofhistorical experience, the nature and volume of the loan portfolio, adversesituations that may affect the borrower’s ability to repay, estimated value ofany underlying collateral and prevailing economic conditions.  This evaluation is inherently subjective asit requires estimates that are susceptible to significant revision as moreinformation becomes available.

 

A loan isconsidered impaired when, based on current information and events, it isprobable that the Company will be unable to collect the scheduled payments ofprincipal or interest when due according to the contractual terms of the loanagreement.  Factors considered bymanagement in determining impairment include payment status, collateral value,and the probability of collecting scheduled principal and interest paymentswhen due.  Loans that experienceinsignificant payment delays and payment shortfalls generally are notclassified as impaired.  Managementdetermines the significance of payment delays and payment shortfalls on a case-by-casebasis, taking into consideration all of the circumstances surrounding the loanand the borrower, including the length of the delay, the reasons for the delay,the borrower’s prior payment record, and the amount of the shortfall inrelation to the principal and interest owed. Impairment is measured on a loan by loan basis for commercial andconstruction loans by either the present value of expected future cash flowsdiscounted at the loan’s effective interest rate, the loan’s obtainable marketprice, or the fair value of the collateral if the loan is collateral dependent.

 

Large groupsof smaller balance homogeneous loans are collectively evaluated forimpairment.  Accordingly, the Companydoes not separately identify individual consumer and residential loans forimpairment disclosures.

 

68

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Loanorigination fees and related discounts:  Loan fees and certain direct loan originationcosts are deferred, and the net fee or cost is recognized as an adjustment tointerest income using the interest method over the contractual life of theloans, adjusted for prepayments.

 

Commitmentfees and costs relating to commitments, the likelihood of exercise of which isremote, are recognized over the commitment period on a straight-linebasis.  If the commitment is subsequentlyexercised during the commitment period, the remaining unamortized commitmentfee at the time of exercise is recognized over the life of the loan as anadjustment of yield.

 

Loan servicing:  The cost allocated to servicing rightspurchased or retained has been recognized as a separate asset and is beingamortized in proportion to and over the period of estimated net servicingincome.  Servicing rights areperiodically evaluated for impairment based on the fair value of thoserights.  Fair values are estimated usingdiscounted cash flows based on current market rates of interest.  For purposes of measuring impairment, therights are stratified by one or more predominant risk characteristics of theunderlying loans.  The Bank stratifiesits capitalized servicing rights based on loan type.  The amount of impairment recognized is theamount, if any, by which the amortized cost of the rights for each loan typeexceed their fair value.  As of June 30,2004, there was no impairment to loan servicing rights purchased and retainedservicing rights.

 

Goodwill:  Goodwill is the difference between thepurchase price and the amounts assigned to the net assets acquired andaccounted for under the purchase method of accounting.  Prior to July 2002, goodwill was amortizedover 10 years.

 

In July 2001, the FinancialAccounting Standards Board (FASB) issued Statement No. 142, *Goodwill and Other Intangible Assets*,which requires that goodwill no longer be amortized to earnings, but instead bereviewed at least annually for impairment. The provisions of FASB Statement No. 142 were implemented by the Companyin the first quarter of fiscal year 2003.

 

In October 2002, the FASBissued Statement No. 147, *Acquisitions ofCertain Financial Institutions*, which provides guidance on theaccounting for the acquisition of a financial institution.  The provisions of FASB Statement No. 147reflect the conclusion that the excess of the fair value of liabilities assumedover the fair value of tangible and identifiable intangible assets acquired ina business combination represents goodwill that should be accounted for underFASB Statement No. 142.  Thus, thespecialized accounting guidance in paragraph 5 of FASB Statement No. 72 doesnot apply after September 30, 2002 for those acquisitions that meet thedefinition of a business combination. The Company adopted FASB Statement No. 147, effective October 1, 2002,and, accordingly, reclassified FASB Statement No. 72 unidentifiable intangibleassets of $416 to goodwill and no longer amortizes these assets after October1, 2002.

 

69

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At June 30, 2004, the Companyhad $4,951 of goodwill that is not being amortized.  The Company performs annual testing todetermine if goodwill is impaired.  As ofJune 30, 2004, management believes there is no impairment with respect tointangible assets.  The impact of FASBStatement No. 142 on the Company’s net income is shown in the following tablefor the periods presented:

 
| ** **                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Reported net income                                  |       | $        | 5,216      |     | $          | 4,975    |       | $ | 3,185 |   |
| Add back:   goodwill amortization, net of taxes |       | —   |       | —   |       | 433      |       |
| Adjusted net income                                  |       | $        | 5,216      |     | $          | 4,975    |       | $ | 3,618 |   |
|                                                 |       |     |       |     |       |     |       |
| Basic earnings per share:                            |       |     |       |     |       |     |       |
| Reported net income                                  |       | $        | 1.47       |     | $          | 1.37     |       | $ | 0.83 |   |
| Goodwill amortization, net of taxes                  |       | —   |       | —   |       | 0.11     |       |
| Adjusted net income                                  |       | $        | 1.47       |     | $          | 1.37     |       | $ | 0.94 |   |
|                                                 |       |     |       |     |       |     |       |
| Diluted earnings per share:                          |       |     |       |     |       |     |       |
| Reported net income                                  |       | $        | 1.43       |     | $          | 1.35     |       | $ | 0.81 |   |
| Goodwill amortization, net of taxes                  |       | —   |       | —   |       | 0.11     |       |
| Adjusted net income                                  |       | $        | 1.43       |     | $          | 1.35     |       | $ | 0.92 |   |

 

Intangible asset:  The intangible asset related to insurancecustomer lists.  The original cost ofthis asset was $350, and it was being amortized over seven years.  Amortization expense was $4, $68 and $50 in2004, 2003 and 2002, respectively.  TheCompany sold the property and casualty book of business of Hometown to a thirdparty effective July 31, 2003 for total proceeds of $375, of which the disposalof $69 of goodwill is included in the net gain of $116 on the sale of thecasualty book of business during 2004.

 

Foreclosedreal estate and other properties:  Real estate and other properties acquiredthrough, or in lieu of, loan foreclosure are initially recorded at lower ofcost or fair value less estimated costs to sell at the date of foreclosure.  Costs relating to improvement of property arecapitalized, whereas costs relating to the holding of property areexpensed.  Valuations are periodicallyperformed by management, and charge-offs to operations are made if the carryingvalue of a property exceeds its estimated fair value less estimated costs tosell.

 

Land held for sale is carriedat the lower of cost, including  cost ofimprovements and amenities incurred subsequent to acquisition, or fair valueless cost to sell.  Costs relating to thedevelopment and improvement of property are capitalized, whereas costs relatingto holding property are expensed.  Thecarrying amount of land held for sale was $1,298 at June 30, 2004 and 2003.

 

During fiscalyear 2003, the Company reclassified a building of $191 from held for use toheld for sale after recording an impairment loss of $200.  Management continues its efforts to marketthe property.  At June 30, 2004 thebuilding remained in property held for sale with no further impairmentnecessary.

 

70

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Officeproperties and equipment:  Land is carried at cost.  All other office properties and equipment arecarried at cost, less accumulated depreciation and amortization.  Buildings and improvements and leaseholdimprovements are depreciated primarily on the straight-line method over theestimated useful lives of the assets which is five to fifty years.  Furniture, fixtures, equipment and automobileare depreciated using both the straight-line and declining balance methods overthe estimated useful lives of the assets which are three to twelve years.

 

Income taxes:  Deferred taxes are provided on an asset andliability method whereby deferred tax assets are recognized for deductibletemporary differences and operating loss and tax credit carryforwards anddeferred tax liabilities are recognized for taxable temporary differences.  Temporary differences are the differencesbetween the reported amounts of assets and liabilities and their tax bases.  Deferred tax assets are reduced by avaluation allowance when, in the opinion of management, it is more likely thannot that some portion or all of the deferred tax assets will not berealized.  Deferred tax assets andliabilities are adjusted for the effects of changes in tax laws and rates onthe date of enactment.

 

Earnings pershare (EPS): Basic EPS represents income available to common stockholders divided bythe weighted-average number of common shares outstanding during theperiod.  Diluted EPS reflects additionalcommon shares that would have been outstanding if dilutive potential commonshares had been issued.

 

During the second quarter offiscal 2004, the Company declared a 1-1/10-for-1 stock split of all of thecommon stock of the Company outstanding, payable in the form of a1/10-for-1stock dividend.  The 10% stock dividendwas paid on December 31, 2003 to shareholders of record as of December 3,2003.  All per share data and number ofcommon shares outstanding have been retroactively adjusted for all periodspresented as a result of the stock split.

 

Segment reporting:  Operating segments are defined as componentsof an enterprise for which separate financial information is available that isevaluated regularly by the chief operating decision makers in deciding how toallocate resources and in assessing performance.  The Company’s reportable segments are“banking” (including leasing activities) and “other”.  The “banking” segment is conducted throughthe Bank and Mid America Leasing and the “other” segment is composed of smallernonreportable segments, the Company and inter-segment eliminations.

 

The management approach is usedas the conceptual basis for identifying reportable segments and is based on theway that management organizes the segments within the enterprise for makingoperating decisions, allocating resources, and monitoring performance, which isprimarily based on products.

 

71

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| **2004**                                                      | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|-----------|------------|-----------|------------|
| Net interest income                                           |       | $           | 27,239     |      | $          | (2,167    | )          | $ | 25,072 |   |
| Intersegment interest income                                  |       | (854        | )          | 854       |       | —    |       |
| Provision for losses on loans and leases                      |       | (2,020      | )          | —    |       | (2,020    | )          |
| Noninterest income                                            |       | 9,915       |       | (87       | )          | 9,828     |       |
| Intersegment noninterest income                               |       | (398        | )          | 398       |       | —    |       |
| Noninterest expense                                           |       | (23,822     | )          | (951      | )          | (24,773   | )          |
| Intersegment noninterest expense                              |       | 4           |       | (4        | )          | —    |       |
| Income (loss) from continuing operations  before income taxes |       | $           | 10,064     |      | $          | (1,957    | )          | $ | 8,107 |   |
|                                                          |       |        |       |      |       |      |       |
| Total assets                                                  |       | $           | 844,783    |      | $          | 2,287     |       | $ | 847,070 |   |

 
| **2003**                                                      | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|-----------|------------|-----------|------------|
| Net interest income                                           |       | $           | 27,256     |      | $          | (991      | )          | $ | 26,265 |   |
| Intersegment interest income                                  |       | (892        | )          | 892       |       | —    |       |
| Provision for losses on loans and leases                      |       | (3,173      | )          | —    |       | (3,173    | )          |
| Noninterest income                                            |       | 11,790      |       | (1,304    | )          | 10,486    |       |
| Intersegment noninterest income                               |       | (548        | )          | 548       |       | —    |       |
| Noninterest expense                                           |       | (26,056     | )          | 8         |       | (26,048   | )          |
| Intersegment noninterest expense                              |       | (3          | )          | 3         |       | —    |       |
| Income (loss) from continuing operations  before income taxes |       | $           | 8,374      |      | $          | (844      | )          | $ | 7,530 |   |
|                                                          |       |        |       |      |       |      |       |
| Total assets                                                  |       | $           | 796,027    |      | $          | 5,076     |       | $ | 801,103 |   |

 
| **2002**                                                      | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|-----------|------------|-----------|------------|
| Net interest income                                           |       | $           | 25,015     |      | $          | (403      | )          | $ | 24,612 |   |
| Intersegment interest income                                  |       | (531        | )          | 531       |       | —    |       |
| Provision for losses on loans and leases                      |       | (1,905      | )          | —    |       | (1,905    | )          |
| Noninterest income                                            |       | 9,974       |       | (148      | )          | 9,826     |       |
| Intersegment noninterest income                               |       | (188        | )          | 188       |       | —    |       |
| Noninterest expense                                           |       | (24,336     | )          | (470      | )          | (24,806   | )          |
| Income (loss) from continuing operations  before income taxes |       | $           | 8,029      |      | $          | (302      | )          | $ | 7,727 |   |
|                                                          |       |        |       |      |       |      |       |
| Total assets                                                  |       | $           | 721,438    |      | $          | 1,479     |       | $ | 722,917 |   |

 

72

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

 

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

 

Securities:  Fair values for investment securities arebased on quoted market prices, except for stock in the Federal Home Loan Bankfor which fair value is assumed to equal cost.

 

Retained interest asset:  Fair values are estimated using discountedcash flows based on current market rates of interest.

 

Loans and leases:  Approximately 53% of loans are variable-rateloans that reprice at various frequencies and have no significant change ininterest rate risk.  Fair values on theseloans are based on carrying values.  Thefair values for fixed-rate loans and leases are estimated using discounted cashflow analyses, using interest rates currently being offered for loans andleases with similar terms to borrowers with similar credit quality or fromquoted market prices of similar loans and leases sold, adjusted for differencesin loan and lease characteristics.

 

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

 

Servicing rights:  Fair values are estimated using discountedcash flows based on current market rates of interest.

