**UNITED STATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-K**

 

**ý****                                ****ANNUAL REPORT PURSUANT TO SECTION 13 OR15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

**Forthe Fiscal Year Ended June 30, 2003**

 

**CommissionFile Number 0-19972**

 

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**HF FINANCIAL CORP.**

(Exact name of registrant as specified in its charter)

 

| **Delaware**                                                     |   | **46-0418532**                       |
|------------------------------------------------------------------|--------|--------------------------------------|
| (State or other jurisdiction of  incorporation  or organization) |   | (I.R.S. Employer Identification No.) |
|                                                             |   |                                 |
| **225 South Main Avenue,  Sioux Falls, SD**                      |   | **57104**                            |
| (Address of principal  executive offices)                        |   | (Zip Code)                           |
|                                                             |   |                                 |
| **(605)  333-7556**                                              |
| (Registrant’s telephone number, including  area code)       |
|                                                             |   |                                 |
| 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 reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports) and (2)has been subject to such requirements for the past 90 days.

YES  ý   NO  o

 

Indicate by check mark if disclosure ofdelinquent filers pursuant to Item 405 of Regulation S-K is not containedherein, and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form 10-K. o

 

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

YES  o   NO  ý

 

As of September 15, 2003, there were3,236,250 issued and outstanding shares of the Registrant’s Common Stock.

 

The aggregate market value of the voting stockheld by non-affiliates of the registrant, computed by reference to the averageof the bid and asked price of such voting stock as of December 31, 2002, thelast business day of the registrant’s most recently completed second fiscalquarter, was $47.3 million.  (Theexclusion from such amount of the market value of the shares owned by anyperson shall not be deemed an admission by the registrant that such person isan affiliate of the registrant.)

 

**DOCUMENTSINCORPORATED BY REFERENCE**

 

Part III of Form 10-K - Portions of the ProxyStatement for 2003 Annual Meeting of Stockholders.

 

 

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**Annual Report on Form 10-K**

**Table of Contents**

 
| **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 and Related Stockholder Matters |
|            |   |
| Item  6.   | Selected  Financial Condition 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 |
|            |   |
| **PART IV**     |
|            |   |
| Item  15.       | Exhibits,  Financial Statement Schedules, and Reports on Form 8-K |
|            |   |
| Form  10-K      | Signature  Page |

 

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**Forward-Looking Statements**

 

This Form 10-K and other reports issued by HF Financial Corp. (the“Company”), including reports filed with the Securities and ExchangeCommission, contain “forward-looking statements” that deal with future results,expectations, plans and performance.  Inaddition, the Company’s management may make forward-looking statements orallyto the media, securities analysts, investors or others.  These forward-looking statements mightinclude one or more of the following:

 

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

•                  Descriptions ofplans or objectives of management for future operations, products or servicesand transactions.

•                  Forecasts offuture 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-looking statements about the Company’sexpected financial results and other plans are subject to certain risks,uncertainties and assumptions.  Theseinclude, but are not limited to, possible legislative changes and adverseeconomic, business and competitive developments, such as shrinking interestmargins; deposit outflows; reduced demand for financial services and loanproducts; changes in accounting policies or guidelines, or in monetary andfiscal policies of the federal government; changes in credit and other risksposed by the Company’s loan portfolios; the ability or inability tosuccessfully enter into a definitive agreement for and close anticipatedtransactions; technological, computer-related or operational difficulties;adverse changes in securities markets; results of litigation; or othersignificant uncertainties.

 

 Forward-lookingstatements speak only as of the date they are made.  The Company does not undertake to update forward-lookingstatements to reflect circumstances or events that occur after the date theforward-looking statements are made.

 

**PARTI**

 

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

 

This section should be read in conjunction with Part II, Item 7,“Management’s Discussion and Analysis of Financial Condition and Results ofOperations”, Part II, Item 7A, “Quantitative and Qualitative Disclosures AboutMarket Risk” and Part II, Item 8, “Financial Statements andSupplementary Data”.

 

## **The Company**

 

HF Financial Corp. (the“Company”), a unitary thrift holding company, was formed in November 1991, forthe purpose of owning all of the outstanding stock of Home Federal Bank (“HomeFederal” or the “Bank”) issued in the mutual to stock conversion of HomeFederal (the “Conversion”).  The Companyacquired all of the outstanding stock of the Bank on April 8, 1992.  The Company is incorporated under the lawsof the State of Delaware and generally is authorized to engage in any activitythat is permitted by the Delaware General Corporation Law.  Unless otherwise indicated, all mattersdiscussed in this Form 10-K relate to the Company, and its direct and indirectsubsidiaries, including without limitation, the Bank.  See “Subsidiary Activities” for further information on theCompany’s and Bank’s subsidiary operations.

 

The executive offices of theCompany and its direct and indirect subsidiaries are located at 225 South MainAvenue, Sioux Falls, South Dakota, 57104. The Company’s telephone number is (605) 333-7556.  The Company’s and Bank’s website is locatedat www.homefederal.com.  Information onthis website does not constitute part of this Form 10-K.

 

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**The Bank**

 

Home Federal was founded in 1929and is a federally chartered stock savings bank headquartered in Sioux Falls,South Dakota.  The Bank providesfull-service consumer and commercial business banking, including an array offinancial products, to meet the needs of its market place.  The Bank attracts deposits from the generalpublic and uses such deposits, together with borrowings and other funds, tooriginate 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 bydeposit accounts and student loans.  TheBank also purchases mortgage-backed securities and invests in U.S. Governmentand agency obligations and other permissible investments.  Home Federal does not hold anynon-investment grade bonds (i.e., “junk bonds”).  The Bank receives loan servicing income on loans serviced forothers and commission income from credit-life insurance on consumer loans.  The Bank, through its wholly-ownedsubsidiaries, offers annuities, health, life, hazard and other insurance productsand equipment leasing services.

 

The Bank’s deposits are insuredup to applicable limits by the Savings Association Insurance Fund (“SAIF”),administered by the Federal Deposit Insurance Corporation (“FDIC”), and theBank is subject to primary regulation and examination by the Office of ThriftSupervision (“OTS”).

 

## **Segments**

 

Operating segments are definedas components of an enterprise for which separate financial information isavailable that is evaluated regularly by the chief operating decision makers indeciding how to allocate resources and in assessing performance.  The Company’s reportable segments are“banking” (including leasing activities) and “other”.  The “banking” segment is conducted through the Bank and MidAmerica Capital Services, Inc. (“Mid America Leasing”) and the “other” segmentis composed of smaller nonreportable segments, the Company and inter-segmenteliminations.  See Note 1 of “Notes toConsolidated Financial Statements”.

 

**SubsidiaryActivities**

 

In addition to the Bank, the Company had fiveother wholly-owned subsidiaries as of June 30, 2003:  HomeFirst Mortgage Corp. (the “Mortgage Corp.”), HF FinancialGroup, Inc. (“HF Group”), HF Financial Capital Trust I (“Trust I”), HFFinancial Capital Trust II (“Trust II”) and HF Financial Capital Trust III(“Trust III”).  During fiscal year 2003,the Company dissolved HF Card Services, LLC (“HF Card”).

 

The Mortgage Corp. is a South Dakotacorporation that, until the fall of 1998, was engaged in the business oforiginating one- to four-family residential loans which were sold into thesecondary market.  The Mortgage Corp.had no activity during fiscal year 2003.

 

In August 2002, the Companyformed HF Group, a South Dakota corporation. HF Group has the exclusive right to market “SybenServices” for the Minneapolis-based corporation, Syben Holdings, Inc. withinthe territory described below.  HF Groupmarkets Syben Services to business customers in a seven-state region of SouthDakota, Minnesota, Iowa, Nebraska, Missouri, Kansas and North Dakota.  Syben Services are internet based servicesthat utilize proprietary software developed to facilitate employee benefitsadministration, payroll processing and management and governmental reporting.The services provided through Syben assist employers with the management oftheir employer sponsored compensation and benefit programs.  The Company anticipates that this marketingventure will provide expanded opportunities to serve the Company’s existingbusiness customers, develop new corporate relationships and increase theCompany’s fee income.

 

In November 2001, the Company formed Trust Ifor the sole purpose of issuing trust preferred securities and investing theproceeds in subordinated debentures of the Company.  These subordinated debentures constitute the sole asset of TrustI.

 

In July 2002, the Company formed Trust II forthe sole purpose of issuing trust preferred securities and investing theproceeds in subordinated debentures of the Company.  These subordinated debentures constitute the sole asset of TrustII.

 

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In December 2002, the Company formed TrustIII 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 III.

 

HF Card, a South Dakota limited liability company, was established inMay 1996 to provide secured, partially-secured and unsecured credit cardsnationwide.  The Company announced thediscontinuance of the subprime credit card operation in June 2002.  During fiscal year 2003, the Companydissolved HF Card.  See Note 2 of  “Notes to Consolidated Financial Statements”and Item 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations” for further discussion on discontinued operations.

 

As a federally chartered thrift institution,the Bank is permitted by OTS regulations to invest up to 2.00% of its assets inthe stock of, or loans to, service corporation subsidiaries.  The Bank may invest an additional 1.00% ofits assets in service corporations where such additional funds are used forinner-city or community development purposes. The Bank currently has less than 1.00% of its assets in investments inits subsidiary service corporations as defined by the OTS.  In addition to investments in servicecorporations, the Bank is permitted to invest an unlimited amount in operatingsubsidiaries engaged solely in activities in which the Bank may engagedirectly.

 

The Bank has five wholly-owned subsidiaries,Hometown Insurors, Inc. (“Hometown”), Mid America Leasing, Home FederalSecuritization Corp. (“HFSC”), Mid-America Service Corporation (“Mid-America”)and PMD, Inc. (“PMD”).

 

Hometown, a South Dakota corporation,provides insurance products to customers of the Bank and members of the generalpublic in the Bank’s market area. Insurance products offered by Hometown include annuities and life,health, homeowners, and auto insurance and, to a lesser extent, certaincommercial-related insurance products. On August 8, 2003, the Company sold the property and casualty book ofbusiness of Hometown to a third party for total proceeds of $375,000.  The sales agreement includes a “Covenant Notto Compete” clause prohibiting Hometown from directly or indirectly sellingproperty or casualty insurance for three years.  The transaction was effective as of July 31, 2003 and had animmaterial impact on the Company’s financial position and results ofoperations.  Hometownobtains 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, 2003, the Bank had advanced $192,000 on anapproved line of credit of $200,000. Intercompany interest income and interest expense are eliminated in thepreparation of consolidated financial statements.

 

Mid America Leasing, a South Dakotacorporation, specializes in equipment finance leasing.  Mid America Leasing 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, 2003, the Bank had advanced $20.6 million on anapproved line of credit of $35.0 million. Intercompany interest income and interest expense are eliminated in thepreparation of consolidated financial statements.

 

HFSC, a Delaware corporation exists for thesole purpose of buying motor vehicle installment loans from the Bank to besecuritized.  See Note 3 of “Notes toConsolidated Financial Statements” and Item 7, “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” for furtherdiscussion on consumer automobile loan securitization.

 

Mid-America is a South Dakota corporationthat, until the third quarter of fiscal 2002, provided residential appraisal servicesto Home Federal and other lenders in the Bank’s market area.  The cessation of operations of Mid-Americahad no material effect on the consolidated financial statements.  Mid-America had no activity during fiscalyear 2003.

 

PMD, a South Dakota corporation, is engagedin the business of buying, selling and managing repossessed real estateproperties.  PMD had no activity duringfiscal year 2003.

 

## **Market Area**

 

Based on total assets at June30, 2003, Home Federal is the largest thrift institution headquartered in SouthDakota.  The Bank has a total of 34banking centers in its market area and 1 internet branch located at

 

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www.homefederal.com.  The Bank’s primary market area includescommunities located in eastern and central South Dakota, including the citiesof Sioux Falls, Brandon, Pierre, Winner, Freeman, Dell Rapids, Hartford,Canton, Parker, Lennox, Mitchell, Aberdeen, Mobridge, Brookings, Redfield,Dakota Dunes, Colman, Crooks, Watertown and Yankton.  During August 2000, the Bank expanded its market area to includea branch in Marshall, Minnesota.  Thebanking center located in Dakota Dunes also serves customers located innorthwestern Iowa.  The Bank’s immediatemarket area features a variety of agri-business, banking, financial services,health care and light manufacturing firms. The internet branch allows access to customers nationwide.

 

Mid America Leasing providesservices to customers primarily in an eight-state area in the upper Midwest, butoriginations can and have expanded nationwide.

 

HF Group provides services tocustomers in a seven-state region of South Dakota, Minnesota, Iowa, Nebraska,Missouri, Kansas and North Dakota.

 

## **Lending Activities**

 

*General*.  The Bankoriginates a variety of loans including one- to four-family mortgages,commercial loans, agricultural loans, consumer loans for automobile purchases,home equity and home improvement loans and student loans.

 

*One- to Four-Family Residential MortgageLending*.  Residential loan originations of this typeare generated 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 currently makes 10-, 15- and 30-yearfixed- and adjustable-rate (“ARM”) one- to four-family residential mortgageloans in amounts up to 95.00% of the appraised value of the collateral propertyprovided that private mortgage insurance is obtained in an amount sufficient toreduce the Bank’s exposure at or below the 80.00% level.  The Bank currently offers an ARM loan whichhas a fixed rate for the initial three to five years and converts to a one-yearARM loan for the remainder of the life of the loan.  The Bank also offers a one-year ARM loan with a rate below theBank’s then current fixed-rate loan for a comparable 15- or 30-year term loan.  These loans provide for an annual cap and alifetime cap at a set percent over the fully-indexed rate.

 

In addition, the Bank offers a 30-yearballoon loan, which is sold on the secondary market and has a fixed-rate forthe first five or seven years of the loan term.  At the end of the five- or seven-year period, the loan convertsto a 23- or 25-year fixed-rate loan at the then current market rate providedthat the borrower qualifies at the new rate. If the borrower fails to qualify at the new rate, the loan becomespayable in full.  The Bank also offers aportfolio five- and seven-year balloon loan that is underwritten to secondarymarket standards but is fully payable at the end of the balloon term.

 

To meet the needs of the Bank’s borrowers andfinancial needs of the communities it serves, the Bank has developed twodistinct types of loan programs.  TheIntegrity Mortgage Program is a limited documentation program that is availableto the upper credit customer with a beacon score of 680 and above.  The Olympic Plus Program is a program forindividuals that do not meet secondary market standards but yet are eligiblefor Private Mortgage Insurance.  Theprogram underwriting guidelines match those as established by the PrivateMortgage Insurance Company.  Borrowersmay choose from either an ARM or balloon product as a financing option.

 

The Bank also offers fixed-rate 15- through30-year mortgage loans that conform to secondary market standards. Interestrates charged on these fixed-rate loans are competitively priced on a dailybasis according to market conditions. Residential loans generally do not include prepayment penalties.

 

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The Bank also originates fixed-rate one- tofour-family mortgage loans through the South Dakota Housing Development Authority(“SDHDA”) program.  These loansgenerally have terms not to exceed 30 years and are either insured by theFederal Housing Administration (“FHA”), Veteran’s Administration (“VA”) orprivate mortgage insuror and must have no more than a 80.00% loan to valueratio.  The Bank receives an originationfee of 1.00% of the loan amount from the borrower and a servicing fee generally0.38% from the SDHDA for these services. The Bank is the largest servicer of loans for the SDHDA.  At June 30, 2003, the Bank serviced $409.5million of mortgage loans for the SDHDA. See Note 7 of “Notes to Consolidated Financial Statements” forinformation on loan servicing.

 

In underwriting one- to four-familyresidential real estate loans, Home Federal evaluates both the borrower’sability to make monthly payments and the value of the property securing theloan.  The property that secures thereal estate loans made by Home Federal is appraised by an appraiser pursuant tothe Home Federal’s appraisal policy. Home Federal requires borrowers to obtain title, fire and casualtyinsurance in an amount not less than the amount of the loan.  Real estate loans originated by the Bankcontain a “due-on-sale” clause allowing the Bank to declare the unpaidprincipal balance due and payable upon the sale of the collateral property.

 

*Commercial Business Lending*.  In orderto serve the needs of the local business community and improve the interestrate sensitivity and yield of its assets, the Bank originates adjustable- andfixed-rate commercial loans.  Interestrates on commercial business loans adjust or float with a designated nationalindex plus a specified margin.  HomeFederal’s commercial business lending activities encompass loans with a varietyof purposes and security, including loans to finance accounts receivable,inventory and equipment and business expansion within the Bank’s marketarea.  The Bank originates commercialbusiness loans directly and through programs sponsored by the Small BusinessAdministration (“SBA”) of which a portion of such loans are also guaranteed inpart by the SBA.  The Bank generallyoriginates commercial business loans for its portfolio and retains theservicing with respect to such loans. In the future, Home Federal anticipates continued expansion and emphasisof its commercial business lending, subject to market conditions and the HomeOwners’ Loan Act (“the HOLA”) restrictions.   See “Regulation–*Business Activities*”for HOLA restrictions.

 

Commercial business loans typically are madeon the basis of the borrower’s ability to make repayment from the cash flow ofthe borrower’s business.  As a result,the availability of funds for the repayment of commercial business loans may besubstantially dependent on the success of the business itself (which, in turn,is likely to be dependent upon the general economic environment).  The Bank’s commercial business loans aresometimes, but not always, secured by business assets, such as accountsreceivable, equipment and inventory. However, the collateral securing the loans may depreciate over time, maybe difficult to appraise and may fluctuate in value based on the success of thebusiness.  Whenever possible, all of theBank’s commercial business loans include personal guarantees of theborrowers.  In addition,on major loans, the loan officer will perform on-site visits, obtain financialstatements and perform a financial review of the loan.

 

*Multi-Family and Commercial Real EstateLending*.  The Bank engages in multi-family andcommercial real estate lending primarily in South Dakota and the adjoiningMidwestern states.  These lendingactivities may include existing property or new construction development orpurchased loans.

 

Loans secured by multi-family and commercialreal estate properties are generally larger and involve a greater degree ofcredit risk than one- to four-family residential mortgage loans. Becausepayments on loans secured by multi-family and commercial real estate propertiesare often dependent on the successful operation or management of the properties,repayment of such loans may be subject to adverse conditions in the real estatemarket or the economy.  If the cash flowfrom the project is reduced (for example, if leases are not obtained orrenewed), the borrower’s ability to repay the loan may be impaired. Inaddition, loans secured by property outside of the Company’s immediate marketarea may contain a higher degree of risk due to the fact that the Company maynot be as familiar with market conditions where such property is located.  The Company does not have a materialconcentration of multi-family or commercial real estate loans outside of SouthDakota and the adjoining Midwestern states.

 

The Bank presently originatesadjustable-rate, short-term balloon payment, fixed-rate multi-family and commercialreal estate loans.  The Bank’smulti-family and commercial real estate loan portfolio is secured primarily byapartment buildings and owner occupied and non-owner occupied commercial realestate. The terms of such loans are negotiated on a case by case basis.  Commercial real estate loans generally haveterms that do not exceed 25 years.  TheBank has a variety of rate adjustment features, call provisions and other termsin its multi-family and commercial real

 

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estate loan portfolio.  Generally, the loans are made in amounts upto 80.00% of the appraised value of the collateral property and with debtservice coverage ratios of 115.00% or higher. The debt service coverage is the ratio of net cash from operationsbefore payment of debt service. However, these percentages may vary depending on the type of securityand the guarantor.  Such loans providefor a negotiated margin over a designated national index.  The Bank analyzes the financial condition ofthe borrower, the borrower’s credit history, the borrower’s prior record forproducing sufficient income from similar loans, references and the reliabilityand predictability of the net income generated by the property securing theloan.  The Bank generally requirespersonal guarantees of borrowers. Depending on the circumstances of the security of the loan or therelationship with the borrower, the Bank may decide to sell participations inthe loan.  The sale of participationinterests in a loan are necessitated by the amount of the loan or thelimitation of Loans to One Borrower. See “Regulation-*Business Activities*”for a discussion of the Loans to One Borrower rule.  In return for servicing these loans for the participants, theBank generally receives a fee of 0.25% to 0.38%.  Also, income is received at loan closing from loan fees anddiscount points.  Appraisals onproperties securing multi-family and commercial real estate loans originated bythe Bank are performed by appraisers approved pursuant to the Bank’s appraisalpolicy.

 

The Financial Institutions Reform, Recovery,and Enforcement Act of 1989 (“FIRREA”) includes a provision that limits theBank’s non-residential real estate lending (i.e., commercial real estatelending, other than lending on certain multi-family residences) to no more thanfour times its total capital.  Thismaximum limitation, which at June 30, 2003 was $281.8 million, has notmaterially limited the Bank’s lending practices.  See “Regulation-*­RegulatoryCapital Requirements*.”

 

Under FIRREA, the maximum amount which HomeFederal may lend to any one borrower is 15.00% of Home Federal’s unimpairedcapital and surplus or $10.4 million at June 30, 2003.  Loans in an amount equal to an additional10.00% of unimpaired capital and surplus may be made to the same borrower ifsuch 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.  Home Federal is in compliancewith the Loans to One Borrower limitation and had no borrowers in excess of theLoans to One Borrower requirements at June 30, 2003.  See “Regulation-*Loans to OneBorrower*” for a discussion of the Loans to One Borrower rule.

 

*Construction and Development Lending*.  The Bankmakes construction loans to individuals for the construction of theirresidences as well as to builders and, to a lesser extent, developers for theconstruction of one- to four-family residences and condominiums and thedevelopment of one- to four-family lots in the Bank’s primary market area.

 

Construction loans to individuals for theirresidences are structured to be converted to permanent loans at the end of theconstruction phase, which typically runs 6 to 12 months.  These construction loans have rates andterms which match the one- to four-family permanent loans offered by theBank.  Residential construction loansare generally underwritten pursuant to the same guidelines used for originatingpermanent residential loans.

 

The Bank also makes loans to developers forthe purpose of developing one- to four-family lots.  These loans typically have terms of one year and carry floatinginterest rates based on a national designated index.  Loan commitment and partial release fees are charged.  These loans generally provide for thepayment of interest and loan fees from loan proceeds.  The principal balance of these loans is typically paid down aslots are sold.  Builder construction anddevelopment loans are obtained principally through continued business fromdevelopers and builders who have previously borrowed from the Bank as well asbroker referrals and direct solicitations of developers and builders.  The application process includes a submissionto the Bank of plans, specifications and costs of the project to be constructedor developed.  These items are used as abasis to determine the appraised value of the subject property.  Loans are based on the lesser of currentappraised value and/or the cost of construction (land plus building).

 

The Bank makes loans for the construction ofmulti-family residential properties. Such loans are generally made at adjustable rates which adjustperiodically based on the appropriate Treasury Note maturity.  At June 30, 2003, all of the Bank’s constructionloans were performing in accordance with their terms, with the exception of oneloan in the amount of $135,000 included in one- to four-family accruing loansand leases delinquent more than 90 days.

 

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Construction loans are generally originatedwith a maximum loan-to-value ratio of 80.00% and land development loans aregenerally originated with a maximum loan-to-value ratio of 60.00%, based uponan independent appraisal.  Because ofthe uncertainties inherent in estimating development and construction costs andthe market for the project upon completion, it is relatively difficult toevaluate accurately the total loan funds required to complete a project, therelated loan-to-value ratios and the likelihood of ultimate success of theproject.  Construction and developmentloans to borrowers other than owner occupants also involve many of the samerisks discussed above regarding multi-family and commercial real estate loansand tend to be more sensitive to general economic conditions than many othertypes of loans.

 

Prior to making a commitment to fund aconstruction loan, the Bank requires an appraisal of the property, or forlarger projects, both an appraisal and a study of the feasibility of the proposedproject.  The Bank’s construction loanpolicy provides for the inspection of properties by independent in-house andoutside inspectors at the commencement of construction and prior todisbursement of funds during the term of the construction loan.

 

*Consumer Lending*. Management considers its consumer loan products to be an importantcomponent of its lending strategy. Specifically, consumer loans generally have shorter terms to maturity andcarry higher rates of interest than do one-to four-family residential mortgageloans.  In addition, management believesthat the offering of consumer loan products helps to expand and create strongerties to its existing customer base, by increasing the number of customer relationshipsand providing cross-marketing opportunities. For these reasons, Home Federal has continued to focus on theorigination of consumer loans.

 

Home Federal currently purchases automobile conditional sales contractsfrom selected dealers within its market area as well as originating automobileloans directly.  The growth in indirectlending is providing securitization opportunities in the capital markets.  On January 31, 2003, the Bank soldapproximately $40.1 million principal of indirect and $9.9 million principal ofdirect automobile receivables in a securitization transaction.  The proceeds will be used in part tocontinue 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, reduces capital requirements andreduces the 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 by second mortgages, togetherwith loans secured by all prior liens, are limited to 100% or less of theappraised value of the property securing the loan and generally have maximumterms that do not exceed 10 to 15 years.

 

The student loans originated by Home Federalare guaranteed as to principal and interest by the South Dakota EducationAssistance Corporation.  Upon thestudent nearing graduation, Home Federal sells such student loans withservicing rights released.

 

Consumer loan terms vary according to the type of collateral, length ofcontract and creditworthiness of the borrower. Home Federal offers both open- and closed-end credit.  Overdraft lending is extended through linesof credit that are tied to a checking account. The credit lines generally bear interest at 18.00% and are generallylimited to no more than $2,000.  Loanssecured by deposit accounts at the Bank are currently originated for up to90.00% of the account balance (although historically the Bank has loaned up to100.00% of the account balance), with a hold placed on the account restrictingthe withdrawal of the account balance. The interest rate on such loans is typically equal to 2.00% above thecontract rate.

 

The underwriting standards employed by theBank for consumer loans, including mobile home loans, include an application, adetermination of the applicant’s payment history on other debts, and anassessment of the ability to meet existing obligations and payments on theproposed 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 riskthan do residential mortgage loans, particularly in the case of consumer loanswhich are unsecured or are secured by rapidly depreciable assets, such asmobile homes, automobiles or boats.  Insuch cases, any repossessed collateral for a defaulted consumer loan may notprovide an adequate source of repayment of the outstanding loan balance as aresult of the greater likelihood of damage, loss or depreciation.  In

 

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addition, consumer loan collections aredependent on the borrower’s continuing financial stability, and thus are morelikely to be affected by adverse personal circumstances. Furthermore, theapplication of various federal and state laws, including bankruptcy andinsolvency laws, may limit 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 agricultural division offers loans toits customers such as: (1) operating loans which are used to fund operatingexpenses which typically have a one year term and are indexed to the nationalprime rate; (2) term loans on machinery, equipment and breeding stock that mayhave a term up to seven years and require annual payments; (3) agricultural farmlandterm loans which are used to fund land purchases or refinances; (4) specializedlivestock loans to fund facilities and equipment for confinement enterprises;and (5) loans to fund ethanol plant development.  Agriculture real estate loans typically will have personalguarantees of the borrowers, a first lien on the real estate, interest ratesadjustable to the national prime rate or Treasury Note rates, and annual,quarterly or monthly payments. Operating and term loans are secured by farm chattels (crops, livestock,machinery, etc.) the operating assets of the borrower.  The Bank also originates agricultural loansdirectly and through programs sponsored by the Farmers Service Agency (“FSA”)of which a portion of such 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 an eight-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, along with audited financial statements, are the basis forthe lease.  On larger leases, bondratings will be reviewed annually as well as financial statements.

 

9

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Loan and Lease PortfolioComposition.  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 loans in process, deferred fees and discounts and allowance for losses) asof the dates indicated.  Balancesrelated to discontinued credit card loan operations have been eliminated forall periods presented.

 
|                                    |   | **At June  30,**            |    |
|-----------------------------------------|--------|-----------------------------|---------|
|                                    |   | **2003**                    |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                    |   | **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)(2)              |   | $                           | 100,065 |   | 16.18 | % | $ | 79,074 |   | 13.78 | % | $ | 124,951 |   | 21.71 | % | $ | 134,014 |   | 23.62 | % | $ | 138,238 |   | 27.29 | % |
| Multi-family                            |   | 49,364                      |    | 7.98 |   | 56,952 |   | 9.92 |   | 44,378 |   | 7.71 |   | 44,793 |   | 7.89 |   | 47,283 |   | 9.33 |   |
| Commercial                              |   | 93,405                      |    | 15.10 |   | 89,111 |   | 15.53 |   | 73,720 |   | 12.81 |   | 68,556 |   | 12.08 |   | 59,061 |   | 11.66 |   |
| Agricultural                            |   | 18,002                      |    | 2.91 |   | 12,722 |   | 2.22 |   | 12,753 |   | 2.21 |   | 11,669 |   | 2.06 |   | 8,714 |   | 1.72 |   |
| Construction and development (2)        |   | 9,083                       |    | 1.47 |   | 12,738 |   | 2.22 |   | 28,419 |   | 4.94 |   | 35,511 |   | 6.26 |   | 19,696 |   | 3.89 |   |
| Total real estate loans                 |   | 269,919                     |    | 43.64 |   | 250,597 |   | 43.67 |   | 284,221 |   | 49.38 |   | 294,543 |   | 51.91 |   | 272,992 |   | 53.89 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other Loans and Leases:                 |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer Loans:                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Mobile home                             |   | 1,468                       |    | 0.24 |   | 2,365 |   | 0.41 |   | 3,920 |   | 0.68 |   | 5,676 |   | 1.00 |   | 8,115 |   | 1.60 |   |
| Automobiles                             |   | 74,066                      |    | 11.98 |   | 84,782 |   | 14.77 |   | 78,082 |   | 13.57 |   | 81,092 |   | 14.29 |   | 74,255 |   | 14.66 |   |
| Deposit account                         |   | 1,463                       |    | 0.24 |   | 1,597 |   | 0.28 |   | 1,917 |   | 0.33 |   | 2,360 |   | 0.42 |   | 2,117 |   | 0.42 |   |
| Student                                 |   | 7,745                       |    | 1.25 |   | 7,340 |   | 1.28 |   | 6,831 |   | 1.19 |   | 7,146 |   | 1.26 |   | 6,996 |   | 1.38 |   |
| Junior liens on mortgages               |   | 81,064                      |    | 13.11 |   | 73,680 |   | 12.84 |   | 61,397 |   | 10.67 |   | 56,243 |   | 9.91 |   | 46,556 |   | 9.19 |   |
| Other                                   |   | 6,035                       |    | 0.98 |   | 8,529 |   | 1.49 |   | 10,939 |   | 1.90 |   | 11,570 |   | 2.04 |   | 12,304 |   | 2.43 |   |
| Total consumer loans                    |   | 171,841                     |    | 27.80 |   | 178,293 |   | 31.07 |   | 163,086 |   | 28.34 |   | 164,087 |   | 28.92 |   | 150,343 |   | 29.68 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial business                     |   | 113,570                     |    | 18.36 |   | 95,462 |   | 16.63 |   | 97,362 |   | 16.92 |   | 87,137 |   | 15.36 |   | 62,315 |   | 12.30 |   |
| Equipment finance leases                |   | 23,016                      |    | 3.72 |   | 22,834 |   | 3.98 |   | 10,509 |   | 1.82 |   | — |   | 0.00 |   | — |   | 0.00 |   |
| Agricultural                            |   | 40,109                      |    | 6.48 |   | 26,707 |   | 4.65 |   | 20,370 |   | 3.54 |   | 21,597 |   | 3.81 |   | 20,896 |   | 4.13 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total other loans and leases            |   | 348,536                     |    | 56.36 |   | 323,296 |   | 56.33 |   | 291,327 |   | 50.62 |   | 272,821 |   | 48.09 |   | 233,554 |   | 46.11 |   |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total gross loans and leases            |   | 618,455                     |    | 100.00 | % | 573,893 |   | 100.00 | % | 575,548 |   | 100.00 | % | 567,364 |   | 100.00 | % | 506,546 |   | 100.00 | % |
|                                    |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                   |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed portion of loans in process |   | (3,576                      | )       |   |   | (4,678 | ) |   |   | (3,853 | ) |   |   | (17,374 | ) |   |   | (7,487 | ) |   |   |
| Deferred fees and discounts             |   | 364                         |    |   |   | 504 |   |   |   | (133 | ) |   |   | (356 | ) |   |   | (1,073 | ) |   |   |
| Allowance for losses                    |   | (3,842                      | )       |   |   | (4,461 | ) |   |   | (5,509 | ) |   |   | (5,499 | ) |   |   | (4,518 | ) |   |   |
| Total loans and leases receivable, net  |   | $                           | 611,401 |   |   |   | $ | 565,258 |   |   |   | $ | 566,053 |   |   |   | $ | 544,135 |   |   |   | $ | 493,468 |   |   |   |

 

----

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

(2)                Includes undisbursed portion of loansin process.

 

10

----

 

The following table shows thecomposition of the Company’s loan and lease portfolio from continuingoperations by fixed- and adjustable-rate at the dates indicated.  Balances related to discontinued credit cardloan operations have been eliminated for all periods presented.

 
|                                           |   | **At June  30,**            |    |
|------------------------------------------------|--------|-----------------------------|---------|
|                                           |   | **2003**                    |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                           |   | **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) (2)                    |   | $                           | 72,472  |   | 11.72 | % | $ | 45,804 |   | 7.98 | % | $ | 78,350 |   | 13.61 | % | $ | 84,478 |   | 14.89 | % | $ | 95,228 |   | 18.80 | % |
| Multi-family, commercial & construction(2) |   | 41,231                      |    | 6.67 |   | 44,842 |   | 7.81 |   | 39,752 |   | 6.91 |   | 36,552 |   | 6.44 |   | 30,954 |   | 6.11 |   |
| Agricultural                                   |   | 4,760                       |    | 0.77 |   | 1,305 |   | 0.23 |   | 3,433 |   | 0.60 |   | 2,843 |   | 0.50 |   | 1,505 |   | 0.30 |   |
| Total real estate loans                        |   | 118,463                     |    | 19.16 |   | 91,951 |   | 16.02 |   | 121,535 |   | 21.12 |   | 123,873 |   | 21.83 |   | 127,687 |   | 25.21 |   |
|                                           |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer (including mobile home loans)         |   | 110,037                     |    | 17.79 |   | 127,488 |   | 22.21 |   | 125,955 |   | 21.88 |   | 130,770 |   | 23.05 |   | 121,814 |   | 24.05 |   |
| Agricultural                                   |   | 5,285                       |    | 0.85 |   | 5,596 |   | 0.98 |   | 6,007 |   | 1.04 |   | 7,632 |   | 1.35 |   | 4,897 |   | 0.97 |   |
| Equipment finance leases                       |   | 23,016                      |    | 3.72 |   | 22,834 |   | 3.98 |   | 10,509 |   | 1.82 |   | — |   | 0.00 |   | — |   | 0.00 |   |
| Commercial business                            |   | 23,839                      |    | 3.85 |   | 21,463 |   | 3.74 |   | 25,983 |   | 4.52 |   | 25,474 |   | 4.49 |   | 16,675 |   | 3.29 |   |
| Total fixed-rate loans and leases              |   | 280,640                     |    | 45.37 |   | 269,332 |   | 46.93 |   | 289,989 |   | 50.38 |   | 287,749 |   | 50.72 |   | 271,073 |   | 53.52 |   |
|                                           |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Adjustable-Rate Loans:                         |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Real estate:                                   |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One- to four-family(1) (2)                     |   | 27,593                      |    | 4.46 |   | 33,270 |   | 5.80 |   | 46,601 |   | 8.10 |   | 49,536 |   | 8.73 |   | 43,010 |   | 8.49 |   |
| Multi-family, commercial & construction(2) |   | 110,621                     |    | 17.89 |   | 113,959 |   | 19.86 |   | 106,765 |   | 18.55 |   | 112,308 |   | 19.80 |   | 95,086 |   | 18.77 |   |
| Agricultural                                   |   | 13,242                      |    | 2.14 |   | 11,417 |   | 1.99 |   | 9,320 |   | 1.62 |   | 9,558 |   | 1.68 |   | 7,209 |   | 1.42 |   |
| Total real estate loans                        |   | 151,456                     |    | 24.49 |   | 158,646 |   | 27.65 |   | 162,686 |   | 28.27 |   | 171,402 |   | 30.21 |   | 145,305 |   | 28.68 |   |
|                                           |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer (including mobile home loans)         |   | 61,804                      |    | 10.00 |   | 50,805 |   | 8.85 |   | 37,131 |   | 6.45 |   | 33,317 |   | 5.87 |   | 28,529 |   | 5.63 |   |
| Agricultural                                   |   | 34,824                      |    | 5.63 |   | 21,111 |   | 3.68 |   | 14,363 |   | 2.50 |   | 13,233 |   | 2.33 |   | 15,999 |   | 3.16 |   |
| Commercial business                            |   | 89,731                      |    | 14.51 |   | 73,999 |   | 12.89 |   | 71,379 |   | 12.40 |   | 61,663 |   | 10.87 |   | 45,640 |   | 9.01 |   |
| Total adjustable-rate loans                    |   | 337,815                     |    | 54.63 |   | 304,561 |   | 53.07 |   | 285,559 |   | 49.62 |   | 279,615 |   | 49.28 |   | 235,473 |   | 46.48 |   |
|                                           |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans and leases                         |   | 618,455                     |    | 100.00 | % | 573,893 |   | 100.00 | % | 575,548 |   | 100.00 | % | 567,364 |   | 100.00 | % | 506,546 |   | 100.00 | % |
|                                           |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                          |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed portion of loans in process        |   | (3,576                      | )       |   |   | (4,678 | ) |   |   | (3,853 | ) |   |   | (17,374 | ) |   |   | (7,487 | ) |   |   |
| Deferred fees and discounts                    |   | 364                         |    |   |   | 504 |   |   |   | (133 | ) |   |   | (356 | ) |   |   | (1,073 | ) |   |   |
| Allowance for loan losses                      |   | (3,842                      | )       |   |   | (4,461 | ) |   |   | (5,509 | ) |   |   | (5,499 | ) |   |   | (4,518 | ) |   |   |
|                                           |   |                        |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans and leases receivable, net         |   | $                           | 611,401 |   |   |   | $ | 565,258 |   |   |   | $ | 566,053 |   |   |   | $ | 544,135 |   |   |   | $ | 493,468 |   |   |   |

 

----

(1)                 Includes one- to four-family loansheld for sale.

(2)                 Includes undisbursed portion of loansin process.

 

11

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The following scheduleillustrates the scheduled principal contractual repayments of the Company’sloan and lease portfolio from continuing operations at June 30, 2003.  Mortgages which have adjustable orrenegotiable interest rates are shown as maturing at the contractual maturitydate.  The schedule does not reflect theeffects of possible prepayments or 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)**    |    |
| Less than 1 year     |   | $                             | 3,440   |                 | $      | 3,020 |   | $ | 8,291 |   | $ | 1,509 |   | $ | 9,083 |   | $ | 42,787 |   | $ | 70,145 |   | $ | 26,718 |   | $ | 164,993 |   |
| 1 to 5 years         |   | 15,859                        |    | 14,240               |   | 38,625 |   | 7,048 |   | — |   | 128,764 |   | 63,880 |   | 10,704 |   | 279,120 |   |
| Greater than 5 years |   | 80,766                        |    | 32,104               |   | 46,489 |   | 9,445 |   | — |   | 290 |   | 2,561 |   | 2,687 |   | 174,342 |   |
| Total                |   | $                             | 100,065 |                 | $      | 49,364 |   | $ | 93,405 |   | $ | 18,002 |   | $ | 9,083 |   | $ | 171,841 |   | $ | 136,586 |   | $ | 40,109 |   | $ | 618,455 |   |

 

----

(1) Includes one- to four-familyloans held for sale.

(2) Includes demand loans, loanshaving no stated maturity and overdraft loans.

(3) Includes equipment financeleases.

 

The total amount of loans due after June 30,2004 which have predetermined interest rates is $227.2 million, while the totalamount of loans due after such date which have floating or adjustable interestrates is $226.2 million.

 

Scheduled contractual principal repayments ofloans do not reflect the actual life of such assets.  The average life of loans is substantially less than theiraverage contractual terms because of prepayments.  In addition, due-on-sale clauses on loans generally give the Bankthe right to declare a conventional loan immediately due and payable in the event,among other things, that the borrower sells the real property subject to themortgage and the loan is not repaid. The average life of mortgage loans tends to increase, however, whencurrent mortgage loan rates are substantially higher than rates on existingmortgage loans and, conversely, decrease when rates on existing mortgages aresubstantially higher than current mortgage loan rates.  One- to four-family mortgage loans haveprepaid significantly and refinanced at lower rates due to the effect of lowermortgage rates during the last year.

 

12

----

 

**Potential Problem Loans**

 

*Nonperforming Assets. *See “Asset Quality” under Management’s Discussionand Analysis for discussion.

 

*Classified Assets*.  Federalregulations provide for the classification of loans, leases and other assetssuch as debt and equity securities considered by the OTS to be of lesserquality as “substandard,” “doubtful” or “loss.” An asset is considered“substandard” if it is inadequately protected by the current net worth and payingcapacity of the obligor or of the collateral pledged, if any.  “Substandard” assets include thosecharacterized by the “distinct possibility” that the Company will sustain “someloss” if the deficiencies are not corrected. Assets classified as “doubtful” have all of the weaknesses inherent inthose classified “substandard,” with the added characteristic that theweaknesses present make “collection or liquidation in full,” on the basis ofcurrently existing facts, conditions, and values, “highly questionable andimprobable.”  Assets classified as“loss” are those considered “uncollectible” and of such little value that theircontinuance as assets without the establishment of a specific loss reserve isnot warranted.  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 Company classifiesproblem assets as “loss,” it is required either to establish a specificallowance for losses equal to 100% of that portion of the asset so classifiedor to charge-off such amount.  TheCompany’s determination as to the classification of its assets and the amountof its valuation allowances is subject to review by the Bank’s RegionalDirector at the regional OTS office, who may order the establishment ofadditional general or specific loss allowances.

 

In connection with the filing ofits periodic reports with the OTS and in accordance with its classification ofassets policy, the Company regularly reviews problem loans and leases in itsportfolio to determine whether any loans or leases require classification inaccordance with applicable regulations. On the basis of management’s monthly review of its assets, atJune 30, 2003, the Company had criticized $4.3 million of its assetsas special mention and classified $12.9 million of its assets.  Other potential problem loans are included incriticized and classified assets.  See“Asset Quality” under Management’s Discussion and Analysis for furtherdiscussion.

 

*Allowance for Loan and Lease Losses*. See “Application of Critical AccountingPolicies” and “Asset Quality” under Management’s Discussion and Analysis fordiscussion.

 

13

----

 

**InvestmentActivities**

 

Home Federal is required under OTS regulationto maintain a sufficient amount of liquid assets.  Liquidity may increase or decrease depending upon theavailability of funds and comparative yields on investments in relation to thereturn on loans.  Historically, the Bankhas maintained its liquid assets above the minimum requirements imposed by theOTS regulations and at a level believed by management adequate to meetrequirements of normal daily activities, repayment of maturing debt andpotential deposit outflows.  As ofJune 30, 2003, the Bank’s liquidity ratio (liquid assets as apercentage of net withdrawable savings deposits and current borrowings) was4.84%. See “Regulation-*Liquidity*.”

 

Federally chartered savings institutions havethe authority to invest in various types of liquid assets, including UnitedStates Treasury obligations, securities of various federal agencies, certaincertificates of deposit of insured banks and savings institutions, certainbankers’ acceptances, repurchase agreements and federal funds.  Subject to various restrictions, federallychartered savings institutions may also invest their assets in commercialpaper, investment grade corporate debt securities and mutual funds whose assetsconform to the investments that a federally chartered savings institution isotherwise authorized to make directly.

 

Generally, the investment policy of the Bankis to invest funds among various categories of investments and maturities basedupon the Bank’s asset/liability management policies, investment quality andmarketability, liquidity needs and performance objectives.

 

At June 30, 2003, the Company’s investmentsin mortgage-backed securities totaled $70.7 million, or 8.8% of its totalassets. As of such date, the Bank also had a $7.0 million investment in thestock of the Federal Home Loan Bank of Des Moines (“FHLB” or “FHLB of DesMoines”) in order to satisfy the FHLB of Des Moines’ requirement formembership.  It is the Bank’s generalpolicy to purchase investment securities which are U.S. Government securitiesand federal agency obligations and other issues rated investment grade.

 

The composition and maturitiesof the investment securities portfolio, excluding equity securities, areindicated in the following table.

 
|                                         |   | **At June 30, 2003**       |   |
|----------------------------------------------|--------|----------------------------|--------|
|                                         |   | **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 |   | $                          | — |   | — |   | $ | 999 |   | 6.02 | % | $ | — |   | — |   | $ | — |   | — |   | $ | 999 |   | $ | 1,030 |   |
| Federal  Home Loan Bank                      |   | 2,000                      |   | 5.39 | % | 1,000 |   | 7.00 | % | — |   | — |   | — |   | — |   | 3,000 |   | 3,132 |   |
| Municipal  bonds                             |   | 1,048                      |   | 3.96 | % | 3,394 |   | 3.05 | % | — |   | — |   | — |   | — |   | 4,442 |   | 4,511 |   |
| Preferred  term securities                   |   | —                     |   | — |   | — |   | — |   | — |   | — |   | 9,000 |   | 3.09 | % | 9,000 |   | 8,989 |   |
| Other                                        |   | 193                        |   | 1.64 | % | — |   | — |   | — |   | — |   | — |   | — |   | 193 |   | 193 |   |
| Mortgage-backed  securities                  |   | 1,352                      |   | 6.00 | % | 7,964 |   | 6.45 | % | 4,898 |   | 4.33 | % | 56,754 |   | 4.98 | % | 70,968 |   | 70,658 |   |
|                                         |   |                       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  investment securities                 |   | $                          | 4,593  |   |   |   | $ | 13,357 |   |   |   | $ | 4,898 |   |   |   | $ | 65,754 |   |   |   | $ | 88,602 |   | $ | 88,513 |   |

 

The Company’s investmentsecurities portfolio also did not contain non-investment grade or othercorporate debt securities (i.e., “junk bonds”).

 

Home Federal’s investmentsecurity portfolio is managed in accordance with a written investment policyadopted by the Board of Directors. Investments may be made by the Bank’s officers within specified limitsand approved in advance by the Board of Directors for transactions over theselimits.  At the present time, the Bank doesnot have any investments that are held for trading purposes.  At June 30, 2003, the Company has $88.5million of securities available for sale, including mortgage-backed securitiesof $70.7 million.  See Note 5 of “Notesto Consolidated Financial Statements.”

 

14

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**Sources of Funds**

 

*General*.  TheCompany’s primary sources of funds are earnings, in-market deposits, FHLBadvances and other borrowings, amortization and repayments of loan principal,mortgage-backed securities and callable agency securities and, to a lesserextent, sales of mortgage loans, sales and/or maturities of securities,mortgage-backed securities, out-of-market deposits and short term investments.

 

Borrowings of the Bank,presently all from the FHLB of Des Moines, may be used on a short-term basis tocompensate for seasonal reductions in deposits or deposit inflows at less thanprojected levels, and may be used on a longer-term basis to support expandedlending activities.  The Bank in recentyears has not relied on outside borrowings other than FHLB borrowings.  The availability of funds from loan sales isinfluenced by general interest rates. See Note 10 of the “Notes to Consolidated Financial Statements” forfurther detail of the Company’s borrowings.

 

*Deposits*.  The Bankoffers a variety of deposit accounts having a wide range of interest rates andterms.  The Bank’s deposits consist ofstatement savings accounts, NOW and checking accounts, money market andcertificate accounts ranging in terms from 30 days to five years.  The Bank primarily solicits deposits fromits market area.  The Bank reliesprimarily on competitive pricing policies, advertising, and customer service toattract and retain these deposits.

 

The flow of deposits is influencedsignificantly by general economic conditions, changes in money market andprevailing interest rates and competition.

 

The variety of deposit accountsoffered by the Bank has allowed it to be competitive in obtaining funds and torespond with flexibility to changes in consumer demand.  In recent years, the Bank has become moresusceptible to short-term fluctuations in deposit flows as customers havebecome 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, NOW 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.

 

15

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The following table sets forththe dollar amount of deposits in the various types of deposit accounts offeredby the Company as of the dates indicated.

 
|                                                                                                         |   | **At June 30,**            |    |
|--------------------------------------------------------------------------------------------------------------|--------|----------------------------|---------|
|                                                                                                         |   | **2003**                   |    | **2002** |   | **2001** |   |
|                                                                                                         |   | **Amount**                 |    | **Percent of  Total** |   | **Amount** |   | **Percent of  Total** |   | **Amount** |   | **Percent of  Total** |   |
|                                                                                                         |   | **(Dollars in Thousands)** |    |
| Transaction Accounts:                                                                                        |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Noninterest  bearing accounts                                                                                |   | $                          | 77,004  |   | 12.39 | % | $ | 61,355 |   | 10.91 | % | $ | 55,003 |   | 9.15 | % |
| Interest  bearing accounts weighted average rates of 0.16%, 0.39% and 1.39% at June 30,  2003, 2002 and 2001 |   | 43,699                     |    | 7.03 |   | 41,669 |   | 7.41 |   | 33,165 |   | 5.52 |   |
| Savings  accounts weighted average rates of 0.68%, 1.13% and 2.81% at June 30, 2003,  2002 and 2001          |   | 54,462                     |    | 8.77 |   | 50,387 |   | 8.95 |   | 49,852 |   | 8.29 |   |
| Money market  accounts(1) weighted average rates of 1.41%, 1.80% and 3.63% at June 30, 2003,  2002 and 2001  |   | 178,113                    |    | 28.66 |   | 157,770 |   | 28.04 |   | 139,467 |   | 23.20 |   |
|                                                                                                         |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Total  transaction accounts                                                                                  |   | 353,278                    |    | 56.85 |   | 311,181 |   | 55.31 |   | 277,487 |   | 46.16 |   |
|                                                                                                         |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| In-Market  Certificates of Deposit:                                                                          |   |                       |    |   |   |   |   |   |   |   |   |   |   |
|                                                                                                         |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| 0.00 - 3.99%                                                                                                 |   | 174,662                    |    | 28.11 |   | 136,062 |   | 24.96 |   | 5,077 |   | 0.85 |   |
| 4.00 - 4.99%                                                                                                 |   | 21,112                     |    | 3.40 |   | 29,089 |   | 5.17 |   | 58,086 |   | 9.66 |   |
| 5.00 - 5.99%                                                                                                 |   | 17,711                     |    | 2.85 |   | 29,752 |   | 5.29 |   | 85,687 |   | 14.25 |   |
| 6.00 - 6.99%                                                                                                 |   | 18,040                     |    | 2.90 |   | 34,167 |   | 6.07 |   | 121,228 |   | 20.16 |   |
| 7.00 - 7.99%                                                                                                 |   | 985                        |    | 0.16 |   | 17,979 |   | 3.20 |   | 53,642 |   | 8.92 |   |
| Total in-market  certificates of deposit                                                                     |   | 232,510                    |    | 37.42 |   | 247,049 |   | 44.69 |   | 323,720 |   | 53.84 |   |
|                                                                                                         |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Out-of-market  certificates of deposit weighted average rate of 2.11% and 2.90% at June 30,  2003 and 2002   |   | 35,593                     |    | 5.73 |   | 4,366 |   | — |   | — |   | — |   |
|                                                                                                         |   |                       |    |   |   |   |   |   |   |   |   |   |   |
| Total  certificates of deposit                                                                               |   | 268,103                    |    | 43.15 |   | 251,415 |   | 44.69 |   | 323,720 |   | 53.84 |   |
| Total deposits                                                                                               |   | $                          | 621,381 |   | 100.00 | % | $ | 562,596 |   | 100.00 | % | $ | 601,207 |   | 100.00 | % |

 

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(1)   Includes out-of-market money market accountsin the amount of $14.1 million, $0 and $0 for 2003, 2002 and 2001,respectively.

 

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The following table sets forth the amount ofthe Company’s certificates of deposit and other deposits by time remaininguntil maturity as of June 30, 2003.

 
|                                         |   | **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  |   | $                          | 35,819 |               | $      | 27,711 |   | $ | 39,767 |   | $ | 84,104 |   | $ | 187,401 |   |
|                                         |   |                       |   |               |   |   |   |   |   |   |   |
| Certificates of  deposit of $100,000 or more |   | 6,117                      |   | 2,727              |   | 5,533 |   | 20,799 |   | 35,176 |   |
|                                         |   |                       |   |               |   |   |   |   |   |   |   |
| Out-of-market  certificates of deposit(1)    |   | 5,314                      |   | 7,621              |   | 13,424 |   | 9,234 |   | 35,593 |   |
|                                         |   |                       |   |               |   |   |   |   |   |   |   |
| Public funds(2)                              |   | 3,877                      |   | 3,182              |   | 1,546 |   | 1,328 |   | 9,933 |   |
|                                         |   |                       |   |               |   |   |   |   |   |   |   |
| Total  certificates of deposit               |   | $                          | 51,127 |               | $      | 41,241 |   | $ | 60,270 |   | $ | 115,465 |   | $ | 268,103 |   |

 

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(1)                                  Includes funds from governmental and other publicentities in the amount of $3,998.

(2)                                  Includes certificates of deposit of $100,000 ormore from governmental and other public entities, excluding out-of-marketcertificates of deposit.

 

The Bank solicits certificates of deposit of$100,000 or greater (“jumbo certificates”) from various state, county and localgovernment units which carry rates which are negotiated at the time ofdeposit.  See Note 9 of “Notes toConsolidated Financial Statements.” Deposits at June 30, 2003 and 2002 include $42.4 million and $37.4million, respectively of deposits from one local governmental entity, themajority of which are savings accounts.

 

*Borrowings*.  Althoughdeposits are the Bank’s primary source of funds, the Bank’s policy has been toutilize borrowings when they are a less costly source of funds or can beinvested at a positive rate of return.

 

The Bank’s borrowings consist primarily ofadvances from the FHLB of Des Moines upon the security of its capital stock ofthe FHLB of Des Moines and certain pledgable loans, including but not limitedto, its mortgage related loans, mortgage-backed securities and U.S. Governmentand other agency securities.  Suchadvances can be made pursuant to several different credit programs, each ofwhich has its own interest rate and range of maturities.  At June 30, 2003, the Bank’s FHLB advancestotaled $84.5 million, representing 11.25% of total Company liabilities.  See Note 10 of  “Notes to Consolidated Financial Statements” for further detailof the Company’s borrowings.

 

The following table sets forth the maximum month-endbalances and average balances of FHLB advances and other borrowings at thedates indicated.

** **

|                        |   | **Years Ended June 30,**   |    |
|-----------------------------|--------|----------------------------|---------|
|                        |   | **2003**                   |    | **2002** |   | **2001** |   |
|                        |   | **(Dollars in Thousands)** |    |
| Maximum  Month-End Balance: |   |                       |    |   |   |   |   |
| FHLB advances               |   | $                          | 134,503 |   | $ | 101,152 |   | $ | 118,631 |   |
| Other  borrowings           |   | 5,321                      |    | 922 |   | 10,623 |   |
|                        |   |                       |    |   |   |   |   |
| Average Balance:            |   |                       |    |   |   |   |   |
| FHLB advances               |   | $                          | 99,064  |   | $ | 85,716 |   | $ | 105,207 |   |
| Other  borrowings           |   | 1,201                      |    | 896 |   | 7,234 |   |

 

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The following table sets forth certaininformation as to the Bank’s FHLB advances and other borrowings of the Companyat the dates indicated.

 

|                                             |   | **June 30,**               |   |
|--------------------------------------------------|--------|----------------------------|--------|
|                                             |   | **2003**                   |   | **2002** |   | **2001** |   |
|                                             |   | **(Dollars in Thousands)** |   |
|                                             |   |                       |   |   |   |   |   |
| FHLB advances                                    |   | $                          | 84,498 |   | $ | 83,434 |   | $ | 100,714 |   |
| Other borrowings                                 |   | 5,321                      |   | 874 |   | 7,662 |   |
| Total  borrowings                                |   | $                          | 89,819 |   | $ | 84,308 |   | $ | 108,376 |   |
|                                             |   |                       |   |   |   |   |   |
| Weighted  average interest rate of FHLB advances |   | 4.70                       | %      | 5.41 | % | 5.69 | % |

 

*Trust Preferred Securities. *The Company issuedtrust preferred securities during fiscal 2003 in order to provide funding forinvestment into the Bank of Tier I (core) capital.  See Note 11 of  “Notes toConsolidated Financial Statements”.

 

*Consumer Automobile Loan Securitization. *The growth inindirect lending is providing securitization opportunities in the capitalmarkets.  On January 31, 2003, the Banksold approximately $40.1 million principal of indirect and $9.9 millionprincipal of direct automobile receivables in a securitization transaction.  The proceeds will be used in part to continueto service the demand of the Bank’s dealer network.  The securitization is a source of funds at a rate lower thanother sources of funds, reduces capital requirements and reduces the creditrisk to the Bank from the loans sold. See Note 3 of  “Notes toConsolidated Financial Statements” for details on the consumer automobile loansecuritization.

 

**Competition**

 

Home Federal faces strong competition, bothin originating real estate, commercial and consumer loans and in attractingdeposits. Competition in originating real estate loans comes primarily fromother commercial banks, credit unions and mortgage bankers making loans securedby real estate located in the Bank’s market areas. Commercial banks and financecompanies provide vigorous competition in consumer lending.  The Bank competes for real estate and otherloans principally on the basis of the quality of services it provides toborrowers, interest rates and loan fees it charges and the types of loans itoriginates.

 

The Bank attracts the majority of itsdeposits through its retail banking offices, primarily from the communities inwhich those retail banking offices are located; therefore, competition forthose deposits is principally from other commercial banks and credit unionslocated in the same communities.  TheBank competes for these deposits by offering a variety of deposit accounts atcompetitive rates, convenient business hours, and convenient branch locationswith interbranch deposit and withdrawal privileges at each.  According to information contained inreports prepared by the FDIC, the Bank is the sixth largest financialinstitution in Minnehaha County based on total deposits with approximately6.00% of the deposit market share. Minnehaha County includes the South Dakota cities of Sioux Falls,Brandon, Dell Rapids, Crooks and Hartford.

 

**Employees**

 

At June 30, 2003, the Bank had a total of 329full-time equivalent employees (“FTEs”) including 15 FTEs of the Bank’s servicecorporations.  The Bank’s employees arenot represented by any collective bargaining group.  Management considers its relations with its employees to be good.

 

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**Regulation**

 

*General*.  The Bankis a federally chartered thrift institution, the deposits of which are federallyinsured by the Savings Association Insurance Fund (the “SAIF”) of theFDIC.  Accordingly, the Bank is subjectto broad federal regulation and oversight extending to all its operations, byits primary federal regulator, the OTS. The Bank is a member of the FHLB of Des Moines and is subject to certainlimited regulation by the Federal Reserve Board (the “FRB”).  As the unitary thrift holding company of theBank, the Company also is subject to federal regulation and oversight by theOTS.  The purpose of the regulation ofthe Company and other holding companies is to protect subsidiary savingsassociations where deposits are federally insured.

 

Certain of these regulatory requirements andrestrictions are discussed below or elsewhere in this document.  The following discussion is intended to be asummary of the material statutes, regulations and policies applicable tosavings associations and their holding companies, and it does not purport to bea complete discussion of all such statutes, regulations and policies.

 

*Regulation of Federal Savings Associations*.  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 20, 2003.  Examiners may require a federal savings association to providefor higher general or specific loan loss-reserves.  In 2002, the OTS realigned its regional supervisory structure andapportioned supervisory responsibilities to other regions.

 

*Assessments.*  The OTShas established a schedule for the assessment of fees upon all savingsassociations to fund the operations of the OTS.  The general assessment, paid on a semiannual basis, iscomputed by totaling three components: the size of the association on which thebasic assessment is based; the association’s supervisory condition, which wouldresult in an additional assessment based on a percentage of the basicassessment for any savings institution with a composite rating of 3, 4 or 5 inits most recent safety and soundness examination; and the complexity of theassociation’s operations, which would result in an additional assessment basedon a percentage of the basic assessment for any savings association thatmanaged over $1.0 billion in trust assets, serviced for others loansaggregating more than $1.0 billion, or had certain off-balance sheet assetsaggregating more than $1.0 billion. ** **The Bank’s OTS assessment (standard assessment)for the fiscal year ended June 30, 2003 was approximately $154,000.

 

*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 a more than aminimal loss or other significant adverse effect on an insured savings association.  Civil penalties cover a wide range ofviolations and actions and range from $5,000 for each day during whichviolations of law, regulations, orders, and certain written agreements andconditions continue, 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 with respectto its capital requirements.  Possibleenforcement actions range from the imposition of a capital plan and capitaldirective to receivership, conservatorship, or the termination of depositinsurance.  Under the FDI Act, the FDIChas the authority to recommend to the Director of OTS that enforcement actionbe 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.*  Pursuantto the FDI Act, as amended by FDICIA and the Riegle Community Development andRegulatory Improvement Act of 1994, the OTS and the federal bank regulatoryagencies adopted a set of guidelines prescribing safety and soundness standardspursuant to FDICIA, as amended.  The guidelinesestablish general standards relating to internal controls, information systems,internal audit systems, loan documentation, credit underwriting, interest rateexposure, asset growth, asset quality, earnings, and compensation, fees andbenefits.  In general, the guidelinesrequire, among other things, appropriate systems and practices to identify andmanage the risks and exposures specified in the guidelines.  The guidelines prohibit excessivecompensation as an unsafe and unsound practice and describe compensation asexcessive when the amounts paid are unreasonable or disproportionate to theservices performed by an executive officer, employee, director or principalstockholder.  In addition, the OTSadopted regulations that authorize, but do not require, the OTS to order aninstitution that has been given notice by the OTS that it is not satisfying anyof such safety and soundness standards to submit a compliance plan.  If, after being so notified, an institutionfails to submit an acceptable compliance plan or fails in any material respectto implement an accepted compliance plan, the OTS must issue an order directingaction to correct the deficiency and may issue an order directing correctiveactions and may issue an order directing 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 OTSand the FDIC are authorized and, under certain circumstances, required to takecertain actions against any association that fails to meet its capitalrequirements.  The OTS is generally requiredto take action to restrict the activities of an “undercapitalized association”(generally defined to be one with less than either a 4.00% core ratio, a Tier 1risked-based capital ratio or an 8.00% risk-based capital ratio).  Any such association must submit a capitalrestoration plan and until such

 

19

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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 to the approval of the capitalrestoration plan, any company controlling an undercapitalized association mustagree that it will enter into a limited capital maintenance guarantee withrespect to the institution’s achievement of its capital requirements.

 

Any savings association that fails to complywith its capital plan or is “significantly undercapitalized” (i.e., Tier 1risk-based or core capital ratios of less than 3.00% or a risk-based capitalratio of less than 6.00%) must be subject to one or more of the additionalspecified actions and operating restrictions mandated by FDICIA.  These actions and restrictions includerequiring the issuance of additional voting securities; limitations on assetgrowth; mandated asset reduction; changes in senior management; divestiture,merger or acquisition of the association; restrictions on executivecompensation; and any other action the OTS deems appropriate.

 

An association that becomes “criticallyundercapitalized” (i.e., a tangible capital ratio of 2.00% or less) is subjectto further restrictions on its activities in addition to those applicable tosignificantly undercapitalized associations. The FDIC must restrict the activities of a critically undercapitalizedassociation and, among other things, prohibit any material transaction outsidethe ordinary course of business or engaging in certain transactions withaffiliates, without the approval of the FDIC. The OTS must appoint a receiver (or conservator with the concurrence ofthe FDIC) for a savings association, with certain limited exceptions, within 90days after it becomes critically undercapitalized.

 

Any undercapitalized association is alsosubject to other possible enforcement actions by the OTS or the FDIC.  Such actions could include a capitaldirective, a cease-and-desist order, civil money penalties, the establishmentof restrictions on all aspects of the association’s operations or theappointment of a receiver or conservator or a forced merger into anotherinstitution.  The grounds forappointment of a conservator or receiver include substantially insufficientcapital and losses or likely losses that will deplete substantially all capitalwith no reasonable prospect for replenishment of capital without federalassistance.

 

If the OTS determines that an association isin an unsafe or unsound condition or is engaged in an unsafe or unsoundpractice it is authorized to reclassify a well-capitalized association as anadequately capitalized association and if the association is adequatelycapitalized, to impose the restrictions applicable to an undercapitalized association.

 

The imposition by the OTS or the FDIC of anyof these measures on the Bank may have a substantial adverse effect on theBank’s and the Company’s operations and profitability and the value of theCompany’s Common Stock.  The Company’sshareholders do not have preemptive rights, and therefore, if the Company isdirected by the OTS or the FDIC to issue additional shares of Common Stock,such issuance may result in the dilution in the percentage of ownership of theCompany of those persons owning shares of the Company’s Common Stock.

 

*Business Activities.*  The Bank derives its lending and investment powers from the HomeOwners’ Loan Act, as amended (the “HOLA”), and the regulations of the OTSthereunder.  Under these laws and regulations,the Bank may invest in mortgage loans secured by residential and commercialreal estate, commercial and consumer loans, certain types of debt securitiesand certain other assets.  The Bank mayalso establish service corporations that may engage in activities not otherwisepermissible for the Bank, including certain real estate equity investments andsecurities and insurance brokerage. These investment powers are subject to various limitations, including(a) a prohibition against the acquisition of any corporate debt security thatis not rated in one of the four highest rating categories; (b) a limit of400.00% of an association’s capital on the aggregate amount of loans secured bynon-residential real estate property; (c) a limit of 20.00% of an association’sassets on the aggregate amount of commercial and agricultural loans and leaseswith the amount of commercial loans in excess of 10.00% of assets being limitedto small business loans; (d) a limit of 35.00% of an association’s assets onthe aggregate amount of consumer loans and acquisitions of certain debtsecurities; (e) a limit of 5.00% of assets on non-conforming loans (loans inexcess of the specific limitations of the HOLA); and (f) a limit of the greaterof 5.00% of assets or an association’s capital on certain construction loansmade for the purpose of financing what is or is expected to become residentialproperty.  In addition, the HOLA and 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.  Asof June 30, 2003, the Bank exceeded the 20.00% limitation by 0.92%.  The Bank has informed the OTS and willsubmit a plan 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.

 

20

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*Loans to One Borrower*.  Underthe HOLA, savings associations are generally subject to the same limits onLoans to One Borrower as are imposed on national banks.  Generally, under these limits, a savingsassociation may not make a loan or extend credit to a single or related groupof borrowers in excess of 15.00% of the association’s unimpaired capital andsurplus.  Additional amounts may beloaned, not in excess of 10.00% of unimpaired capital and surplus, if suchloans 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, 2003, the Bank’s lending limit under this restriction was $10.4million.  Home Federal is in compliancewith the Loans to One Borrower limitation and had no borrowers in excess of theLoans to One Borrower requirements at June 30, 2003.