 

Off-statement-of-financial-conditioninstruments: Fair values for the Company’soff-statement-of- financial-condition instruments (unused lines of credit andletters of credit), which are based upon fees currently charged to enter intosimilar agreements taking into account the remaining terms of the agreementsand counterparties’ credit standing, are not significant.

 

Deposits:  The fair values for deposits with no definedmaturities equal their carrying amounts, which represent the amount payable ondemand.  Fair values for fixed-ratecertificates of deposit are estimated using a discounted cash flow calculationthat applies interest rates currently being offered on certificates to aschedule of aggregated expected monthly maturities on certificates of deposit.

 

Borrowed funds:  The carrying amounts reported for variablerate advances approximate their fair values. 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.

 

Subordinated debentures payableto trusts:  Thecarrying amounts for subordinated debentures payable to trusts approximatetheir fair values.

 

Accrued interest payable andadvances by borrowers for taxes and insurance:  The carrying values of accrued interestpayable and advances by borrowers for taxes and insurance approximate theirfair values.

 

73

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Stock-basedcompensation: The Company accounts for stock-based compensation in accordance withAccounting Principles Board (APB) Opinion No. 25., *Accounting for Stock Issued to Employees*, and relatedinterpretations.  No stock-based employeecompensation cost has been recognized for grants under the fixed stock optionplans, as all options granted under those plans had an exercise price equal tothe market value of the underlying common stock on the date of grant.  The following table illustrates the effect onnet income and earnings per share if the Company had applied the fair valuerecognition provisions of FASB Statement No. 123, *Accounting for Stock-Based Compensation*, to stock-basedemployee compensation.

 
| ** **                                                                                                                                   | ** ** | **Years Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                   | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net income, as reported                                                                                                                      |       | $                        | 5,216      |   | $ | 4,975 |   | $ | 3,185 |   |
| Add stock-based employee compensation  expense included in reported net income, net of related tax effects                                   |       | 154                      |       | 110 |   | 77 |   |
| Deduct total stock-based employee  compensation expense determined under fair value based method for all awards,  net of related tax effects |       | (289                     | )          | (246 | ) | (214 | ) |
| Pro forma net income                                                                                                                         |       | $                        | 5,081      |   | $ | 4,839 |   | $ | 3,048 |   |
|                                                                                                                                         |       |                     |       |   |   |   |   |
| Basic earnings per share:                                                                                                                    |       |                     |       |   |   |   |   |
| As reported                                                                                                                                  |       | $                        | 1.47       |   | $ | 1.37 |   | $ | 0.83 |   |
| Pro forma                                                                                                                                    |       | 1.43                     |       | 1.34 |   | 0.80 |   |
|                                                                                                                                         |       |                     |       |   |   |   |   |
| Diluted earnings per share:                                                                                                                  |       |                     |       |   |   |   |   |
| As reported                                                                                                                                  |       | $                        | 1.43       |   | $ | 1.35 |   | $ | 0.81 |   |
| Pro forma                                                                                                                                    |       | 1.39                     |       | 1.31 |   | 0.77 |   |

 

The fair value of eachincentive stock option grant is estimated at the grant date using theBlack-Scholes option-pricing model.  Thefollowing weighted average assumptions were used for grants in fiscal years2004, 2003 and 2002, respectively:  adividend rate as a percentage of stock price of 2.79%, 2.59% and 3.52%; pricevolatility of 24.00%, 25.00% and 25.00%; risk-free interest rates of 4.26%,3.64% and 4.58% and expected lives of seven years for all three years.

 

Self-insurance:  The Company has a self-insured health planfor its employees.  The accrual estimatefor pending 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.  Amounts charged to expenserelated to the self-insured health plan during fiscal years 2004, 2003 and 2002were $1,662, $1,575 and $699, respectively.

 

74

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Reclassification:  During fiscal year 2004, the Companyreclassified certain deferred loan origination fees and other loan fees andcosts.  This process was done upon afuller interpretation of Statement No. 91 as issued by the FASB and RegulationS-X (“Reg S-X”) as issued by the Securities and Exchange Commission.  All periods presented have been revised inpresentation to reflect this reclassification and there was no change to netincome or earnings per share as a result of this reclassification.

 

**Note 2.**                                  DiscontinuedOperations and Sale

** **

During the fourth quarter offiscal year 2002, management committed to a plan to sell the subprime creditcard operations which were previously reported in the credit card segment ofthe Company.  At June 30, 2002, theCompany estimated the net realizable value based on estimates from a thirdparty and reclassified the net realizable value of $1,115 at that time fromloans receivable to loans held for sale. The Bank ceased processing subprime credit card applications in March1999 and had been managing the portfolio from a balance of $18,062 at June 30,1999, to the sale of the receivables as of January 31, 2003.  On December 31, 2002, the Company, throughthe Bank, entered into an agreement to sell the discontinued credit cardoperations to an independent third party. Amounts of revenue (including interest income on loans and noninterestincome) and pretax profit (loss) reported in discontinued operations for theyears ended June 30, 2004, 2003 and 2002 were $0 and $0; $818 and $44; and$2,413 and $(2,554), respectively.  TheCompany dissolved the operations of HF Card during the third quarter of fiscal2003.

 

**Note 3.**                                  ConsumerAutomobile Loan Securitization

** **

On January 31, 2003, the Banksecuritized and sold motor vehicle installment loans with principal balancestotaling $50,002 for a gain of $308 through HFSC and the AutomobileSecuritization Trust.  As part of thesales transaction, the Bank retains servicing responsibilities.  In addition, the Bank retains the rights tocash flows remaining after investors in the Automobile Securitization Trusthave received their contractual payments and has pledged a $1,500 reserve fundto the Automobile Securitization Trust. These retained interests are subordinated to investors’ interests.  The investors and Automobile SecuritizationTrust have no recourse to the Bank’s other assets for failure of debtors to paywhen due.

 

The gain recognized on the saleof these loans was determined by allocating the carrying amount of the loansbetween the loans sold and the interests retained.  The Bank determined that 50 basis points ofthe 100 basis points servicing contract represented was excess servicing andwas capitalized as part of the transaction utilizing a market discount rate of10.0%.  This asset is amortized in proportionto, and over the period of, estimated net servicing income.

 

Key economic assumptions usedin measuring the fair value of retained interests at the date of thesecuritization resulting from securitization completed during fiscal year 2003were as follows:

 
| Prepayment speed (ABS annual rate)      |   | 18.00 | % (1)  |
|-----------------------------------------|--------|-------|--------|
| Weighted-average life (in years)        |   | 3.58  |   |
| Expected credit losses (annual rate)    |   | .63   | %      |
| Discount rate for the retained interest |   | 15.00 | %      |
| Discount rate for loan servicing rights |   | 10.00 | %      |

 

----

(1)           18.00% ABS is the equivalent to 20.21% CPR and 721.61 PSA.

 

75

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Key economic assumptions usedand the sensitivity of fair value of the retained interest as of June 30, 2004are as follows:

 
| ** **                                 | ** ** | **Retained  Interest** | ** ** | **Servicing  Rights** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------|------------|
| Fair value                                 |       | $                      | 1,878      |                  | $          | 70 |   |
| Weighted average life (in years)           |       | 2.62                   |       | 2.62                  |       |
| Prepayment speed (ABS annual rate):        |       | 21.60                  | %          | 21.60                 | %          |
| Impact on fair value of 10% adverse change |       | $                      | (17        | )                     | $          | (7 | ) |
| Impact on fair value of 20% adverse change |       | (41                    | )          | (12                   | )          |
| Credit losses (annual rate):               |       | 0.63                   | %          | 0.63                  | %          |
| Impact on fair value of 10% adverse change |       | $                      | (10        | )                     | $          | — |   |
| Impact on fair value of 20% adverse change |       | (20                    | )          | —                |       |
| Discount rate:                             |       | 10.32                  | %          | 10.00                 | %          |
| Impact on fair value of 10% adverse change |       | $                      | (21        | )                     | $          | — |   |
| Impact on fair value of 20% adverse change |       | (42                    | )          | (1                    | )          |

 

These sensitivities arehypothetical and should be used with caution. Changes in fair value based on a 10 percent variation in assumptionsgenerally cannot be extrapolated because the relationship of the change in assumptionto the change in fair value may not be linear. Also, in this table, the effect of a variation in a particularassumption on the fair value of the retained interest is calculated withoutchanging any other assumption; in reality, changes in one factor may result inchanges in another (for example, increases in market interest rates may resultin lower prepayments and increased credit losses), which might magnify orcounteract the sensitivities.

 

Static pool losses arecalculated by summing the actual credit losses and dividing the total by theoriginal balance of the pool of loans. The expected static pool losses of the loans securitized in 2003 is..55%.

 

The table below summarizescertain cash flows received from and paid to the securitization trust duringfiscal years 2004 and 2003:

 
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Proceeds from new securitizations               |       | $        | —     |     | $          | 48,151 |   |
| Servicing fees received                         |       | 263      |       | 170      |       |
| Other cash flows received on retained  interest |       | 1,998    |       | —   |       |
|                                                 |            |          |            |          |            |  |  |

 

76

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The following table presentsdelinquencies, net credit losses, and components of securitized financialassets and other loans managed together with them as of June 30, 2004 and 2003:

 
| ** **                                                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Automobile loans held in portfolio                                     |       | $        | 101,669    |     | $          | 74,066 |   |
| Automobile loans serviced for others                                   |       | 17,180   |       | 35,533   |       |
| Total managed automobile loans                                         |       | $        | 118,849    |     | $          | 109,599 |   |
|                                                                   |       |     |       |     |       |
| Principal amount of managed automobile  loans 60 days or more past due |       | $        | 306        |     | $          | 564 |   |
|                                                                   |       |     |       |     |       |
| Net credit losses for automobile loans for  the year                   |       | $        | 511        |     | $          | 592 |   |

 

**Note 4.**                                  Investments inSecurities

** **

The amortizedcost and fair values of investments in securities, all of which are classifiedas available for sale according to management’s intent, are as follows:

 
| ** **                                | ** ** | **June 30, 2004**   | ** ** |
|-------------------------------------------|------------|---------------------|------------|
| ** **                                | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Fair Value** | ** ** |
| Debt securities:                          |       |                |       |   |   |   |   |   |   |
| U.S. government agencies and corporations |       | $                   | 2,999      |   | $ | — |   | $ | (14 | ) | $ | 2,985 |   |
| Federal Home Loan Bank                    |       | 1,000               |       | 30 |   | — |   | 1,030 |   |
| Municipal bonds                           |       | 4,618               |       | 11 |   | (16 | ) | 4,613 |   |
| Preferred term securities                 |       | 9,000               |       | 34 |   | — |   | 9,034 |   |
|                                      |       | 17,617              |       | 75 |   | (30 | ) | 17,662 |   |
|                                      |       |                |       |   |   |   |   |   |   |
| Equity securities:                        |       |                |       |   |   |   |   |   |   |
| FNMA                                      |       | 8                   |       | 21 |   | — |   | 29 |   |
| Federal Agricultural Mortgage             |       | 7                   |       | 2 |   | — |   | 9 |   |
|                                      |       | 15                  |       | 23 |   | — |   | 38 |   |
|                                      |       |                |       |   |   |   |   |   |   |
| Mortgage-backed securities                |       | 107,267             |       | 8 |   | (2,260 | ) | 105,015 |   |
|                                      |       | $                   | 124,899    |   | $ | 106 |   | $ | (2,290 | ) | $ | 122,715 |   |

 

77

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| ** **                                | ** ** | **June 30, 2003**   | ** ** |
|-------------------------------------------|------------|---------------------|------------|
| ** **                                | ** ** | **Amortized  Cost** | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Fair Value** | ** ** |
| Debt securities:                          |       |                |       |   |   |   |   |   |   |
| U.S. government agencies and corporations |       | $                   | 999        |   | $ | 31 |   | $ | — |   | $ | 1,030 |   |
| Federal Home Loan Bank                    |       | 3,000               |       | 132 |   | — |   | 3,132 |   |
| Municipal bonds                           |       | 4,442               |       | 70 |   | (1 | ) | 4,511 |   |
| Preferred term securities                 |       | 9,000               |       | — |   | (11 | ) | 8,989 |   |
| Other                                     |       | 193                 |       | — |   | — |   | 193 |   |
|                                      |       | 17,634              |       | 233 |   | (12 | ) | 17,855 |   |
|                                      |       |                |       |   |   |   |   |   |   |
| Equity securities:                        |       |                |       |   |   |   |   |   |   |
| FNMA                                      |       | 8                   |       | — |   | (1 | ) | 7 |   |
| Federal Agricultural Mortgage             |       | 7                   |       | — |   | — |   | 7 |   |
|                                      |       | 15                  |       | — |   | (1 | ) | 14 |   |
|                                      |       |                |       |   |   |   |   |   |   |
| Mortgage-backed securities                |       | 70,968              |       | 289 |   | (599 | ) | 70,658 |   |
|                                      |       | $                   | 88,617     |   | $ | 522 |   | $ | (612 | ) | $ | 88,527 |   |

 

The following table presents theage of gross unrealized losses and fair value by investment category inaccordance with Emerging Issues Task Force Issue No. 03-1, *The Meaning of Other-Than-Temporary Impairment andIts Application to Certain Investments*.

 
| ** **                                | ** ** | **June 30, 2004**       | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **Fair  Value**         | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Losses)** | ** ** |
| Debt securities:                          |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies and corporations |       | $                       | 2,985      |   | $ | (14 | ) | $ | — |   | $ | — |   | $ | 2,985 |   | $ | (14 | ) |
| Municipal bonds                           |       | 1,968                   |       | (16 | ) | 235 |   | (1 | ) | 2,203 |   | (17 | ) |
|                                      |       | 4,953                   |       | (30 | ) | 235 |   | (1 | ) | 5,188 |   | (31 | ) |
|                                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage-backed securities                |       | 78,673                  |       | (1,860 | ) | 22,244 |   | (400 | ) | 100,917 |   | (2,260 | ) |
|                                      |       | $                       | 83,626     |   | $ | (1,890 | ) | $ | 22,479 |   | $ | (401 | ) | $ | 106,105 |   | $ | (2,291 | ) |

 

Management does not believe anyindividual unrealized losses as of June 30, 2004 represent another-than-temporary impairment.  Theunrealized losses reported for mortgage-backed securities relate primarily to securitiesissued by FNMA, GNMA and FHLMC.  Theseunrealized losses are primarily attributable to changes in interest rates andas a group were less than 2% of its respective amortized cost basis.  The Company has the ability to hold thesecurities to maturity contained in this table for a time necessary to recoverthe amortized cost.

 

78

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The amortized cost and fairvalues of debt securities as of June 30, 2004, by contractual maturity, areshown below.  Expected maturities willdiffer from contractual maturities because the borrowers may have the right tocall or prepay obligations with or without call or prepayment penalties.

 
| ** **                             | ** ** | **Amortized  Cost** | ** ** | **Fair Value** | ** ** |
|----------------------------------------|------------|---------------------|------------|----------------|------------|
| Due in one year or less                |       | $                   | 3,049      |           | $          | 3,081 |   |
| Due after one year through five years  |       | 5,568               |       | 5,547          |       |
| Due after five years through ten years |       | —              |       | —         |       |
| Due after ten years                    |       | 9,000               |       | 9,034          |       |
|                                   |       | 17,617              |       | 17,662         |       |
| Mortgage-backed securities             |       | 107,267             |       | 105,015        |       |
|                                   |       | $                   | 124,884    |           | $          | 122,677 |   |

 

Equitysecurities have been excluded from the maturity table above because they do nothave contractual maturities associated with debt securities.

 

The componentsof other comprehensive income (loss) - net change in unrealized gain (loss) onsecurities available for sale are as follows:

 
| ** **                                                                       | ** ** | **Years Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------|------------|
| ** **                                                                       | ** ** | **2004**                 | ** ** | **2003** | ** ** | **2002** | ** ** |
| Unrealized holding gain (loss) arising  during the year                          |       | $                        | (2,051     | ) | $ | (541 | ) | $ | 393 |   |
| Less reclassification adjustment for net  gains realized in net income           |       | (43                      | )          | (352 | ) | (135 | ) |
| Net change in unrealized gain (loss) before  income taxes                        |       | (2,094                   | )          | (893 | ) | 258 |   |
| Income (taxes) benefit                                                           |       | 796                      |       | 339 |   | (98 | ) |
| Other comprehensive income - net change in  unrealized gain (loss) on securities |       | $                        | (1,298     | ) | $ | (554 | ) | $ | 160 |   |

 

Proceeds fromthe sale of securities available for sale in 2004 were $6,324 and resulted ingross gains of $43.  Proceeds from thesale of securities available for sale in 2003 were $15,210 and resulted ingross gains of $352.  Proceeds from thesale of securities available for sale in 2002 were $14,831 and resulted ingross gains of $170 and gross losses of $(35).

 

At June 30,2004 and 2003, securities with a fair value of $109,029 and $74,820,respectively, were pledged as collateral for public deposits and otherpurposes.

 

79

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**Note 5.           Loans and Leases Receivable**

** **

Loans and leases receivable atJune 30, 2004 and 2003 consist of the following:

 
| ** **                                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Loans secured by real estate:                                   |       |     |       |     |       |
| Residential:                                                    |       |     |       |     |       |
| One-to-four family                                              |       | $        | 94,465     |     | $          | 84,081 |   |
| Multi-family                                                    |       | 42,721   |       | 49,364   |       |
| Commercial                                                      |       | 89,538   |       | 93,405   |       |
| Agriculture                                                     |       | 20,449   |       | 18,002   |       |
| Construction and development                                    |       | 15,044   |       | 9,083    |       |
| Business, consumer and other:                                   |       |     |       |     |       |
| Commercial business                                             |       | 124,158  |       | 113,570  |       |
| Automobile                                                      |       | 101,669  |       | 74,066   |       |
| Junior liens on real estate                                     |       | 85,684   |       | 81,064   |       |
| Agriculture                                                     |       | 42,953   |       | 40,109   |       |
| Equipment financing leases                                      |       | 26,942   |       | 23,016   |       |
| Other loans                                                     |       | 4,900    |       | 6,035    |       |
| Loans on savings accounts                                       |       | 1,489    |       | 1,463    |       |
| Mobile home                                                     |       | 848      |       | 1,468    |       |
| Education                                                       |       | —   |       | 7,745    |       |
|                                                            |       | 650,860  |       | 602,471  |       |
| Add (less):                                                     |       |     |       |     |       |
| Undisbursed portion of loans in process                         |       | (7,338   | )          | (3,576   | )          |
| Deferred loan fees and unamortized  discounts and premiums, net |       | 1,029    |       | 364      |       |
| Allowance for loan and lease losses                             |       | (3,605   | )          | (3,842   | )          |
|                                                            |       | $        | 640,946    |     | $          | 595,417 |   |

 

Loans held forsale totaling $10,351 at June 30, 2004 consist of $10,027 one-to-four familyfixed-rate loans and $324 of student loans. At June 30, 2003, loans held for sale totaling $15,984 consisted ofone-to-four family fixed-rate loans.

 

80

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Activity inthe allowance for loan and lease losses included in continuing operations issummarized as follows for the years ended June 30:

 
| ** **                                                                                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Balance, beginning                                                                           |       | $        | 3,842      |     | $          | 4,461    |       | $ | 6,544 |   |
| Provision charged to income                                                                  |       | 2,020    |       | 3,173    |       | 1,905    |       |
| Allowance related to assets acquired  (sold), net                                            |       | —   |       | (264     | )          | —   |       |
| Reclassification of allowance for loan  losses directly against credit card loans receivable |       | —   |       | —   |       | (577     | )          |
| Charge offs related to discontinued credit  card loan operations, net                        |       | —   |       | —   |       | (458     | )          |
| Other charge offs                                                                            |       | (2,564   | )          | (4,001   | )          | (3,407   | )          |
| Recoveries                                                                                   |       | 307      |       | 473      |       | 454      |       |
| Balance, ending                                                                              |       | $        | 3,605      |     | $          | 3,842    |       | $ | 4,461 |   |

 

The followingis a summary of information pertaining to impaired loans and nonaccrual loansas of and for the years ended June 30, 2004, 2003 and 2002:

 
| ** **                                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Impaired loans without a valuation  allowance           |       | $        | 248        |     | $          | 27       |       | $ | — |   |
| Impaired loans with a valuation allowance               |       | 4        |       | 2,647    |       | 3,977    |       |
| Total impaired loans                                    |       | $        | 252        |     | $          | 2,674    |       | $ | 3,977 |   |
|                                                    |       |     |       |     |       |     |       |
| Valuation allowance related to impaired  loans          |       | $        | 4          |     | $          | 846      |       | $ | 980 |   |
|                                                    |       |     |       |     |       |     |       |
| Nonaccruing loans and leases                            |       | $        | 1,561      |     | $          | 4,365    |       | $ | 10,242 |   |
| Accruing loans and leases delinquent more  than 90 days |       | 502      |       | 1,466    |       | 906      |       |
| Average investment in impaired loans                    |       | 1,702    |       | 5,199    |       | 2,662    |       |
| Interest income recognized on impaired  loans           |       | 505      |       | 17       |       | 42       |       |

 

No additional funds arecommitted to be advanced in connection with impaired loans.

 

81

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**Note 6.**                                  Loan Servicing

** **

Mortgage loansserviced for others (primarily the South Dakota Housing Development Authority)are not included in the accompanying consolidated statements of financialcondition.  The unpaid principal balancesof mortgage loans serviced for others was $462,708 and $482,790 at June 30,2004 and 2003, respectively.

 

Custodialbalances maintained in connection with mortgage loan servicing, and included inadvances by borrowers for taxes and insurance, were approximately $1,015 and$3,037 at June 30, 2004 and 2003, respectively.

 

The carryingvalues of mortgage and consumer servicing rights were $4,620 and $4,003 at June30, 2004 and 2003, respectively.  Thefair values of these rights were $7,763 and $8,725 at June 30, 2004 and 2003,respectively.  The fair values of theservicing rights were estimated as the present value of the expected futurecash flows using a discount rate of 10%. During fiscal years 2004 and 2003, servicing rights of $1,136 and$1,018, respectively, were capitalized. The Company recognized expense for amortization of the cost of servicingrights in the amount of $519, $482 and $347 for the years ended June 30, 2004,2003 and 2002, respectively.

 

No valuationallowances were provided for servicing rights capitalized during the yearsended June 30, 2004 and 2003.

 

**Note 7.**                                  OfficeProperties and Equipment

 

Officeproperties and equipment at June 30, 2004 and 2003 consist of the following:

 
| ** **                                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Land                                            |       | $        | 1,832      |     | $          | 1,832 |   |
| Buildings and improvements                      |       | 15,802   |       | 15,619   |       |
| Leasehold improvements                          |       | 1,475    |       | 1,463    |       |
| Furniture, fixtures, equipment and  automobile  |       | 12,868   |       | 12,131   |       |
|                                            |       | 31,977   |       | 31,045   |       |
| Less accumulated depreciation and  amortization |       | (19,422  | )          | (17,907  | )          |
|                                            |       | $        | 12,555     |     | $          | 13,138 |   |

 

In addition,the Company leases several branch facilities under operating lease agreementswhich require minimum rentals totaling $1,081 through the year ending June 30,2009.

 

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**Note 8.**                                  Deposits

** **

Deposits atJune 30, 2004 and 2003 consist of the following:

 
| ** **                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------------|------------|----------|------------|----------|------------|
| Noninterest bearing checking accounts |       | $        | 75,251     |     | $          | 77,004 |   |
| Interest bearing accounts             |       | 45,738   |       | 43,699   |       |
| Money market accounts                 |       | 211,928  |       | 178,113  |       |
| Savings accounts                      |       | 63,670   |       | 54,462   |       |
| Certificates of deposit               |       | 262,132  |       | 268,103  |       |
|                                  |       | $        | 658,719    |     | $          | 621,381 |   |

 

Scheduledmaturities of certificates of deposit are as follows:

 
| **Maturing in fiscal year:** |   |   |    |
|------------------------------|--------|--------|---------|
| 2005                         |   | $      | 162,719 |   |
| 2006                         |   | 48,394 |    |
| 2007                         |   | 28,193 |    |
| 2008                         |   | 15,002 |    |
| 2009                         |   | 7,810  |    |
| Thereafter                   |   | 14     |    |
|                         |   | $      | 262,132 |   |

 

Deposit accounts are insured upto $100 by the Savings Association Insurance Fund (SAIF) under management ofthe Federal Deposit Insurance Corporation (FDIC).  The aggregate amount of jumbo certificates ofdeposit with a minimum denomination of $100 was approximately $74,574 and$74,929 at June 30, 2004 and 2003, respectively.  Deposits at June 30, 2004 and 2003 include$53,008 and $42,386, respectively, of deposits from one local governmentalentity, the majority of which are savings accounts.

 

83

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**Note 9.**                                  Advances FromFederal Home Loan Bank and Other Borrowings

** **

Advances fromthe Federal Home Loan Bank of Des Moines (FHLB) and the Federal Reserve Bank ofMinneapolis at June 30, 2004 and 2003 are summarized as follows:

 
| ** **                                                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|
| Fixed-rate advances (with rates ranging  from 1.9% to 6.4%)    |       | $        | 77,223     |     | $          | 84,498 |   |
| Variable-rate advances (with rates ranging  from 1.5% to 2.3%) |       | 15,762   |       | —   |       |
|                                                           |       | $        | 92,985     |     | $          | 84,498 |   |

 

Aggregatematurities of advances, computed based on call date, are as follows:  2005 $87,262; 2006 $5,223; 2007 $0; 2008 $0;and 2009 $500.  Prepayment of thecallable advances results in a prepayment fee as negotiated between the Bankand the Federal Home Loan Bank.