 

*Insurance of Accounts and Regulation by theFDIC*.  The Bank is a member of the SAIF, which isadministered by the FDIC.  Savingsdeposits are insured up to $100,000 per insured member (as defined by law andregulation) by the FDIC and such insurance is backed by the full faith andcredit of the United States Government. As insurer, the FDIC imposes deposit insurance premiums and isauthorized to conduct examinations of and to require reporting by FDIC-insuredinstitutions.  It also may prohibit anyFDIC-insured institution from engaging in any activity the FDIC determines byregulation or order to pose a serious risk to the FDIC.  The FDIC also has the authority to initiateenforcement actions against savings associations, after giving the OTS anopportunity to take such action, and may terminate the deposit insurance if itdetermines that the institution has engaged or is engaging in unsafe or unsoundpractices, or is in an unsafe or unsound condition.

 

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 oneof three supervisory subcategories within each capital group.  The supervisory subgroup to which aninstitution is assigned is based on a supervisory evaluation provided to theFDIC by the institution’s primary federal regulator and information that theFDIC determines to be relevant to the institution’s financial condition and therisk posed to the deposit insurance funds. An institution’s assessment rate depends on the capital category andsupervisory subcategory to which it is assigned.  Under the regulation, there are nine assessment riskclassifications (i.e., combinations of capital groups and supervisorysubgroups) 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 at June 30,2003.

 

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 are assessed the same FICOrates.

 

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, such as the Bank, are requiredto maintain a minimum level of regulatory capital.  The OTS has established capital standards, including a tangiblecapital requirement, a leverage ratio (or core capital) requirement and arisk-based capital requirement applicable to such savings associations.  These capital requirements must be generallyas stringent as the comparable capital requirements for national banks.  The OTS is also authorized to impose capitalrequirements in excess of these standards on individual associations on acase-by-case basis.

 

The capital regulations require tangiblecapital not less than 1.50% of adjusted total assets (as defined byregulation).  Tangible capital generallyincludes common stockholders’ equity and retained earnings, and certainnoncumulative perpetual preferred stock and related earnings on withdrawableaccounts and deposits that qualify as core capital.  In addition, all intangible assets, other than a limited amountof mortgage servicing rights and other categories must be deducted fromtangible capital.  At June 30, 2003,Home Federal had $4.0 million of unamortized loan servicing rights.  Included in total unamortized loan servicingwas $193,000 of nonmortgage servicing rights which was required to be deductedfrom tangible capital.

 

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The OTS regulations establish specialcapitalization requirements for savings associations that ownsubsidiaries.  Under these regulationscertain subsidiaries are consolidated for capital purposes and others areexcluded from assets and capital.  Indetermining compliance with the capital requirements, all subsidiaries engagedsolely in activities permissible for national banks or engaged in certain otheractivities solely as agent for its customers such as mortgage bankingactivities are “includable” subsidiaries that are consolidated for capitalpurposes in proportion to the association’s level of ownership, including theassets of includable subsidiaries in which the association has a minorityinterest that is not consolidated for GAAP purposes.  All subsidiaries of the Bank are includable subsidiaries.

 

The capital standards also require corecapital equal to at least 4.00% of adjusted total assets (as defined byregulation).  Core capital generallyconsists of tangible capital plus certain intangible assets, and up to 25% ofother intangibles which meet certain separate salability and market valuationtests.  At June 30, 2003, the Bank had$5.2 million in intangible assets which were subject to these tests.  The amount of servicing rights includable ascore capital is limited to 50.00% of such capital.  At June 30, 2003, the Bank had Tier I (core) capital equal to$65.3 million, or 8.25% of adjusted total assets, which is $33.6 million abovethe minimum leverage ratio requirement of 4.00% as in effect on that date.

 

The OTS risk-based capital requirementrequires savings associations to have total capital of at least 8.00% ofrisk-weighted assets.  Total capitalconsists of core capital, as defined above, and supplementary capital.  Supplementary capital consists of certainpermanent and maturing capital instruments that do not qualify as core capitaland general valuation loan and lease loss allowances up to a maximum of 1.25%of risk-weighted assets.  Supplementarycapital may be used to satisfy the risk-based requirement only to the extent ofcore capital up to 100.00% of core capital. At June 30, 2003, Home Federal had no capital instruments thatqualified as supplementary capital and $3.0 million of general loss reserves,which was not in excess of 1.25% of risk-weighted assets.

 

Certain exclusions from capital and assetsare required to be made for the purpose of calculating total capital, inaddition to the adjustments required for calculating core capital.  Such exclusions consist of equityinvestments (as defined by regulation) and that portion of land loans andnonresidential construction loans in excess of an 80% loan-to-value ratio andreciprocal holdings of qualifying capital instruments.  Home Federal had $3.5 million in dollar fordollar exclusions from capital and assets at June 30, 2003 for the retainedinterest from securitized automobile loans.

 

In determining the amount of risk-weightedassets, all assets, including certain off-balance sheet items, will bemultiplied by the appropriate risk weight based on the risks inherent in thetype of assets.  The risk weightsassigned by the OTS for principal categories of assets are (i) 0.00% for cashand securities issued by the United States Government or unconditionally backedby the full faith and credit of the United States Government, (ii) 20.00% forsecurities (other than equity securities) issued by United States Governmentsponsored agencies, high quality mortgage-backed securities  and mortgage-backed securities issued by, orfully guaranteed as to principal and interest by, the FNMA or the FHLMC exceptfor those classes with residual characteristics or stripped mortgaged-relatedsecurities, (iii) 50.00% for prudently underwritten permanent one- tofour-family first lien mortgage loans not more than 90 days delinquent andhaving a loan-to-value ratio of not more than 80.00% at origination unlessinsured to such ratio by an insurer approved by FNMA or FHLMC, and (iv) 100.00%for all other loans and investments, including consumer loans, commercialloans, repossessed and loans more than 90 days past due and all other assets.

 

On June 30, 2003, the Bank had totalrisk-based capital of $64.8 million (including $65.3 million in core capital,$3.0 million in qualifying supplementary capital and dollar for dollarexclusions for the retained interest from securitized automobile loans of $3.5million) and risk-weighted assets of $635.2 million (including $24.9 million inconverted off-balance sheet assets), or total capital of 10.20% ofrisk-weighted assets.  This amount was$14.0 million above the 8.00% requirement in effect on that date.

 

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The following table sets forth Home Federal’scompliance with its capital requirements at June 30, 2003.

 
|                     |   | **Amount****(2)**          |       | **Percent of  Applicable  Assets(1)** |       |
|--------------------------|--------|----------------------------|------------|---------------------------------------|------------|
|                     |   | **(Dollars in Thousands)** |       |
|                     |   |                       | ** ** |                                  | ** ** |
| GAAP capital             |   | $                          | 70,447     |                                  | 8.84       | % |
|                     |   |                       | ** ** |                                  | ** ** |
| Tier I (core)  capital   |   | $                          | 65,303     |                                  | 8.25       | % |
| Required                 |   | 31,661                     |       | 4.00                                  |       |
| Excess over  requirement |   | $                          | 33,642     |                                  | 4.25       | % |
|                     |   |                       |       |                                  |       |
| Risk-based  capital(3)   |   | $                          | 64,825     |                                  | 10.20      | % |
| Required                 |   | 50,820                     |       | 8.00                                  |       |
| Excess over  requirement |   | $                          | 14,005     |                                  | 2.20       | % |

 

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(1)                                  Tier I (core) capital figures are determined as apercentage of total adjusted assets; risk-based capital figures are determinedas a percentage of risk-weighted assets.

(2)                                  The Bank’s investment in its subsidiaries isincluded for purposes of calculating regulatory capital.

(3)                                  Includes qualifying supplementary capital of $3.0million and dollar for dollar exclusion for the retained interest fromsecuritized automobile loans of $3.5 million.

 

Under FDICIA all the Federal bankingagencies, including the OTS, must revise their risk-based capital requirementsto ensure that such requirements account for interest rate risk, concentrationof credit risk and the risks of non-traditional activities, and that theyreflect the actual performance of and expected loss on multi-family loans.  On May 10, 2002, the OTS adopted anamendment to its capital regulations that eliminated the interest rate riskcomponent of the risk-based capital requirement.

 

*Limitations on Dividends and Other CapitalDistributions*.  OTS regulations impose various restrictionsor requirements on associations with respect to their ability to pay dividendsor make other distributions of capital. OTS regulations prohibit an association from declaring or paying anydividends or from repurchasing any of its stock if, as a result, the regulatorycapital of the association would be reduced below the amount required to bemaintained for the liquidation account established in connection with itsmutual to stock conversion.

 

The OTS imposes various restrictions orrequirements on the Bank’s ability to make capital distributions, includingcash dividends.  A savings institutionthat is the subsidiary of a savings and loan holding company must file a noticewith the OTS at least 30 days before making a capital distribution.  The Bank must file an application for priorapproval if the total amount of its capital distributions, including theproposed distribution, for the applicable calendar year would exceed an amountequal to the Bank’s net income for that year plus retained net income for theprevious two years.

 

The OTS may disapprove of a notice orapplication if:

 

•                  the Bank would be undercapitalized following thedistribution;

•                  the proposed capital distribution raises safetyand soundness concerns; or

•                  the capital distribution would violate aprohibition contained in any statute, regulation or agreement.

 

*Liquidity*.  Allsavings associations, including Home Federal, are required to maintain asufficient amount of liquid assets to ensure its safe and sound operation.  For a discussion of what the Bank includesin liquid assets, see “Management’s Discussion and Analysis of FinancialCondition and Results of Operations - Liquidity and Capital Resources.”  At June 30, 2003, the Bank’soverall liquid asset ratio was 4.84%.

 

*Branching.*  Subjectto certain limitations, the HOLA and the OTS regulations permit federallychartered savings associations to establish branches in any state of the UnitedStates.  The authority to establish suchbranches is available (a) in states that expressly authorize branches ofsavings associations located in another state or (b) to an association thatqualifies as a “domestic building and loan association” under the InternalRevenue Code of 1986, as amended, which imposes qualification requirementssimilar to those for a “qualified thrift lender” under the HOLA.  See the section below entitled “QualifiedThrift Lender Test.”  The authority fora federal savings association to establish an interstate branch network wouldfacilitate a geographic diversification of the association’s activities.  This authority under the HOLA and the OTSregulations preempts any state law purporting to regulate branching by federalsavings associations.

 

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*Community Reinvestment.*  Under theCommunity Reinvestment Act (the “CRA”), as implemented by OTS regulations, asavings association has a continuing and affirmative obligation consistent withits safe and sound operation to help meet the credit needs of its entirecommunity, including low and moderate income neighborhoods.  The CRA does not establish specific lendingrequirements or programs for financial institutions nor does it limit aninstitution’s discretion to develop the types of products and services that itbelieves are best suited to its particular community, consistent with theCRA.  The CRA requires the OTS, inconnection with its examination of a savings association, to assess theassociation’s record of meeting the credit needs of its community and to takesuch record into account in its evaluation of certain applications by suchassociation.  The CRA also requires allinstitutions to make public disclosure of their CRA ratings.  The Association received an  “Outstanding” CRA rating in its most recentexamination.

 

The CRA regulations rate an institution basedon its actual performance in meeting community needs.  In particular, the rating system focuses on three tests:  (a) a lending test, to evaluate theinstitution’s record of making loans in its assessment areas; (b) an investmenttest, to evaluate the institution’s record of investing in communitydevelopment projects, affordable housing, and programs benefiting low ormoderate income individuals and businesses; and (c) a service test, to evaluatethe institution’s delivery of services through its branches, ATMs and otheroffices.  The amended CRA regulationsalso clarify how an institution’s CRA performance would be considered in theapplication process.

 

*Qualified Thrift Lender Test*.  Allsavings associations, including the Bank, are required to meet a qualified thriftlender (“QTL”) test to avoid certain restrictions on their operations.  This test requires a savings association tohave at least 65.00% of its portfolio assets (which consists of total assetsless the sum of goodwill and other intangible assets, properties used toconduct the savings association’s business and specified liquid assets notexceeding 20.00% of total assets) in qualified thrift investments on a monthlyaverage for nine out of every 12 months on a rolling basis.  At June 30, 2003, the Bank maintained 77.95%of its portfolio assets in qualified thrift investments, and thus met thetest.  The Bank has met the QTL testsince its inception.

 

Loans and mortgage-backed securities securedby domestic residential housing, FHLB stock, credit card loans, educationalloans and certain small business loans as well as certain obligations of theFederal Savings and Loan Insurance Corporation (“FSLIC”), the FDIC and certainother related entities may be included in qualifying thrift investments withoutlimit.  FHLMC and FNMA stock and certainother housing-related and non-residential real estate loans and investments,including loans to develop churches, nursing homes, hospitals and schools, andconsumer loans and investments in subsidiaries engaged in housing-relatedactivities may also be included, in varying amounts, not to exceed 20.00% ofportfolio assets.

 

Any savings association that fails to meetthe QTL test must either convert to a national bank charter or operate undercertain restrictions on its activities, unless it requalifies as a QTL andthereafter remains a QTL.  If anyassociation that fails the QTL test is controlled by a holding company, thenwithin one year after the failure, the holding company must register as a bankholding company and become subject to all restrictions on bank holdingcompanies.  See the section belowentitled “Holding Company Regulation.”

 

*Transactions with Affiliates*.  TheBank’s authority to engage in transactions with its “affiliates” is limited bythe OTS regulations and by Sections 23A and 23B of the Federal Reserve Act (the“FRA”).  In general, an affiliate of theAssociation is any company that controls the Association or any other companythat is controlled by a company that controls the Association, excluding theAssociation’s subsidiaries other than those that are insured depositoryinstitutions.  The OTS regulationsprohibit a savings association (a) from lending to any of its affiliates thatis engaged in activities that are not permissible for bank holding companiesunder Section 4(c) of the BHC Act and (b) from purchasing the securities of anyaffiliate other than a subsidiary. Section 23A of the FRA limits the aggregate amount of transactions withany individual affiliate to 10.00% of the capital and surplus of the savingsassociation and also limits the aggregate amount of transactions with allaffiliates to 20.00% of the savings association’s capital and surplus.  Extensions of credit to affiliates arerequired to be secured by collateral in an amount and of a type described inSection 23A of the FRA, and the purchase of low quality assets from affiliatesis generally prohibited.  Section 23B ofthe FRA provides that certain transactions with affiliates, including loans andasset purchases, must be on terms and under circumstances, including creditstandards, that are substantially the same or at least as favorable to theassociation as those prevailing at the time for comparable transactions withnon-affiliated companies.  In theabsence of comparable transactions, such transactions may only occur underterms and circumstances, including credit standards, that in good faith wouldbe offered to or would apply to non-affiliated companies.

 

Effective April 1, 2003, the FRB is rescinding its interpretations ofSections 23A and 23B of the FRA and is replacing 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 before December12, 2002, which either became subject to Sections 23A and 23B of the FRA solelybecause of Regulation W, and all transactions covered by Sections 23A and 23Bof the FRA, the treatment of which will change solely because of Regulation W,will become subject to Regulation W on July 1, 2003.  All other covered affiliate transactions become subject toRegulation W on April 1, 2003.  The FRBexpects each depository institution that is subject to Sections 23A and 23B ofthe FRA to implement policies and procedures to ensure compliance withRegulation W.  The Company does notexpect that the changes made by Regulation W will have a material adverseeffect on its business.

 

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The Association’s authority to extend creditto its directors, executive officers, and 10.00% shareholders, as well as toentities controlled by such persons, is currently governed by the requirementsof Sections 22(g) and 22(h) of the FRA and Regulation O of the FRB thereunder.  Among other things, these provisions requirethat extensions of credit to insiders (a) be made on terms that aresubstantially the same as, and follow credit underwriting procedures that arenot less stringent than, those prevailing for comparable transactions withunaffiliated persons and that do not involve more than the normal risk ofrepayment or present other unfavorable features and (b) not exceed certainlimitations on the amount of the association’s capital.  In addition, extensions of credit in excessof certain limits must be approved by the association’s board ofdirectors.  Section 402 ofthe Sarbanes-Oxley Act of 2002 (the “Sarbanes-Oxley Act”) prohibits theextension of personal loans to directors and executive officers of issuers (asdefined in the Sarbanes-Oxley Act).  Theprohibition, however, does not apply to mortgages advanced by an insureddepository institution, such as the Bank, that are subject to the insiderlending restrictions of Section 22(h) of the FRA.

 

Certain transactions with directors, officersor controlling persons are also subject to conflict of interest regulationsenforced by the OTS.  These conflict ofinterest regulations and other statutes also impose restrictions on loans tosuch persons and their related interests. Among other things, such loans must be made on terms substantially thesame as those for loans to unaffiliated individuals.

 

*Real Estate Lending Standards.*  The OTSand the other federal banking agencies adopted regulations to prescribestandards for extensions of credit that (a) are secured by real estate or (b)are made for the purpose of financing the construction of improvements on realestate.  The OTS regulations requireeach savings association to establish and maintain written internal real estatelending standards 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 OTS regulations adopted pursuant to the Gramm-Leach-BlileyAct of 1999 (“GLB Act”), the Bank is required to adopt procedures to protectcustomers’ “nonpublic personal information.” The new regulations generally require that the Bank disclose its privacypolicy, including identifying with whom it shares a customer’s “nonpublicpersonal information,” to customers at the time of establishing the customerrelationship and annually thereafter. In addition, the Bank is required to provide its customers with theability to “opt-out” of having it share their personal information withunaffiliated third parties and not to disclose account numbers or access codesto nonaffiliated third parties for marketing purposes.  The Bank currently has a privacy protectionpolicy in place, which has been reviewed, for compliance with the regulations.

 

*Federal Reserve System*.  UnderFRB regulations, the Bank is required to maintain non-interest-earning reservesagainst its transaction accounts.  FRBregulations generally require that (a) reserves of 3.00% must be maintainedagainst aggregate transaction accounts of $42.1 million or less, subject toadjustment by the FRB, and (b) a reserve of $1.083 million plus 10.00% (subjectto adjustment by the FRB between 8.00% and 14.00%) must be maintained againstthat portion of total transaction accounts in excess of $42.1 million.  The first $5.7 million of otherwisereservable balances are exempted from the reserve requirements.  The Bank is in compliance with these reserverequirements.  Because required reservesmust be maintained in the form of either vault cash, a noninterest bearing accountat a FRB, or a passthrough account as defined by the FRB, the effect of thisreserve requirement is to reduce the Bank’s interest-earning assets to theextent that the requirement exceeds vault cash.

 

Savings associations are authorized to borrowfrom the FRB “discount window,” but FRB regulations require associations toexhaust other reasonable alternative sources of funds, including FHLBborrowings, before borrowing from the FRB.

 

*Federal Home Loan Bank System*.  The Bankis a member of the FHLB of Des Moines, which is one of 12 regional FHLBs thatadministers the home financing credit function of savings associations.  Each FHLB serves as a reserve or centralbank for its members within its assigned region.  It is funded primarily from proceeds derived from the sale ofconsolidated obligations of the FHLB System. It makes loans to members (i.e., advances) in accordance with policiesand procedures established by the board of directors of the FHLB.  These policies and procedures are subject tothe regulation and oversight of the Federal Housing Finance Board.  All advances from the FHLB are required tobe fully secured by sufficient collateral as determined by the FHLB.  In addition, all long-term advances arerequired to provide funds for residential home financing.

 

Pursuant to regulations promulgated by the Federal Housing FinanceBoard, as required by GLB Act, the FHLB of Des Moines has adopted a capitalplan, which is expected to become effective during the second half of 2003,that will change the foregoing minimum stock ownership requirements for FHLB ofDes Moines stock.  Under the new capitalplan, each member of the FHLB of Des Moines will have to maintain a minimuminvestment in FHLB of Des Moines capital stock in an amount equal to the sum of(i) the greater of $1,000 or 0.20% of the member’s mortgage-related assets and(ii) 4.50% of the dollar amount of any outstanding advances under such member’sAdvances, Collateral Pledge and Security Agreement with the FHLB of Des Moines.  The capital plan allows any FHLB of DesMoines member that became a member on or prior to November 12, 1999, to electto meet the new minimum stock ownership requirements by purchasing additionalFHLB of Des Moines stock in two equal installments, with the first installmentto be paid within three months after the effective date of the capital plan andthe second installment to be paid within six months after the effective date.

 

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At June 30, 2003, Home Federal had $7.0million in FHLB stock, which was in compliance with this requirement.  In past years, the Bank has receivedsubstantial dividends on its FHLB stock. Over the past five fiscal years such dividend yields have averaged 5.11%and were 3.00% for fiscal year 2003. For the fiscal year ended June 30, 2003, dividends paid by the FHLB ofDes Moines to Home Federal totaled approximately $204,000, which constitutes a$19,000 decrease in the amount of dividends received in fiscal 2002.  This reduction is primarily due to adecrease in interest rates from the prior year.

 

Under federal law, the FHLBs are required toprovide funds for the resolution of troubled savings associations and tocontribute to low and moderately-priced housing programs through direct loansor interest subsidies on advances targeted for community investment and low-and moderate-income housing projects. These contributions have affected adversely the level of FHLB dividendspaid and could continue to do so in the future.  These contributions could also have an adverse effect on thevalue of FHLB stock in the future.  Areduction in value of the Bank’s FHLB stock may result in a correspondingreduction in Home Federal’s capital.

 

*USA Patriot Act*.  In response to the events of September 11th, PresidentGeorge W. Bush signed into law the Uniting and Strengthening America byProviding Appropriate Tools Required to Intercept and Obstruct Terrorism Act of2001 (the “USA PATRIOT Act”) on October 26, 2001.  The USA PATRIOT Act gives the federal government new powers toaddress terrorist 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 theUSA PATRIOT Act imposes the following requirements with respect to financialinstitutions:

 

•                  Pursuant to Section 352, *all* financial institutions must establishanti-money laundering programs that include, at minimum: (i) internal policies,procedures, and controls, (ii) specific designation of an anti-money launderingcompliance officer, (iii) ongoing employee training programs, and (iv) anindependent audit function to test the anti-money laundering program.  Interim final rules implementing Section 352were issued by the Treasury Department on April 29, 2002, and were subsequentlyamended on November 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 laundering programthat complies with the anti-money laundering regulations of its federalfunctional regulator.  Home Federal isin compliance with the OTS’s anti-money laundering regulations.

 

•                  Pursuant to Section 326, on May 9,2003, the OTS, in conjunction with other bank regulators, issued a Joint FinalRule that provides for minimum standards with respect to customeridentification and verification.  Therules require financial institutions to establish a program specifyingprocedures for obtaining identifying information from customers seeking to opennew accounts.  This identifyinginformation would be essentially the same information currently obtained bymost financial institutions for individual customers generally.  A financial institution’s program would alsohave to contain procedures to verify the identity of customers within areasonable period of time, generally through the use of the same forms ofidentity verification currently in use, such as through driver’s licenses,passports, credit reports and other similar means.

 

•                  Section 312 requires financialinstitutions that establish, maintain, administer, or manage private bankingaccounts or correspondent accounts in the United States for non-United Statespersons or their representatives (including foreign individuals visiting theUnited States) to establish appropriate, specific, and, where necessary,enhanced due diligence policies, procedures, and controls designed to detectand report money laundering.  A finalrule under Section 312 was issued by the Treasury Department on September 26, 2002.  The rule states that a due diligence programis reasonable if it comports with existing best practices standards for banksthat maintain correspondent accounts for foreign banks and evidences good faithefforts to incorporate due diligence procedures for accounts posing increasedrisk of money laundering.  In addition,an enhanced due diligence program is reasonable if it comports with bestpractices standards and focuses enhanced due diligence measures on thosecorrespondent accounts posing a particularly high risk of money launderingbased on the bank’s overall assessment of the risk posed by the foreigncorrespondent bank.  Finally, a privatebanking due diligence program must be reasonably designed to detect and reportmoney laundering and the existence of proceeds of foreign corruption.  Such a program is reasonable if it focuseson those private banking accounts the present a high risk of moneylaundering.  The deadline for compliancewith this rule, as extended, is March 31, 2003.

 

•                  Effective December 25, 2001,financial institutions are prohibited from establishing, maintaining,administering or managing correspondent accounts for foreign shell banks(foreign banks that do not have a physical presence in any country), and willbe subject to certain recordkeeping obligations with respect to correspondentaccounts of foreign banks.

 

•                  Bank regulators are directed toconsider a holding company’s effectiveness in combating money laundering whenruling on FRA and Bank Merger Act applications.

 

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Although the Company anticipates that it willincur additional expense in complying with the provisions of the USA PATRIOTAct and the resulting regulations, management does not expect that suchcompliance will have a material impact on the results of operations orfinancial condition of the Company.

 

*The Sarbanes-Oxley Act*.  On July 30, 2002, President George W. Bushsigned into law the Sarbanes-Oxley Act. The Sarbanes-Oxley Act implements a broad range of corporate governanceand accounting measures for public companies designed to promote honesty andtransparency in corporate America and better protect investors from the type ofcorporate wrongdoing that occurred in Enron, WorldCom and similar companies.  The Sarbanes-Oxley Act generally applies toall companies, both U.S. and non-U.S., that file or are required to fileperiodic reports with the Securities and Exchange Commission (the “SEC”), underthe Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Given the extensive SEC role in implementingrules relating to many of the Sarbanes-Oxley Act’s new requirements, the finalscope of these requirements remains to be determined.

 

The Sarbanes-Oxley Act includes very specificadditional disclosure requirements and new corporate governance rules, requiresthe SEC and securities exchanges to adopt extensive additional disclosure,corporate governance and other related rules and mandates further studies ofspecified issues by the SEC and the Comptroller General.  The Sarbanes-Oxley Act representssignificant federal involvement in matters traditionally left to stateregulatory systems, such as the regulation of the accounting profession, and tostate corporate law, such as the relationship between a board of directors andmanagement and between a board of directors and its committees.

 

The Sarbanes-Oxley Act’s principallegislation includes:

 

•                                          thecreation of an independent accounting oversight board;

 

•                                          auditorindependence provisions which restrict non-audit services that accountants mayprovide to their audit clients;

 

•                                          additionalcorporate governance and responsibility measures, including the requirementthat the chief executive officer and chief financial officer certify financialstatements;

 

•                                          theforfeiture of bonuses or other incentive-based compensation and profits fromthe sale of an issuer’s securities by directors and senior officers in thetwelve month period following initial publication of any financial statementsthat later require restatement;

 

•                                          anincrease in the oversight of, and enhancement of certain requirements relatingto audit committees of public companies and how they interact with theCompany’s independent auditors.

 

•                                          requirementthat audit committee members must be independent and are absolutely barred fromaccepting consulting, advisory or other compensatory fees from the issuer;

 

•                                          requirementthat companies disclose whether at least one member of the committee is an“audit committee financial expert” (as such term is defined by the SEC) and ifnot, why not;

 

•                                          expandeddisclosure requirements for corporate insiders, including accelerated reportingof stock transactions by insiders and a prohibition  on insider  trading duringpension blackout periods;

 

•                                          aprohibition on personal loans to directors and officers, except certain loansmade by insured financial institutions;

 

•                                          disclosureof a code of ethics and filing a Form 8-K for a change or waiver of such code;

 

•                                          mandatorydisclosure by analysts of potential conflicts of interest; and

 

•                                          arange of enhanced penalties for fraud and other violations.

 

The SEC has been delegated the task of enacting rules to implementvarious provisions with respect to, among other matters, disclosure in periodicfilings pursuant to the Exchange Act. To date, the SEC has implemented some of the provisions of theSarbanes-Oxley Act.  However, the SECcontinues to issue final rules, reports and press releases.  As the SEC provides new requirements, theCompany reviews those rules and complies as required.

 

Furthermore, the NASDAQ Stock Market (the “NASDAQ”) has also proposedcorporate governance rules which would implement the mandates of the Sarbanes-Oxley Act.  The proposed NASDAQ rulesinclude ensuring that a majority of the board of directors are independent ofmanagement, establishing and publishing a code of conduct for directors andofficers and requiring stockholder approval of all new stock option plans andall modifications.  The proposed NASDAQrules are still tentative in nature

 

27

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because they are subject to SEC review and approval, which is expectedto occur later this year.  Oncefinalized, the rules will not be effective until the earlier of the Company’sfirst annual meeting of stockholders after January 15, 2004 or October 31,2004.  These rules, if adopted, wouldaffect the Company because its common stock is listed on the NASDAQ under thesymbol “HFFC.”

 

Although the Company anticipates that it will incur additional expensein complying with the provisions of the Sarbanes-Oxley Act and the resultingregulations, management does not expect that such compliance will have amaterial impact on the Company’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 loan holding company pursuant to a charter applicationfiled with the OTS after May 4, 1999, is prohibited from engaging innon-financial activities or affiliating with non-financial companies.  All unitary savings and loan holdingcompanies 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 enforcement authority over the Companyand its non-savings association subsidiaries which also permits the OTS torestrict or prohibit activities that are determined to be a serious risk to thesubsidiary savings association.

 

As a “grandfathered” unitary thrift holdingcompany, the Company generally is not subject to activity restrictions.  If the Company acquires control of another savingsassociation as a separate subsidiary, it would become a multiple savings andloan holding company, and the activities of the Company and any of itssubsidiaries (other than the Bank or any other SAIF-insured savingsassociation) would become subject to such restrictions unless such otherassociations each qualify as a QTL and were acquired in a supervisoryacquisition.

 

If the Bank fails the QTL test, the Companymust obtain the approval of the OTS prior to continuing after such failure,directly or through its other subsidiaries, any business activity other thanthose approved for multiple savings and loan holding companies or theirsubsidiaries.  In addition, within oneyear of such failure the Company must register as, and will become subject to, therestrictions applicable to bank holding companies.  The activities authorized for a bank holding company are morelimited than are the activities authorized for a unitary or multiple savingsand loan holding company.  See thesection above entitled “Qualified Thrift Lender Test.”

 

In addition, for grandfathered savings and loan holding companies, suchas the Company, the GLB Act also prohibits the sale of such entities tononfinancial companies.  Thisprohibition is intended to restrict the transfer of grandfathered rights toother entities and, thereby, prevent evasion of the limitation on the creationof new unitary savings and loan holding companies.

 

*Federal Securities Law*.  Thestock of the Company is registered with the SEC under the Exchange Act.  The Company is subject to the information,proxy solicitation, insider trading restrictions and other requirements of theSEC under the Exchange Act.

 

Company stock held by persons who areaffiliates (generally officers, directors and principal stockholders) of theCompany may not be resold without registration or unless sold in accordancewith certain resale restrictions.  Ifthe Company meets specified current public information requirements, eachaffiliate of the Company is able to sell in the public market, withoutregistration, a limited number of shares in any three-month period.

 

**Federaland State Taxation**

 

The Company and its direct and indirect subsidiaries file aconsolidated federal income tax return on a fiscal year basis.  In addition, Trust I, Trust II and Trust IIIare required to file a trust return on a calendar year basis.

 

In addition to the regular income tax,corporations, including savings associations such as the Bank, generally aresubject to a minimum tax.  Analternative 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 extent earnings appropriated to asavings association’s bad debt reserves for “qualifying real property loans”and deducted for federal income tax purposes exceed the allowable amount ofsuch reserves computed under the experience method and to the extent of theassociation’s supplemental reserves for losses on loans (“Excess”), such Excessmay not, without adverse tax consequences, be utilized for the payment of cashdividends or other distributions to a shareholder (including distributions onredemption, dissolution or liquidation) or for any other purpose (except toabsorb bad debt losses).  As of June 30,2003, the Bank’s Excess for tax purposes totaled approximately $4.8 million.

 

The Bank and its consolidated subsidiarieshave been audited by the IRS with respect to consolidated federal income taxreturns through 1985. With respect to years examined by the IRS, alldeficiencies have been satisfied.

 

28

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*South Dakota Taxation*.  The Bankis subject to the South Dakota Franchise tax to the extent that suchcorporations are engaged in business in the state of South Dakota. South Dakotadoes not have a corporate income tax. The franchise tax will be imposed at a rate of 6.00% on franchisetaxable income which is computed in the same manner as federal taxable incomewith some minor variations to comply with South Dakota law, other than thecarryover of net operating losses which is not permitted under South Dakotalaw.  A South Dakota return of franchisetax must be filed annually.

 

*MinnesotaTaxation.*  The Bank is subject to the Minnesota CorporateIncome tax to the extent that such corporations are engaged in business in thestate of Minnesota.  The CorporateIncome tax is imposed at a rate of 9.8% on corporate taxable income which is computed in the same manner as federaltaxable income with some minor variations to comply with Minnesota law.  A Minnesota return of Corporate Income taxmust be filed annually.

 

*Delaware Taxation*.  As aDelaware holding company, the Company is exempted from Delaware corporateincome tax but is required to file an annual report with and pay an annual feeto the State of Delaware.  The Companyis also subject to an annual franchise tax imposed by the State of Delaware.

 

**ExecutiveOfficers of the Company**

The following information as to the businessexperience during the past five years is supplied with respect to executiveofficers of the Company and the Bank.