 

Advances withthe FHLB are secured by stock in the FHLB, one-to-four family first mortgageloans, multi-family first mortgage loans and investment securities.  In order to provide additional borrowingcollateral, commercial real estate first mortgage loans, home equity line ofcredit loans and home equity second mortgages have also been pledged with theFHLB.

 

Advances withthe Federal Reserve Bank are secured by commercial business loans.

 

Convertibleadvances without a strike rate are subject to be called at the Federal HomeLoan Bank’s discretion.  Convertibleadvances tied to LIBOR strike rates may only be called if the three month LIBORrate is equal to or greater than the indicated strike rate.

 

The Bank had a$12,000 letter of credit from the Federal Home Loan Bank of Des Moines, onwhich nothing was drawn at June 30, 2004 and expired on July 9, 2004.

 

The Bankcurrently has two $10,000 unsecured lines of federal funds with correspondentbanks.  There were no funds drawn oneither line of credit at June 30, 2004.

 

Otherborrowings consist of the following:

 

The Company hasa contract for deed which requires monthly payments of $9, plus interest at7.0%, to October 2013.  The contract fordeed, which is secured by land held for sale with a carrying value of $1,298,had a balance of $765 and $821 at June 30, 2004 and 2003, respectively.  Aggregate maturities of the contract for deedare as follows:  2005 $60; 2006 $65; 2007$69; 2008 $74; 2009 $80; and thereafter $417.

 

In June 2003,the Company entered into two unsecured revolving note agreements with anunrelated bank with credit lines of $1,500 and $3,000, which had balances of$1,500 and $3,000, respectively, at June 30, 2003.  The line for $1,500 matured on September 30,2003 and was not renewed.  The line for$3,000 was renewed in June 2004 and had no amounts outstanding at June 30,2004.  The maturity date of the $3,000note is May 30, 2005.

 

83

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**Note 10.**                           SubordinatedDebentures Payable to Trusts

** **

On November 28, 2001, the Company issued10,000 shares totaling $10,000 of Company Obligated Mandatorily RedeemablePreferred Securities of Trust I.  Trust Iexists for the sole purpose of issuing trust preferred securities and investingthe proceeds in subordinated debentures of the Company.  These subordinated debentures constitute thesole asset of Trust I.  The securitiesprovide for cumulative cash distributions calculated at a rate based onsix-month LIBOR plus 3.75% adjusted semi-annually.  The Company may, at one or more times, deferinterest payments on the capital securities for up to 10 consecutivesemi-annual periods, but not beyond December 8, 2031.  At the end of the deferral period, allaccumulated and unpaid distributions must be paid.  The capital securities must be redeemed onDecember 8, 2031; however, the Company has the option to shorten the maturitydate to a date not earlier than December 8, 2006.  The capital securities have no voting rights,are unsecured, and rank junior in priority of the payment to all of the Company’sindebtedness and senior to the Company’s capital stock.

 

On July 11, 2002, the Companyissued 5,000 shares totaling $5,000 of Company Obligated Mandatorily RedeemablePreferred Securities of Trust II.  TrustII was established and exists for the sole purpose of issuing trust preferredsecurities and investing the proceeds in subordinated debentures of theCompany.  These subordinated debenturesconstitute the sole asset of  Trust II.  The securities provide for cumulative cashdistributions calculated at a rate based on three-month LIBOR plus 3.65%adjusted quarterly.  The Company may, atone or more times, defer interest payments on the capital securities for up to20 consecutive quarterly periods, but not beyond October 7, 2032.  The capital securities must be redeemed onOctober 7, 2032; however, the Company has the option to shorten the maturitydate to a date not earlier than July 7, 2007. 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 December 19, 2002, theCompany issued 5,000 shares totaling $5,000 of Company Obligated MandatorilyRedeemable Preferred Securities of Trust III. Trust III exists for the sole purpose of issuing trust preferredsecurities and investing the proceeds in subordinated debentures of theCompany.  These subordinated debenturesconstitute the sole asset of Trust III. The securities provide for cumulative cash distributions calculated at arate based on three-month LIBOR plus 3.35% adjusted quarterly.  The Company may, at one or more times, deferinterest payments on the capital securities for up to 20 consecutive quarterlyperiods, but not beyond January 7, 2033. At the end of the deferral period, all accumulated and unpaiddistributions must be paid.  The capitalsecurities must be redeemed on January 7, 2033; however, the Company has theoption to shorten the maturity date to a date not earlier than January 7, 2008.  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.

 

84

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On September 25, 2003, theCompany issued 7,000 shares totaling $7,000 of Company Obligated MandatorilyRedeemable Preferred Securities of Trust IV. Trust IV exists for the sole purpose of issuing trust preferredsecurities and investing the proceeds in subordinated debentures of theCompany.  These subordinated debenturesconstitute the sole asset of Trust IV. The securities provide for cumulative cash distributions calculated at arate based on three-month LIBOR plus 3.10% adjusted quarterly.  The Company may, at one or more times, deferinterest payments on the capital securities for up to 20 consecutive quarterlyperiods, but not beyond October 8, 2033. At the end of the deferral period, all accumulated and unpaiddistributions must be paid.  The capitalsecurities must be redeemed on October 8, 2033; however, the Company has theoption to shorten the maturity date to a date not earlier than October 8,2008.  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.

 

FASB Interpretation No. 46(Revised December 2003), *Consolidation ofVariable Interest Entities* (FIN 46R) replaces in its entirety FASBInterpretation No. 46, *Consolidation ofVariable Interest Entities*, that was issued by the FASB in January2003.  FIN 46R provides guidance relatedto identifying variable interest entities (previously known generally asspecial purpose entities or SPEs) and determining whether such entities shouldbe consolidated.  Key to theconsolidation determination is whether such entities disperse risks among theparties involved.  If those risks are notdispersed, and therefore an enterprise bears the majority of the risks orrewards related to the variable interest entity, it would consolidate thatvariable interest entity.

 

The subordinated trust entitiesof the Company were deconsolidated during 2004 and the June 30, 2003 balancesheet was restated as provided by FIN 46R. As a result, the 2004 and 2003 balance sheets include $27,837 and$20,620, respectively, of subordinated debentures to these trusts, which waspreviously included on the balance sheet at June 30, 2003 as $20,000 of Companyobligated mandatorily redeemable preferred securities of subsidiary trusts thatsolely hold subordinated debentures after a consolidation elimination of$620.  The terms of the subordinateddebentures correspond to the related preferred securities.  The overall effect on the Company’s financialposition and operating results of the deconsolidation was not material, and didnot affect reported equity or net income.

 

**Note 11.**                           Income TaxMatters

** **

The Companyand subsidiaries file a consolidated federal income tax return on a fiscal yearbasis.  The Bank is allowed bad debtdeductions based on actual charge-offs.

 

Theconsolidated provision for income taxes from continuing operations consists ofthe following for the years ended June 30:

 
| ** **       | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:         |       |     |       |     |       |     |       |
| Federal          |       | $        | 1,485      |     | $          | 412      |       | $ | 2,039 |   |
| State            |       | 430      |       | 463      |       | 383      |       |
| Deferred expense |       | 976      |       | 1,709    |       | 434      |       |
|             |       | $        | 2,891      |     | $          | 2,584    |       | $ | 2,856 |   |

 

85

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Income taxexpense is different from that calculated at the statutory federal income taxrate to pretax income from continuing operations.  The reasons for this difference in the taxexpense are as follows:

 
| ** **                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Computed “expected” tax expense            |       | $        | 2,837      |     | $          | 2,636    |       | $ | 2,704 |   |
| Increase (decrease) in income taxes  resulting from: |       |     |       |     |       |     |       |
| Tax exempt income                                    |       | (116     | )          | (224     | )          | (79      | )          |
| State taxes, net of federal benefit                  |       | 320      |       | 331      |       | 262      |       |
| Increase in cash surrender value of life  insurance  |       | (184     | )          | (16      | )          | (15      | )          |
| Benefit of income taxed at lower rates               |       | (67      | )          | (65      | )          | (75      | )          |
| Amortization of intangible assets                    |       | —   |       | —   |       | 148      |       |
| Change in valuation allowance                        |       | (76      | )          | —   |       | 38       |       |
| Other, net                                           |       | 177      |       | (78      | )          | (127     | )          |
|                                                 |       | $        | 2,891      |     | $          | 2,584    |       | $ | 2,856 |   |

 

The componentsof the net deferred tax asset (liability) as of June 30, 2004 and 2003 are asfollows:

 
| ** **                                            | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                                  |       |     |       |     |       |
| Allowance for loan and leases losses                  |       | $        | 1,181      |     | $          | 1,229 |   |
| Accrued expenses                                      |       | 399      |       | 272      |       |
| Net unrecognized pension costs                        |       | —   |       | 419      |       |
| Net unrealized loss on securities available  for sale |       | 830      |       | 34       |       |
| Other                                                 |       | 542      |       | 634      |       |
|                                                  |       | 2,952    |       | 2,588    |       |
| Less valuation allowance                              |       | (6       | )          | (82      | )          |
|                                                  |       | 2,946    |       | 2,506    |       |
|                                                  |       |     |       |     |       |
| Deferred tax liabilities:                             |       |     |       |     |       |
| Property and equipment                                |       | 2,626    |       | 1,647    |       |
| Federal Home Loan Bank stock                          |       | —   |       | 148      |       |
| Mortgage servicing rights                             |       | 235      |       | 186      |       |
| Other assets                                          |       | 155      |       | —   |       |
| Other                                                 |       | 18       |       | —   |       |
|                                                  |       | 3,034    |       | 1,981    |       |
|                                                  |       | $        | (88        | )        | $          | 525 |   |

 

86

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Retained earnings at June 30,2004 and 2003, include approximately $4,805 related to the pre-1987 allowancefor loan losses for which no deferred federal income tax liability has beenrecognized.  These amounts represent anallocation of income to bad debt deductions for tax purposes only.  If the Bank no longer qualifies as a bank, orin the event of a liquidation of the Bank, income would be created for taxpurposes only, which would be subject to the then current corporate income taxrate.  The unrecorded deferred income taxliability on the above amount for financial statement purposes wasapproximately $1,634.

 

**Note 12.**                           RegulatoryCapital

** **

The Bank is subject to variousregulatory capital requirements administered by federal banking agencies.  Failure to meet minimum capital requirementscan initiate certain mandatory - and possibly additional discretionary -actions by regulators that, if undertaken, could have a direct material effecton the Bank’s financial statements. Under capital adequacy guidelines and the regulatory framework forprompt corrective action, the Bank must meet specific capital guidelines thatinvolve quantitative measures of the Bank’s assets, liabilities, and certainoff-balance-sheet items as calculated under regulatory accountingpractices.  The Bank’s capital amountsand classification are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

Quantitative measuresestablished by regulation to ensure capital adequacy require the Bank tomaintain minimum amounts and ratios (set forth in the following table) of totaland Tier I capital (as defined in the regulations) to risk-weighted assets (asdefined), and of Tier I capital (as defined) to adjusted total assets (asdefined).  Management believes, as ofJune 30, 2004 and 2003, that the Bank meets all capital adequacy requirementsto which it is subject.

 

As of June 30, 2004, the mostrecent notification from the Office of Thrift Supervision (OTS) categorized theBank as “well capitalized” under the regulatory framework for prompt correctiveaction.  To be categorized as wellcapitalized, the Bank must maintain minimum total risk-based, Tier Irisk-based, and Tier I (core) capital ratios as set forth in the table.  There are no conditions or events since thatnotification that management believes have unfavorably changed the Bank’scategory.

 

87

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The following table summarizesthe Bank’s compliance with its regulatory capital requirements at June 30, 2004and 2003:

 
| ** **                                          | ** ** | **Actual** | ** ** | **Minimum Capital  Requirement** |       | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** | ** ** |
|-----------------------------------------------------|------------|------------|------------|----------------------------------|------------|-------------------------------------------------------------------------|------------|
| ** **                                          | ** ** | **Amount** | ** ** | **Percent**                      | ** ** | **Amount**                                                              | ** ** | **Percent** |   | **Amount** | ** ** | **Percent** | ** ** |
| As of June 30, 2004:                                |       |       |       |                             |       |                                                                    |       |   |   |   |   |   |   |
| Tier I (core) capital (to adjusted total  assets)   |       | $          | 69,762     |                             | 8.28       | %                                                                       | $          | 33,689 |   | 4.00 | % | $ | 42,112 |   | 5.00 | % |
| Total risk-based capital (to risk-weighted  assets) |       | 71,502     |       | 10.54                            |       | 54,270                                                                  |       | 8.00 |   | 67,838 |   | 10.00 |   |
| Tangible capital (to tangible assets)               |       | 69,762     |       | 8.28                             |       | 12,633                                                                  |       | 1.50 |   | N/A |   | N/A |   |
| Tier 1 (core) capital (to risk-weighted  assets)    |       | 69,762     |       | 10.28                            |       | N/A                                                                     |       | N/A |   | 40,703 |   | 6.00 |   |
|                                                |       |       |       |                             |       |                                                                    |       |   |   |   |   |   |   |
| As of June 30, 2003:                                |       |       |       |                             |       |                                                                    |       |   |   |   |   |   |   |
| Tier I (core) capital (to adjusted total  assets)   |       | $          | 65,303     |                             | 8.25       | %                                                                       | $          | 31,661 |   | 4.00 | % | $ | 39,577 |   | 5.00 | % |
| Total risk-based capital (to risk-weighted  assets) |       | 64,825     |       | 10.20                            |       | 50,820                                                                  |       | 8.00 |   | 63,525 |   | 10.00 |   |
| Tangible capital (to tangible assets)               |       | 65,303     |       | 8.23                             |       | 11,870                                                                  |       | 1.50 |   | N/A |   | N/A |   |
| Tier 1 (core) capital (to risk-weighted  assets)    |       | 65,303     |       | 10.28                            |       | N/A                                                                     |       | N/A |   | 38,115 |   | 6.00 |   |

 

88

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**Note 13.**                           Stockholders’Equity

** **

The Companycurrently has in effect a stock buy back program in which up to 10% of thecommon stock of the Company outstanding on May 1, 2004 may be acquired throughApril 30, 2005.  A total of 106,090shares of common stock have been purchased pursuant to this current program andthe previous program in effect during fiscal year 2004.  Pursuant to a series of stock buy backprograms initiated by the Company since 1996, the Company has purchased anaggregate of 1,815,036 shares of common stock through June 30, 2004, whichincludes a block of 340,021 shares of common stock repurchased in a privatetransaction in February 2002.  As of June30, 2004, the maximum number of shares that may yet be purchased under thecurrent program was 172,161 shares.

 

The Companyhas authorized 50,000 shares of Preferred Stock, designated as “Series A JuniorParticipating Preferred Stock” with a stated value of $1.00 per share.  Outstanding shares of the Junior PreferredStock are entitled to cumulative dividends. Such shares have voting rights of 100 votes per share and a preferencein liquidation.  The shares are notredeemable after issuance.

 

The Companyalso has preferred share purchase rights (Rights). Each Right entitles theregistered holder to purchase from the Company one one-hundredth of a share ofSeries A Junior Participating Preferred Stock at a price of $65 perone-hundredth of a preferred share, subject to the complete terms as stated inthe Rights Agreement.  The Rights becomeexercisable immediately after the earlier of (i) ten business days following apublic announcement that a person or group has acquired beneficial ownership of20% or more of the outstanding common shares of the Company (subject to certainexclusions), (ii) ten business days following the commencement or announcementof an intention to make a tender offer or exchange offer, the consummation ofwhich would result in the beneficial ownership by a person or group of 20% ormore of such outstanding common shares. The Rights expire on October 22, 2006, which date may be extendedsubject to certain additional conditions. There were no outstanding Rights as of June 30, 2004.

 

Under currentregulations, the Bank is not permitted to pay dividends on its stock if itsregulatory capital would reduce below (i) the amount required for theliquidation account established to provide a limited priority claim to theassets of the Bank to qualifying depositors (Eligible Account Holders) at March31, 1992 who continue to maintain deposits at the Bank after its conversionfrom a federal mutual savings and loan association to a federal stock savingsbank pursuant to its Plan of Conversion adopted August 21, 1991, or (ii) theBank’s regulatory capital requirements. Capital distributions are limited to the greater of 100% of net income forthe year to date plus 50% of the amount by which the lesser of theinstitution’s tangible, core or risk-based capital exceeds its capitalrequirement for such capital commitment, as measured at the beginning of thecalendar year or up to 75% of net income over the most recent four quarter period.  Subsequent to June 30, 2004, the Bank sentwritten notification to the OTS of its intention to pay up to 50% of the Bank’snet income for each quarter in the year ending June 30, 2005, to the Company.

 

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**Note 14.**                           Earnings PerShare

 

Areconciliation of the income and common stock share amounts used in thecalculation of basic and diluted EPS for the fiscal years ended June 30, 2004,2003 and 2002 follow.

 
| ** **                                                                                     | ** ** | **2004**  | ** ** | **2003**  | ** ** | **2002**  | ** ** |
|------------------------------------------------------------------------------------------------|------------|-----------|------------|-----------|------------|-----------|------------|
| Earnings:                                                                                      |       |      |       |      |       |      |       |
| Income from continuing operations                                                              |       | $         | 5,216      |      | $          | 4,946     |       | $ | 4,871 |   |
| Discontinued operations, net of tax                                                            |       | —    |       | 29        |       | (1,686    | )          |
| Net income                                                                                     |       | $         | 5,216      |      | $          | 4,975     |       | $ | 3,185 |   |
|                                                                                           |       |      |       |      |       |      |       |
| Basic EPS:                                                                                     |       |      |       |      |       |      |       |
| Weighted average number of common shares  outstanding                                          |       | 3,557,860 |       | 3,631,431 |       | 3,864,167 |       |
|                                                                                           |       |      |       |      |       |      |       |
| Earnings per common share:                                                                     |       |      |       |      |       |      |       |
| Income from continuing operations                                                              |       | $         | 1.47       |      | $          | 1.36      |       | $ | 1.27 |   |
| Discontinued operations, net of tax                                                            |       | —    |       | 0.01      |       | (0.44     | )          |
| Net income                                                                                     |       | $         | 1.47       |      | $          | 1.37      |       | $ | 0.83 |   |
|                                                                                           |       |      |       |      |       |      |       |
| Diluted EPS:                                                                                   |       |      |       |      |       |      |       |
| Weighted average number of common shares  outstanding                                          |       | 3,557,860 |       | 3,631,431 |       | 3,864,167 |       |
| Common share equivalents - stock options  and stock issuable under employee compensation plans |       | 98,292    |       | 67,873    |       | 74,705    |       |
| Weighted average number of common shares  and common share equivalents                         |       | 3,656,152 |       | 3,699,304 |       | 3,938,872 |       |
|                                                                                           |       |      |       |      |       |      |       |
| Earnings per common share:                                                                     |       |      |       |      |       |      |       |
| Income from continuing operations                                                              |       | $         | 1.43       |      | $          | 1.34      |       | $ | 1.24 |   |
| Discontinued operations, net of tax                                                            |       | —    |       | 0.01      |       | (0.43     | )          |
| Net income                                                                                     |       | $         | 1.43       |      | $          | 1.35      |       | $ | 0.81 |   |

 

Options outstanding ofapproximately 43,000 and 99,000 shares of common stock at weighted averageshare prices of $16.23 and $14.20 during the years ended June 30, 2004 and2003, respectively, were not included in the computation of diluted earningsper share because the exercise prices of those instruments exceeded the averagemarket prices of the common shares during the years.

 

90

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**Note 15.**                           Defined BenefitPlan

** **

The Company has anoncontributory (cash balance) defined benefit pension plan covering allemployees of the Company and its wholly-owned subsidiaries who have attainedthe age of 21 and have completed 1,000 hours in a plan year.  The benefits are based on 6% of each eligibleparticipant’s annual compensation, plus income earned in the accounts at a ratedetermined annually based on 30-year treasury note rates.  The Company’s funding policy is to make theminimum annual required contribution plus such amounts as the Company maydetermine to be appropriate from time to time. One hundred percent vesting occurs after five years with a retirementage of 65.  Information relative to thecomponents of net periodic benefit cost for the Company’s defined benefit planis presented below.

 
| ** **                             | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|----------|------------|----------|------------|
| Changes in benefit obligations:        |       |     |       |     |       |
| Benefit obligations, beginning         |       | $        | 4,473      |     | $          | 3,713 |   |
| Service cost                           |       | 431      |       | 622      |       |
| Interest cost                          |       | 324      |       | 282      |       |
| Benefits paid                          |       | (169     | )          | (180     | )          |
| Actuarial loss (gain)                  |       | (583     | )          | 36       |       |
| Benefit obligations, ending            |       | $        | 4,476      |     | $          | 4,473 |   |
|                                   |       |     |       |     |       |
| Changes in plan assets:                |       |     |       |     |       |
| Fair value of plan assets, beginning   |       | $        | 2,793      |     | $          | 2,416 |   |
| Actual return on plan assets           |       | 381      |       | 59       |       |
| Company contributions                  |       | 670      |       | 498      |       |
| Benefits paid                          |       | (169     | )          | (180     | )          |
| Fair value of plan assets, ending      |       | $        | 3,675      |     | $          | 2,793 |   |
|                                   |       |     |       |     |       |
| Funded status at end of year:          |       |     |       |     |       |
| Plan assets (deficient) of obligations |       | $        | (801       | )        | $          | (1,680 | ) |
| Unrecognized losses                    |       | 721      |       | 1,495    |       |
| Unrecognized prior service (benefit)   |       | —   |       | (44      | )          |
| Unrecognized transition asset          |       | 22       |       | 35       |       |
| (Accrued) benefit cost at end of year  |       | $        | (58        | )        | $          | (194 | ) |

 

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The componentsof pension cost for the years ended June 30 consist of the following:

 
| ** **                        | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Service cost                      |       | $        | 431        |     | $          | 622      |       | $ | 581 |   |
| Interest cost                     |       | 324      |       | 282      |       | 229      |       |
| Expected return on plan assets    |       | (244     | )          | (204     | )          | (198     | )          |
| Amortization of prior losses      |       | 55       |       | 113      |       | —   |       |
| Accretion of prior service cost   |       | (44      | )          | (46      | )          | (46      | )          |
| Recognized net actuarial losses   |       | —   |       | —   |       | 82       |       |
| Amortization of transition asset  |       | 12       |       | 12       |       | 11       |       |
| Total costs recognized in expense |       | $        | 534        |     | $          | 779      |       | $ | 659 |   |

 

The componentsin the balance sheet consist of:

 
| ** **                                                  | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------|------------|----------|------------|----------|------------|
| (Accrued) benefit cost                                      |       | $        | (58        | )        | $          | (194 | ) |
| Accrued benefit liability                                   |       | —   |       | (1,094   | )          |
| Intangible asset                                            |       | —   |       | (9       | )          |
| Accumulated other comprehensive loss                        |       | —   |       | 1,103    |       |
| Net (liability) recorded in the  consolidated balance sheet |       | $        | (58        | )        | $          | (194 | ) |

 

Theweighted-average assumptions used to determine benefit obligations at June 30are as follows:

 
| ** **                     | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------|------------|----------|------------|----------|------------|
| Discount rate - preretirement  |       | 7.50     | %          | 7.50     | %          |
| Discount rate - postretirement |       | 4.93     |       | 5.40     |       |
| Rate of compensation increase  |       | 5.50     |       | 5.50     |       |

 

Theweighted-average assumptions used to determine net periodic benefit cost foryears ended June 30 are as follows:

 
| ** **                               | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------|------------|----------|------------|----------|------------|
| Discount rate - preretirement            |       | 7.50     | %          | 7.50     | %          |
| Discount rate - postretirement           |       | 4.81     |       | 4.81     |       |
| Expected long-term return on plan assets |       | 8.00     |       | 8.00     |       |
| Rate of compensation increase            |       | 5.50     |       | 5.50     |       |

 

The overallexpected long-term rate of return on assets is based on economic forecasts,projected asset allocation and benefit obligations.

 

92

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Plan assets:  The Company’s pension plan weighted-averageasset allocations at June 30, 2004 and 2003, by asset category are as follows:

 
| ** **                | ** ** | **June 30, 2004** | ** ** |
|---------------------------|------------|-------------------|------------|
| **Investment Category**   | ** ** | **Cost**          | ** ** | **Market Value** | ** ** | **Unrealized  Gain / (Loss)** | ** ** | **Actual Asset  Mix as a % of  Market Value** | ** ** | **Target Asset  Mix as a % of  Market Value** | ** ** |
| Equities                  |       | $                 | 2,392      |   | $ | 2,381 |   | $ | (11 | ) | 64.8 | % | 65.0 | % |
| Fixed                     |       | 1,090             |       | 1,107 |   | 17 |   | 30.1 |   | 30.0 |   |
| Cash and cash equivalents |       | 187               |       | 187 |   | — |   | 5.1 |   | 5.0 |   |
| Total pension plan assets |       | $                 | 3,669      |   | $ | 3,675 |   | $ | 6 |   | 100.0 | % | 100.0 | % |

 
| ** **                | ** ** | **June 30, 2003** | ** ** |
|---------------------------|------------|-------------------|------------|
| **Investment Category**   | ** ** | **Cost**          | ** ** | **Market Value** | ** ** | **Unrealized  Gain / (Loss)** | ** ** | **Actual Asset  Mix as a % of  Market Value** | ** ** | **Target Asset  Mix as a % of  Market Value** | ** ** |
| Equities                  |       | $                 | 2,403      |   | $ | 1,694 |   | $ | (709 | ) | 70.1 | % | 60.0 | % |
| Fixed                     |       | 877               |       | 936 |   | 59 |   | 25.5 |   | 30.0 |   |
| Cash and cash equivalents |       | 163               |       | 163 |   | — |   | 4.4 |   | 10.0 |   |
| Total pension plan assets |       | $                 | 3,443      |   | $ | 2,793 |   | $ | (650 | ) | 100.0 | % | 100.0 | % |

 

The objective of the pensionplan investment policy for equities is to pursue a growth strategy that resultsin capital appreciation.  The objectiveof the pension plan investment policy for fixed rate instruments and cashequivalents is to ensure safety of principal and interest.