 

*Curtis L. Hage*- Mr. Hage, age 57, 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 the positionof President and Chief Executive Officer since February 1991.  Prior to such time, Mr. Hage served asExecutive Vice President of the Bank since 1986.  Since joining the Bank in 1968, he served in various capacitiesprior to being elected Executive Vice President.  Mr. Hage received his M.B.A. from the University of South Dakotaand attended the Graduate School of Savings Institution Management at theUniversity of Texas.

 

*Jack P. Hearst*– Mr. Hearst, age 51, is Executive Vice President/Chief Operations Officer ofthe Company and the Bank.  He joined theBank in 1999 as Vice President/Credit Cards and was promoted to Senior VicePresident/Subsidiary Operations in October 2000.  Prior to joining the Bank, he was employed by Citicorp-CorporateControl and Risk Assessment as the Audit Director for Citicorp Bankcards, acredit card company.  Mr. Hearstreceived a B.S. from the University of Missouri.

 

*Darrel L. Posegate*– Mr. Posegate, age 45, is Executive Vice President/Chief Financial Officer andTreasurer of the Company and the Bank, a position he has held since January2002.  He was employed as ChiefFinancial Officer for West Des Moines State Bank, Des Moines, IA, a statebanking institution, from 1998 until joining Home Federal.  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 41, is Senior Vice President/Business Banking, a position hehas held since November 1999.  Prior tojoining Home Federal, Mr. Brown served as Vice President/Manager CommercialBanking at Firstar Bank, Sioux City, Iowa, a national banking institution, aposition he held since December 1998. Mr. Brown received his Masters of Business Administration and a B.S. inBusiness Administration from University of South Dakota.

 

*Mary F. Hitzemann*- Ms. Hitzemann, age 50, is Senior Vice President/Human Resources, a positionshe has held since October 1993.  Ms.Hitzemann also serves as Senior Vice President of HF Group.  Ms. Hitzemann joined Home Federal in January1993.  Prior to that time, she wasemployed as Vice President of Human Resources for Rapid City Regional Hospitalfrom May 1989 to May 1992.  Ms.Hitzemann received her B.A. degree from Augustana College.

 

*Sharon A. Manuel*– Ms. Manuel, age 53, is Senior Vice President/Corporate Services, a positionshe has held since November 2001.  Sincejoining the Bank in April 1994, she served as Vice President/RegionalCoordinator in the Retail Banking area as well as being responsible for thetelephone banking department.  She thenassumed the responsibility for managing technology-orientated projects, such asinternet banking, bill payment, debit card and Home Federal’s internetwebsite.  Prior to joining Home Federal,she was employed by Citibank for thirteen years.  She received a two-year business degree from Mankato BusinessCollege.

 

*John E. Roers*- Mr. Roers, age 56, is Senior Vice President/Agricultural Lending, a positionhe has held since joining Home Federal on October 31, 1995.  Prior to that time, he was employed asAgricultural Loan Officer and Department Manager for Western Bank, Sioux Falls(then First Bank) from June 1981 to October 1996 and for Western Bank,Marshall, Minnesota from February 1974 to May 1981.  Mr. Roers received his Bachelor of Science and Masters ofScience from North Dakota State University.

 

*Mark S. Sivertson*- Mr. Sivertson, age 45, is Senior Vice President/Trust Officer, a positionhe has held since July 1996.  He joinedHome Federal in February 1995 as Vice President/Trust Officer.  Prior to joining Home Federal, Mr. Sivertsonwas Vice President and Trust Officer in charge of the Investment Management andTrust Department at Western Bank.  Heholds a law degree from the University of North Dakota and the Certified TrustFinancial Advisor designation from the American Bankers Association.

 

29

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*Gary L. Smith –*Mr.Smith, age 49, is Senior Vice President/Information Systems, a position he hasheld since July 1998.  Mr. Smith joinedHome Federal in 1979 and was promoted to Vice President in 1988.  He received his B.S. from the University ofSouth Dakota.

 

*Natalie A. Solberg –*Ms. Solberg, age 40, is Senior Vice President/Service and Support.  Since joining the Bank in February 1994, shehas been responsible for managing automated telephone banking, deposit operationsand retail support functions.  She waspromoted to Vice President/In-Touch Banking in October 1995, and subsequently,held the position of Vice President/Retail Support.  Prior to joining Home Federal, she was employed by the Bank ofNew York from October 1989 to October 1993. Ms. Solberg received her B.S. from Northern State University.

 

*Michael H. Zimmerman*- Mr. Zimmerman, age 50, is Senior Vice President/Senior Retail Banking.  He joined the Bank in August 1996 as SeniorVice President/Senior Retail Lending Officer. Prior to that time, he was employed as Vice President/Mortgage LoanManager for First Trust and Savings Bank, Cedar Rapids, Iowa from October 1995to August 1996 and as Vice President/Eastern Regional Manager for HomelandSavings Bank FSB, Waterloo, Iowa from May 1995 to October 1995; and as VicePresident/ Manager Real Estate Lending for Homeland Bank, N.A., Waterloo, Iowafrom August 1992 to April 1995.  Mr.Zimmerman received his B.A. from Dana College, Blair, Nebraska.

 

*Cristie M. Lawson–*Ms. Lawson, age 34, is Vice President/Controller for the Bank.  Ms. Lawson joined the Bank in March 1995 asStaff Accountant.  She has held variouspositions of increasing responsibility within the Accounting Department and waspromoted to her current position in July 2000. Ms. Lawson received her B.A. from Augustana College.

 

*Raymond C. Wilson*– Mr. Wilson, age 45, is Vice President/Senior Controller for the Bank.  Mr. Wilson joined the Bank in September2003.  Since 1999, Mr. Wilson was CorporateFinance Director for Interactive Information Service, Inc., a softwaredevelopment company, located in Cleveland, Ohio.  Prior to that time, he held senior financial and accountingmanagement positions with two community banks. Mr. Wilson received his BBA and MAFIS from Cleveland State University,Cleveland, Ohio.

 

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

 

The Company and its direct and indirectsubsidiaries conduct their business at the main office located at 225 SouthMain Avenue, Sioux Falls, South Dakota, 57104. Currently, the Bank also conducts business from 33 other offices locatedin its primary market area.  Of such 34total business offices, the Company owns 20 and leases 14 others.

 

The total net book value of the Company’spremises and equipment (including land, building, leasehold improvements andfurniture, fixtures and equipment) at June 30, 2003 was $13.1 million.  In April 2003, the Company reclassified oneof its office buildings as real estate held for sale and will be proceeding tosell the facility.  See Note 1 of “Notesto Consolidated Financial Statements.”

 

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

 

The Company, Home Federal and itssubsidiaries are involved as plaintiff or defendant in various legal actionsarising in the normal course of their businesses.  While the ultimate outcome of these proceedings cannot bepredicted with certainty, it is the opinion of management, after consultationwith counsel representing Home Federal and the Company in the proceedings, thatthe resolution of these proceedings should not have a material effect on theCompany’s consolidated financial position or results of operations.  The Company and its direct and indirectsubsidiaries are not aware of any legal actions or other proceedings contemplatedby governmental authorities outside of the normal course of business.

 

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

 

No matter was submitted to a vote of securityholders, through the solicitation of proxies or otherwise, during the quarterended June 30, 2003.

 

30

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**PART II**

 

**Item 5.****  Market forRegistrant’s Common Equity and Related Stockholder Matters**

 

**StockListing**

 

The Company’s Common Stock is traded underthe symbol “HFFC” on the NASDAQ National Market System.

 

The following table sets forth the range ofhigh and low sale prices for the Company’s Common Stock for each of the fiscalquarters of the two years ended June 30, 2003 and 2002.  Quotations for such periods are as reported bythe NASDAQ National Market System.

 

| **FISCAL 2003** |   | **HIGH** |   | **LOW** |   |
|-----------------|--------|----------|--------|---------|--------|
| 1st Quarter     |   | $        | 12.99  |    | $      | 10.75 |   |
| 2nd Quarter     |   | $        | 15.00  |    | $      | 10.50 |   |
| 3rd Quarter     |   | $        | 17.01  |    | $      | 13.81 |   |
| 4th Quarter     |   | $        | 19.75  |    | $      | 16.00 |   |

 

| **FISCAL 2002** |   | **HIGH** |   | **LOW** | ** ** |
|-----------------|--------|----------|--------|---------|------------|
| 1st Quarter     |   | $        | 14.45  |    | $          | 10.89 |   |
| 2nd Quarter     |   | $        | 12.34  |    | $          | 11.00 |   |
| 3rd Quarter     |   | $        | 12.45  |    | $          | 10.86 |   |
| 4th Quarter     |   | $        | 13.45  |    | $          | 12.00 |   |

 

As of September 15, 2003, the Company had 537holders of record of its Common Stock.

 

The transfer agent for the Company’s CommonStock is Mellon Investor Services, PO Box 3315, South Hackensack, New Jersey,07606-1915.

 

**Dividends**

 

On a quarterly basis, the Company paid cashdividends of $0.115 per share throughout fiscal 2003 as compared to $0.11 pershare throughout fiscal 2002.  The Boardof Directors intends to continue the payment of quarterly cash dividends,dependent on the results of operations and financial condition of the Company,tax considerations, industry standards, economic conditions, general businesspractices and other factors the Board of Directors deems relevant.  On July 23, 2003, the Board of Directorsapproved an increase in cash dividends to $0.1175 per share and the Companypaid the respective cash dividends on August 20, 2003 to shareholders of recordon August 6, 2003.  The Company’sability to pay dividends is dependent on the dividend payments it receives fromits subsidiary, the Bank, which are subject to OTS regulations.  In addition, the Company's ability to paydividends is subject to the terms of its line of credit with the FirstTennessee Bank, NA.  See Item 7,"Management's Discussion and Analysis of Financial Condition of Results ofOperations – Liquidity and Capital Resources."

 

**Salesof Unregistered Stock**

The Company had no sales of unregisteredstock during the fiscal year ended June 30, 2003.

 

31

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**Item 6.****  SelectedFinancial Data**

The following table sets forth selectedfinancial data with respect to the Company for the periods indicated.  This information should be read inconjunction with the Financial Statements and related notes appearing elsewherein this Form 10-K and “Management’s Discussion and Analysis of FinancialCondition 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,**            |    |
|-------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------|---------|
|                                                                                                                          |   | **2003**                    |    | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                                                                          |   | **(Dollars  in Thousands)** |    |
| **Selected Statement  of Financial Condition Data:**                                                                          |   |                        |    |   |   |   |   |   |   |   |   |
| Total assets                                                                                                                  |   | $                           | 800,483 |   | $ | 722,917 |   | $ | 784,002 |   | $ | 724,997 |   | $ | 658,622 |   |
| Securities available for sale                                                                                                 |   | 88,527                      |    | 82,804 |   | 87,387 |   | 107,316 |   | 97,343 |   |
| FHLB stock                                                                                                                    |   | 7,025                       |    | 6,332 |   | 6,332 |   | 6,130 |   | 5,263 |   |
| Loans and leases receivable, net                                                                                              |   | 595,417                     |    | 559,814 |   | 563,836 |   | 542,494 |   | 492,302 |   |
| Loans held for sale                                                                                                           |   | 15,984                      |    | 6,559 |   | 7,270 |   | 8,257 |   | 11,755 |   |
| Deposits                                                                                                                      |   | 621,381                     |    | 562,596 |   | 601,207 |   | 545,497 |   | 510,730 |   |
| Advances from FHLB and other borrowings                                                                                       |   | 89,819                      |    | 84,308 |   | 108,376 |   | 113,020 |   | 81,613 |   |
| Company obligated mandatorily redeemable  preferred securities of subsidiary trusts that solely hold subordinated  debentures |   | 20,000                      |    | 10,000 |   | — |   | — |   | — |   |
| Stockholders’ equity                                                                                                     |   | 49,358                      |    | 48,536 |   | 52,525 |   | 46,943 |   | 48,558 |   |
|                                                                                                                               |        |                             |         |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
|                                                                         |   | **Years Ended June 30,**                          | ** ** |
|------------------------------------------------------------------------------|--------|---------------------------------------------------|------------|
|                                                                         |   | **2003**                                          |       | **2002** |   | **2001** |   | **2000** |   | **1999** | ** ** |
|                                                                         |   | **(Dollars in Thousands, Except Per Share Data)** | ** ** |
| **Selected Statement  of Income Data:**                                      |   |                                              |       |   |   |   |   |   |   |   |   |
| Interest and dividend income                                                 |   | $                                                 | 43,560     |   | $ | 48,017 |   | $ | 58,162 |   | $ | 51,653 |   | $ | 44,206 |   |
| Interest expense                                                             |   | 17,997                                            |       | 23,573 |   | 35,051 |   | 29,141 |   | 24,054 |   |
| Net interest income                                                          |   | 25,563                                            |       | 24,444 |   | 23,111 |   | 22,512 |   | 20,152 |   |
| Provision for losses on loans and leases                                     |   | 3,173                                             |       | 1,905 |   | 1,482 |   | 1,682 |   | 1,300 |   |
| Net interest income after provision for  losses on loans and leases          |   | 22,390                                            |       | 22,539 |   | 21,629 |   | 20,830 |   | 18,852 |   |
| Loan servicing income                                                        |   | 1,610                                             |       | 1,858 |   | 1,567 |   | 1,381 |   | 1,263 |   |
| Gain on sale of loans, net                                                   |   | 1,664                                             |       | 1,518 |   | 842 |   | 635 |   | 673 |   |
| Loan fees and service charges                                                |   | 2,290                                             |       | 1,266 |   | 982 |   | 1,131 |   | 1,231 |   |
| Gain on sale of securities, net                                              |   | 352                                               |       | 135 |   | — |   | 185 |   | 1 |   |
| Other noninterest income                                                     |   | 6,895                                             |       | 6,369 |   | 6,032 |   | 4,959 |   | 3,835 |   |
| Noninterest expense                                                          |   | (27,671                                           | )          | (25,958 | ) | (23,528 | ) | (20,515 | ) | (18,340 | ) |
| Income from continuing operations before  income taxes                       |   | 7,530                                             |       | 7,727 |   | 7,524 |   | 8,606 |   | 7,515 |   |
| Income tax expense                                                           |   | 2,584                                             |       | 2,856 |   | 2,929 |   | 3,077 |   | 2,808 |   |
| Income from continuing operations                                            |   | 4,946                                             |       | 4,871 |   | 4,595 |   | 5,529 |   | 4,707 |   |
| Discontinued Operations:                                                     |   |                                              |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations of  discontinued segment (net of income taxes) |   | 253                                               |       | (246 | ) | 12 |   | (262 | ) | (3,656 | ) |
| (Loss) on discontinued segment (net of  income taxes)                        |   | (224                                              | )          | (1,440 | ) | — |   | — |   | — |   |
| Income (loss) from discontinued operations                                   |   | 29                                                |       | (1,686 | ) | 12 |   | (262 | ) | (3,656 | ) |
|                                                                         |   |                                              |       |   |   |   |   |   |   |   |   |
| Net income                                                                   |   | $                                                 | 4,975      |   | $ | 3,185 |   | $ | 4,607 |   | $ | 5,267 |   | $ | 1,051 |   |

 

32

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|                                                                                                       |   | **Years  Ended June 30,**   |   |
|------------------------------------------------------------------------------------------------------------|--------|-----------------------------|--------|
|                                                                                                       |   | **2003**                    |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                                                       |   | **(Dollars  in Thousands)** |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Basic earnings (loss) per share:                                                                           |   |                        |   |   |   |   |   |   |   |   |   |
| Income from continuing operations                                                                          |   | $                           | 1.50   |   | $ | 1.39 |   | $ | 1.25 |   | $ | 1.43 |   | $ | 1.12 |   |
| Income (loss) from discontinued operations                                                                 |   | 0.01                        |   | (0.48 | ) | — |   | (0.07 | ) | (0.87 | ) |
| Net income                                                                                                 |   | 1.51                        |   | 0.91 |   | 1.25 |   | 1.36 |   | 0.25 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Diluted earnings (loss) per share:                                                                         |   |                        |   |   |   |   |   |   |   |   |   |
| Income from continuing operations                                                                          |   | 1.47                        |   | 1.36 |   | 1.23 |   | 1.41 |   | 1.09 |   |
| Income (loss) from discontinued operations                                                                 |   | 0.01                        |   | (0.47 | ) | — |   | (0.07 | ) | (0.85 | ) |
| Net income                                                                                                 |   | 1.48                        |   | 0.89 |   | 1.23 |   | 1.34 |   | 0.24 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Dividends declared per share                                                                               |   | 0.46                        |   | 0.44 |   | 0.42 |   | 0.40 |   | 0.37 |   |
| Dividends payout ratio from continuing  operations (1)                                                     |   | 30.81                       | %      | 31.92 | % | 33.62 | % | 27.93 | % | 32.10 | % |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| **Other data from  continuing operations: (2)**                                                            |   |                        |   |   |   |   |   |   |   |   |   |
| Interest rate spread (average during  period)                                                              |   | 3.32                        | %      | 3.22 | % | 2.78 | % | 3.13 | % | 3.23 | % |
| Net interest margin (3)                                                                                    |   | 3.62                        |   | 3.63 |   | 3.32 |   | 3.57 |   | 3.72 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Average interest-earning assets to average  interest-bearing liabilities                                   |   | 1.12                        |   | 1.12 |   | 1.11 |   | 1.10 |   | 1.11 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Equity to total assets (end of period)                                                                     |   | 6.17                        |   | 6.71 |   | 6.70 |   | 6.47 |   | 7.37 |   |
| Equity-to-assets ratio (ratio of average  equity to average total assets)                                  |   | 6.52                        |   | 7.17 |   | 6.77 |   | 6.85 |   | 8.96 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Nonperforming assets to total assets (end  of period)                                                      |   | 0.77                        |   | 1.59 |   | 0.76 |   | 0.33 |   | 0.23 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses to  nonperforming loans and leases (end of period) (4)                 |   | 65.89                       |   | 40.02 |   | 97.73 |   | 264.63 |   | 432.34 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses to  total loans and leases (end of period)                             |   | 0.62                        |   | 0.78 |   | 0.96 |   | 1.00 |   | 0.91 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Nonperforming loans and leases to total  loans and leases (end of period) (4)                              |   | 0.95                        |   | 1.96 |   | 0.99 |   | 0.38 |   | 0.21 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Other noninterest expense to average total  assets                                                         |   | 3.63                        |   | 3.58 |   | 3.17 |   | 3.01 |   | 3.11 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Net interest income after provision for  losses on loans and leases to noninterest expense (end of period) |   | 80.92                       |   | 86.83 |   | 91.93 |   | 101.54 |   | 102.79 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Return on assets  (ratio of income from continuing operations to average total  assets)               |   | 0.65                        |   | 0.67 |   | 0.62 |   | 0.81 |   | 0.80 |   |
| Return on assets  (ratio of net income to average total assets)                                       |   | 0.65                        |   | 0.44 |   | 0.62 |   | 0.77 |   | 0.18 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Return on equity (ratio of income from  continuing operations to average equity)                           |   | 9.96                        |   | 9.37 |   | 9.14 |   | 11.83 |   | 8.91 |   |
| Return on equity (ratio of net income to  average equity)                                                  |   | 10.02                       |   | 6.13 |   | 9.16 |   | 11.27 |   | 1.99 |   |
|                                                                                                       |   |                        |   |   |   |   |   |   |   |   |   |
| Efficiency Ratio (5)                                                                                       |   | 72.11                       |   | 72.94 |   | 72.32 |   | 66.60 |   | 67.54 |   |
| Number of full-service offices                                                                             |   | 34                          |   | 33 |   | 31 |   | 27 |   | 25 |   |
|                                                                                                            |        |                             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)     Cash dividends paid divided by income fromcontinuing operations.

(2)     All periods presented have been restated toeliminate effect of discontinued operations.

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

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

(5)     Total noninterest expense divided by the sum ofnet interest income plus total noninterest income.

 

33

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**Item 7.****      Management’s Discussion and Analysis ofFinancial Condition and Results of Operations**

 

This section should be read in conjunction with Item 8, “FinancialStatements and Supplementary Data”, as well as Item 7A, “Quantitative andQualitative Disclosures About Market Risk” and Part I, Item 1, “Business”.

 

**General**

 

The Company is a financial services provider and, as such, has inherentrisks that must be managed in order to achieve net income.  Primary risks that affect net income includecredit risk, liquidity risk, operational risk, regulatory compliance risk andreputation risk.  The Company’s netincome is derived by management of the net interest margin, the ability tocollect fees from services provided, by controlling the costs of deliveringservices and the management of loan and lease losses.  The primary source of revenues comes from the net interestmargin, which represents the difference between income on interest-earningassets (i.e. loans and investment securities) and expense on interest-bearingliabilities (i.e. deposits and borrowed funding).  The net interest margin is affected by regulatory, economic andcompetitive factors that influence interest rates, loan demand and depositflows.  Fees earned include charges fordeposit services, trust services and loan services.  Personnel costs are the primary expenses required to deliver theservices to customers.  Other costsinclude occupancy and equipment and general and administrative expenses.

 

During the fourth quarter of fiscal 2002, management committed to aplan to sell the subprime credit card operations which were previously reportedin the credit card segment of the Company. At June 30, 2002, the Company estimated the net realizable value basedon estimates from a third party and reclassified the net realizable value of$1.1 million at that time from loans receivable to loans held for sale.  The Bank ceased processing subprime credit cardapplications in March 1999 and managed the portfolio from a balance of $18.1million at June 30, 1999, to the sale of the receivables as of January 31,2003.  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 on January 31, 2003, andthe Company dissolved the operations of HF Card during the third quarter offiscal 2003.  See Note 2 of “Notes toConsolidated Financial Statements” for further discussion on discontinuedoperations.

 

**Financial ConditionData**

 

At June 30, 2003, the Company had total assets of $800.5 million, anincrease of $77.6 million from the level at June 30, 2002.  The increase in assets was due primarily toincreases in loans and leases receivable of $35.6 million, cash and cashequivalents of $16.7 million, loans held for sale of $9.4 million, investmentsecurities available for sale of $5.7 million, cash value of life insurance of$5.4 million and other assets of $4.1 million. The increase in liabilities of $76.7 million was due to increases indeposits of $58.8 million, the liability for company obligated mandatorilyredeemable preferred securities of $10.0 million and advances from the FHLB andother borrowings of $5.5 million from the levels at June 30, 2002.  In addition, stockholders’ equity increasedto $49.4 million at June 30, 2003 from $48.5 million at June 30, 2002 primarilydue to net income of $5.0 million offset by the cost of treasury stock acquiredof $2.4 million and cash dividends paid of $1.5 million.

 

The increase in loans and leases receivable of $35.6 million was dueprimarily to an increase in purchases and originations over sales, amortizationand repayments of principal.  Commercialbusiness, commercial real estate and agricultural loan balances increased $41.1million over the levels at June 30, 2002. Residential mortgage production increased 45.5% in dollar volume for theyear ended June 30, 2003 as compared to the prior year.

 

The increase in cash and cash equivalents of $16.7 million wasprimarily due to increased liquidity. See “Liquidity and Capital Resources.”

 

The $9.4 million increase in loans held for sale was primarily due toan increase in the pipeline of one- to four-family loans originated for saleinto the secondary market as compared to the prior year.  This increase was also due in part to theincrease in residential mortgage production of 45.5% for the year ended June30, 2003 as compared to the prior year.

 

The increase in investment securities available for sale of $5.7million was primarily the result of purchases of $61.6 million exceeding sales,maturities, calls and repayments of $54.4 million.  The purchases consisted of $40.2 million in variable-ratemortgage-backed securities.  Variable-ratemortgage-backed securities comprise 60.5% of the Company’s securities availablefor sale portfolio.  Included insecurities purchases was $4.0 million of trust preferred securities for a totalof $9.0 million investment in trust preferred securities at June 30, 2003.  This investment is limited by OTS regulationto 15.00% of equity of the Bank. Management is utilizing the purchase of trust preferred securities tomitigate the Company’s interest rate risk from the total issuance of $20.0million in company obligated mandatorily redeemable preferred securitiesthrough June 30, 2003.

 

The increase in cash value of life insurance of $5.4 million wasprimarily due to the Bank’s purchase of additional bank owned life insurance(“BOLI”) for purposes of insuring against the unforeseen death of selectemployees and to increase noninterest income due to increase in cash surrendervalue.

 

34

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The increase in other assets of $4.1 million was primarily due to $3.5million of retained interest as the result of securitization of consumer  automobile loans during the third quarter offiscal 2003.  See Note 3 of  “Notes to Consolidated Financial Statements”for further discussion.

 

The $58.8 million increase in deposits was primarily due to increasesin out-of-market certificates of deposit of $31.2 million, money marketaccounts of $20.3 million, demand accounts of $17.7 million and savingsaccounts of $4.1 million offset by a decrease in in-market certificates of depositsof  $14.5 million as compared to theprior year.

 

The liability for company obligated mandatorily redeemable preferredsecurities increased $10.0 million due to the Company issuing additional trustpreferred securities through Trust II and Trust III.

 

Advances from the FHLB and other borrowings increased $5.5 million forthe year ended June 30, 2003 primarily due to the Company obtaining two noteagreements, totaling $4.5 million, from First Tennessee Bank, NA during June2003.  See Note 10 of  “Notes to Consolidated Financial Statements”for further discussion and Exhibits 10.19 to 10.21.

 

35

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**Analysis of NetInterest Income**

 

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

 

*Average Balances, Interest Rates and Yields.*  The following table presents for the periodsindicated, the total dollar amount of interest income from averageinterest-earning assets and the resulting yields, as well as the interestexpense on average interest-bearing liabilities, expressed both in dollars andrates, and the net interest margin.  Thetable does not reflect any effect of income taxes.  All average balances are monthly average balances and include thebalances of nonaccruing loans.  Theyields and costs for the years ended June 30, 2003, 2002 and 2001 include feeswhich are considered adjustments to yield. Balances related to discontinued credit card loan operations have beenreclassified to non-interest earning assets for all periods presented.

 
|                                                                                                                         |   | **Years Ended June 30,**          |    |
|------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------|---------|
|                                                                                                                         |   | **2003**                          |    | **2002** |   | **2001** |   |
|                                                                                                                         |   | **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)                                                                                              |   | $                                 | 594,873 |   | $ | 39,538 |   | 6.65 | % | $ | 546,055 |   | $ | 42,290 |   | 7.74 | % | $ | 560,208 |   | $ | 50,016 |   | 8.93 | % |
| Investment securities (2)                                                                                                    |   | 103,902                           |    | 3,801 |   | 3.66 | % | 120,982 |   | 5,504 |   | 4.55 | % | 128,918 |   | 7,795 |   | 6.05 | % |
| FHLB stock                                                                                                                   |   | 6,854                             |    | 221 |   | 3.22 | % | 6,332 |   | 223 |   | 3.52 | % | 6,279 |   | 351 |   | 5.59 | % |
| Total interest-earning assets                                                                                                |   | 705,629                           |    | $ | 43,560 |   | 6.17 | % | 673,369 |   | $ | 48,017 |   | 7.13 | % | 695,405 |   | $ | 58,162 |   | 8.36 | % |
| Noninterest-earning assets                                                                                                   |   | 55,921                            |    |   |   |   |   | 51,132 |   |   |   |   |   | 46,822 |   |   |   |   |   |
| Total assets                                                                                                                 |   | $                                 | 761,550 |   |   |   |   |   | $ | 724,501 |   |   |   |   |   | $ | 742,227 |   |   |   |   |   |
|                                                                                                                         |   |                              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                                                                                |   |                              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                                                                    |   |                              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Checking and money market                                                                                                    |   | $                                 | 195,394 |   | $ | 2,647 |   | 1.35 | % | $ | 189,705 |   | $ | 3,875 |   | 2.04 | % | $ | 158,639 |   | $ | 7,369 |   | 4.65 | % |
| Savings                                                                                                                      |   | 39,998                            |    | 298 |   | 0.75 | % | 39,169 |   | 564 |   | 1.44 | % | 40,212 |   | 1,469 |   | 3.65 | % |
| Certificates of deposit                                                                                                      |   | 278,397                           |    | 9,566 |   | 3.44 | % | 279,323 |   | 13,994 |   | 5.01 | % | 316,994 |   | 19,582 |   | 6.18 | % |
| Total interest-bearing deposits                                                                                              |   | 513,789                           |    | 12,511 |   | 2.44 | % | 508,197 |   | 18,433 |   | 3.63 | % | 515,845 |   | 28,420 |   | 5.51 | % |
| FHLB advances and other  borrowings                                                                                          |   | 100,200                           |    | 4,565 |   | 4.56 | % | 87,512 |   | 4,766 |   | 5.45 | % | 112,421 |   | 6,631 |   | 5.90 | % |
| Company obligated mandatorily  redeemable preferred securities of subsidiary trusts that soley hold  subordinated debentures |   | 17,844                            |    | 921 |   | 5.16 | % | 6,744 |   | 374 |   | 5.55 | % | — |   | — |   | — |   |
| Total interest-bearing  liabilities                                                                                          |   | 631,833                           |    | $ | 17,997 |   | 2.85 | % | 602,453 |   | $ | 23,573 |   | 3.91 | % | 628,266 |   | $ | 35,051 |   | 5.58 | % |
| Noninterest-bearing deposits                                                                                                 |   | 60,201                            |    |   |   |   |   | 48,757 |   |   |   |   |   | 41,365 |   |   |   |   |   |
| Other liabilities                                                                                                            |   | 19,869                            |    |   |   |   |   | 21,323 |   |   |   |   |   | 22,319 |   |   |   |   |   |
| Total liabilities                                                                                                            |   | 711,903                           |    |   |   |   |   | 672,533 |   |   |   |   |   | 691,950 |   |   |   |   |   |
| Equity                                                                                                                       |   | 49,647                            |    |   |   |   |   | 51,968 |   |   |   |   |   | 50,277 |   |   |   |   |   |
| Total liabilities and equity                                                                                                 |   | $                                 | 761,550 |   |   |   |   |   | $ | 724,501 |   |   |   |   |   | $ | 742,227 |   |   |   |   |   |
|                                                                                                                         |   |                              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest income; interest  rate spread                                                                                   |   |                              |    | $ | 25,563 |   | 3.32 | % |   |   | $ | 24,444 |   | 3.22 | % |   |   | $ | 23,111 |   | 2.78 | % |
|                                                                                                                         |   |                              |    |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net interest margin (3)                                                                                                      |   |                              |    |   |   | 3.62 | % |   |   |   |   | 3.63 | % |   |   |   |   | 3.32 | % |

 

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(1) Includes interest on accruing loans andleases past due 90 days or more.

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

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

 

36

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**Rate/Volume Analysisof Net Interest Income**

 

The following schedule presents the dollar amount of changes ininterest income and interest expense for major components of interest-earningassets and interest-bearing liabilities. It distinguishes between the increases and decreases due to fluctuatingoutstanding balances that are due to the levels and volatility of interestrates.  For each category of interest-earningassets and 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,**              |   |
|-------------------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------|--------|----------------------------------------|--------|
|                                                                                                                          |   | **2003 vs.  2002**                       |   | **2002 vs.  2001**                     |   |
|                                                                                                                          |   | **(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)                                                                                               |   | $                                        | 3,781  |                                   | $      | (6,533 | ) | $ | (2,752 | ) | $ | (1,264 | ) | $ | (6,462 | ) | $ | (7,726 | ) |
| Investment securities                                                                                                         |   | (777                                     | )      | (926                                   | )      | (1,703 | ) | (499 | ) | (1,792 | ) | (2,291 | ) |
| FHLB stock                                                                                                                    |   | 18                                       |   | (20                                    | )      | (2 | ) | 3 |   | (131 | ) | (128 | ) |
|                                                                                                                          |   |                                     |   |                                   |   |   |   |   |   |   |   |   |   |
| Total interest-earning assets                                                                                                 |   | $                                        | 3,022  |                                   | $      | (7,479 | ) | $ | (4,457 | ) | $ | (1,760 | ) | $ | (8,385 | ) | $ | (10,145 | ) |
|                                                                                                                          |   |                                     |   |                                   |   |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:                                                                                                 |   |                                     |   |                                   |   |   |   |   |   |   |   |   |   |
| Deposits:                                                                                                                     |   |                                     |   |                                   |   |   |   |   |   |   |   |   |   |
| Checking and money market                                                                                                     |   | $                                        | 116    |                                   | $      | (1,344 | ) | $ | (1,228 | ) | $ | 1,451 |   | $ | (4,945 | ) | $ | (3,494 | ) |
| Savings                                                                                                                       |   | 12                                       |   | (278                                   | )      | (266 | ) | (38 | ) | (867 | ) | (905 | ) |
| Certificates of deposit                                                                                                       |   | (46                                      | )      | (4,382                                 | )      | (4,428 | ) | (2,327 | ) | (3,261 | ) | (5,588 | ) |
| Total deposits                                                                                                                |   | 82                                       |   | (6,004                                 | )      | (5,922 | ) | (914 | ) | (9,073 | ) | (9,987 | ) |
| FHLB advances and other borrowings                                                                                            |   | 691                                      |   | (892                                   | )      | (201 | ) | (1,469 | ) | (396 | ) | (1,865 | ) |
| Company obligated mandatorily redeemable  preferred securities of subsidiary trusts that solely hold subordinated  debentures |   | 616                                      |   | (69                                    | )      | 547 |   | 374 |   | — |   | 374 |   |
|                                                                                                                          |   |                                     |   |                                   |   |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities                                                                                            |   | $                                        | 1,389  |                                   | $      | (6,965 | ) | $ | (5,576 | ) | $ | (2,009 | ) | $ | (9,469 | ) | $ | (11,478 | ) |
|                                                                                                                          |   |                                     |   |                                   |   |   |   |   |   |   |   |   |   |
| Net interest income increase                                                                                                  |   |                                     |   |                                   |   | $ | 1,119 |   |   |   |   |   | $ | 1,333 |   |

 

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(1) Includes interest on accruing loans andleases past due 90 days or more.