 

The Company expects tocontribute $662 to its pension plan in 2005.

 

Estimatedfuture benefit payments:  The following benefit payments, which reflectexpected future service, as appropriate, are expected to be paid during theyears ended June 30:

 
| 2005              |   | $     | 170    |   |
|-------------------|--------|-------|--------|--------|
| 2006              |   | 107   |   |
| 2007              |   | 109   |   |
| 2008              |   | 70    |   |
| 2009              |   | 75    |   |
| Years 2010 - 2014 |   | 1,984 |   |

 

93

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**Note 16.**                           RetirementSavings Plan

** **

The Company has a retirementsavings plan covering all full-time employees of the Company who have attainedage 21 and completed one year of service during which they worked at least1,000 hours.  The plan is intended to bea qualified profit sharing plan with a cash or deferred arrangement pursuant toCode Section 401(k) and regulations issued thereunder. The plan allowsvoluntary contributions by eligible employees, and also allows discretionarycontributions by the Company, as determined annually by the Board ofDirectors.  The total compensation costcharged to expense related to the plan was $233, $251 and $216 for 2004, 2003and 2002, respectively.

 

**Note 17.**                           Stock-BasedCompensation Plans

** **

The Company had a 1991 StockOption and Incentive Plan (1991 Option Plan), in which awards for an aggregateamount of 910,800 common shares may have been granted to directors andemployees of the Bank.  Options grantedhad a maximum term of 10 years.  The 1991Option Plan also provided for the award of stock appreciation rights, limitedstock appreciation rights and restricted stock.

 

During fiscal year 2003, theCompany established the 2002 Stock Option and Incentive Plan (2002 OptionPlan), and ceased granting options under the 1991 Option Plan.  Under the 2002 Option Plan, awards for anaggregate amount of 825,000 common shares may be granted to directors andemployees of the Bank.  Options grantedunder the Option Plan may be either options that qualify as Incentive StockOptions, as defined in the Code, or options that do not qualify.  Options granted may have a maximum term of 10years.  The 2002 Option Plan alsoprovides for the award of stock appreciation rights, limited stock appreciationrights and restricted stock.

 

The Company has a long-termincentive plan, which provides for the grant of restricted stock awards and forstock options under the option plans if the Company achieves certainperformance levels.  During fiscal years2004, 2003 and 2002, the Company met a performance level in the plan, andaccordingly, for fiscal year 2004 restricted stock with a value of $698 will beissued in fiscal year 2005.  Duringfiscal years 2004 and 2003, 15,817 and 13,989 shares, respectively, ofrestricted stock were issued under the 1991 and 2002 Option Plans,respectively.  These shares vest 33 1/3%after 3 years, 66 2/3% after 4 years, and 100% after 5 years of continuedemployment.  The issuance value of theseshares was $282 and $153 for 2004 and 2003, respectively, and is beingamortized over the vesting period of five years, with the unamortized balanceincluded in deferred compensation in the consolidated statements of financialcondition.  During fiscal years 2004,2003 and 2002, $89, $50 and $21, respectively, was recorded as amortizationexpense.

 

Also in connection with meetinga performance level of the long-term incentive plan, 83,864 stock options and40,244 shares of restricted stock will be issued in fiscal year 2005 under theplan.

 

94

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The Company has a pool of11,000 restricted shares (1991 Pool), which was increased to 18,700 restrictedshares in fiscal year 2003.  Awards fromthe 1991 Pool are at the discretion of the Chairman of the Board of Directorson a spot basis to employees and were provided for under the 1991 OptionPlan.  The restricted shares vest 33 1/3%after 3 years, 66 2/3% after 4 years, and 100% after 5 years of continuedemployment.  Key provisions of the 1991Pool include: outright grant of shares with restrictions as to sale, transfer,and pledging; during the restriction period, the grantee receives dividends andhas voting rights related to the shares awarded; and all nonvested shares areforfeited upon termination.   During fiscalyear 2004, the Company created a pool of 11,000 restricted shares for grantsunder the 2002 Option Plan (2002 Pool). The provisions of the 2002 Pool are the same as the 1991 Pool.  During fiscal years 2004 and 2003, 1,005 and11,815 restricted shares, respectively, were awarded under the Pool.  The issuance value of these restricted shareswas $16 and $123 in 2004 and 2003, respectively, and is being amortized overthe vesting period of five years, with the unamortized balance included indeferred compensation in the consolidated balance sheet.  During fiscal years 2004, 2003 and 2002, $29,$26 and $37, respectively, was recorded as amortization expense.

 

A summary of the status of theplans and changes during the years ended June 30 are as follows:

 
| ** **                       | ** ** | **2004**   | ** ** | **2003**                               | ** ** | **2002**   | ** ** |
|----------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| **Fixed Options**                | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
| Outstanding at beginning of year |       | 352,059    |       | $                                      | 11.00      |       | 312,311    |   | $ | 10.96 |   | 376,938 |   | $ | 9.39 |   |
| Granted                          |       | 42,987     |       | 16.23                                  |       | 75,628     |       | 10.91 |   | 81,098 |   | 11.36 |   |
| Forfeited                        |       | (16,075    | )          | 9.99                                   |       | (22,343    | )          | 10.68 |   | (57,514 | ) | 11.43 |   |
| Exercised                        |       | (77,228    | )          | 10.69                                  |       | (13,537    | )          | 10.14 |   | (88,211 | ) | 4.30 |   |
| Outstanding at end of year       |       | 301,743    |       | $                                      | 11.22      |       | 352,059    |   | $ | 11.00 |   | 312,311 |   | $ | 10.96 |   |

 

Options for 238,389, 254,152and 201,711 shares were exercisable at June 30, 2004, 2003 and 2002,respectively.  The weighted average fairvalue of options granted was $3.83, $2.57 and $2.50 for the fiscal years endedJune 30, 2004, 2003 and 2002, respectively.

 

95

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Fixed options outstanding atJune 30, 2004 are summarized as follows:

 
| **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|-------------------------|------------|-------------------------|------------|
| **Number  Outstanding** | ** ** | **Number  Exercisable** | ** ** | **Remaining  Contractual  Life** | ** ** | **Exercise  Price** | ** ** |
| 14,245                  |       | 14,245                  |       | 1 year |   | $ | 7.42 |   |
| 52,984                  |       | 39,538                  |       | 7 years |   | 8.52 |   |
| 18,188                  |       | 18,188                  |       | 3 years |   | 9.28 |   |
| 369                     |       | 369                     |       | 2 years |   | 10.15 |   |
| 58,986                  |       | 35,815                  |       | 9 years |   | 10.91 |   |
| 39,342                  |       | 39,342                  |       | 8 years |   | 11.36 |   |
| 40,080                  |       | 40,080                  |       | 5 years |   | 13.98 |   |
| 37,460                  |       | 37,460                  |       | 4 years |   | 14.77 |   |
| 40,089                  |       | 13,352                  |       | 10 years |   | 16.23 |   |
| 301,743                 |       | 238,389                 |       |   |   |   |   |
|                         |            |                         |            |  |  |  |  |  |

 

The Company has a DirectorRestricted Stock Plan which provides that awards of restricted shares of theCompany’s common stock be made to outside directors of the Company.  The plan is designed to allow for payment ofthe annual retainer fee in shares of the Company’s common stock, with theinclusion of an annual cost of living adjustment based on the Consumer PriceIndex.  Each outside director is entitledto all voting, dividend and distribution rights during the restrictionperiod.  The effective date of the planwas July 1, 1997.  The plan has 82,500shares allocated to it and is in effect for a period of ten years.  During fiscal years 2004, 2003 and 2002,6,604, 7,880 and 8,316 shares were awarded and $116, $90 and $89 of expense wasincurred under the plan as the annual retainer for the Company’s Board ofDirectors for the years ending June 30, 2004, 2003 and 2002, respectively.

 

**Note 18.**                           AccumulatedOther Comprehensive Loss

** **

The components of accumulatedother comprehensive loss as of June 30 are as follows:

 
| ** **                                                                                       | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| Unrealized loss on securities available for  sale, net of related tax effect of $(830) and $(34) |       | $        | (1,354     | )        | $          | (56 | ) |
| Fair value change in retained interest, net  of related deferred tax effect of $17 and $3        |       | 27       |       | 5        |       |
| Unrecognized pension costs, net of related  deferred tax effect of $0 and $(419)                 |       | —   |       | (684     | )          |
|                                                                                             |       | $        | (1,327     | )        | $          | (735 | ) |

 

96

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**Note 19.**                           FinancialInstruments

 

The Bank is a party tofinancial instruments with off-balance-sheet risk in the normal course ofbusiness to meet the financing needs of its customers.  These financial instruments includecommitments to extend credit, standby letters of credit and financialguarantees.  Those instruments involve,to varying degrees, elements of credit and interest-rate risk in excess ofamounts recognized in the consolidated statements of financial condition.  The contract or notional amounts of thoseinstruments reflect the extent of the Bank’s involvement in particular classesof financial instruments.

 

The Bank’s exposure to creditloss in the event of nonperformance by the other party to the financialinstrument for commitments to extend credit, standby letters of credit, andfinancial guarantees written is represented by the contractual notional amountof those instruments.  The Bank uses thesame credit policies in making commitments and conditional obligations as itdoes for on-balance-sheet instruments.

 

Unless noted otherwise, theBank does not require collateral or other security to support financialinstruments with credit risk.

 

Estimated fair values of theCompany’s financial instruments are as follows at June 30:

 
| ** **                                                                  | ** ** | **June 30,**         | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                  | ** ** | **2004**             | ** ** | **2003** | ** ** |
| ** **                                                                  | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** | **Carrying  Amount** | ** ** | **Fair Value** | ** ** |
| Financial Assets                                                            |       |                 |       |   |   |   |   |   |   |
| Cash and cash equivalents                                                   |       | $                    | 20,474     |   | $ | 20,474 |   | $ | 44,214 |   | $ | 44,214 |   |
| Securities                                                                  |       | 122,715              |       | 122,715 |   | 88,527 |   | 88,527 |   |
| Federal Home Loan Bank stock                                                |       | 5,469                |       | 5,469 |   | 7,025 |   | 7,025 |   |
| Loans and leases                                                            |       | 651,297              |       | 661,214 |   | 611,401 |   | 634,195 |   |
| Accrued interest receivable                                                 |       | 4,056                |       | 4,056 |   | 4,298 |   | 4,298 |   |
| Servicing rights                                                            |       | 4,620                |       | 7,763 |   | 4,003 |   | 8,725 |   |
| Retained interest asset                                                     |       | 1,878                |       | 1,878 |   | 3,468 |   | 3,468 |   |
|                                                                        |       |                 |       |   |   |   |   |   |   |
| Financial Liabilities                                                       |       |                 |       |   |   |   |   |   |   |
| Deposits                                                                    |       | 658,719              |       | 659,944 |   | 621,381 |   | 626,850 |   |
| Borrowed funds                                                              |       | 93,750               |       | 92,922 |   | 89,819 |   | 94,287 |   |
| Subordinated debentures payable to trusts                                   |       | 27,837               |       | 27,837 |   | 20,620 |   | 20,620 |   |
| Accrued interest payable and advances by borrowers  for taxes and insurance |       | 9,236                |       | 9,236 |   | 10,999 |   | 10,999 |   |
|                                                                             |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

97

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**Note 20.**                           Commitments,Contingencies and Credit Risk

** **

The Bank originates firstmortgage, consumer and other loans primarily in eastern South Dakota and holdsresidential and commercial real estate loans which were purchased from otheroriginators of loans located throughout the United States.  Collateral for substantially all consumerloans are security agreements and/or Uniform Commercial Code (UCC) filings onthe purchased asset.  At June 30, 2004and 2003, the Bank has approximately $24 and $55 of loans sold with recourse tothe Federal National Mortgage Association (FNMA).  The collateral securing these loans areone-to-four family mortgage loans, which are seasoned.  Unused lines of credit amounted to $77,519and $92,995 at June 30, 2004 and 2003, respectively.  Unused letters of credit amounted to $12,000 and$5,359 at June 30, 2004 and 2003, respectively. The lines of credit and letters of credit are collateralized insubstantially the same manner as loans receivable.

 

The Bank had outstandingcommitments to originate or purchase loans of $55,813  and to sell loans of approximately $17,022 atJune 30, 2004.  The portion of commitmentsto originate or purchase fixed rate loans totaled $34,729 with a range ininterest rates of 3.75% to 7.50%.  Nolosses are expected to be sustained in the fulfillment of any of thesecommitments.

 

The Company is involved invarious claims and legal actions arising in the ordinary course ofbusiness.  In the opinion of management,based upon consultation with legal counsel, the ultimate disposition of thesematters will not have a material adverse effect on the Company’s consolidatedfinancial position.