 

37

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# **Application of CriticalAccounting 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 setaside reserves or maintain an allowance against probable loan and lease lossesin 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 allowance is compiled by utilizing the Company’s loan risk ratingsystem which is structured 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 servicingasset for contractually separated servicing from the underlying mortgageloans.   The asset is initially recordedat fair value and represents an intangible asset backed by an income streamfrom the serviced assets.  The asset isamortized in proportion to and over the period of estimated net servicingincome.

 

At each balance sheet date, the MSRs need to be analyzed for impairmentwhich occurs when the fair value of the MSRs is lower than the amortized bookvalue. The Company’s MSRs are primarily servicing rights acquired on SouthDakota Housing Development Authority first time home buyers program.  Due to the lack of quoted markets for theCompany’s portfolio, the Company estimates the fair value of the MSRs using presentvalue of future cash flow analysis.  Ifthe analysis produces a fair value that is greater than or equal to theamortized book value of the MSRs, no impairment is recognized.  If the fair value is less than the bookvalue, an expense for the difference is charged to earnings by initiating a MSRvaluation account.  If the Companydetermines 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 severalquarters, 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.

 

Retained Interest from Securitization – The Company recorded an assetas a result of the automobile securitization. See Note 3 of “Notes to Consolidated Financial Statements.”  This asset is recorded based on presentvalue concepts of future expected cash flows. The assumptions used to calculate the initial retained interest valueand subsequent assumptions are based the best information available.  The value of the retained interest maychange significantly if actual cash flows differ from expected cash flows.

 

**Asset Quality**

 

When a borrower fails to make arequired payment on real estate secured loans within 10 to 15 days after thepayment is due, the Bank generally institutes collection procedures by issuinga late notice.  The customer iscontacted again when the payment is 30 days past due.  In the case of consumer loans, the borrower is sent a notice whena loan is 10 days past due and is contacted by telephone when a loan is 30 dayspast due.  In most cases, delinquenciesare cured promptly; however, if a loan has been delinquent for more than 30days, the Bank attempts additional written as well as verbal contacts and, ifnecessary, personal contact with the borrower in order to determine the reasonfor the delinquency and to effect a cure, and, where appropriate, reviews thecondition of 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 issatisfied the credit problem is correctable.

 

38

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Loans are generally classified as nonaccrual when there are reasonabledoubts as to the collectibility of principal and/or interest and/or whenpayment becomes 90 days past due, except loans which are well secured and inthe process of collection.  Interestcollections on nonaccrual loans, for which the ultimate collectibility ofprincipal is uncertain, are applied as principal reductions.

 

Nonperforming assets (nonaccrual loans and leases, accruing loans andleases delinquent more than 90 days and foreclosed assets) decreased to $6.2million at June 30, 2003 from $11.5 million at June 30, 2002, a decrease of$5.4 million, or 46.5%.  In addition,the ratio of nonperforming assets to total assets, which is one indicator ofcredit risk exposure, decreased to 0.77% at June 30, 2003 as compared to 1.59%at June 30, 2002.  The decrease in theratio of nonperforming assets to total assets at June 30, 2003 compared to theprior year was due to the decrease in nonperforming assets of $5.4 million andan increase in total assets of $77.6 million.

 

Nonaccruing loans and leases decreased 57.4%, or $5.9 million to $4.4million at June 30, 2003 compared to $10.2 million at June 30, 2002.  Included in nonaccruing loans and leases atJune 30, 2003 were four loans totaling $103,000 secured by one- to four-familyreal estate, four loans in the amount of $310,000 secured by commercial realestate, three mobile home loans totaling $34,000, 13 commercial business loanstotaling $472,000, eight agricultural loans totaling $2.5 million, sixequipment finance leases totaling $30,000 and 43 consumer loans totaling$875,000.  One loan, secured bycommercial real estate, in the amount of $2.4 million included in nonaccrualloan balances at June 30, 2002 was paid in full during the first quarter offiscal 2003.  During the first quarterof fiscal 2003, the Bank modified a $2.4 million agricultural participationloan as a troubled debt restructuring with specific reserve allowance andplaced the loan on nonaccrual.  The Banktook an additional fourth quarter fiscal 2003 charge to provision in the amountof $893,000 and charged off $1.4 million upon significant deterioration of theborrower’s credit from levels previously estimated.  This participation loan was included in nonaccruing loans andleases at June 30, 2002.  Despite theparticipation loan charge-off, overall asset quality has improved from theprior year.  See Note 6 of “Notes toConsolidated Financial Statements” for information concerning interest incomerecognized on impaired loans.

 

The Company’s nonperforming loans and leases, which representnonaccrual and past due 90 days and still accruing, have decreased $5.3million, or 47.7%, from the levels at June 30, 2002.  The risk rating system in place is designed to identify andmanage the nonperforming loans and leases. Commercial and agricultural loans and equipment finance leases will havespecific reserve allocations based on collateral values or based on the presentvalue of expected cash flows if the loans or leases are deemed impaired.  Loans and leases that are not performing donot necessarily result in a loss.

 

As of June 30, 2003, the Company had $335,000 of foreclosedassets.  The balance of foreclosedassets at June 30, 2003 consisted of $77,000 in consumer collateral and$258,000 in single-family residences. The Company did not have any foreclosed assets secured by mobile homesat June 30, 2003.

 

At June 30, 2003, the Company hadcriticized $4.3 million of its assets as special mention and classified $12.9million of its assets that management has determined need to be closelymonitored because of possible credit problems of the borrowers or the cashflows of the secured properties.  AtJune 30, 2003, the Company had $50.0 million in multi-family, commercial realestate and agricultural participation loans purchased, of which $3.3 million or6.5%, were included in the Company’s $12.9 million of classified assets.  These loans and leases were considered indetermining the adequacy of the allowance for loan and lease losses.  The allowance for loan and lease losses isestablished based on management’s evaluation of the risks probable in the loanand lease portfolio and changes in the nature and volume of loan and leaseactivity.  Such evaluation, whichincludes a review of all loans and leases for which full collectability may notbe reasonably assured, considers the estimated fair market value of theunderlying collateral, present value of expected principal and interestpayments, economic conditions, historical loss experience and other factorsthat warrant recognition in providing for an adequate loan and lease lossallowance.

 

The Company implemented a formal risk-rating system for classifyingleases in the first half of fiscal 2003.

 

Although the Company’s management believes that the June 30, 2003recorded allowance for loan and lease losses was adequate to provide forprobable losses on the related loans and leases, there can be no assurance thatthe allowance existing at June 30, 2003 will be adequate in the future.

 

In accordance with the Company’s internal classification of assetspolicy, management evaluates the loan and lease portfolio on a monthly basis toidentify loss potential and determines the adequacy of the allowance for loanand lease losses quarterly.  Loans areplaced on nonaccrual status when the collection of principal and/or interestbecome doubtful.  Foreclosed assetsinclude assets 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.

 

39

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|                                                                  |   | **At June 30,**            |   |
|-----------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                  |   | **2003**                   |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                  |   | **(Dollars in Thousands)** |   |
| Nonaccruing  loans and leases:                                        |   |                       |   |   |   |   |   |   |   |   |   |
| One- to  four-family                                                  |   | $                          | 103    |   | $ | 886 |   | $ | 723 |   | $ | 551 |   | $ | 209 |   |
| Commercial real  estate                                               |   | 310                        |   | 3,678 |   | 385 |   | 165 |   | 46 |   |
| Multi-family                                                          |   | —                     |   | 290 |   | — |   | — |   | — |   |
| Commercial  business                                                  |   | 472                        |   | 1,872 |   | 3,223 |   | 971 |   | 111 |   |
| Equipment  finance leases                                             |   | 30                         |   | — |   | — |   | — |   | — |   |
| Consumer(1)                                                           |   | 875                        |   | 690 |   | 518 |   | 317 |   | 359 |   |
| Agricultural                                                          |   | 2,541                      |   | 2,801 |   | 373 |   | 31 |   | 307 |   |
| Mobile homes                                                          |   | 34                         |   | 25 |   | 88 |   | 43 |   | 13 |   |
| Total                                                                 |   | 4,365                      |   | 10,242 |   | 5,310 |   | 2,078 |   | 1,045 |   |
|                                                                  |   |                       |   |   |   |   |   |   |   |   |   |
| Accruing loans  and leases delinquent more than 90 days               |   |                       |   |   |   |   |   |   |   |   |   |
| One- to  four-family                                                  |   | 330                        |   | — |   | — |   | — |   | — |   |
| Commercial real  estate                                               |   | 42                         |   | — |   | — |   | — |   | — |   |
| Multi-family                                                          |   | —                     |   | — |   | 304 |   | — |   | — |   |
| Commercial  business                                                  |   | 779                        |   | 512 |   | — |   | — |   | — |   |
| Equipment  finance leases                                             |   | 313                        |   | 229 |   | — |   | — |   | — |   |
| Consumer(1)                                                           |   | 2                          |   | — |   | — |   | — |   | — |   |
| Agricultural                                                          |   | —                     |   | 165 |   | 23 |   | — |   | — |   |
| Total                                                                 |   | 1,466                      |   | 906 |   | 327 |   | — |   | — |   |
|                                                                  |   |                       |   |   |   |   |   |   |   |   |   |
| Foreclosed  assets:                                                   |   |                       |   |   |   |   |   |   |   |   |   |
| One- to  four-family                                                  |   | 258                        |   | 239 |   | 203 |   | 214 |   | 366 |   |
| Consumer(1)                                                           |   | 77                         |   | 132 |   | 105 |   | 67 |   | 49 |   |
| Mobile homes                                                          |   | —                     |   | 3 |   | 2 |   | 15 |   | 49 |   |
| Total(2)                                                              |   | 335                        |   | 374 |   | 310 |   | 296 |   | 464 |   |
|                                                                  |   |                       |   |   |   |   |   |   |   |   |   |
| Total  nonperforming assets(3)                                        |   | $                          | 6,166  |   | $ | 11,522 |   | $ | 5,947 |   | $ | 2,374 |   | $ | 1,509 |   |
| Ratio of  nonperforming assets to total assets(4)                     |   | 0.77                       | %      | 1.59 | % | 0.76 | % | 0.33 | % | 0.23 | % |
| Ratio of  nonperforming loans and leases to total loans and leases(5) |   | 0.95                       | %      | 1.96 | % | 0.99 | % | 0.38 | % | 0.21 | % |

 

----

(1)             Consists of nonperforming consumer loans exclusiveof mobile home loans and credit card loans.

(2)             Total foreclosed assets do not include land orother real estate owned held for sale.

(3)             Nonperforming assets include nonaccruing loans andleases, accruing loans and leases delinquent more than 90 days and foreclosedassets.

(4)             Percentage is calculated based upon total assetsof the Company and its direct and indirect subsidiaries on a consolidatedbasis.

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

 

40

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The following table sets forth information with respect to activity inthe Company’s allowance for loan and lease losses from continuing operationsduring the periods indicated.  Balancesrelated to discontinued credit card loan operations have been eliminated forall periods presented.

 
|                                                                                                    |   | **Years Ended June 30,**   |   |
|---------------------------------------------------------------------------------------------------------|--------|----------------------------|--------|
|                                                                                                    |   | **2003**                   |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                                                                                    |   | **(Dollars in Thousands)** |   |
| Balance at  beginning of period                                                                         |   | $                          | 4,461  |   | $ | 5,509 |   | $ | 5,499 |   | $ | 4,518 |   | $ | 4,021 |   |
|                                                                                                    |   |                       |   |   |   |   |   |   |   |   |   |
| Charge-offs:                                                                                            |   |                       |   |   |   |   |   |   |   |   |   |
| One- to  four-family                                                                                    |   | (9                         | )      | (38 | ) | (21 | ) | (92 | ) | (56 | ) |
| Commercial real  estate                                                                                 |   | —                     |   | (76 | ) | (361 | ) | — |   | (11 | ) |
| Commercial  business                                                                                    |   | (1,234                     | )      | (1,484 | ) | (253 | ) | (54 | ) | (124 | ) |
| Equipment  finance leases                                                                               |   | (124                       | )      | (323 | ) | (131 | ) | — |   | — |   |
| Consumer                                                                                                |   | (1,164                     | )      | (1,323 | ) | (1,106 | ) | (827 | ) | (914 | ) |
| Agricultural                                                                                            |   | (1,429                     | )      | (108 | ) | — |   | (11 | ) | (487 | ) |
| Mobile homes                                                                                            |   | (41                        | )      | (55 | ) | (51 | ) | (56 | ) | (84 | ) |
| Total  charge-offs                                                                                      |   | (4,001                     | )      | (3,407 | ) | (1,923 | ) | (1,040 | ) | (1,676 | ) |
| Recoveries:                                                                                             |   |                       |   |   |   |   |   |   |   |   |   |
| One- to  four-family                                                                                    |   | 3                          |   | 2 |   | — |   | 12 |   | 16 |   |
| Commercial real  estate                                                                                 |   | —                     |   | 2 |   | — |   | 6 |   | 46 |   |
| Commercial  business                                                                                    |   | 5                          |   | 59 |   | — |   | — |   | 72 |   |
| Equipment  finance leases                                                                               |   | 41                         |   | 45 |   | 16 |   | — |   | — |   |
| Consumer                                                                                                |   | 319                        |   | 296 |   | 325 |   | 282 |   | 227 |   |
| Agricultural                                                                                            |   | 100                        |   | 28 |   | — |   | — |   | — |   |
| Mobile homes                                                                                            |   | 5                          |   | 22 |   | 13 |   | 39 |   | 48 |   |
| Total  recoveries                                                                                       |   | 473                        |   | 454 |   | 354 |   | 339 |   | 409 |   |
|                                                                                                    |   |                       |   |   |   |   |   |   |   |   |   |
| Net  (charge-offs)                                                                                      |   | (3,528                     | )      | (2,953 | ) | (1,569 | ) | (701 | ) | (1,267 | ) |
|                                                                                                    |   |                       |   |   |   |   |   |   |   |   |   |
| Additions  charged to operations                                                                        |   | 3,173                      |   | 1,905 |   | 1,482 |   | 1,682 |   | 1,300 |   |
| Allowance  related to assets acquired (sold), net                                                       |   | (264                       | )      | — |   | 97 |   | — |   | 464 |   |
| Balance at end  of period                                                                               |   | 3,842                      |   | $ | 4,461 |   | $ | 5,509 |   | $ | 5,499 |   | $ | 4,518 |   |
|                                                                                                    |   |                       |   |   |   |   |   |   |   |   |   |
| Ratio of net  (charge-offs) during theperiod  to average loans and leases outstanding during the period |   | (0.59                      | )%     | (0.54 | )% | (0.28 | )% | (0.14 | )% | (0.28 | )% |
|                                                                                                    |   |                       |   |   |   |   |   |   |   |   |   |
| Ratio of  allowance for loan and lease losses to total loans and leases at end of  period               |   | 0.62                       | %      | 0.78 | % | 0.96 | % | 1.00 | % | 0.91 | % |
|                                                                                                    |   |                       |   |   |   |   |   |   |   |   |   |
| Ratio of  allowance for loan and lease losses to nonperforming loans and leases at end  of period(1)    |   | 65.89                      | %      | 40.02 | % | 97.73 | % | 264.63 | % | 432.34 | % |
|                                                                                                         |        |                            |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

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

 

41

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The distribution of theCompany’s allowance for loan and lease losses and impaired loss summary at thedates indicated are summarized in the following tables.  Balances related to discontinued credit cardloan operations have been eliminated for all periods presented.

 
|                                        |   | **At June 30,**            |   |
|---------------------------------------------|--------|----------------------------|--------|
|                                        |   | **2003**                   |   | **2002** |   | **2001** |   | **2000** |   | **1999** |   |
|                                        |   | **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** |   | **Amount** |   | **Percent of  Loans in  Each  Category to  Total Loans** |   |
|                                        |   | **(Dollars in Thousands)** |   |
| One-to four-family(1)                       |   | $                          | 28     |   | 17.39 | % | $ | 81 |   | 16.00 | % | $ | 1,196 |   | 26.65 | % | $ | 1,299 |   | 29.88 | % | $ | 1,233 |   | 31.18 | % |
| Commercial and multi-family  real estate(1) |   | 241                        |   | 23.34 |   | 606 |   | 25.45 |   | 1,402 |   | 20.52 |   | 1,442 |   | 19.97 |   | 1,124 |   | 20.99 |   |
| Commercial business(2)                      |   | 1,033                      |   | 22.09 |   | 1,460 |   | 20.61 |   | 1,033 |   | 18.74 |   | 844 |   | 15.36 |   | 556 |   | 12.30 |   |
| Consumer                                    |   | 1,538                      |   | 27.55 |   | 1,889 |   | 30.66 |   | 1,524 |   | 27.66 |   | 1,536 |   | 27.92 |   | 1,269 |   | 28.08 |   |
| Agricultural                                |   | 945                        |   | 9.39 |   | 375 |   | 6.87 |   | 317 |   | 5.75 |   | 323 |   | 5.87 |   | 264 |   | 5.85 |   |
| Mobile homes                                |   | 57                         |   | 0.24 |   | 50 |   | 0.41 |   | 37 |   | 0.68 |   | 55 |   | 1.00 |   | 72 |   | 1.60 |   |
| Total                                       |   | $                          | 3,842  |   | 100.00 | % | $ | 4,461 |   | 100.00 | % | $ | 5,509 |   | 100.00 | % | $ | 5,499 |   | 100.00 | % | $ | 4,518 |   | 100.00 | % |

 

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(1) Includes construction and developmentloans.

(2) Includes equipment finance leases.

(3) The Company migrated its allocationmethodology of reserves by type in 2002 to reflect a more systematic methodbased in part on the Company’s historical charge-offs by each loan type ascompared to primarily a pro rata allocation based on loan balances in prioryears.

 

|                      |   | **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, 2003**                              |   | **At June 30, 2002**                              |   |
|                      |   | **(Dollars in Thousands)**                        |   |                                              |   |                                              |   |
|                      |   |                                              |   |                                              |   |                                              |   |                                              |   |
| One-  to four-family      |   | $                                                 | 28     |                                              | $      | —                                            |   | $                                                 | 81     |   | $ | — |   |
| Commercial  real estate   |   | 130                                               |   | —                                            |   | 490                                               |   | —                                            |   |
| Multi-family  real estate |   | 111                                               |   | —                                            |   | 116                                               |   | —                                            |   |
| Commercial  business      |   | 652                                               |   | 131                                               |   | 481                                               |   | 683                                               |   |
| Equipment  finance leases |   | 250                                               |   | —                                            |   | 296                                               |   | —                                            |   |
| Consumer                  |   | 1,538                                             |   | —                                            |   | 1,889                                             |   | —                                            |   |
| Agricultural              |   | 230                                               |   | 715                                               |   | 78                                                |   | 297                                               |   |
| Mobile  homes             |   | 57                                                |   | —                                            |   | 50                                                |   | —                                            |   |
|                      |   |                                              |   |                                              |   |                                              |   |                                              |   |
| Total                     |   | $                                                 | 2,996  |                                              | $      | 846                                               |   | $                                                 | 3,481  |   | $ | 980 |   |

 

42

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**FASB 114Impaired 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, 2003**           |   | **At June 30, 2002** |   |
|                     |   | **(Dollars in Thousands)**     |   |
|                     |   |                           |   |                 |   |                                    |   |                           |   |              |   |                                    |   |
| Commercial  real estate  |   | —                         |   | $                    | — |                                    | $      | —                         |   | $                 | — |                                    | $      | — |   | $ | — |   |
| Commercial  business     |   | 8                              |   | 354                  |   | 132                                     |   | 5                              |   | 1,597             |   | 683                                     |   |
| Agriculture  real estate |   | 1                              |   | 27                   |   | —                                  |   | —                         |   | —            |   | —                                  |   |
| Other  agriculture loans |   | 3                              |   | 2,293                |   | 714                                     |   | 2                              |   | 2,380             |   | 297                                     |   |
|                     |   |                           |   |                 |   |                                    |   |                           |   |              |   |                                    |   |
| Total                    |   | 12                             |   | $                    | 2,674  |                                    | $      | 846                            |   | 7                 |   | $                                       | 3,977  |   | $ | 980 |   |
|                          |        |                                |        |                      |        |                                         |        |                                |        |                   |        |                                         |        |  |  |  |  |  |

 

The allowance for loan and lease losses was $3.8 million at June 30,2003 as compared to $4.5 million at June 30, 2002.   The ratio of the allowance for loan and lease losses to totalloans and leases was 0.62% at June 30, 2003 compared to 0.78% at June 30, 2002,a decrease of 20.5%.  The Company’smanagement has considered nonperforming assets and other assets of concern inestablishing the allowance for loan and lease losses.  The Company continues to monitor its allowance for possible loanand lease losses and make future additions or reductions in light of the levelof loans and leases in its portfolio and as economic conditions dictate.  The current level of the allowance for loanand lease losses is a result of management’s assessment of the risks within theportfolio based on the information revealed in credit reporting processes. TheCompany utilizes a risk-rating system on all commercial business, agricultural,construction, multi-family and commercial real estate loans, includingpurchased loans.  A periodic creditreview is performed on all types of loans and leases to establish the necessaryreserve based on the estimated risk within the portfolio. This assessment ofrisk takes into account the composition of the loan and lease portfolio,historical loss experience for each loan and lease category, previous loan andlease experience, concentrations of credit, current economic conditions andother factors that in management’s judgment deserve recognition. OTS regulatorshave reviewed the Company’s methodology for determining allowance requirementson the Company’s loan and lease portfolio and have made no requiredrecommendations for increases in the allowances during the three year periodended June 30, 2003.

 

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

 

Although management believes thatit uses the best information available to determine the allowances, unforeseenmarket conditions could result in adjustments and net earnings beingsignificantly affected if circumstances differ substantially from theassumptions used in making the final determinations.  Future additions to the Company’s allowances result from periodicloan, property and collateral reviews and thus cannot be predicted inadvance.  See Note 1 of “Notes toConsolidated Financial Statements” for a description of the Company’s policyregarding the provision for losses on loans and leases.

 

43

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

 

**ContinuingOperations**

 

*General*. The Company’s income from continuing operations was $4.9 million or$1.50 and $1.47 for basic and diluted earnings per share, respectively, for theyear ended June 30, 2003, a $75,000 increase in earnings compared to $4.9million or $1.39 and $1.36 for basic and diluted earnings per share, respectively,for the prior year.  Basic and dilutedearnings per share increased 7.9% and 8.1%, respectively, for the year endedJune 30, 2003 as compared to the prior year primarily due to the decrease inshares outstanding as a result of Company stock repurchases.  For the year ended June 30, 2003, the returnon average equity from continuing operations was 9.96%, a 6.3% increasecompared to 9.37% in the prior year. For the year ended June 30, 2003, the return on average assets fromcontinuing operations was 0.65%, a 3.0% decrease compared to 0.67% in the prioryear.  As discussed in more detailbelow, the increases were due to a variety of key factors, including increasesin net interest income of $1.1 million and noninterest income of $1.7 millionand a decreaese in income tax expense of $272,000 offset by increases inprovision for losses on loans and leases of $1.3 million, noninterest expenseof $1.7 million

 

*Interest and Dividend Income.*  Interest and dividend income was $43.6million for the year ended June 30, 2003 as compared to $48.0 million for theprior year, a decrease of $4.5 million, or 9.3%.  A $7.5 million decrease in interest and dividend income was theresult of a 13.5% decrease in the average yield on interest-earningassets.  The average yield oninterest-earning assets was 6.17% for the year ended June 30, 2003 as comparedto 7.13% for the prior year.  For theyear ended June 30, 2003, the average yield on loans and leases receivable was6.65%, a decrease of 14.1% from 7.74% in the prior year.  The Company continues to manage yields bychanging the types of loans that comprise the portfolio to loans that have ahigher yield than single-family real estate loans.  Commercial business loans, agricultural business loans andequipment finance leases comprise 31.5% of the total loan and lease portfolioat June 30, 2003 as compared to 25.26% at June 30, 2002.  The percentages of business loans areexpected to remain stable at these levels due to restrictions imposed by HOLAat 20.00% of total Bank assets.  As ofJune 30, 2003, the Bank exceeded the 20.00% limitation by 0.92%.  The Bank has informed the OTS and willsubmit a plan 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%.  Average volume increases in loans and leases receivable of $48.8million resulted in a $3.8 million increase in interest and dividend incomeoffset by a decrease of $17.1 million in investment securities, or $777,000decrease in interest and dividend income as compared to the prior year.

 

*Interest Expense.*  Interest expense was $18.0 million for the year ended June 30,2003 as compared to $23.6million for the prior year, a decrease of $5.6 millionor 23.7%.  A $7.0 million decrease wasthe result 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 on FHLBadvances and other borrowings decreased 16.3% to 4.56% at June 30, 2003 from5.45% at June 30, 2002 and contributed to a $892,000 decrease in interestexpense.  Average volume increases of$12.7 million and $11.1 million for FHLB advances and other borrowings andpreferred securities of subsidiary trusts, respectively, contributed to anincrease in interest expense of $691,000 and $616,000, respectively, for theyear ended June 30, 2003 as compared to the prior year.

 

*Net Interest Income.* The Company’s netinterest income from continuing operations for the year ended June 30, 2003increased $1.1 million, or 4.6%, to $25.6 million compared to $24.4 million forthe prior year.  The increase in netinterest income was due primarily to an increasing net interest margin duringthe first quarter of fiscal 2003 as national interest rates weredeclining.  The net interest margin thenbegan to decrease 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 at3.62% for the year ended June 30, 2003 as compared to 3.63% for the prior year.

 

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

 

44

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Provision for losses on loans and leases increased $1.3 million, or66.6%, to $3.2 million for the year ended June 30, 2003 as compared to $1.9million in the prior year.  The increasewas primarily due to a $1.4 million participation loan charge-off in the fourthquarter of fiscal 2003.  The Companymodified this loan as a troubled debt restructuring with specific reserveallowance during the first quarter of fiscal 2003 and took an additional fourthquarter fiscal 2003 charge to provision in the amount of $893,000 uponsignificant deterioration of the borrower’s credit from levels previouslyestimated.  See “Asset Quality” forfurther discussion.

 

The allowance for loan and lease losses at June 30, 2003 was $3.8million.  The allowance decreased fromthe June 30, 2002 balance of $4.5 million primarily as a result of charge-offsexceeding recoveries by $3.5 million offset by the provision for losses on loansand leases of $3.2 million.  The ratioof allowance for loan and lease losses to nonperforming loans and leases atJune 30, 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.

 

*Noninterest Income.*  Noninterest income was $12.8 million for the year ended June 30,2003 as compared to $11.1 million for the year ended June 30, 2002, an increaseof $1.7 million, or 14.9%.  The increasein noninterest income was due primarily to increases in loan fees and servicecharges of $1.0 million, fees on deposits of $363,000, net gain on sale ofsecurities of $217,000 and other noninterest income of $383,000 offset bydecreases in commission and insurance income of $256,000 and loan servicingincome of $248,000.

 

Loan fees and service charges increased 80.9% to $2.3 million for theyear ended June 30, 2003 compared to $1.3 million in the prior year.  This increase was primarily due to anincrease in residential mortgage loan production of 45.5% in dollar volume ascompared to the prior year.  In aperiodic review of fees received and costs to originate loans, managementreduced the loan origination deferral amount during the first quarter of fiscal2003 due to an increase in the cost estimated to originate loans, thusincreasing immediate loan origination fee income.  This change in estimate, which is accounted for prospectively,resulted in an increase of approximately $822,000 over the same period in theprior year.

 

Fees on deposits increased 9.2% to $4.3 million for the year ended June30, 2003 compared to $3.9 million in the prior year primarily due to a $17.7million and $4.1 million increase in demand deposit and savings accountbalances, respectively, at June 30, 2003 compared to balances at June 30, 2002and an increase in monthly fees charged on savings accounts.

 

Net gain on sale of securities increased $217,000 for the year endedJune 30, 2003 as compared to the prior year.   Long-term fixed-rate mortgage-backed securities were sold to reduce thepotential market value loss of rising interest rates.

 

Other noninterest income increased 53.6% to $1.1 million for the yearended June 30, 2003 compared to $715,000 in the prior year primarily due toincome in the amount of $237,000 recorded on the retained interest obtainedthrough the securitization of automobile loans during the last half of fiscal2003.  See Note 3 of  “Notes to Consolidated FinancialStatements.”  In addition, the Bankrecorded an increase of $494,000 in other noninterest income for bank ownedlife insurance (“BOLI”) as compared to the prior year.  These increases were offset by a $163,000decrease in appraisal income due to the cessation of operations of Mid AmericaAppraisal during the third quarter of fiscal 2002.

 

Commission and insurance income was $1.0 million for the year endedJune 30, 2003 compared to $1.3 million in the prior year, a decrease of19.9%.  Hometown’s personal andcommercial insurance lines are down compared to the prior year primarily due toless emphasis on the property and casualty line of business.  The Company sold the property and casualtybook of business in August 2003.  SeeNote 23 of “Notes to Consolidated Financial Statements” for discussion onsubsequent event.

 

Loan servicing income was $1.6 million for the year ended June 30, 2003compared to $1.9 million in the prior year, a decrease of 13.3%.  The decrease was primarily due to thepackage sale of $23.1 million of one- to four- family, 15- and 30-yearfixed-rate loans during the first quarter of fiscal 2002.

 

*Noninterest Expense.*  Noninterest expense was $27.7 million for the year ended June 30,2003 as compared to $26.0 for the prior year, an increase of $1.7 million, or 6.6%.  The increase in noninterest expense was dueprimarily to increases in compensation and employee benefits of $1.1 million,other expenses of $431,000 and occupancy and equipment of $188,000.

 

Compensation and employee benefits increased 6.8% to $17.5 million forthe year ended June 30, 2003 as compared to $16.4 million for the prior year inpart due to increased employee base compensation and variable compensation

 

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(performance incentives) of $592,000 and health insurance claimaccruals of $747,000 offset by a reduction of $257,000 in compensation fordeferred loan origination costs.  TheCompany has had a self-insured health plan for nine years.  Although health claims were significantlyhigher for the year ended June 30, 2003 as compared to the prior year, theCompany does not believe the claim level will continue at the currentrate.  Management believes the currentstructure is a reasonable alternative to traditional health care plans over thelong run.  Five new in-store locationsopened since September 30, 2001 attributed to an increase in employeecompensation, related benefits and payroll taxes of approximately $451,000 forthe year ended June 30, 2003 as compared to the prior year.

 

Other expensesincreased 8.8% to $5.3 million for the year ended June 30, 2003 as compared to$4.9 million for the prior year in part due to increases in computer and dataprocessing expenses of $561,000, charitable contributions expense of $183,000and consulting expense of $255,000 offset by a reduction in amortization ofgoodwill of $432,000 and audit expense of $113,000.

 

Occupancy andequipment increased 5.6% to $3.5 million for the year ended June 30, 2003 ascompared to $3.4 million for the prior year. The increase was primarily due to an increase in rent expense of $99,000for new branch locations and furniture and fixture expense of $169,000,including a valuation impairment of $200,000 recorded in the third quarter offiscal 2003 as a result of a significant change in market value of propertythat the Company no longer uses in its banking operations.  The Company reclassed the property as heldfor sale during the fourth quarter of fiscal 2003.  See Note 1 of  “Notes toConsolidated Financial Statements” for long –lived asset impairment.

 

*Income tax expense.*  The Company’s income tax expense decreased $272,000, or 9.5%, forthe year ended June 30, 2003 to $2.6 million compared to $2.9 million for theprior year.  The decrease was primarilydue to the decrease in the Company’s effective tax rate due to changes inpermanent tax differences.  Theeffective rate was 34.32% and 36.96% for the years ended June 30, 2003 and June30, 2002, respectively.

 

## **Discontinued Operations**

 

*Income (loss) from discontinued operations. *Income fromdiscontinued operations increased $1.7 million, or 101.7%, for the year endedJune 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.

 

**Comparisonof the Years Ended June 30, 2002 and June 30, 2001**

 

**ContinuingOperations**

 

*General*. The Company’s income from continuing operations was $4.9 million or$1.39 and $1.36 for basic and diluted earnings per share, respectively for theyear ended June 30, 2002, a $276,000 increase in earnings compared to $4.6million or $1.25 and $1.23 for basic and diluted earnings per share,respectively, for the prior year.  Basicand diluted earnings per share increased 11.2% and 10.6%, respectively, for theyear ended June 30, 2002 as compared to the prior year primarily due to thedecrease in shares outstanding as a result of Company stock purchases.  For the year ended June 30, 2002, the returnon average equity from continuing operations was 9.37%, a 2.5% increasecompared to 9.14% in the prior year. For the year ended June 30, 2002, the return on average assets fromcontinuing operations was 0.67%, an 8.1% increase compared to 0.62% in theprior year.  As discussed in more detailbelow, the increase was due to a variety of key factors, including an increasein net interest income of $1.3 million and an increase in noninterest income of$1.7 million offset by a decrease in operating expenses of $2.4 million.