 

**Note 21.**                           Cash FlowInformation

** **

Changes in other assets andliabilities for the years ended June 30, 2004, 2003 and 2002 consist of:

 
| ** **                                                     | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Decrease in accrued interest receivable                        |       | $        | 242        |     | $          | 112      |       | $ | 1,002 |   |
| Increase (decrease) in net deferred loan  fees                 |       | 666      |       | 140      |       | (637     | )          |
| Earnings on cash value of life insurance                       |       | (619     | )          | (431     | )          | —   |       |
| (Increase) decrease in other assets                            |       | 2,836    |       | (6,121   | )          | (485     | )          |
| Increase (decrease) in accrued expenses and  other liabilities |       | (3,300   | )          | 1,016    |       | (4,609   | )          |
|                                                           |       | $        | (175       | )        | $          | (5,284   | )          | $ | (4,729 | ) |

 

98

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**Note 22.**                           FinancialInformation of HF Financial Corp. (Parent Only)

** **

The Company’s condensed balancesheets as of June 30, 2004 and 2003 and related condensed statements of incomeand cash flows for each of the years in the three year period ended June 30,2004 are as follows:

 

Condensed Balance Sheets

 
| ** **                    | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------|------------|----------|------------|----------|------------|
| Assets                        |       |     |       |     |       |
| Cash, primarily with the Bank |       | $        | 2,557      |     | $          | 730 |   |
| Investments in subsidiaries   |       | 73,596   |       | 71,368   |       |
| Land held for sale            |       | 1,298    |       | 1,298    |       |
| Other                         |       | 3,449    |       | 2,104    |       |
|                          |       | $        | 80,900     |     | $          | 75,500 |   |
|                          |       |     |       |     |       |
| Liabilities                   |       |     |       |     |       |
| Other borrowings              |       | $        | 28,603     |     | $          | 25,941 |   |
| Other liabilities             |       | 648      |       | 201      |       |
| Stockholders’ equity     |       | 51,649   |       | 49,358   |       |
|                          |       | $        | 80,900     |     | $          | 75,500 |   |

 

Condensed Statements of Income

 
| ** **                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|----------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Dividends from subsidiaries                                          |       | $        | 2,575      |     | $          | 2,551    |       | $ | 5,317 |   |
| Interest and other income                                            |       | 52       |       | 80       |       | 633      |       |
| Income from operations of discontinued  segment, net of income taxes |       | —   |       | 72       |       | —   |       |
| Expenses                                                             |       | (1,752   | )          | (1,415   | )          | (850     | )          |
| Income tax benefit                                                   |       | 568      |       | 546      |       | 1,067    |       |
| Equity in undistributed income of  subsidiaries                      |       | 3,773    |       | 3,141    |       | (2,982   | )          |
| Net income                                                           |       | $        | 5,216      |     | $          | 4,975    |       | $ | 3,185 |   |

 

99

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Condensed Statements of Cash Flows

 
| ** **                                                                         | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Cash Flows From Operating Activities                                               |       |     |       |     |       |     |       |
| Net income                                                                         |       | $        | 5,216      |     | $          | 4,975    |       | $ | 3,185 |   |
| Adjustments to reconcile net income to net  cash provided by operating activities: |       |     |       |     |       |     |       |
| Realized (gain) on sale of securities, net                                         |       | —   |       | (1       | )          | —   |       |
| Amortization                                                                       |       | 26       |       | 20       |       | 7        |       |
| Equity in (earnings) of subsidiaries                                               |       | (6,348   | )          | (5,692   | )          | (2,335   | )          |
| Cash dividends received from subsidiaries                                          |       | 2,575    |       | 2,551    |       | 5,317    |       |
| Increase (decrease) in liabilities                                                 |       | 447      |       | (191     | )          | 262      |       |
| Other, net                                                                         |       | (354     | )          | (335     | )          | (757     | )          |
| Net cash provided by operating activities                                          |       | 1,562    |       | 1,327    |       | 5,679    |       |
|                                                                               |       |     |       |     |       |     |       |
| Cash Flows From Investing Activities                                               |       |     |       |     |       |     |       |
| Disbursements on note receivable from HF  Card                                     |       | —   |       | (2,476   | )          | (1,505   | )          |
| Repayments on note receivable from HF Card                                         |       | —   |       | 225      |       | 540      |       |
| Proceeds from maturities and sales of  securities                                  |       | —   |       | 283      |       | 101      |       |
| Capital contribution to the Bank                                                   |       | —   |       | (9,000   | )          | (5,300   | )          |
| Capital contribution to HF Group                                                   |       | —   |       | (600     | )          | —   |       |
| Capital contribution to the Mortgage Corp.                                         |       | —   |       | —   |       | —   |       |
| Net cash (used in) investing activities                                            |       | —   |       | (11,568  | )          | (6,164   | )          |
|                                                                               |       |     |       |     |       |     |       |
| Cash Flows From Financing Activities                                               |       |     |       |     |       |     |       |
| Purchase of treasury stock                                                         |       | (1,862   | )          | (2,403   | )          | (5,571   | )          |
| Cash dividends paid                                                                |       | (1,530   | )          | (1,524   | )          | (1,555   | )          |
| Proceeds from issuance of common stock                                             |       | 1,153    |       | 513      |       | 637      |       |
| Proceeds from issuance of subordinated  debentures                                 |       | 7,000    |       | 10,000   |       | 10,000   |       |
| Proceeds from other borrowings                                                     |       | —   |       | 4,500    |       | —   |       |
| Payments on other borrowings                                                       |       | (4,338   | )          | (53      | )          | (3,048   | )          |
| Payment of debt issue costs                                                        |       | (158     | )          | (300     | )          | (350     | )          |
| Net cash provided by financing activities                                          |       | 265      |       | 10,733   |       | 113      |       |
| Increase (decrease) in cash                                                        |       | 1,827    |       | 492      |       | (372     | )          |
|                                                                               |       |     |       |     |       |     |       |
| Cash at beginning of period                                                        |       | 730      |       | 238      |       | 610      |       |
| Cash at end of period                                                              |       | $        | 2,557      |     | $          | 730      |       | $ | 238 |   |

 

100

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**Note 23.**                           QuarterlyFinancial Information (Unaudited)

** **

(Dollars in thousands exceptper share data)

 
| **Fiscal year 2004**                       | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|--------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
| Total interest income                      |       | $               | 10,284     |            | $          | 9,844           |       | $               | 9,837      |   | $ | 10,295 |   |
| Net interest income                        |       | 6,369           |       | 6,120           |       | 6,171           |       | 6,412           |       |
| Provision for losses on loans and leases   |       | 437             |       | 634             |       | 607             |       | 342             |       |
| Income from continuing operations          |       | 1,322           |       | 1,269           |       | 973             |       | 1,652           |       |
| Income (loss) from discontinued operations |       | —          |       | —          |       | —          |       | —          |       |
| Net income                                 |       | 1,322           |       | 1,269           |       | 973             |       | 1,652           |       |
|                                       |       |            |       |            |       |            |       |            |       |
| Earnings per share - basic:                |       |            |       |            |       |            |       |            |       |
| Income from continuing operations          |       | $               | 0.41       |            | $          | 0.35            |       | $               | 0.27       |   | $ | 0.47 |   |
| Discontinued operations, net of tax        |       | —          |       | —          |       | —          |       | —          |       |
| Net income                                 |       | $               | 0.41       |            | $          | 0.35            |       | $               | 0.27       |   | $ | 0.47 |   |
|                                       |       |            |       |            |       |            |       |            |       |
| Earnings per share - diluted:              |       |            |       |            |       |            |       |            |       |
| Income from continuing operations          |       | $               | 0.40       |            | $          | 0.34            |       | $               | 0.26       |   | $ | 0.46 |   |
| Discontinued operations, net of tax        |       | —          |       | —          |       | —          |       | —          |       |
| Net income                                 |       | $               | 0.40       |            | $          | 0.34            |       | $               | 0.26       |   | $ | 0.46 |   |

 
| **Fiscal year 2003**                       | ** ** | **1st Quarter** | ** ** | **2nd Quarter** | ** ** | **3rd Quarter** | ** ** | **4th Quarter** | ** ** |
|--------------------------------------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|-----------------|------------|
| Total interest income                      |       | $               | 11,689     |            | $          | 11,516          |       | $               | 10,649     |   | $ | 10,408 |   |
| Net interest income                        |       | 6,918           |       | 6,779           |       | 6,269           |       | 6,299           |       |
| Provision for losses on loans and leases   |       | 1,034           |       | 449             |       | 391             |       | 1,299           |       |
| Income from continuing operations          |       | 1,451           |       | 1,544           |       | 1,516           |       | 435             |       |
| Income (loss) from discontinued operations |       | 59              |       | (110            | )          | 85              |       | (5              | )          |
| Net income                                 |       | 1,510           |       | 1,434           |       | 1,601           |       | 430             |       |
|                                       |       |            |       |            |       |            |       |            |       |
| Earnings per share - basic:                |       |            |       |            |       |            |       |            |       |
| Income from continuing operations          |       | $               | 0.39       |            | $          | 0.42            |       | $               | 0.42       |   | $ | 0.12 |   |
| Discontinued operations, net of tax        |       | 0.02            |       | (0.03           | )          | 0.02            |       | —          |       |
| Net income                                 |       | $               | 0.41       |            | $          | 0.39            |       | $               | 0.44       |   | $ | 0.12 |   |
|                                       |       |            |       |            |       |            |       |            |       |
| Earnings per share - diluted:              |       |            |       |            |       |            |       |            |       |
| Income from continuing operations          |       | $               | 0.39       |            | $          | 0.41            |       | $               | 0.41       |   | $ | 0.12 |   |
| Discontinued operations, net of tax        |       | 0.02            |       | (0.03           | )          | 0.02            |       | —          |       |
| Net income                                 |       | $               | 0.41       |            | $          | 0.38            |       | $               | 0.43       |   | $ | 0.12 |   |

 

101

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**Item 9****.  Changes in andDisagreements with Accountants on Accounting and Financial Disclosures**

 

During the Company’s twomost recent fiscal years there have been no disagreements between the Companyand its independent accountant on any matter of accounting principle orfinancial statement disclosure.

 

**Item9A****.  Controls and Procedures**

 

As of June 30, 2004 anevaluation was performed by the Company’s management, including the Company’sChairman, President and Chief Executive Officer and the Company’s ExecutiveVice President, Chief Financial Officer and Treasurer, of the effectiveness ofthe design and operation of the Company’s disclosure controls and procedures(as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act).  Based upon, and as of the date of thatevaluation, the Company’s Chairman, President and Chief Executive Officer andthe Company’s Executive Vice President, Chief Financial Officer and Treasurerconcluded that the Company’s disclosure controls and procedures were effective,in all material respects, to ensure that information required to be disclosedin the reports the Company files and submits under the Exchange Act isrecorded, processed, summarized and reported as and when required.  There were no significant changes in theCompany’s internal control over financial reporting or identified in theabove-referenced evaluation that materially affected, or is reasonably likelyto materially effect, the Company’s internal control over financial reporting.

 

**PART III**

 

**Item 10****.  Directors and ExecutiveOfficers of the Registrant**

 

**Compliancewith Section 16(a) of the Exchange Act**

 

Information regardinguntimely filings pursuant to Section 16 of the Securities Exchange Act of 1934,as amended, is incorporated in this Form 10-K by reference from the Company’sdefinitive Proxy Statement for the Annual Meeting of Stockholders to be held in2004, a copy of which will be filed not later than 120 days after June 30,2004.

 

**Code ofEthics**

 

Information regarding acode of ethics is incorporated in this Form 10-K by reference to the Company’sdefinitive Proxy Statement for the Annual Meeting of Stockholders to be held in2004, a copy of which will be filed not later than 120 days after June 30,2004.

 

**Directors**

 

Information regardingDirectors of the Company is incorporated in this Form 10-K by reference fromthe definitive Proxy Statement for the Annual Meeting of Stockholders to beheld in 2004, a copy of which will be filed not later than 120 days after June30, 2004.

 

**Executive officers**

 

Information required bythis item regarding the business experience of the executive officers of theCompany and the Bank is contained in Part I, Item 1 of this Form 10-K pursuantto Instruction 3 and Item 401(b) of Regulation S-K is incorporated herein byreference.

 

**Item 11****.  Executive Compensation**

 

Information concerningexecutive compensation is incorporated in this Form 10-K by reference from thedefinitive Proxy Statement for the Annual Meeting of Stockholders to be held in2004, a copy of which will be filed not later than 120 days after June 30,2004.  Information contained under theheadings “Board Compensation Committee Report on Executive Compensation” and“Stockholder Return Performance Presentation” is not incorporated in this Form10-K.

 

102

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**Item 12****.  Security Ownership ofCertain Beneficial Owners and Management**

 

Information set forthbelow, information concerning security ownership of certain beneficial owners,directors and certain executive officers is incorporated in this Form 10-K byreference from the definitive Proxy Statement for the Annual Meeting ofStockholders to be held in 2004, a copy of which will be filed not later than120 days after June 30, 2004.