 

*Interest and Dividend Income.*  Interest and dividend income was $48.0million for the year ended June 30, 2002 as compared to  $58.2 million for the prior year, a decreaseof $10.1 million, or 17.5%.  Thedecrease in interest income was primarily due to repricing of loans andinvestments that generally reflected the decline in national interestrates.  From June 30, 2001 to June 30,2002 the prime rate dropped from 6.75% to 4.75%.  The total change of $10.1 million consisted of $8.3 million dueto rate changes and $1.8 million due to volume changes.  Average loan balances decreased $14.2million due to amortizations, prepayments and proceeds from sales of loans andleases exceeding originations and purchases. The Company continues to manage yields by changing the types of loansthat comprise the portfolio to loans that have a higher yield thansingle-family real estate loans. Commercial business loans, agricultural business loans and equipmentfinance leases comprise 25.26% of the total loan and lease portfolio at June30, 2002 as compared to 22.28% at June 30, 2001.  In addition, one-to four-family loans comprise 13.78% of thetotal loan portfolio at June 30, 2002 as compared to 21.71% at June 30,2001.  The yield on average earningassets decreased to 7.13% as compared to 8.36% one year ago.

 

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*Interest Expense.*  Interest expense decreased $11.5 million, or 3.3%,  from $35.1 million for the year ended June30, 2001 to $23.6 million for the year ended June 30, 2002.  The $25.8 million decrease of averageinterest-bearing liabilities resulted in a $2.0 million decrease in interestexpense.  The average balance ofdeposits decreased $7.6 million at June 30, 2002 as compared to the priorfiscal year.  The average rate paid ondeposits decreased to 3.63% as compared to 5.51% one year ago.  The average balance of FHLB advances andother borrowings decreased $24.9 million during fiscal year 2002.  The average rate paid on FHLB advances andother borrowings decreased to 5.45% at June 30, 2002 from 5.90% at June 30,2001.  See “Financial Condition Data”for further discussion.

 

*Net Interest Income.* The Company’s netinterest income from continuing operations for the year ended June 30, 2002increased $1.3 million, or 5.77%, to $24.4 million compared to $23.1 millionfor the same period ended June 30, 2001. The increase in net interest income was due primarily to an increasingnet interest margin as earning asset balances and national interest rates weredeclining.  The Company’s earning assetbalances declined primarily because higher yielding mortgage loans wererefinancing at lower rates while certificate of deposits funding wererefinancing as well.  The Companyexperienced considerable runoff in its one- to four-family loan portfolio dueprimarily to lower national mortgage loan rates.

 

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

 

During the year ended June 30, 2002, the Company recorded a provisionfor losses on loans and leases of $1.9 million compared to $1.5 million for theyear ended June 30, 2001, an increase of $423,000.

 

The allowance for loan and lease losses at June 30, 2002 was $4.5million.  The allowance decreased fromthe June 30, 2001 balance primarily as a result charge-offs exceedingrecoveries by $3.0 million offset by the provision for losses on loans of $1.9million.  The ratio of allowance forloan and lease losses to nonperforming loans and leases at June 30, 2002 was40.02% compared to 97.73% at June 30, 2001. The allowance for loan and lease losses to total loans and leases atJune 30, 2002 was 0.78% compared to 0.96% at June 30, 2001.  The Bank’s management believes that the June30, 2002 recorded allowance for loan losses was adequate to provide forprobable losses on the related loans and leases, based on its evaluation of thecollectability of loans and leases and prior loss experience.

 

*Noninterest Income.*  Noninterest income was $11.1 million for the year ended June 30,2002 as compared to $9.4 million for the year ended June 30, 2001, an increaseof $1.7 million, or 1.8%.

 

Fees on deposits increased $300,000 due primarily to an increase in volumefrom deposits acquired in new branch acquisitions/openings during the last halfof fiscal 2001 and an increase in monthly fees charged on savings accounts.

 

Loan servicing income increased $291,000 for the year ended June 30,2002 as compared to the same period in the prior fiscal year primarily due tothe package sale of $23.1 million of one- to four- family, 15- and 30-yearfixed-rate loans during the first quarter of fiscal 2002.

 

Gain on sale of loans increased $676,000 for the year ended June 30, 2002as compared to the same period in the prior fiscal year.  This increase was due to increased salesinto the secondary market, which included $116,000 net gain on the package saleof $23.1 million one- to four-family, 15- and 30-year fixed rate loans duringthe first quarter of fiscal 2002.  Inaddition, the volume of loans originated for resale into the secondary marketincreased to $158.3 million as compared to $76.4 million in the prior fiscalyear.

 

Loan fees and service charges increased $284,000 for the year endedJune 30, 2002.  This increase wasprimarily due to an increase in loans originated and held in portfolio of $43.4million over the prior year.

 

Gain on sale of securities increased $135,000 for the year ended June30, 2001 as compared to the same period in the prior fiscal year.  This increase was due to no sales occurringin the prior fiscal year.  Long-termfixed-rate mortgage-backed securities were sold to reduce the potential marketvalue loss of rising interest rates.

 

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*Noninterest Expense.*  Noninterest expense increased $2.4 million, or 10.3%, from $23.5million for the year ended June 30, 2001 to $26.0 million for the year endedJune 30, 2002.  This increase wasprimarily due to an increase in compensation and employee benefits of $2.0million, an increase in other general and administrative expenses of $311,000and an increase in advertising expense of $293,000 offset by a decrease infederal insurance premiums of $165,000.

 

The increase in compensation and employee benefits was primarilyrelated to seven new bank branches opened and one branch acquisition since thefirst half of fiscal 2001.  In addition,pension costs increased $381,000 for the year ended June 30, 2002 as compared tothe same period in the prior fiscal year due to a combination of higher payrollcovered and the investment performance of the pension trust account.

 

The increase in advertising was primarily due to a new marketingcampaign and logo change undertaken in fiscal 2002.

 

The Companyexpects the cost for property and casualty coverage will be increasing at itsnext renewal date due to the terrorists attacks of September 11, 2001.  The Company has been informed by itsproperty and casualty insurance carrier that due to terrorist attacks of September 11, 2001, and the resultingunavailability of reinsurance in the market, insurance contracts will be amended with exclusionary language that willclearly define what is considered war and terrorist activity and excludescoverage for certain war and terrorist actions.  Management believes that these exclusions could have an impact onthe Company’s financial performance should an event such as the events ofSeptember 11, 2001 take place in the Company’s trade territory.

 

*Income tax expense.*  The Company’s income tax expense for both of the years ended June30, 2002 and June 30, 2001 was $2.9 million, a decrease of $73,000.  This decrease was primarily due to the decreasein the Company’s effective tax rate from 38.93% at June 30, 2001 to 36.96% atJune 30, 2002 due to changes in permanent tax differences.

 

## **Discontinued Operations**

 

*Income (loss) from discontinuedoperations. *The$1.7 million loss from discontinued operations for the year ended June 30, 2002as compared to income of $12,000 for the prior fiscal year was primarily due tothe write down of the credit card portfolio to net realizable value of $1.1million and one-time closing costs of $108,000.  See Note 2 of “Notes to Consolidated Financial Statements” forfurther discussion on discontinued operations.

 

**Liquidity and Capital Resources**

 

The Bank’s primary sources of funds are earnings, in-market deposits,FHLB advances and other borrowings, repayments of loan principal,mortgage-backed securities and callable agency securities and, to a lesserextent, sales of mortgage loans, sales and maturities of securities,mortgage-backed securities, out-of-market deposits and short-terminvestments.  While scheduled loanpayments and maturing securities are relatively predictable, deposit flows andloan prepayments are more influenced by interest rates, general economicconditions and competition. The Bank attempts to price its deposits to meet itsasset/liability objectives consistent with local market conditions.  Excess balances are invested in overnightfunds.

 

Liquidity management is both a daily and long-term responsibility ofmanagement.  The Bank adjusts itsinvestments in liquid assets based upon management’s assessment of (i) expectedloan demand, (ii) projected loan sales, (iii) expected deposit flows, (iv)yields available on interest-bearing deposits and (v) the objectives of itsasset/liability management program. Excess liquidity is invested generally ininterest-bearing overnight deposits and other short-term government and agencyobligations.  At June 30, 2003, the Bankhad $24.0 million invested in federal funds sold. During the year ended June30, 2003, the Bank increased its borrowings with the FHLB by $1.1 million.

 

The Bank anticipates that it will have sufficient funds available tomeet current loan commitments.  At June30, 2003, the Bank had outstanding commitments to originate and purchasemortgage and commercial loans of $91.6 million and to sell mortgage loans of$43.3 million.  Commitments by the Bankto originate loans are not necessarily executed by the customer. The Bankmonitors the ratio of commitments to funding for use in liquidity management.At June 30, 2003, the Bank had outstanding commitments to purchase investmentsecurities available for sale of $260,000 and no commitments to sell investmentsecurities available for sale.

 

The growth in indirect lending is providing securitizationopportunities in the capital markets. On January 31, 2003, the Bank sold approximately $40.1 million principalof indirect and $9.9 million principal of direct automobile receivables in asecuritization transaction.  Theproceeds will be used in part to continue to service the demand of the Bank’sdealer

 

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network.  The securitization isa source of funds at a rate lower than other sources of funds, reduces capitalrequirements and reduces the credit risk to the Bank from the loans sold.  See Note 3 of  “Notes to Consolidated Financial Statements” for details on theconsumer automobile securitzation.

 

Although in-market deposits are the Bank’s primary source of funds, theBank’s policy has been to utilize borrowings where the funds can be invested ineither loans or securities at a positive rate of return or to use the funds forshort-term liquidity purposes.  Duringfiscal 2002, the Bank increased the amount of pledgeable loans at the FHLB inorder to increase 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, 2003.  Also, the Bankhas implemented arrangements to acquire out-of-market certificate of depositsand money market accounts as an additional source of funding.  As of June 30, 2003, the Bank had $35.6million in out-of-market certificates of deposit and $14.1 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 Company executed a line of credit with First Tennessee Bank, NA forliquidity needs in the Company.  Thenotes are short-term in duration and are subject to annual review.  In case of default on the notes, theCompany’s ability to pay cash dividends may be restricted.  See Note 10 of  “Notes to Consolidated Financial Statements” and “FinancialCondition Data” and Exhibits 10.19 to 10.21 for further details.

 

The Company issued trust preferred securities during fiscal 2003 inorder to provide funding for investment into the Bank of Tier I (core)capital.  See Note 11 of  “Notes to Consolidated FinancialStatements”.

 

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

 

The Company currently has in effect a stock buy back program in whichup to 10.00% of the common stock of the Company outstanding on May 1, 2003 maybe acquired through April 30, 2004.  Atotal of 149,916 shares of common stock have been purchased pursuant to thiscurrent program and the previous program in effect during fiscal 2003, with48,600 shares purchased in the fourth quarter of fiscal 2003 pursuant to thecurrent program.

 

Savings institutions insured by the Federal Deposit InsuranceCorporation are required by the Financial Institutions Reform, Recovery andEnforcement Act of 1989 (“FIRREA”) to meet three regulatory capitalrequirements.  If a requirement is notmet, regulatory authorities may take legal or administrative actions, includingrestrictions on growth or operations or, in extreme cases, seizure.  Institutions not in compliance may apply foran exemption from the requirements and submit a recapitalization plan.  Under these capital requirements, at June30, 2003, the Bank met all current capital requirements.

 

The OTS has adopted capital requirements for savings institutionscomparable to the requirement for national banks.  The minimum OTS core capital requirement for well capitalizedinstitutions is 3.00% of total adjusted assets for thrifts.  The Bank had tier 1 (core) capital of 8.25%at June 30, 2003.  The minimum OTSrisk-based capital requirement for well capitalized institutions is 8.00% ofrisk-weighted assets.  The Bank hadrisk-based capital of 10.20% at June 30, 2003.

 

# **Off-Balance Sheet FinancingArrangements**

 

During fiscal 2003, the Bank securitized and sold consumer automobileloans in the amount of $50.0 million through HFSC and Home Federal AutomobileSecuritization Trust 2003-A.  As aresult of this securitization transaction, the Bank had sold automobile loansin the amount of $35.5 million at June 30, 2003.  As part of the sales transaction, the Bank retains servicingresponsibilities and a retained interest in the receivables which issubordinated to third party investors’ interests.  The receivables were sold without legal recourse to third partyconduits.  The sale provided the Bankwith an additional source of liquidity at interest rates more favorable than itcould receive through other forms of financing.  It also assisted in reducing capital requirements and credit riskto the Bank, in addition to giving the Bank access to the national capital markets. See Notes 1 and 3 of “Notes to Consolidated Financial Statements” and“Comparison of the Years Ended June 30, 2003 and June 30, 2002” for furtherdetail.

 

**Impact of Inflationand Changing Prices**

 

The Consolidated Financial Statements and Notes thereto presented inthis Form 10-K have been prepared in accordance with GAAP, which require themeasurement of financial position and operating results in terms of historicaldollars without considering the change in the relative purchasing power ofmoney over time due to inflation.  Theimpact of

 

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inflation is reflected in the increased cost of the Bank’soperations.  Unlike most industrialcompanies, nearly all the assets and liabilities of the Bank are monetary innature.  As a result, interest rateshave a greater impact on the Bank’s performance than do the effects of generallevels of inflation.  Interest rates donot necessarily move in the same direction or to the same extent as the pricesof goods and services.

 

**Effect of NewAccounting Standards**

 

InDecember 2002, the Financial Accounting Standards Board (“FASB”) issuedStatement of Financial Accounting Standards (“SFAS”) Statement No. 148, *Accounting for Stock-based Compensation — Transitionand Disclosure,*an amendment of SFAS Statement No. 123, *Accounting for Stock-Based Compensation*. This Statement amends SFAS Statement No. 123 to provide alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation.  In addition, this Statement amendsthe disclosure requirements of SFAS Statement No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results.  Disclosure modifications are required for theCompany’s fiscal year ended June 30, 2003, and are included in Company’s notesto its consolidated financial statements.  The adoption of thisStatement did not have material effect on the Company’s financial position,liquidity or results of operations.

 

In March 2003, the FASB started a project to address issues related tostock-based compensation (“SBC”). The objective of the project is to cooperatewith the International Accounting Standards Board to achieve convergence to onesingle, high-quality global accounting standard on SBC.   The FASB has discussed several issuesrelating to SBC arrangements, but continues to 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 Company continues to monitor the progress of the FASB regarding itsSBC project and will continue applying the guidance of APB Opinion No. 25.  The Company will reevaluate its accountingpolicy on SBC upon the FASB’s issuance of an exposure draft and finalaccounting standard regarding SBC as a result of its current SBC project.

 

Effective January 1, 2003, the initial recognition and measurementprovisions of FASB Interpretation No. 45 *“Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including Guarantees ofIndebtedness of Others”* applied to the Company.  This Interpretation elaborates on thedisclosures to be made by a guarantor about its obligations under certainguarantees issued.  It also clarifiesthat a guarantor is required to recognize, at the inception of a guarantee, aliability for the fair value of the obligation undertaken in issuing theguarantee.  The Interpretation alsoidentifies several situations where the recognition of a liability at inceptionfor a guarantor’s obligation is not required. The Interpretation expands on the accounting guidance of SFAS StatementNo. 5 *“Accounting for Contingencies,”*SFAS Statement No. 57 *“Related PartyDisclosures”* and SFAS Statement No. 107 *“Disclosures about Indirect Guarantees of Indebtedness of Others”*which it supersedes.  The adoption ofthis Interpretation did not have material effect on the Company’s financialposition, liquidity or results of operations. See Note 21 of “Notes to Consolidated Financial Statements.”

 

In January 2003, the FASB issued Interpretation No. 46 *“Consolidation of Variable Interest Entities.”*  This Interpretation was issued in an effortto expand upon and strengthen existing accounting guidance that addresses whena company should include in its financial statements the assets, liabilitiesand activities of another entity.  Ingeneral, a variable interest entity is a corporation, partnership, trust, or anyother legal structure used for business purposes that either (i) does not haveequity investors with voting rights or (ii) has equity investors that do notprovide sufficient financial resources for the entity to support itsactivities.  A variable interest entityoften holds financial assets, including loans or receivables, real estate orother property.  To further assistfinancial statement users in assessing a company’s risks, the Interpretationalso requires disclosures about variable interest entities that the Company isnot required to consolidate but in which it has a significant variableinterest.  The consolidated requirementsof Interpretation No. 46 apply immediately to period interest entities created afterJanuary 31, 2003.  The consolidationrequirements apply to older entities in the first fiscal year or interim periodregardless of when the variable interest entity was established.  Management does not believe that thisInterpretation will have a material effect on the Company’s financial position,liquidity or results of operations, however, management continues to reviewguidance from the FASB and Federal Reserve.

 

In April 2003, FASB issued SFAS Statement No. 149, *“Amendment of Statement 133 on Derivative Instrumentsand Hedging Activities.”* This Statement improves financial reporting by requiring that contractswith comparable characteristics

 

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be accounted for similarly.  Inparticular, this Statement (i) clarifies under what circumstances a contractwith an initial net investment meets the characteristics of a derivativediscussed in paragraph 6(b) of Statement 133, (ii) clarifies when a derivativecontains a financing component, (iii) amends the definition of an underlying toconform it to language used in FASB Interpretation No. 45, *“Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others”*and (iv) amends certain other existing pronouncements.  The changes will result in more consistentreporting on contracts and hedging relationships entered into or modified afterJune 30, 2003.   Management does notbelieve the above pronouncements will have a material effect on the Company’s financialposition, liquidity or results of operations.

 

In May 2003, FASB issued SFAS Statement No. 150, *“Accounting for Certain Financial Instruments withCharacteristics of both Liabilities and Equity”*.  This Statement establishes standards for howan issuer classifies and measures certain financial instruments withcharacteristics of both liabilities and equity. It requires that an issuerclassify a financial instrument that is within its scope as a liability (or anasset in some circumstances). This Statement is effective for financial instrumentsentered into or modified after May 31, 2003, and otherwise is effective at thebeginning of the first interim period beginning after June 15, 2003, except formandatorily redeemable financial instruments of nonpublic entities.  Management does not believe the abovepronouncements will have a material effect on the Company’s financial position,liquidity or results of operations, however, management continues to reviewguidance 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 a continuing part of its financial strategy, the Bank considersmethods of managing this asset/liability mismatch consistent with maintainingacceptable levels of net interest income. In order to properly monitor interest rate risk, the Board of Directorshas created an Asset/Liability Committee whose principal responsibilities areto assess the Bank’s asset/liability mix and recommend strategies to the Boardthat will enhance income while managing the Bank’s vulnerability to changes ininterest rates.

 

In managing market risk and the asset/liability mix, the Bank hasplaced its emphasis on developing a portfolio in which, to the extentpracticable, assets and liabilities reprice within similar periods. The goal ofthis policy is to provide a relatively consistent level of net interest incomein varying interest rate cycles and to minimize the potential for significantfluctuations from period to period.

 

One approach used to quantify interest rate risk is the net portfoliovalue (“NPV”) analysis.  In essence,this analysis calculates the difference between the present value of theliabilities and the present value of expected cash flows from assets andoff-balance sheet contracts.  Thefollowing table sets forth, at June 30, 2003 and June 30, 2002, an analysis ofthe Company’s interest rate risk as measured by the estimated changes in NPVresulting from instantaneous and sustained parallel shifts in the yield curve(+ 300 or -100 basis points, measured in 100 basis point increments).  Due to the abnormally low prevailinginterest rate environment, -200 and -300 NPV were not estimated by the OTS.

 

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, 2003” and “SelectedAsset and Liability Price Tables as of June 30, 2002”.  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.

 

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June 30, 2003

 

| **Change in  Interest Rates** |   | **Estimated  NPV  Amount**  |   | **Estimated  Increase  (Decrease) in NPV** |   |
|-------------------------------|--------|-----------------------------|--------|--------------------------------------------|--------|
| **Amount**                    |   | **Percent**                 |
|                          |   | **(Dollars  in Thousands)** |   |                                       |   |
| Basis Points                  |   |                        |   |                                       |   |   |   |
|                          |   |                        |   |                                       |   |   |   |
| +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 | ) |
|                               |        |                             |        |                                            |        |  |  |  |  |

 

June 30, 2002

 

| **Change in  Interest Rates** |   | **Estimated  NPV  Amount**  |   | **Estimated  Increase  (Decrease) in NPV** |   |
|-------------------------------|--------|-----------------------------|--------|--------------------------------------------|--------|
| **Amount**                    |   | **Percent**                 |
|                          |   | **(Dollars  in Thousands)** |   |                                       |   |
| Basis Points                  |   |                        |   |                                       |   |   |   |
|                          |   |                        |   |                                       |   |   |   |
| +300                          |   | $                           | 88,292 |                                       | $      | 9 |   | 0 | % |
| +200                          |   | 89,899                      |   | 1,615                                      |   | 2 |   |
| +100                          |   | 90,194                      |   | 1,910                                      |   | 2 |   |
| —                        |   | 88,284                      |   | —                                     |   | — |   |
| -100                          |   | 83,720                      |   | (4,564                                     | )      | (5 | ) |
|                               |        |                             |        |                                            |        |  |  |  |  |

 

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**Item 7A****.   Quantitative and Qualitative DisclosuresAbout Market Risk**

 

*Interest Rate Risk Management*

 

The Company’s net income is largely dependent on its net interestincome. Net interest income is susceptible to interest rate risk to the degreethat interest-bearing liabilities mature or reprice on a different basis thaninterest-earning assets. When interest-bearing liabilities mature or repricemore quickly than interest-earning assets in a given period, a significantincrease in market rates of interest could adversely affect net interestincome. Similarly, when interest-earning assets mature or reprice more quicklythan interest-bearing liabilities, falling interest rates could result in adecrease in net income.

 

In an attempt to manage its exposure to change in interest rates,management monitors the Company’s interest rate risk. Management’sAsset-Liability Committee meets periodically to review the Company’s interestrate risk position and profitability, and to recommend adjustments forconsideration by executive management. Management also reviews the Bank’ssecurities portfolio, formulates investment strategies, and oversees the timingand implementation of transactions to assure attainment of the Board ‘sobjectives in the most effective manner. Notwithstanding the Company’s interestrate risk management activities, the potential for changing interest rates is anuncertainty that can have an adverse effect on net income.

 

In adjusting the Company’s asset/liability position, managementattempts to manage the Company’s interest rate risk while enhancing netinterest margins. At times, depending on the level of general interest rates,the relationship between long and short-term interest rates, market conditionsand competitive factors, management may determine to increase the Company’sinterest rate risk position somewhat in order to increase its net interestmargin. The Company’s results of operations and net portfolio values remainvulnerable to increases in interest rates and to fluctuations in the differencebetween long- and short-term interest rates.

 

Consistent with the asset/liability management philosophy describedabove, the Company has taken several steps to manage its interest rate risk.First, the Company has structured the security portfolio to shorten therepricing of its interest-earning assets. The Company’s recent purchases ofmortgage-backed securities and securities available for sale have had eithershort or medium terms to maturity or adjustable interest rates. At June 30,2003, the Company had investment securities available for sale of $18.0 millionwith contractual maturities of five years or less.  Variable-rate mortgage-backed securities totaled $53.6 million atJune 30, 2003. Mortgage-backed securities amortize and experience prepaymentsof principal.  The Company has receivedaverage cash flows from principal paydowns, maturities, sales and calls of allsecurities available for sale of $63.6 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, 2003, the Company had $54.5 million of savings accounts, $178.1 million ofmoney market accounts and $120.7 million of checking accounts, representing56.9% of total depositor accounts.

 

One approach used to quantify interest rate risk is the NPV analysis.In essence, this analysis calculates the difference between the present valueof liabilities and the present value of expected cash flows from assets andoff-balance sheet contracts.  See Item7, “Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Asset/Liability and Risk Management” for further discussion.

 

The Company does not currently engage in trading activities or usederivative instruments to control interest rate risk. Even though suchactivities may be permitted with the approval of the Board of Directors, theCompany does not intend to engage in such activities in the immediate future.

 

Interest rate risk is the most significant market risk affecting theCompany. Other types of market risk, such as foreign currency exchange raterisk and commodity price risk, do not arise in the normal course of theCompany’s business activities.

 

53

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**Item 8.  Financial Statements and SupplementaryData**

 

**Contents**

 
| INDEPENDENT AUDITOR’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                    |

 

54

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**IndependentAuditor’s Report**

 

To the Board of Directors andStockholdersHF Financial Corp.Sioux Falls, South Dakota

 

We have audited theaccompanying consolidated statements of financial condition of HF FinancialCorp. and subsidiaries as of June 30, 2003 and 2002, and the relatedconsolidated statements of income, stockholders’ equity and cash flows for eachof the three years in the period ended June 30, 2003.  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 conducted our audits inaccordance with auditing standards generally accepted in the United States ofAmerica.  Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement.  An audit includes examining, on a testbasis, evidence supporting the amounts and disclosures in the financialstatements.  An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statementpresentation.  We believe that ouraudits provide a reasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in all materialrespects, the financial position of HF Financial Corp. and subsidiaries as ofJune 30, 2003 and 2002, and the results of their operations and their cashflows for each of the three years in the period ended June 30, 2003, inconformity with accounting principles generally accepted in the United Statesof America.

 

As described in Note 1 to thefinancial statements, the Company changed its method of accounting for goodwillas of July 1, 2002.

 
|                                             | /s/  McGladrey & Pullen, LLP |   |
|--------------------------------------------------|----------------------------------|--------|
|                                             |                             |
| Sioux Falls,  South Dakota  August 13, 2003 |                             |

 

McGladrey & Pullen, LLP isa member firm of RSM International,an affiliation of separate and independent legal entities.

 

55

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**HF Financial Corp. and Subsidiaries**

 

**Consolidated Statements of Financial Condition****June 30, 2003 and 2002(Dollars in Thousands)**

 
|                                                                                                                                              |   | **2003**    |        | **2002**   |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------|-------------|------------|--------|
|                                                                                                                                              |   |        |        |       |   |
| **Assets**                                                                                                                                        |   |        | ** **  |       |   |
| Cash  and cash equivalents                                                                                                                        |   | **$**       | **44,214**  | ** ** | $      | 27,546 |   |
| Securities  available for sale (Note 5)                                                                                                           |   | **88,527**  | ** **  | 82,804     |   |
| Federal  Home Loan Bank stock (Note 10)                                                                                                           |   | **7,025**   | ** **  | 6,332      |   |
| Loans  held for sale (Note 6)                                                                                                                     |   | **15,984**  | ** **  | 6,559      |   |
| Loans  and leases receivable (Notes 6 and 10)                                                                                                     |   | **595,417** | ** **  | 559,814    |   |
| Accrued  interest receivable                                                                                                                      |   | **4,298**   | ** **  | 4,410      |   |
| Office  properties and equipment, net of accumulated depreciation (Note 8)                                                                        |   | **13,138**  | ** **  | 13,714     |   |
| Foreclosed  real estate and other properties                                                                                                      |   | **1,812**   | ** **  | 1,672      |   |
| Cash  value of life insurance                                                                                                                     |   | **11,432**  | ** **  | 6,001      |   |
| Servicing  rights (Note 7)                                                                                                                        |   | **4,003**   | ** **  | 3,467      |   |
| Goodwill,  net (Note 4)                                                                                                                           |   | **5,020**   | ** **  | 5,020      |   |
| Intangible  asset                                                                                                                                 |   | **175**     | ** **  | 243        |   |
| Other  assets (Notes 3 and 12)                                                                                                                    |   | **9,438**   | ** **  | 5,335      |   |
|                                                                                                                                              |   | **$**       | **800,483** |       | $      | 722,917 |   |
|                                                                                                                                              |   |        | ** **  |       |   |
| **Liabilities and Stockholders’ Equity**                                                                                                     |   |        | ** **  |       |   |
| Liabilities                                                                                                                                       |   |        | ** **  |       |   |
| Deposits  (Note 9)                                                                                                                                |   | **$**       | **621,381** | ** ** | $      | 562,596 |   |
| Advances  from Federal Home Loan Bank and other borrowings (Note 10)                                                                              |   | **89,819**  | ** **  | 84,308     |   |
| Company  obligated mandatorily redeemable preferred securities of subsidiary trusts  that solely hold subordinated debentures (Note 11)           |   | **20,000**  | ** **  | 10,000     |   |
| Advances  by borrowers for taxes and insurance                                                                                                    |   | **7,901**   | ** **  | 6,436      |   |
| Accrued  expenses and other liabilities (Note 16)                                                                                                 |   | **12,024**  | ** **  | 11,041     |   |
| **Total liabilities**                                                                                                                             |   | **751,125** | ** **  | 674,381    |   |
|                                                                                                                                              |   |        | ** **  |       |   |
| Commitments  and Contingencies (Notes 8 and 21)                                                                                                   |   |        | ** **  |       |   |
|                                                                                                                                              |   |        | ** **  |       |   |
| Stockholders’  Equity (Notes 12, 13, 14, 16 and 17)                                                                                          |   |        | ** **  |       |   |
| 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, $.01 par value, 10,000,000 shares  authorized, 4,930,391 and 4,886,494 shares  issued at June 30, 2003 and 2002, respectively |   | **49**      | ** **  | 49         |   |
| Common  stock subscribed for but not issued 21,395 shares                                                                                         |   | **382**     | ** **  | —     |   |
| Additional  paid-in capital                                                                                                                       |   | **16,527**  | ** **  | 16,014     |   |
| Retained  earnings, substantially restricted                                                                                                      |   | **57,967**  | ** **  | 54,516     |   |
| Deferred  compensation (Note 18)                                                                                                                  |   | **(733**    | **)**       | (141       | )      |
| Accumulated  other comprehensive income (loss), net of related deferred tax effect (Note  19)                                                     |   | **(735**    | **)**       | (206       | )      |
| Less  cost of treasury stock, 1,708,946 and 1,559,030 shares at June 30, 2003  and 2002, respectively                                        |   | **(24,099** | **)**       | (21,696    | )      |
|                                                                                                                                              |   | **49,358**  |        | 48,536     |   |
|                                                                                                                                              |   | **$**       | **800,483** |       | $      | 722,917 |   |

 

See Notes to ConsolidatedFinancial Statements.

 

56

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**HF Financial Corp. and Subsidiaries**

 

**Consolidated Statements of Income****Years Ended June 30, 2003, 2002 and 2001(Dollars in Thousands, Except Per Share Data)**

 
|                                                                                                |   | **2003**   |       | **2002** |   | **2001** |   |
|-----------------------------------------------------------------------------------------------------|--------|------------|------------|----------|--------|----------|--------|
| Interest  and dividend income:                                                                      |   |       |       |     |   |     |   |
| Loans  and leases receivable                                                                        |   | **$**      | **39,538** |     | $      | 42,290   |   | $ | 50,016 |   |
| Investment  securities and interest-bearing deposits                                                |   | **4,022**  |       | 5,727    |   | 8,146    |   |
|                                                                                                |   | **43,560** |       | 48,017   |   | 58,162   |   |
| Interest  expense:                                                                                  |   |       |       |     |   |     |   |
| Deposits                                                                                            |   | **12,511** |       | 18,433   |   | 28,420   |   |
| Advances  from Federal Home Loan Bank and other borrowings                                          |   | **5,486**  |       | 5,140    |   | 6,631    |   |
|                                                                                                |   | **17,997** |       | 23,573   |   | 35,051   |   |
| **Net interest income**                                                                             |   | **25,563** |       | 24,444   |   | 23,111   |   |
| Provision  for losses on loans and leases                                                           |   | **3,173**  |       | 1,905    |   | 1,482    |   |
| **Net interest income after provision for losses on loans and  leases**                             |   | **22,390** |       | 22,539   |   | 21,629   |   |
| Noninterest  income:                                                                                |   |       |       |     |   |     |   |
| Fees  on deposits                                                                                   |   | **4,294**  |       | 3,931    |   | 3,631    |   |
| Loan  fees and service charges                                                                      |   | **2,290**  |       | 1,266    |   | 982      |   |
| Gain  on sale of loans, net                                                                         |   | **1,664**  |       | 1,518    |   | 842      |   |
| Loan  servicing income                                                                              |   | **1,610**  |       | 1,858    |   | 1,567    |   |
| Commission  and insurance income                                                                    |   | **1,032**  |       | 1,288    |   | 1,343    |   |
| Trust  income                                                                                       |   | **471**    |       | 435      |   | 392      |   |
| Gain  on sale of securities, net                                                                    |   | **352**    |       | 135      |   | —   |   |
| Other                                                                                               |   | **1,098**  |       | 715      |   | 666      |   |
|                                                                                                |   | **12,811** |       | 11,146   |   | 9,423    |   |
| Noninterest  expense:                                                                               |   |       |       |     |   |     |   |
| Compensation  and employee benefits                                                                 |   | **17,499** |       | 16,388   |   | 14,416   |   |
| Occupancy  and equipment                                                                            |   | **3,547**  |       | 3,359    |   | 3,451    |   |
| Advertising                                                                                         |   | **917**    |       | 1,042    |   | 749      |   |
| Foreclosed  real estate and other properties, net                                                   |   | **371**    |       | 263      |   | 182      |   |
| Other                                                                                               |   | **5,337**  |       | 4,906    |   | 4,730    |   |
|                                                                                                |   | **27,671** |       | 25,958   |   | 23,528   |   |
| **Income from continuing operations before income taxes**                                           |   | **7,530**  |       | 7,727    |   | 7,524    |   |
| Income  tax expense (Note 12)                                                                       |   | **2,584**  |       | 2,856    |   | 2,929    |   |
| **Income from continuing operations**                                                               |   | **4,946**  |       | 4,871    |   | 4,595    |   |
| Discontinued  operations (Note 2):                                                                  |   |       |       |     |   |     |   |
| Income  (loss) from operations of discontinued segment, net of income taxes of $131,  $(127) and $6 |   | **253**    |       | (246     | )      | 12       |   |
| (Loss)  on discontinued segment, net of income taxes of $(116) and $(741)                           |   | **(224**   | **)**      | (1,440   | )      | —   |   |
| **Income (loss) from discontinued operations**                                                      |   | **29**     |       | (1,686   | )      | 12       |   |
| **Net income**                                                                                      |   | **$**      | **4,975**  |     | $      | 3,185    |   | $ | 4,607 |   |
|                                                                                                |   |       |       |     |   |     |   |
| Basic  earnings (loss) per share (Note 15):                                                         |   |       |       |     |   |     |   |
| Income  from continuing operations                                                                  |   | **$**      | **1.50**   |     | $      | 1.39     |   | $ | 1.25 |   |
| Income  (loss) from discontinued operations                                                         |   | **0.01**   |       | (0.48    | )      | —   |   |
| Net  income                                                                                         |   | **1.51**   |       | 0.91     |   | 1.25     |   |
|                                                                                                |   |       |       |     |   |     |   |
| Diluted  earnings (loss) per share (Note 15):                                                       |   |       |       |     |   |     |   |
| Income  from continuing operations                                                                  |   | **1.47**   |       | 1.36     |   | 1.23     |   |
| Income  (loss) from discontinued operations                                                         |   | **0.01**   |       | (0.47    | )      | —   |   |
| Net  income                                                                                         |   | **1.48**   |       | 0.89     |   | 1.23     |   |
|                                                                                                |   |       |       |     |   |     |   |
| Dividend  declared per share                                                                        |   | **0.46**   |       | 0.44     |   | 0.42     |   |

 

See Notes to ConsolidatedFinancial Statements.

 

57

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**HF Financial Corp. and Subsidiaries**

 

**Consolidated Statements of Stockholders’ Equity****Years Ended June 30, 2003, 2002 and 2001(Dollars in Thousands, Except Per Share Data)**

 
|                                                                                          |   | **Common  Stock** |   | **Common  Stock  Subscribed** |   | **Additional  Paid-In  Capital** |       | **Retained  Earnings** |       | **Deferred  Compensation** |   | **Accumulated  Other  Comprehensive  Income (Loss)** |       | **Treasury  Stock** |     | **Total** |   |
|-----------------------------------------------------------------------------------------------|--------|-------------------|--------|-------------------------------|--------|----------------------------------|------------|------------------------|------------|----------------------------|--------|------------------------------------------------------|------------|---------------------|----------|-----------|--------|
|                                                                                          |   |              |   |                          |   |                             |       |                   |       |                       |   |                                                 |       |                |     |      |   |
| Balance, June 30,  2000                                                                  |   | $                 | 48     |                          | $      | —                           |       | $                      | 15,260     |                       | $      | 49,824                                               |       | $                   | (113     | )         | $      | (1,951 | ) | $ | (16,125 | ) | $ | 46,943 |   |
| Comprehensive income:                                                                         |   |              |   |                          |   |                             |       |                   |       |                       |   |                                                 |       |                |     |      |   |
| Net income                                                                                    |   | —            |   | —                        |   | —                           |       | 4,607                  |       | —                     |   | —                                               |       | —              |     |      |   |
| Net change in unrealized  (loss) on securities available for sale, net of deferred taxes      |   | —            |   | —                        |   | —                           |       | —                 |       | —                     |   | 2,289                                                |       | —              |     |      |   |
| Comprehensive income                                                                          |   | —            |   | —                        |   | —                           |       | —                 |       | —                     |   | —                                               |       | —              |     | 6,896     |   |
| Issuance of restricted  stock and exercise of stock options                                   |   | —            |   | —                        |   | 118                              |       | —                 |       | —                     |   | —                                               |       | —              |     | 118       |   |
| Cash dividends paid on  common stock                                                          |   | —            |   | —                        |   | —                           |       | (1,545                 | )          | —                     |   | —                                               |       | —              |     | (1,545    | )      |
| Amortization of deferred  compensation                                                        |   | —            |   | —                        |   | —                           |       | —                 |       | 113                        |   | —                                               |       | —              |     | 113       |   |
| 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 18)                         |   | —            |   | —                        |   | 513                              |       | —                 |       | (669                       | )      | —                                               |       | —              |     | (156      | )      |
| 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** | ** ** |

 

See Notes to ConsolidatedFinancial Statements.

 

58

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**HF Financial Corp. and Subsidiaries**

 

**Consolidated Statements of Cash Flows****Years Ended June 30, 2003, 2002 and 2001(Dollars in Thousands)**

 
|                                                                                           |   | **2003**     |       | **2002**   |   | **2001** |   |
|------------------------------------------------------------------------------------------------|--------|--------------|------------|------------|--------|----------|--------|
| Cash  Flows From Operating Activities                                                          |   |         | ** ** |       |   |     |   |
| Net  income                                                                                    |   | **$**        | **4,975**  | ** ** | $      | 3,185    |   | $ | 4,607 |   |
| Adjustments  to reconcile net income to net cash provided by (used in) operating  activities:  |   |         | ** ** |       |   |     |   |
| Provision  for losses on loans and leases                                                      |   | **3,173**    | ** ** | 2,543      |   | 2,432    |   |
| Depreciation                                                                                   |   | **1,659**    | ** ** | 1,683      |   | 1,888    |   |
| Amortization  of discounts and premiums on securities and other                                |   | **1,549**    | ** ** | 994        |   | 775      |   |
| Stock  based compensation                                                                      |   | **166**      | ** ** | 117        |   | 100      |   |
| Deferred  income taxes (credits)                                                               |   | **2,629**    | ** ** | (267       | )      | 645      |   |
| Loans  originated for resale                                                                   |   | **(219,671** | **)**      | (158,329   | )      | (76,395  | )      |
| Proceeds  from the sale of loans                                                               |   | **211,461**  | ** ** | 161,234    |   | 78,050   |   |
| (Gain)  on sale of loans, net                                                                  |   | **(1,664**   | **)**      | (1,518     | )      | (842     | )      |
| Realized  (gain) on sale of securities, net                                                    |   | **(352**     | **)**      | (135       | )      | —   |   |
| Losses  and provision for losses on sales of foreclosed real estate and other  properties, net |   | **150**      | ** ** | 129        |   | 27       |   |
| Loss  on disposal of office properties and equipment, net                                      |   | **243**      | ** ** | 8          |   | 15       |   |
| Change  in other assets and liabilities (Note 22)                                              |   | **(5,284**   | **)**      | (4,729     | )      | 800      |   |
| **Net cash provided by (used in) operating activities**                                        |   | **(966**     | **)**      | 4,915      |   | 12,102   |   |
|                                                                                           |   |         | ** ** |       |   |     |   |
| Cash  Flows From Investing Activities                                                          |   |         | ** ** |       |   |     |   |
| Loans  and leases purchased                                                                    |   | **(1,466**   | **)**      | (33,340    | )      | (4,067   | )      |
| Loans  and leases originated and held                                                          |   | **(203,562** | **)**      | (249,705   | )      | (206,337 | )      |
| Principal  collected on loans and leases                                                       |   | **164,911**  | ** ** | 282,495    |   | 196,023  |   |
| Securities  available for sale:                                                                |   |         | ** ** |       |   |     |   |
| Sales,  maturities and repayments                                                              |   | **54,398**   | ** ** | 89,410     |   | 47,065   |   |
| Purchases                                                                                      |   | **(61,641**  | **)**      | (84,574    | )      | (23,365  | )      |
| Purchase  of Federal Home Loan Bank stock                                                      |   | **(693**     | **)**      | —     |   | (202     | )      |
| Purchase  cash value of life insurance                                                         |   | **(5,000**   | **)**      | (5,000     | )      | —   |   |
| Business  acquisitions, net of cash acquired                                                   |   | **—**   | ** ** | —     |   | (789     | )      |
| Proceeds  from sale of office properties and equipment                                         |   | **14**       | ** ** | 13         |   | 18       |   |
| Purchase  of office properties and equipment                                                   |   | **(1,531**   | **)**      | (1,662     | )      | (1,754   | )      |
| Purchase  of servicing rights                                                                  |   | **(569**     | **)**      | (600       | )      | (702     | )      |
| Proceeds  from sale of foreclosed real estate and other properties                             |   | **1,102**    | ** ** | 1,358      |   | 871      |   |
| **Net cash provided by (used in) investing activities**                                        |   | **(54,037**  | **)**      | (1,605     | )      | 6,761    |   |
|                                                                                                |        |              |            |            |        |          |        |  |  |  |

 

See Notes to ConsolidatedFinancial Statements.

 

59

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|                                                                         |   | **2003**     |       | **2002**   |   | **2001** |   |
|------------------------------------------------------------------------------|--------|--------------|------------|------------|--------|----------|--------|
| Cash  Flows From Financing Activities                                        |   |         | ** ** |       |   |     |   |
| Net  increase (decrease) in deposit accounts                                 |   | **$**        | **58,785** | ** ** | $      | (38,611  | )      | $ | 51,591 |   |
| Proceeds  of advances from Federal Home Loan Bank and other borrowings       |   | **565,250**  | ** ** | 89,900     |   | 221,174  |   |
| Payments  on advances from Federal Home Loan Bank and other borrowings       |   | **(559,739** | **)**      | (113,968   | )      | (232,399 | )      |
| Payment  of debt issue costs                                                 |   | **(300**     | **)**      | (350       | )      | —   |   |
| Proceeds  from issuance of preferred securities                              |   | **10,000**   | ** ** | 10,000     |   | —   |   |
| Increase  (decrease) in advances by borrowers                                |   | **1,465**    | ** ** | (901       | )      | 794      |   |
| Purchase  of treasury stock                                                  |   | **(2,403**   | **)**      | (5,571     | )      | —   |   |
| Proceeds  from issuance of common stock                                      |   | **137**      | ** ** | 379        |   | 18       |   |
| Cash  dividends paid                                                         |   | **(1,524**   | **)**      | (1,555     | )      | (1,545   | )      |
| **Net cash provided by (used in) financing activities**                      |   | **71,671**   | ** ** | (60,677    | )      | 39,633   |   |
| **Increase (decrease) in cash and cash equivalents**                         |   | **16,668**   | ** ** | (57,367    | )      | 58,496   |   |
|                                                                         |   |         | ** ** |       |   |     |   |
| Cash  and Cash Equivalents                                                   |   |         | ** ** |       |   |     |   |
| Beginning                                                                    |   | **27,546**   | ** ** | 84,913     |   | 26,417   |   |
| Ending                                                                       |   | **$**        | **44,214** | ** ** | $      | 27,546   |   | $ | 84,913 |   |
|                                                                         |   |         | ** ** |       |   |     |   |
| Supplemental  Disclosures of Cash Flows Information                          |   |         | ** ** |       |   |     |   |
| Cash  payments for interest                                                  |   | **$**        | **18,650** | ** ** | $      | 27,890   |   | $ | 34,286 |   |
| Cash  payments for income and franchise taxes, net                           |   | **2,487**    | ** ** | 2,715      |   | 2,293    |   |
|                                                                         |   |         | ** ** |       |   |     |   |
| Supplemental  Schedule of Noncash Investing and Financing Activities    |   |         | ** ** |       |   |     |   |
| Foreclosed  real estate and other properties acquired in settlement of loans |   | **$**        | **1,201**  | ** ** | $      | 379      |   | $ | 1,097 |   |
| Loans  receivable reclassified as held for sale                              |   | **—**   | ** ** | 1,115      |   | —   |   |
| Office  property reclassified as held for sale                               |   | **191**      | ** ** | —     |   | —   |   |
|                                                                         |   |         | ** ** |       |   |     |   |
| Acquisitions,  net of cash and cash equivalents acquired, allocated to:      |   |         | ** ** |       |   |     |   |
| Assets                                                                       |   |         | ** ** |       |   |     |   |
| Loans  and leases receivable                                                 |   | **$**        | **—** | ** ** | $      | —   |   | $ | 10,082 |   |
| Office  properties and equipment                                             |   | **—**   | ** ** | —     |   | 206      |   |
| Other  assets                                                                |   | **—**   | ** ** | —     |   | 226      |   |
| Goodwill                                                                     |   | **—**   | ** ** | —     |   | 1,053    |   |
| Liabilities  assumed                                                         |   |         | ** ** |       |   |     |   |
| Deposits                                                                     |   | **—**   | ** ** | —     |   | (4,119   | )      |
| Notes  payable and other liabilities                                         |   | **—**   | ** ** | —     |   | (6,659   | )      |
| Net  cash paid on acquisitions                                               |   | **$**        | **—** | ** ** | $      | —   |   | $ | 789 |   |

 

60

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**HF Financial Corp. and Subsidiaries**

 

**Notesto Consolidated Financial Statements****(Dollars in Thousands)**

 

**Note 1.****                                  Summaryof Significant Accounting Policies**

 

The accounting and reportingpolicies of HF Financial Corp. (the Company) and subsidiaries conform toaccounting principles generally accepted in the United States of America and togeneral practice within the industry. The following is a description of the more significant of those policiesthat the Company follows in preparing and presenting its consolidated financialstatements.

 

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), HF Financial Capital Trust I (Trust I), HF Financial CapitalTrust II (Trust II), HF Financial Capital Trust III (Trust III), and HomeFederal Bank (the Bank) and the Bank’s wholly-owned subsidiaries, HometownInsurors, Inc. (Hometown), Mid America Capital Services, Inc. (Mid AmericaLeasing), Home Federal Securitization Corp. (HFSC), Mid-America ServiceCorporation and PMD, Inc. HF Card was dissolved during fiscal year 2003 (Note2) and HF Group, Trust II, Trust III, and HFSC were formed during fiscal year2003.  All intercompany balances andtransactions have been eliminated in consolidation.

 

Basis offinancial statement presentation:  In preparing the financial statements,management is required to make estimates and assumptions that affect thereported amounts of assets and liabilities as of the date of the statement offinancial condition and revenues and expenses for the year.  Actual results could differ significantlyfrom those estimates.  Materialestimates that are particularly susceptible to significant change in thenear-term relate to the determination of the allowance for loan and leaselosses, the retained interest 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.

 

Securities available for saleare those debt securities that the Company intends to hold for an indefiniteperiod of time, but not necessarily to maturity, and all equitysecurities.  Any decision to sell asecurity 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 and discounts onsecurities are amortized over the contractual lives of those securities, exceptfor mortgage-backed securities, for which prepayments are probable andpredictable, which are amortized over the estimated expected repayment terms ofthe underlying mortgages.  The method ofamortization results in a constant effective yield on those securities (theinterest method).  Interest on debtsecurities is recognized in income as accrued. Realized gains and losses on the sale of securities are determined usingthe specific identification method.

 

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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.  The retainedinterest asset is initially recognized based upon an allocation of the carryingvalue of the assets which are securitized in proportion to the relative fairvalues of the assets sold and interests retained.  After the securitization, these interests are treated asavailable for sale and are adjusted to fair value with the adjustment reflectedas an unrealized gain or loss in the accumulated other comprehensive incomecategory in stockholders’ equity, unless a decline in fair value is determinedto be other than temporary, in which case the loss is charged 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 reflectcertain assumptions for prepayment speeds, discount rates and chargeoff ratesas well as 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 the initial allocatedretained interest plus the interest accrued on the outstanding amortizedbalance less excess cash payments received from the Automobile SecuritizationTrust and less any recognized 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.

 

Impairment usually occurs wheneverthe current fair value of the retained interest is lower than its currentamortized cost.  If this occurs, a testmust take place to see if an impairment charge for the deficiency is requiredto be taken through current earnings. If there has been an adverse change in estimated cash flows consideringboth the timing and amount of flows, the retained interest must be written downto fair value, which becomes the new amortized cost basis for futureamortization.  No impairment losses wererecorded during fiscal year 2003.

 

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 and premiums on loansare amortized to income using the interest method over the remaining period tocontractual maturity, adjusted for prepayments.

 

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Loans are generally classifiedas nonaccrual when there are reasonable doubts as to the collectibility ofprincipal and/or interest and/or when payment becomes 90 days past due, exceptloans which are well secured and in the process of collection.  Uncollectible interest on loans that areimpaired or contractually past due is charged off based on management’speriodic evaluation.  The charge tointerest income is equal to all interest previously accrued, and income issubsequently recognized only to the extent cash payments are received until, inmanagement’s judgment, the borrower’s ability to make periodic interest andprincipal payments is no longer in doubt, in which case the loan is returned toaccrual status.

 

The Company’s leases receivableare classified as direct finance leases. Under the direct financing method ofaccounting for leases, the total net payments receivable under the leasecontracts and the residual value of the leased equipment, net of unearnedincome, are recorded as a net investment in direct financing leases and theunearned income is recognized each month on a basis which approximates theinterest method. Accrual of interest income is suspended when collection isdoubtful.

 

The allowance for loan andlease losses is established as losses are estimated to have occurred through aprovision for loan losses charged to earnings. Loan losses are charged against the allowance when management believesthe uncollectibility of a loan balance is confirmed.  Subsequent recoveries, if any, are credited to the allowance.

 

The allowance for loan lossesis evaluated on a regular basis by management and is based upon management’speriodic review of the collectibility of the loans in light of historicalexperience, the nature and volume of the loan portfolio, adverse situationsthat may affect the borrower’s ability to repay, estimated value of anyunderlying 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 is considered impairedwhen, based on current information and events, it is probable that the Companywill be unable to collect the scheduled payments of principal or interest whendue according to the contractual terms of the loan agreement.  Factors considered by management indetermining impairment include payment status, collateral value, and theprobability of collecting scheduled principal and interest payments whendue.  Loans that experienceinsignificant payment delays and payment shortfalls generally are notclassified as impaired.  Managementdetermines the significance of payment delays and payment shortfalls on acase-by-case basis, taking into consideration all of the circumstancessurrounding the loan and the borrower, including the length of the delay, thereasons for the delay, the borrower’s prior payment record, and the amount ofthe shortfall in relation to the principal and interest owed.  Impairment is measured on a loan by loanbasis for commercial and construction loans by either the present value ofexpected future cash flows discounted at the loan’s effective interest rate,the loan’s obtainable market price, or the fair value of the collateral if theloan is collateral dependent.

 

Large groups of smaller balancehomogeneous loans are collectively evaluated for impairment.  Accordingly, the Company does not separatelyidentify individual consumer and residential loans for impairment disclosures.

 

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Loanorigination fees and related discounts:  Loan fees and certain direct loanorigination costs are deferred, and the net fee or cost is recognized as anadjustment to interest income using the interest method over the contractuallife of the loans, adjusted for prepayments.

 

Commitment fees and costsrelating to commitments, the likelihood of exercise of which is remote, arerecognized over the commitment period on a straight-line basis.  If the commitment is subsequently exercisedduring the commitment period, the remaining unamortized commitment fee at thetime of exercise is recognized over the life of the loan as an adjustment ofyield.

 

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 the amount, if any, bywhich the amortized cost of the rights for each loan type exceed their fairvalue.

 

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 wasamortized over 10 years.

 

In July 2001, theFinancial Accounting Standards Board (FASB) issued Statement No. 142, *Goodwill and Other Intangible Assets*,which requires that goodwill no longer be amortized to earnings, but instead byreviewed at least annually for impairment. The provisions of FASB Statement No. 142 were implemented by the Companyin the first quarter of fiscal 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.  TheCompany 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 afterOctober 1, 2002.

 

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At June 30, 2003, the Company had $5,020 of goodwill that is notbeing amortized.  The Company hasperformed its impairment testing to determine if goodwill is impaired.  As of June 30, 2003, managementbelieves there is no impairment with respect to intangible assets.  The impact of FASB Statement No. 142 on theCompany’s net income is shown in the following table for the periods presented:

 
|                                          |   | **2003** |   | **2002** |   | **2001** |   |
|-----------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Reported net  income                          |   | $        | 4,975  |     | $      | 3,185    |   | $ | 4,607 |   |
| Addback: goodwill  amortization, net of taxes |   | —   |   | 433      |   | 417      |   |
| Adjusted net income                           |   | $        | 4,975  |     | $      | 3,618    |   | $ | 5,024 |   |
|                                          |   |     |   |     |   |     |   |
| Basic earnings per share:                     |   |     |   |     |   |     |   |
| Reported net income                           |   | $        | 1.51   |     | $      | 0.91     |   | $ | 1.25 |   |
| Goodwill amortization, net  of taxes          |   | —   |   | 0.12     |   | 0.11     |   |
| Adjusted net income                           |   | $        | 1.51   |     | $      | 1.03     |   | $ | 1.36 |   |
|                                          |   |     |   |     |   |     |   |
| Diluted earnings per  share:                  |   |     |   |     |   |     |   |
| Reported net income                           |   | $        | 1.47   |     | $      | 0.89     |   | $ | 1.23 |   |
| Goodwill amortization, net  of taxes          |   | —   |   | 0.12     |   | 0.11     |   |
| Adjusted net income                           |   | $        | 1.47   |     | $      | 1.01     |   | $ | 1.34 |   |

 

Intangible asset:  The intangible asset relates to insurance customer lists.  The original cost of this asset was $350,and it is being amortized over seven years. Amortization expense was $68, $50 and $50 in 2003, 2002 and 2001,respectively.  Subsequent toJune 30, 2003, this insurance list was sold (see Note 23).

 

Foreclosed real 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 offoreclosure.  Costs relating toimprovement of property are capitalized, whereas costs relating to the holdingof property are expensed.  Valuationsare periodically performed by management, and charge-offs to operations aremade if the carrying value of a property exceeds its estimated fair value lessestimated costs to sell.

 

Land held for sale is carried at the lower of cost, including cost ofimprovements and amenities incurred subsequent to acquisition, or fair valueless cost to sell.  Costs relating tothe development and improvement of property are capitalized, whereas costsrelating to holding property are expensed. The carrying amount of land held for sale was $1,298 at June 30,2003 and 2002.

 

During fiscal year 2003, the Company reclassified a building of $191from held for use to held for sale after recording an impairment loss of $200.

 

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Office properties and equipment:  Land is carried at cost.  All other office properties and equipmentare carried 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 andautomobile are depreciated using both the straight-line and declining balancemethods over the estimated useful lives of the assets which are three to twelveyears.

 

Income taxes: Deferred taxes are provided on an asset and liability method wherebydeferred tax assets are recognized for deductible temporary differences andoperating loss and tax credit carryforwards and deferred tax liabilities arerecognized for taxable temporary differences. Temporary differences are the differences between the reported amountsof assets and liabilities and their tax bases. Deferred tax assets are reduced by a valuation allowance when, in theopinion of management, it is more likely than not that some portion or all ofthe deferred tax assets will not be realized. Deferred tax assets and liabilities are adjusted for the effects ofchanges in tax laws and rates on the date of enactment.

 

Earnings per share (EPS):  Basic EPS represents income available tocommon stockholders divided by the weighted-average number of common sharesoutstanding during the period.  DilutedEPS reflects additional common shares that would have been outstanding ifdilutive potential common shares had been issued.

 

Segment reporting:  Operating segments are defined as components of an enterprise forwhich separate financial information is available that is evaluated regularlyby the chief operating decision makers in deciding how to allocate resourcesand in assessing performance.  TheCompany’s reportable segments are “banking” (including leasing activities) and“other”.  The “banking” segment isconducted through the Bank and Mid America Leasing and the “other” segment iscomposed of smaller nonreportable segments, the Company and inter-segmenteliminations.

 

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

 
| **2003**                                                      |   | **Banking** |    | **Other** |   | **Total** |   |
|---------------------------------------------------------------|--------|-------------|---------|-----------|--------|-----------|--------|
| Net interest income                                           |   | $           | 26,554  |      | $      | (991      | )      | $ | 25,563 |   |
| Intersegment interest  income                                 |   | (892        | )       | 892       |   | —    |   |
| Provision for losses on  loans and leases                     |   | (3,173      | )       | —    |   | (3,173    | )      |
| Noninterest income                                            |   | 12,492      |    | 319       |   | 12,811    |   |
| Noninterest expense                                           |   | (26,056     | )       | (1,615    | )      | (27,671   | )      |
| Intersegment noninterest  expense                             |   | (3          | )       | 3         |   | —    |   |
| Income (loss) from  continuing operations before income taxes |   | $           | 8,922   |      | $      | (1,392    | )      | $ | 7,530 |   |
|                                                          |   |        |    |      |   |      |   |
| Total assets                                                  |   | $           | 795,407 |      | $      | 5,076     |   | $ | 800,483 |   |

 

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| **2002**                                                      |   | **Banking** |    | **Other** |   | **Total** |   |
|---------------------------------------------------------------|--------|-------------|---------|-----------|--------|-----------|--------|
| Net interest income                                           |   | $           | 24,847  |      | $      | (403      | )      | $ | 24,444 |   |
| Intersegment interest  income                                 |   | (531        | )       | 531       |   | —    |   |
| Provision for losses on  loans and leases                     |   | (1,905      | )       | —    |   | (1,905    | )      |
| Noninterest income                                            |   | 10,142      |    | 1,004     |   | 11,146    |   |
| Noninterest expense                                           |   | (24,336     | )       | (1,622    | )      | (25,958   | )      |
| Income (loss) from  continuing operations before income taxes |   | $           | 8,217   |      | $      | (490      | )      | $ | 7,727 |   |
|                                                          |   |        |    |      |   |      |   |
| Total assets                                                  |   | $           | 721,438 |      | $      | 1,479     |   | $ | 722,917 |   |

 
| **2001**                                                      |   | **Banking** |    | **Other** |   | **Total** |   |
|---------------------------------------------------------------|--------|-------------|---------|-----------|--------|-----------|--------|
| Net interest income                                           |   | $           | 23,313  |      | $      | (202      | )      | $ | 23,111 |   |
| Intersegment interest  income                                 |   | (84         | )       | 84        |   | —    |   |
| Provision for losses on  loans and leases                     |   | (1,482      | )       | —    |   | (1,482    | )      |
| Noninterest income                                            |   | 8,050       |    | 1,373     |   | 9,423     |   |
| Noninterest expense                                           |   | (21,783     | )       | (1,745    | )      | (23,528   | )      |
| Income (loss) from  continuing operations before income taxes |   | $           | 8,014   |      | $      | (490      | )      | $ | 7,524 |   |
|                                                          |   |        |    |      |   |      |   |
| Total assets                                                  |   | $           | 782,648 |      | $      | 1,354     |   | $ | 784,002 |   |

 

Fair value of financial instruments:  The following methods and assumptions wereused by the Company in estimating 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.

 

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Loans and leases:  Approximately 55% of loans are variable-rateloans that reprice frequently and have no significant change in creditrisk.  Fair values on these loans arebased on carrying values.  The fairvalues for fixed-rate loans and leases are estimated using discounted cash flowanalyses, using interest rates currently being offered for loans and leaseswith similar terms to borrowers with similar credit quality or from quotedmarket prices of similar loans and leases sold, adjusted for differences inloan and lease characteristics.

 

Accrued interest receivable:  The carrying value of accrued interest receivableapproximates 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 ofdeposit.

 

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.

 

Preferred securities of subsidiary trusts:  The carrying amounts for Company obligatedmandatorily redeemable preferred securities of subsidiary trusts that solelyhold subordinated debentures approximate their fair values.

 

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

 

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Stock-based compensation:  The Company accounts for stock-basedcompensation in accordance with Accounting Principles Board (APB) Opinion No.25., *Accounting for Stock Issued toEmployees*, and related interpretations.  No stock-based employee compensation cost has been recognized forgrants under the fixed stock option plans, as all options granted under thoseplans had an exercise price equal to the market value of the underlying commonstock on the date of grant.  Thefollowing table illustrates the effect on net income and earnings per share if theCompany had applied the fair value recognition provisions of FASB Statement No.123, *Accounting for Stock-Based Compensation*,to stock-based employee compensation.

 
|                                                                                                                                         |   | **Years Ended June 30,** |   |
|----------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                                                                                         |   | **2003**                      |   | **2002** |   | **2001** |   |
| Net income, as reported                                                                                                                      |   | $                             | 4,975  |   | $ | 3,185 |   | $ | 4,607 |   |
| Deduct total stock-based  employee compensation expense determined under fair value based method for  all awards, net of related tax effects |   | (136                          | )      | (137 | ) | (139 | ) |
| Pro forma net income                                                                                                                         |   | $                             | 4,839  |   | $ | 3,048 |   | $ | 4,468 |   |
|                                                                                                                                         |   |                          |   |   |   |   |   |
| Basic earnings per share:                                                                                                                    |   |                          |   |   |   |   |   |
| As reported                                                                                                                                  |   | $                             | 1.51   |   | $ | 0.91 |   | $ | 1.25 |   |
| Pro forma                                                                                                                                    |   | 1.47                          |   | 0.88 |   | 1.21 |   |
|                                                                                                                                         |   |                          |   |   |   |   |   |
| Diluted earnings per  share:                                                                                                                 |   |                          |   |   |   |   |   |
| As reported                                                                                                                                  |   | $                             | 1.48   |   | $ | 0.89 |   | $ | 1.23 |   |
| Pro forma                                                                                                                                    |   | 1.44                          |   | 0.85 |   | 1.20 |   |

 

The fair value of each incentive stock option grant is estimated at thegrant date using the Black-Scholes option-pricing model.  The following weighted average assumptionswere used for grants in fiscal years 2003, 2002 and 2001, respectively:  a dividend rate as a percentage of stock priceof 2.59%, 3.52% and 3.02%; price volatility of 25.00%, 25.00% and 26.00%;risk-free interest rates of 3.64%, 4.58% and 5.10% and expected lives of sevenyears for all three years.

 

**Note 2.****                                  DiscontinuedOperations and Sale**

 

During the fourth quarter of fiscal year 2002, management committed toa plan to sell the subprime credit card operations which were previouslyreported in the credit card segment of the Company.  At June 30, 2002, the Company estimated the net realizablevalue based on estimates from a third party and reclassified the net realizablevalue of $1,115 at that time from loans receivable to loans held for sale.  The Bank ceased processing subprime creditcard applications in March 1999 and had been managing the portfolio from abalance of $18,062 at June 30, 1999, to the sale of the receivables as ofJanuary 31, 2003.  OnDecember 31, 2002, the Company, through the Bank, entered into anagreement to sell the discontinued credit card operations to an independentthird party.  Amounts of revenue(including interest income on loans and noninterest income) and pretax profit(loss) reported in discontinued operations for the years ended June 30,2003, 2002 and 2001 were $818 and $44; $2,413 and $(2,554); and $3,848 and $18,respectively.  The Company dissolved theoperations of HF Card during the third quarter of fiscal 2003.

 

69

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**Note 3.****                                  ConsumerAutomobile Loan Securitization**

 

On January 31, 2003, the Bank securitized and sold motor vehicleinstallment loans with principal balances totaling $50,002 for a gain of $308through HFSC and the newly formed Automobile Securitization Trust.  As part of the sales transaction, the Bankretains servicing responsibilities.  Inaddition, the Bank retains the rights to cash flows remaining after investorsin the Automobile Securitization Trust have received their contractual paymentsand has pledged a $2,255 reserve fund to the Automobile SecuritizationTrust.  These retained interests aresubordinated to investors’ interests. The investors and Automobile Securitization Trust have no recourse tothe Bank’s other assets for failure of debtors to pay when due.

 

The gain recognized on the sale of these loans was determined byallocating the carrying amount of the loans between the loans sold and theinterests retained.  The Bank determinedthat 50 basis points of the 100 basis points servicing contract represented wasexcess servicing and was capitalized as part of the transaction utilizing amarket discount rate of 10.0%.  Thisasset is amortized in proportion to, and over the period of, estimated netservicing income.

 

Key economic assumptions used in measuring the fair value of retainedinterests at the date of the securitization resulting from securitization completedduring the current year were 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% CPRand 721.61 PSA.

 

Key economic assumptions used and the sensitivity of fair value of theretained interest as of June 30, 2003 are as follows:

 
|                                        |   | **Retained  Interest** |   | **Servicing  Rights** |   |
|---------------------------------------------|--------|------------------------|--------|-----------------------|--------|
| Fair value                                  |   | $                      | 3,469  |                  | $      | 193 |   |
| Weighted average life (in  years)           |   | 3.26                   |   | 3.26                  |   |
| Prepayment speed (ABS  annual rate):        |   | 21.60                  | %      | 21.60                 | %      |
| Impact on fair value of  10% adverse change |   | $                      | (54    | )                     | $      | (13 | ) |
| Impact on fair value of  20% adverse change |   | (105                   | )      | (25                   | )      |
| Credit losses (annual  rate):               |   | 0.63                   | %      | 0.63                  | %      |
| Impact on fair value of  10% adverse change |   | $                      | (27    | )                     | $      | — |   |
| Impact on fair value of  20% adverse change |   | (54                    | )      | —                |   |
| Discount rate:                              |   | 12.09                  | %      | 10.00                 | %      |
| Impact on fair value of  10% adverse change |   | $                      | (51    | )                     | $      | (1 | ) |
| Impact on fair value of  20% adverse change |   | (102                   | )      | (3                    | )      |

 

70

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These sensitivities are hypothetical and should be used withcaution.  Changes in fair value based ona 10 percent variation in assumptions generally cannot be extrapolated becausethe relationship of the change in assumption to the change in fair value maynot be linear.  Also, in this table, theeffect of a variation in a particular assumption on the fair value of theretained interest is calculated without changing any other assumption; inreality, changes in one factor may result in changes in another (for example,increases in market interest rates may resulting lower prepayments andincreased credit losses), which might magnify or counteract the sensitivities.