 

The following table setsforth certain information about the Common Stock that may be issued uponexercise of options, warrants and rights under all of the Company’s existingequity compensation plans as of June 30, 2004, including the 1996 DirectorRestricted Stock Plan and 2002 Stock Option Plan.  The 1991 Stock Option Plan expired on October27, 2002.  As a result, although the column below entitled “Number ofSecurities to be Issued Upon Exercise of Outstanding Options, Warrants andRights” includes securities to be issued upon unexpired options issued underthe 1991 Stock Option Plan, no securities remain available for future issuanceunder the 1991 Stock Option Plan.

 

**Equity Compensation Plan Information**

 
| **Plan Category**                                            | ** ** | **Number of Shares to be  Issued Upon Exercise of  Outstanding Options,  Warrants and Rights** | ** ** | **Weighted-Average  Exercise Price of  Outstanding Options,  Warrants and Rights** | ** ** | **Number of Shares Remaining  Available for Future Issuance  Under Equity Compensation  Plans (Excluding Shares  Reflected in the First Column)** | ** ** |
|--------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|
|                                                         |       |                                                                                           |       |                                                                               |       |                                                                                                                                              |       |
| Equity plan compensation plans approved by  stockholders     |       | 301,743                                                                                        |       | $                                                                                  | 11.22      |                                                                                                                                              | 786,800    |   |
| Equity plan compensation plans not approved  by stockholders |       | N/A                                                                                            |       | N/A                                                                                |       | N/A                                                                                                                                               |       |
|                                                         |       |                                                                                           |       |                                                                               |       |                                                                                                                                              |       |
| Total                                                        |       | 301,743                                                                                        |       | $                                                                                  | 11.22      |                                                                                                                                              | 786,800    |   |

 

**Item 13****.  Certain Relationships andRelated Transactions**

 

Information concerningcertain relationships and related transactions is incorporated in this Form10-K by reference from the definitive Proxy Statement for the Annual Meeting ofStockholders to be held in 2004, a copy of which will be filed not later than120 days after June 30, 2004.  Informationcontained under the headings “Board Compensation Committee Report on ExecutiveCompensation” and “Stockholder Return Performance Presentation” is notincorporated in this Form 10-K.

 

**Item14****.  Principal Accounting Fees and Services**

 

Information concerningprincipal accounting fees and services and the pre-approval policies andprocedures of the Company’s Audit Committee are incorporated into this Form10-K by reference from the definitive Proxy Statement for the Annual Meeting ofStockholders to be held in 2004, a copy of which will be filed not later than120 days after June 30, 2004.

 

**PART IV**

 

**Item 15****.  Exhibits, FinancialStatement Schedules, and Reports on Form 8-K**

 

(a)                                  Thefollowing documents are as part of this Annual Report on Form 10-K:

(1)          See “HF Financial Corp.Index to Consolidated Financial Statements” under Item 8, “Financial Statementsand Supplementary Data” of this report.

(2)          All supplementalschedules are omitted because of the absence of conditions under which they arerequired or because the information is shown in the Consolidated FinancialStatements or notes thereto.

 

103

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**(3)Exhibits**

 
| **Regulation  S-K Exhibit****Number** | ** ** | **Document**                                                                                                   | ** ** | **Reference to  Prior Filing****or Exhibit****Number****Attached****Hereto** |
|---------------------------------------|------------|----------------------------------------------------------------------------------------------------------------|------------|------------------------------------------------------------------------------|
| 3.1                                   |       | Articles of  Incorporation                                                                                     |       | (1)                                                                          |
| 3.2                                   |       | By-Laws                                                                                                        |       | (1)                                                                          |
| 4.1                                   |       | Rights Agreement                                                                                               |       | (4)                                                                          |
| 10.1                                  |       | Employment Contract  between Home Federal Bank and Curtis L. Hage                                    |       | (1) #                                                                        |
| 10.2                                  |       | Amendment to Employment  Contract between Home Federal Bank and Curtis L. Hage                                 |       | (3) #                                                                        |
| 10.3                                  |       | HF Financial Corp. 1991  Stock Option and Incentive Plan                                                       |       | (2) #                                                                        |
| 10.4                                  |       | Amendment to the HF  Financial Corp 1991 Stock Option and Incentive Plan                                       |       | (5) #                                                                        |
| 10.5                                  |       | HF Financial Corp. 1996  Director Restricted Stock Plan                                                        |       | (5) #                                                                        |
| 10.6                                  |       | Employment Contract between  Home Federal Bank and Mark S. Sivertson                                           |       | (6) #                                                                        |
| 10.7                                  |       | Change in Control  Contract between Home Federal Bank and Mark S. Sivertson                                    |       | (6) #                                                                        |
| 10.8                                  |       | Employment Contract  between Home Federal Bank and David A. Brown                                              |       | (7) #                                                                        |
| 10.9                                  |       | Change in Control  Contract between Home Federal Bank and David A. Brown                                       |       | (7) #                                                                        |
| 10.10                                 |       | Guarantee Agreement  dated November 28, 2001, by and between HF Financial Corp. and Wilmington  Trust Company  |       | (8)                                                                          |
| 10.11                                 |       | Indenture Agreement  dated November 28, 2001, by and between HF Financial Corp. and Wilmington  Trust Company  |       | (8)                                                                          |
| 10.12                                 |       | Guarantee Agreement  dated July 11, 2002, by and between HF Financial Corp. and Wilmington Trust  Company      |       | (9)                                                                          |
| 10.13                                 |       | Indenture Agreement  dated July 11, 2002, by and between HF Financial Corp. and Wilmington Trust  Company      |       | (9)                                                                          |
| 10.14                                 |       | Guarantee Agreement  dated December 19, 2002, by and between HF Financial Corp. and Wilmington  Trust Company  |       | (10)                                                                         |
| 10.15                                 |       | Indenture Agreement  dated December 19, 2002, by and between HF Financial Corp. and Wilmington  Trust Company  |       | (10)                                                                         |
| 10.16                                 |       | Guarantee Agreement  dated September 25, 2003, by and between HF Financial Corp. and Wilmington  Trust Company |       | (11)                                                                         |
| 10.17                                 |       | Indenture Agreement  dated September 25, 2003, by and between HF Financial Corp. and Wilmington  Trust Company |       | (11)                                                                         |
| 10.18                                 |       | Letter Agreement dated  July 12, 2004 between HF Financial Corp. and First Tennessee Bank, NA                  |       | (12)                                                                         |
| 10.19                                 |       | $3.0 Million Promissory  Note between HF Financial Corp. and First Tennessee Bank, NA                          |       | (12)                                                                         |
| 10.20                                 |       | HF Financial Corp. 2002  Stock Option and Incentive Plan                                                       |       | (13)                                                                         |

 

104

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| **Regulation  S-K Exhibit****Number** |   | **Document**                                                                                                                                 |   | **Reference to  Prior Filing****or Exhibit****Number****Attached****Hereto** |
|---------------------------------------|--------|----------------------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------------------------------------|
| 21.1                                  |   | Subsidiaries of  Registrant                                                                                                                  |   | 21.1                                                                         |
| 23.1                                  |   | Consent of Independent  Registered Public Accounting Firm                                                                                    |   | 23.1                                                                         |
| 31.1                                  |   | Certification of  Chairman, President and Chief Executive Officer Pursuant to Section 302 of  the Sarbanes-Oxley Act of 2002                 |   | 31.1                                                                         |
| 31.2                                  |   | Certification of  Executive Vice President, Chief Financial Officer and Treasurer Pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002 |   | 31.2                                                                         |
| 32.1                                  |   | Certification of  Chairman, President and Chief Executive Officer Pursuant to Section 906 of  the Sarbanes-Oxley Act of 2002                 |   | 32.1                                                                         |
| 32.2                                  |   | Certification of  Executive Vice President, Chief Financial Officer and Treasurer Pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002 |   | 32.2                                                                         |

 

----

(1)          Filed as exhibitsto the Company’s Registration Statement on Form S-1 filed on December 6,1991 (File No. 33-44383).

(2)          Filed as an exhibit tothe Company’s Annual Report on Form 10-K for the fiscal year ended June 30,1993.

(3)          Filed as exhibitsto the Company’s Annual Report on Form 10-K for the fiscal year ended June 30,1996.

(4)          Filed as anexhibit to the Company’s filing on Form 8-A, filed on October 28, 1996.

(5)          Filed as exhibitsto the Company’s Annual Report on Form 10-K for the fiscal year ended June 30,1997.

(6)          Filed as exhibitsto the Company’s Annual Report on Form 10-K for the fiscal year ended June 30,1998.

(7)          Filed as exhibitsto the Company’s Annual Report on Form 10-K for the fiscal year ended June 30,2001.

(8)          Filed as exhibitsto the Company’s Quarterly Report on Form 10-Q for the quarter ended December31, 2001.

 (9)        Filed as exhibits to the Company’sQuarterly Report on Form 10-Q for the quarter ended September 30, 2002.

(10)    Filed as exhibits to theCompany’s Quarterly Report on Form 10-Q for the quarter ended December 31,2002.

(11) Filed as exhibits to the Company’s QuarterlyReport on Form 10-Q for the quarter ended September 30, 2003.

(12) Filed as exhibits to the Company’s AnnualReport on Form 10-K for the fiscal year ended June 30, 2003.

(13) Filed as Appendix A to the Company’s definitiveProxy Statement in Schedule 14A, filed on September 27, 2002.

#      Management or compensatory plan orarrangements required to be filed.

 

All of such previouslyfiled documents are hereby incorporated in this Annual Report on Form 10-K byreference in accordance with Item 601 of Regulation S-K.

 

**(b) Reports on Form 8-K**

 

On April 26, 2004, the Companyfiled a current report on Form 8-K, under Item 5, “Other Events,” theannouncement of  the approval by theCompany’s Board of Directors to repurchase up to 10% of its outstanding commonstock through April 30, 2005, and announcing the Company’s intent to pay itsregular cash dividend of 10.75 cents per share for the third quarter of the2004 fiscal year.

 

 **(c) Exhibits**

 

SeeItem 15(a)(3) above.

 

105

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**SIGNATURES**

 

Pursuant to therequirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, theRegistrant has duly caused this report to be signed on its behalf by theundersigned, thereunto duly authorized.

 

 
|   | HF FINANCIAL CORP. |
|--------|--------------------|
|   |               |
|   |               |
|   | By                 | /s/ Curtis L. Hage |   |
|   |               | Curtis L. Hage,  Chairman, President and  Chief Executive Officer  (Duly Authorized Representative) |

 

Pursuant to therequirements of the Securities Exchange Act of 1934, this report has beensigned below by the following persons in the capacities and on the datesindicated.

 

 
| /s/ Curtis L. Hage                                                                                               |                                                                                                                                 | /s/ Darrel L. Posegate |   |
|------------------------------------------------------------------------------------------------------------------|--------------------------------------------------------------------------------------------------------------------------------------|------------------------|--------|
| Curtis L. Hage,  Chairman, President and  Chief Executive Officer *(Principal Executive and  Operating Officer)* | Darrel L. Posegate,  Executive Vice President, Chief  Financial Officer and Treasurer *(Principal Financia  and Accounting Officer)* |
|                                                                                                             |                                                                                                                                 |
|                                                                                                             |                                                                                                                                 |
| Date:                                                                                                            | September 24, 2004                                                                                                                   |                   | Date:  | September 24, 2004 |   |
|                                                                                                                  |                                                                                                                                      |                        |        |  |  |

 

 
| /s/ Thomas L. Van Wyhe        |                        | /s/ Robert L. Hanson |   |
|-------------------------------|-----------------------------|----------------------|--------|
| Thomas L. Van Wyhe,  Director | Robert L. Hanson,  Director |
|                          |                        |
|                          |                        |
| Date:                         | September 24, 2004          |                 | Date:  | September 24, 2004 |   |
|                               |                             |                      |        |  |  |  |

 

 
| /s/ Jeffrey G. Parker        |                         | /s/ Steven R. Sershen |   |
|------------------------------|------------------------------|-----------------------|--------|
| Jeffrey G. Parker,  Director | Steven R. Sershen,  Director |
|                         |                         |
|                         |                         |
| Date:                        | September 24, 2004           |                  | Date:  | September 24, 2004 |   |
|                              |                              |                       |        |  |  |  |

 

 
| /s/ William G. Pederson         |               |   |
|---------------------------------|--------------------|--------|
| William. G. Pederson,  Director |               |
|                            |               |
|                            |               |
| Date:                           | September 24, 2004 |   |   |
|                                 |                    |        |  |

 

106

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**Index to Exhibits**

 
| **Exhibit  Number** | ** ** | ** ** |
|---------------------|------------|------------|
|                |       |       |
|                | 10.19      |       | Letter  Agreement dated July 12, 2004 between HF Financial Corp. and First Tennessee  Bank, NA |
|                |       |       |   |
|                | 21.1       |       | Subsidiaries  of Registrant |
|                |       |       |   |
|                | 23.1       |       | Consents of  Independent Registered Public Accounting Firm |
|                |       |       |   |
|                | 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 |

 

107

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