 

Static pool losses are calculated by summing the actual and projectedfuture credit losses and dividing the total by the original balance of the poolof loans.  The expected static poollosses of the loans securitized in 2003 is .55%.

 

The table below summarizes certain cash flows received from and paid tothe securitization trust:

 
| Proceeds from new  securitizations              |   | $      | 48,151 |   |
|-------------------------------------------------|--------|--------|--------|--------|
| Servicing fees received                         |   | 170    |   |
| Other cash flows received  on retained interest |   | — |   |

 

The following table presents delinquencies, net credit losses, andcomponents of securitized financial assets and other loans managed togetherwith them as of June 30, 2003:

 
| Automobile loans held in  portfolio                                    |   | $      | 74,066  |   |
|------------------------------------------------------------------------|--------|--------|---------|--------|
| Automobile loans serviced  for others                                  |   | 35,533 |    |
| Total managed automobile  loans                                        |   | $      | 109,599 |   |
|                                                                   |   |   |    |
| Principal amount of  managed automobile loans 60 days or more past due |   | $      | 564     |   |
|                                                                   |   |   |    |
| Net credit losses for  automobile loans for the year                   |   | $      | 592     |   |

 

71

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**Note 4.****                                  Acquisitions**

 

During the year ended June 30, 2001, the Mortgage Corp. purchased100% of the outstanding capital stock of Mid America Leasing for net cashconsideration of $2,857.  Goodwill of$723 was recorded.  This acquisition wasaccounted for under the purchase method of accounting.

 

Results of operations of the acquired entity since the date ofacquisition are included in the consolidated financial statements. Unauditedpro forma consolidated results of continuing operations for the year endedJune 30, 2001 as though the entity had been acquired as of the beginningof the fiscal year prior to the acquisition follows (in thousands, except pershare data):

 
|                          |   | **2001** |   |
|-------------------------------|--------|----------|--------|
| Interest and dividend  income |   | $        | 59,382 |   |
| Net income                    |   | 4,551    |   |
| Earnings per share:           |   |     |   |
| Basic                         |   | $        | 1.24   |   |
| Diluted                       |   | 1.22     |   |

 

The unaudited pro forma combined summary of operations does not purportto be indicative of the results which actually would have been obtained if theacquisition had been made at the beginning of the fiscal year prior to therespective acquisition, or of those results which may be obtained in thefuture. The unaudited pro forma combined summary of operations includes theeffects of additional interest expense on debt incurred in connection with theacquisition as if the debt had been outstanding since the beginning of theperiod presented.  In addition, thesummary of operations includes amortization of the cost of goodwill acquired inconnection with the acquisition as if it had been acquired as of the beginningof the period presented.

 

During the year ended June 30, 2001, several smaller acquisitionswere also made.  The Bank acquired theassets and liabilities of a branch of a local commercial bank and received cashconsideration of $2,218, as the liabilities assumed exceeded the assetsacquired.  Goodwill of $330 wasrecorded.  This acquisition was treatedas a purchase for accounting purposes, and the results of operations of theacquired branch since the date of acquisition are included in the consolidatedfinancial statements.

 

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**Note 5.****                                  Investmentsin Securities**

 

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

 
|                                       |   | **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 |   |

 
|                                       |   | **June 30, 2002** |   |
|--------------------------------------------|--------|------------------------|--------|
|                                       |   | **Amortized  Cost**    |   | **Gross  Unrealized  Gains** |   | **Gross  Unrealized  (Losses)** |   | **Fair Value** |   |
| Debt securities:                           |   |                   |   |   |   |   |   |   |   |
| U.S. government agencies  and corporations |   | $                      | 5,999  |   | $ | 93 |   | $ | — |   | $ | 6,092 |   |
| Federal Home Loan Bank                     |   | 8,200                  |   | 173 |   | — |   | 8,373 |   |
| Municipal bonds                            |   | 3,509                  |   | 81 |   | (1 | ) | 3,589 |   |
| Preferred term securities                  |   | 5,000                  |   | — |   | — |   | 5,000 |   |
|                                       |   | 22,708                 |   | 347 |   | (1 | ) | 23,054 |   |
|                                       |   |                   |   |   |   |   |   |   |   |
| Equity securities:                         |   |                   |   |   |   |   |   |   |   |
| FNMA                                       |   | 8                      |   | — |   | (1 | ) | 7 |   |
| Federal Agricultural  Mortgage             |   | 7                      |   | 1 |   | — |   | 8 |   |
|                                       |   | 15                     |   | 1 |   | (1 | ) | 15 |   |
|                                       |   |                   |   |   |   |   |   |   |   |
| Mortgage-backed securities                 |   | 59,278                 |   | 588 |   | (131 | ) | 59,735 |   |
|                                       |   | $                      | 82,001 |   | $ | 936 |   | $ | (133 | ) | $ | 82,804 |   |

 

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The amortized cost and fair values of debt securities as ofJune 30, 2003, by contractual maturity, are shown below.  Expected maturities will differ fromcontractual maturities because the borrowers may have the right to call orprepay obligations with or without call or prepayment penalties.

 
|                                    |   | **Amortized  Cost** |   | **Fair Value** |   |
|-----------------------------------------|--------|---------------------|--------|----------------|--------|
| Due in one year or less                 |   | $                   | 3,241  |           | $      | 3,289 |   |
| Due after one year through  five years  |   | 5,393               |   | 5,577          |   |
| Due after five years  through ten years |   | —              |   | —         |   |
| Due after ten years                     |   | 9,000               |   | 8,989          |   |
|                                    |   | 17,634              |   | 17,855         |   |
| Mortgage-backed securities              |   | 70,968              |   | 70,658         |   |
|                                    |   | $                   | 88,602 |           | $      | 88,513 |   |

 

Equity securities have been excluded from the maturity table above becausethey do not have contractual maturities associated with debt securities.

 

The components of other comprehensive income (loss) - net change inunrealized gain (loss) on securities available for sale are as follows:

 
|                                                                             |   | **Years Ended June 30,** |   |
|----------------------------------------------------------------------------------|--------|-------------------------------|--------|
|                                                                             |   | **2003**                      |   | **2002** |   | **2001** |   |
| Unrealized holding gain  (loss) arising during the year                          |   | $                             | (541   | ) | $ | 393 |   | $ | 3,691 |   |
| Less reclassification  adjustment for net gains realized in net income           |   | (352                          | )      | (135 | ) | — |   |
| Net change in unrealized  gain (loss) before income taxes                        |   | (893                          | )      | 258 |   | 3,691 |   |
| Income (taxes) benefit                                                           |   | 339                           |   | (98 | ) | (1,402 | ) |
| Other comprehensive income  - net change in unrealized gain (loss) on securities |   | $                             | (554   | ) | $ | 160 |   | $ | 2,289 |   |

 

Proceeds from the sale of securities available for sale in 2003 were$15,210 and resulted in gross gains of $352. Proceeds from the sale of securities available for sale in 2002 were$14,831 and resulted in gross gains of $170 and gross losses of $(35).  There were no sales of securities in 2001,and accordingly, no realized gains or losses.

 

At June 30, 2003 and 2002, securities with a fair value of $74,820and $74,200, respectively, were pledged as collateral for public deposits andother purposes.

 

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**Note 6.**                                  **Loans and Leases Receivable**

 

Loans and leases receivable atJune 30, 2003 and 2002 consist of the following:

 
|                                                         |   | **2003** |    | **2002** |   |
|--------------------------------------------------------------|--------|----------|---------|----------|--------|
| Loans  secured by real estate:                               |   |     |    |     |   |
| Residential:                                                 |   |     |    |     |   |
| One-to-four family                                           |   | $        | 84,081  |     | $      | 73,630 |   |
| Multi-family                                                 |   | 49,364   |    | 56,952   |   |
| Commercial                                                   |   | 93,405   |    | 89,111   |   |
| Agriculture                                                  |   | 18,002   |    | 12,722   |   |
| Construction and  development                                |   | 9,083    |    | 12,738   |   |
| Business, consumer and  other:                               |   |     |    |     |   |
| Commercial business                                          |   | 113,570  |    | 95,462   |   |
| Junior liens on real  estate                                 |   | 81,064   |    | 73,680   |   |
| Automobile                                                   |   | 74,066   |    | 84,782   |   |
| Agriculture                                                  |   | 40,109   |    | 26,707   |   |
| Equipment financing leases                                   |   | 23,016   |    | 22,834   |   |
| Education                                                    |   | 7,745    |    | 7,340    |   |
| Other loans                                                  |   | 6,035    |    | 8,529    |   |
| Mobile home                                                  |   | 1,468    |    | 2,365    |   |
| Loans on savings accounts                                    |   | 1,463    |    | 1,597    |   |
|                                                         |   | 602,471  |    | 568,449  |   |
| Add (less):                                                  |   |     |    |     |   |
| Undisbursed portion of loans  in process                     |   | (3,576   | )       | (4,678   | )      |
| Deferred loan fees and  unearned discounts and premiums, net |   | 364      |    | 504      |   |
| Allowance for loan and  lease losses                         |   | (3,842   | )       | (4,461   | )      |
|                                                         |   | $        | 595,417 |     | $      | 559,814 |   |

 

Loans held for sale totaling $15,984 atJune 30, 2003 consist of one-to-four family fixed-rate loans.  At June 30, 2002, loans held for saletotaling $6,559 consisted of one-to-four family fixed-rate loans and creditcard loans (Note 2).

 

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Activity in the allowance forloan and lease losses included in continuing operations is summarized asfollows for the years ended June 30:

 
|                                                                                         |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Balance,  beginning                                                                          |   | $        | 4,461  |     | $      | 6,544    |   | $ | 8,475 |   |
| Provision charged to  income                                                                 |   | 3,173    |   | 1,905    |   | 1,482    |   |
| Allowance related to  assets acquired (sold), net                                            |   | (264     | )      | —   |   | 97       |   |
| Reclassification of  allowance for loan losses directly against credit card loans receivable |   | —   |   | (577     | )      | —   |   |
| Charge offs related to  discontinued credit card loan operations, net                        |   | —   |   | (458     | )      | (1,941   | )      |
| Other charge offs                                                                            |   | (4,001   | )      | (3,407   | )      | (1,923   | )      |
| Recoveries                                                                                   |   | 473      |   | 454      |   | 354      |   |
| Balance, ending                                                                              |   | $        | 3,842  |     | $      | 4,461    |   | $ | 6,544 |   |

 

The following is a summary of information pertaining to impaired loansand nonaccrual loans as of and for the years ended June 30, 2003, 2002 and2001:

 
|                                                    |   | **2003** |   | **2002** |   | **2001** |   |
|---------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Impaired loans without a  valuation allowance           |   | $        | — |     | $      | —   |   | $ | — |   |
| Impaired loans with a  valuation allowance              |   | 2,674    |   | 3,977    |   | 3,028    |   |
| Total impaired loans                                    |   | $        | 2,674  |     | $      | 3,977    |   | $ | 3,028 |   |
|                                                    |   |     |   |     |   |     |   |
| Valuation allowance  related to impaired loans          |   | $        | 846    |     | $      | 980      |   | $ | 1,501 |   |
|                                                    |   |     |   |     |   |     |   |
| Nonaccruing loans and  leases                           |   | $        | 4,365  |     | $      | 10,242   |   | $ | 5,310 |   |
| Accruing loans and leases  delinquent more than 90 days |   | 1,466    |   | 906      |   | 327      |   |
| Average investment in  impaired loans                   |   | 5,199    |   | 2,662    |   | 1,614    |   |
| Interest income recognized  on impaired loans           |   | 17       |   | 42       |   | 38       |   |

 

No additional funds are committed to be advanced in connection withimpaired loans.

 

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**Note 7.**                                  **Loan Servicing**

 

Mortgage loans serviced for others (primarilythe South Dakota Housing Development Authority) are not included in theaccompanying consolidated statements of financial condition.  The unpaid principal balances of mortgageloans serviced for others was $482,790 and $520,250 at June 30, 2003 and2002, respectively.

 

Custodial balances maintained in connectionwith the foregoing loan servicing, and included in deposits and advances byborrowers for taxes and insurance, were approximately $3,037 and $2,017 atJune 30, 2003 and 2002, respectively.

 

The carrying values of servicing rights were$4,003 and $3,467 at June 30, 2003 and 2002, respectively.  The fair values of these rights were $8,725and $5,275 at June 30, 2003 and 2002, respectively.  The fair values of the servicing rights wereestimated as the present value of the expected future cash flows using adiscount rate of 10%.  The Companyrecognized expense for amortization of the cost of servicing rights in theamount of $482, $347 and $272 for the years ended June 30, 2003, 2002 and2001, respectively.

 

No valuation allowances were provided formortgage servicing rights capitalized during the years ended June 30, 2003and 2002.

 

**Note 8.**                                  **Office Properties and Equipment**

 

Office properties and equipment atJune 30, 2003 and 2002 consist of the following:

 
|                                            |   | **2003** |   | **2002** |   |
|-------------------------------------------------|--------|----------|--------|----------|--------|
| Land                                            |   | $        | 1,832  |     | $      | 1,958 |   |
| Buildings and improvements                      |   | 15,619   |   | 16,133   |   |
| Leasehold improvements                          |   | 1,463    |   | 1,416    |   |
| Furniture, fixtures,  equipment and automobile  |   | 12,131   |   | 11,411   |   |
|                                            |   | 31,045   |   | 30,918   |   |
| Less accumulated  depreciation and amortization |   | (17,907  | )      | (17,204  | )      |
|                                            |   | $        | 13,138 |     | $      | 13,714 |   |

 

In addition, the Bank leases several branch facilities under operatinglease agreements which require minimum rentals totaling $911 through the yearending June 30, 2007.

 

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**Note 9.**                                  **Deposits**

 

Deposits at June 30, 2003 and 2002consist of the following:

 
|                                   |   | **2003** |    | **2002** |   |
|----------------------------------------|--------|----------|---------|----------|--------|
| Noninterest bearing  checking accounts |   | $        | 77,004  |     | $      | 61,355 |   |
| Interest bearing accounts              |   | 43,699   |    | 41,669   |   |
| Money market accounts                  |   | 178,113  |    | 157,770  |   |
| Savings accounts                       |   | 54,462   |    | 50,387   |   |
| Certificates of deposit                |   | 268,103  |    | 251,415  |   |
|                                   |   | $        | 621,381 |     | $      | 562,596 |   |

 

Scheduled maturities of certificates of deposit are as follows:

 
| **Maturing  in fiscal year:** |   |   | ** ** |
|-------------------------------|--------|--------|------------|
| 2004                          |   | $      | 152,638    |   |
| 2005                          |   | 74,641 |       |
| 2006                          |   | 19,675 |       |
| 2007                          |   | 11,060 |       |
| 2008                          |   | 9,770  |       |
| Thereafter                    |   | 319    |       |
|                          |   | $      | 268,103    |   |

 

Deposit accounts are insured up to $100 by the Savings AssociationInsurance Fund (SAIF) under management of the Federal Deposit Insurance Corporation(FDIC). The aggregate amount of jumbo certificates of deposit with a minimumdenomination of $100 was approximately $74,929 and $46,905 at June 30,2003 and 2002, respectively.  Depositsat June 30, 2003 and 2002 include $42,386 and $37,390, respectively, ofdeposits from one local governmental entity, the majority of which are savingsaccounts.

 

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**Note 10.**                           **Advances From Federal Home Loan Bank and OtherBorrowings**

 

Advances from the Federal HomeLoan Bank of Des Moines at June 30, 2003 and 2002 are summarized asfollows:

 
|                                                        |   | **2003** |   | **2002** | ** ** |
|-------------------------------------------------------------|--------|----------|--------|----------|------------|
| Fixed-rate advances (with  rates ranging from 1.9% to 6.5%) |   | $        | 84,498 |     | $          | 67,434 |   |
| Variable-rate advance  (with a rate of 2.1%)                |   | —   |   | 16,000   |       |
|                                                        |   | $        | 84,498 |     | $          | 83,434 |   |

 

Aggregate maturities ofadvances, computed based on call date, are as follows:  2004 $57,462; 2005 $11,090; 2006 $6,070;2007 $1,048; 2008 $1,104; and thereafter $7,724.  Prepayment of the callable advances results in a prepayment feeas negotiated between the Bank and the Federal Home Loan Bank.

 

Advances are secured by stockin the Federal Home Loan Bank of Des Moines, one-to-four family first mortgageloans with balances exceeding 120% of the amount of the related advances andmulti-family first mortgage loans with balances exceeding 140% of the amount ofthe related advances.  In order toprovide additional borrowing collateral, commercial real estate first mortgageloans with balances exceeding 155% of the amount of the related advances havealso been pledged with the Federal Home Loan Bank.  In addition, home equity line of credit loans and home equitysecond mortgages (with balances exceeding 200% and 175% of the amount ofrelated advances, respectively) have been pledged to provide borrowing collateral.

 

The Bank had a $7,500 line ofcredit from the Federal Home Loan Bank of Des Moines, on which nothing wasdrawn at June 30, 2003 and expired on July 2, 2003.

 

The Bank currently has two$10,000 unsecured lines of federal funds with correspondent banks.  There were no funds drawn on either line ofcredit at June 30, 2003.

 

Other borrowings consist of thefollowing:

 

The Company has a contract fordeed which requires monthly payments of $9, plus interest at 7.0%, toOctober 2013.  The contract fordeed, which is secured by land held for sale with a carrying value of $1,298,had a balance of $821 and $874 at June 30, 2003 and 2002,respectively.  Aggregate maturities ofthe contract for deed are as follows: 2004 $56; 2005 $60; 2006 $65; 2007 $69; 2008 $74; and thereafter $497.

 

In June 2003, the Companyentered into two unsecured revolving note agreements with an unrelated bankwith credit lines of $1,500 and $3,000, which had balances of $1,500 and$3,000, respectively, at June 30, 2003. The maturity dates of the notes are September 30, 2003 andMay 30, 2004, respectively.  Thesenotes may be prepaid before maturity without a prepayment penalty.

 

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**Note 11.**                           **Company Obligated Mandatorily Redeemable PreferredSecurities of Subsidiary Trusts Holding Solely Subordinated Debentures**

 

On November 28, 2001, theCompany issued 10,000 shares totaling $10,000 of Company Obligated MandatorilyRedeemable Preferred Securities of Trust I. Trust I 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 I. The securities provide for cumulative cash distributions calculated at arate based on six-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 on December 8, 2031;however, the Company has the option to shorten the maturity date to a date notearlier than December 8, 2006.  Thecapital securities have no voting rights, are unsecured, and rank junior inpriority of the payment to all of the Company’s indebtedness and senior to theCompany’s capital stock.

 

On July 11, 2002, theCompany issued 5,000 shares totaling $5,000 of Company Obligated MandatorilyRedeemable Preferred Securities of Trust II. Trust II was established and exists for the sole purpose of issuingtrust preferred securities and investing the proceeds in subordinateddebentures of the Company.  Thesesubordinated debentures constitute 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 thematurity date to a date not earlier than July 7, 2007.  Holders of the capital securities have novoting rights, are unsecured, and rank junior in priority of the payment to allof the Company’s indebtedness and senior to the Company’s capital stock.

 

On December 19, 2002, the Company issued5,000 shares totaling $5,000 of Company Obligated Mandatorily RedeemablePreferred 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 hasthe option to shorten the maturity date to a date not earlier thanJanuary 7, 2008.  Holders of thecapital securities have no voting rights, are unsecured, and rank junior inpriority of the payment to all of the Company’s indebtedness and senior to theCompany’s capital stock.

 

80

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**Note 12.**                           **Income Tax Matters**

 

The Company and subsidiaries file aconsolidated federal income tax return on a fiscal year basis.  The Bank is allowed bad debt deductionsbased on actual charge-offs.  Inaddition, the Trusts file trust returns on a calendar year basis.

 

The consolidated provision for income taxesfrom continuing operations consists of the following for the years endedJune 30:

 
|             |   | **2003** |   | **2002** |   | **2001** |   |
|------------------|--------|----------|--------|----------|--------|----------|--------|
| Current:         |   |     |   |     |   |     |   |
| Federal          |   | $        | 412    |     | $      | 2,039    |   | $ | 1,912 |   |
| State            |   | 463      |   | 383      |   | 372      |   |
| Deferred expense |   | 1,709    |   | 434      |   | 645      |   |
|             |   | $        | 2,584  |     | $      | 2,856    |   | $ | 2,929 |   |

 

Income tax expense is different from thatcalculated at the statutory federal income tax rate to pretax income fromcontinuing operations.  The reasons forthis difference in the tax expense are as follows:

 
|                                                 |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Computed “expected” tax  expense           |   | $        | 2,636  |     | $      | 2,704    |   | $ | 2,633 |   |
| Increase (decrease) in  income taxes resulting from: |   |     |   |     |   |     |   |
| Tax exempt interest income                           |   | (224     | )      | (79      | )      | (99      | )      |
| State taxes, net of  federal benefit                 |   | 331      |   | 262      |   | 221      |   |
| Benefit of income taxed at  lower rates              |   | (65      | )      | (75      | )      | (73      | )      |
| Amortization of intangible  assets                   |   | —   |   | 148      |   | 116      |   |
| Change in valuation  allowance                       |   | —   |   | 38       |   | —   |   |
| Other, net                                           |   | (94      | )      | (142     | )      | 131      |   |
|                                                 |   | $        | 2,584  |     | $      | 2,856    |   | $ | 2,929 |   |

 

81

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The components of the net deferred tax assetas of June 30, 2003 and 2002 are as follows:

 
|                                                  |   | **2003** |   | **2002** |   |
|-------------------------------------------------------|--------|----------|--------|----------|--------|
| Deferred tax assets:                                  |   |     |   |     |   |
| Allowance for loan and  leases losses                 |   | $        | 1,229  |     | $      | 1,425 |   |
| Deferred loan fees                                    |   | 46       |   | 73       |   |
| Discounts on loans from  acquired associations        |   | 28       |   | 43       |   |
| Accrued expenses                                      |   | 272      |   | 387      |   |
| Net unrecognized pension  costs                       |   | 419      |   | 432      |   |
| Net unrealized loss on  securities available for sale |   | 34       |   | —   |   |
| Discontinued operations                               |   | —   |   | 920      |   |
| Other                                                 |   | 634      |   | 186      |   |
|                                                  |   | 2,662    |   | 3,466    |   |
| Less valuation allowance                              |   | (82      | )      | (82      | )      |
|                                                  |   | 2,580    |   | 3,384    |   |
|                                                  |   |     |   |     |   |
| Deferred tax liabilities:                             |   |     |   |     |   |
| Loans and leases  receivable                          |   | 1,721    |   | —   |   |
| Net unrealized gain on  securities available for sale |   | —   |   | 305      |   |
| FHLB stock dividends                                  |   | 148      |   | 148      |   |
| Mortgage servicing rights                             |   | 186      |   | 100      |   |
|                                                  |   | 2,055    |   | 553      |   |
|                                                  |   | $        | 525    |     | $      | 2,831 |   |

 

Retained earnings at June 30, 2003 and2002, include approximately $4,805 related to the pre-1987 allowance for loanlosses 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,or in 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 incometax liability on the above amount for financial statement purposes wasapproximately $1,634.

 

82

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**Note 13.**                           **Regulatory Capital**

 

The Bank is subject to various regulatorycapital 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 accounting practices.  The Bank’s capital amounts andclassification are also subject to qualitative judgments by the regulatorsabout components, risk weightings, and other factors.

 

Quantitative measures established byregulation to ensure capital adequacy require the Bank to maintain minimum amountsand ratios (set forth in the following table) of total and Tier I capital (asdefined in the regulations) to risk-weighted assets (as defined), and of Tier Icapital (as defined) to adjusted total assets (as defined).  Management believes, as of June 30,2003 and 2002, that the Bank meets all capital adequacy requirements to whichit is subject.

 

As of June 30, 2003, the most recentnotification from the Office of Thrift Supervision (OTS) categorized the Bankas “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.

 

83

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The following table summarizes the Bank’scompliance with its regulatory capital requirements at June 30, 2003 and2002:

 
|                                                |   | **Actual** |   | **Minimum Capital  Requirement** |       | **To Be Well  Capitalized Under  Prompt Corrective  Action Provisions** |       |
|-----------------------------------------------------|--------|------------|--------|----------------------------------|------------|-------------------------------------------------------------------------|------------|
|                                                |   | **Amount** |   | **Percent**                      | ** ** | **Amount**                                                              | ** ** | **Percent** | ** ** | **Amount** | ** ** | **Percent** | ** ** |
| 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 |   |
|                                                |   |       |   |                             |       |                                                                    |       |   |   |   |   |   |   |
| As of June 30, 2002:                           |   |       |   |                             |       |                                                                    |       |   |   |   |   |   |   |
| Tier I (core) capital (to  adjusted total assets)   |   | $          | 53,284 |                             | 7.44       | %                                                                       | $          | 28,656 |   | 4.00 | % | $ | 35,820 |   | 5.00 | % |
| Total risk-based capital  (to risk-weighted assets) |   | 57,745     |   | 10.04                            |       | 46,023                                                                  |       | 8.00 |   | 57,529 |   | 10.00 |   |
| Tangible capital (to  tangible assets)              |   | 53,284     |   | 7.44                             |       | 10,746                                                                  |       | 1.50 |   | N/A |   | N/A |   |
| Tier 1 (core) capital (to  risk-weighted assets)    |   | 53,284     |   | 9.26                             |       | N/A                                                                     |       | N/A |   | 34,517 |   | 6.00 |   |

 

84

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**Note 14.**                           **Stockholders’ Equity**

 

The Company currently has in effect a stockbuy back program in which up to 10% of the common stock of the Companyoutstanding on May 1, 2003 may be acquired through April 30,2004.  A total of 149,916 shares ofcommon stock have been purchased pursuant to this current program and theprevious program in effect during fiscal year 2003.  Pursuant to a series of stock buy back programs initiated by theCompany since 1996, the Company has purchased an aggregate of 1,708,946 sharesof common stock through June 30, 2003, which includes a block of 340,021shares of common stock repurchased in a private transaction inFebruary 2002.

 

The Company has authorized 50,000 shares ofPreferred Stock, designated as “Series A Junior Participating Preferred Stock”with a stated value of $1.00 per share. Outstanding shares of the Junior Preferred Stock are entitled tocumulative dividends.  Such shares havevoting rights of 100 votes per share and a preference in liquidation.  The shares are not redeemable afterissuance.

 

The Company also has preferred share purchaserights (Rights). Each Right entitles the registered holder to purchase from theCompany one one-hundredth of a share of Series A Junior Participating PreferredStock at a price of $65 per one-hundredth of a preferred share, subject to thecomplete terms as stated in the Rights Agreement.  The Rights become exercisable immediately after the earlier of(i) ten business days following a public announcement that a person or grouphas acquired beneficial ownership of 20% or more of the outstanding commonshares of the Company (subject to certain exclusions), (ii) ten business daysfollowing the commencement or announcement of an intention to make a tenderoffer or exchange offer, the consummation of which would result in thebeneficial ownership by a person or group of 20% or more of such outstandingcommon shares.  The Rights expire onOctober 22, 2006, which date may be extended subject to certain additionalconditions.

 

Under current regulations, theBank is not permitted to pay dividends on its stock if its regulatory capitalwould reduce below (i) the amount required for the liquidation accountestablished to provide a limited priority claim to the assets of the Bank toqualifying depositors (Eligible Account Holders) at March 31, 1992 whocontinue to maintain deposits at the Bank after its conversion from a federalmutual savings and loan association to a federal stock savings bank pursuant toits Plan of Conversion adopted August 21, 1991, or (ii) the Bank’sregulatory capital requirements. Capital distributions are limited to the greater of 100% of net incomefor the 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 quarterperiod.  On August 11, 2003, theBank sent written notification to the OTS of its intention to pay up to 50% ofthe Bank’s net income for each quarter in the year ending June 30, 2004,to the Company.

 

85

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**Note 15.**                           **Earnings Per Share**

 

A reconciliation of the incomeand common stock share amounts used in the calculation of basic and dilutedearnings per share (EPS) for the fiscal years ended June 30, 2003, 2002and 2001 follow.

 
|                                                                                           |   | **2003**  |   | **2002**  |   | **2001**  |   |
|------------------------------------------------------------------------------------------------|--------|-----------|--------|-----------|--------|-----------|--------|
| Earnings:                                                                                      |   |      |   |      |   |      |   |
| Income from continuing  operations                                                             |   | $         | 4,946  |      | $      | 4,871     |   | $ | 4,595 |   |
| Discontinued operations,  net of tax                                                           |   | 29        |   | (1,686    | )      | 12        |   |
| Net income                                                                                     |   | $         | 4,975  |      | $      | 3,185     |   | $ | 4,607 |   |
|                                                                                           |   |      |   |      |   |      |   |
| Basic EPS:                                                                                     |   |      |   |      |   |      |   |
| Weighted average number of  common shares outstanding                                          |   | 3,301,301 |   | 3,512,879 |   | 3,680,796 |   |
|                                                                                           |   |      |   |      |   |      |   |
| Earnings per common share:                                                                     |   |      |   |      |   |      |   |
| Income from continuing  operations                                                             |   | $         | 1.50   |      | $      | 1.39      |   | $ | 1.25 |   |
| Discontinued operations,  net of tax                                                           |   | 0.01      |   | (0.48     | )      | —    |   |
| Net income                                                                                     |   | $         | 1.51   |      | $      | 0.91      |   | $ | 1.25 |   |
|                                                                                           |   |      |   |      |   |      |   |
| Diluted EPS:                                                                                   |   |      |   |      |   |      |   |
| Weighted average number of  common shares outstanding                                          |   | 3,301,301 |   | 3,512,879 |   | 3,680,796 |   |
| Common share equivalents -  stock options and stock issuable under employee compensation plans |   | 61,703    |   | 67,914    |   | 56,817    |   |
| Weighted average number of  common shares and common share equivalents                         |   | 3,363,004 |   | 3,580,793 |   | 3,737,613 |   |
|                                                                                           |   |      |   |      |   |      |   |
| Earnings per common share:                                                                     |   |      |   |      |   |      |   |
| Income from continuing  operations                                                             |   | $         | 1.47   |      | $      | 1.36      |   | $ | 1.23 |   |
| Discontinued operations,  net of tax                                                           |   | 0.01      |   | (0.47     | )      | —    |   |
| Net income                                                                                     |   | $         | 1.48   |      | $      | 0.89      |   | $ | 1.23 |   |

 

Options outstanding of approximately 90,000and 180,000 shares of common stock at weighted average share prices of $15.78and $14.44 during the years ended June 30, 2003 and 2002, respectively,were not included in the computation of diluted earnings per share because theexercise prices of those instruments exceeded the average market prices of thecommon shares during the years.

 

86

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**Note 16.****                           DefinedBenefit Plan**

 

The Company has anoncontributory (cash balance) defined benefit pension plan covering allemployees of the Company and its wholly-owned subsidiaries who have attainedthe age of twenty-one and have completed one year of service.  The benefits are based on 6% of eacheligible participant’s annual compensation, plus income earned in the accountsat a rate determined 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, and retirement atage 65.

 

Information relative to theCompany’s defined benefit plan is presented below:

 
|                                           |   | **2003** |   | **2002** |   |
|------------------------------------------------|--------|----------|--------|----------|--------|
| Changes in benefit  obligations:               |   |     |   |     |   |
| Benefit obligations,  beginning                |   | $        | 3,713  |     | $      | 3,203 |   |
| Service cost                                   |   | 622      |   | 581      |   |
| Interest cost                                  |   | 282      |   | 229      |   |
| Benefits paid                                  |   | (180     | )      | (189     | )      |
| Actuarial loss (gain)                          |   | 36       |   | (111     | )      |
| Benefit obligations,  ending                   |   | $        | 4,473  |     | $      | 3,713 |   |
|                                           |   |     |   |     |   |
| Changes in plan assets:                        |   |     |   |     |   |
| Fair value of plan assets,  beginning          |   | $        | 2,416  |     | $      | 2,411 |   |
| Actual return on plan  assets                  |   | 59       |   | (229     | )      |
| Company contributions                          |   | 498      |   | 423      |   |
| Benefits paid                                  |   | (180     | )      | (189     | )      |
| Fair value of plan assets,  ending             |   | $        | 2,793  |     | $      | 2,416 |   |
|                                           |   |     |   |     |   |
| Funded status at end of  year:                 |   |     |   |     |   |
| Plan assets (deficient) of  obligations        |   | $        | (1,680 | )        | $      | (1,297 | ) |
| Unrecognized losses                            |   | 1,495    |   | 1,427    |   |
| Unrecognized prior service  (benefit)          |   | (44      | )      | (90      | )      |
| Unrecognized transition  asset                 |   | 35       |   | 47       |   |
| (Accrued) prepaid benefit  cost at end of year |   | $        | (194   | )        | $      | 87 |   |

 

87

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The components of pension costfor the years ended June 30 consist of the following:

 
|                               |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Service cost                       |   | $        | 622    |     | $      | 581      |   | $ | 480 |   |
| Interest cost                      |   | 282      |   | 229      |   | 202      |   |
| Expected return on plan  assets    |   | (204     | )      | (198     | )      | (240     | )      |
| Amortization of prior  losses      |   | 113      |   | —   |   | 12       |   |
| Accretion of prior service  cost   |   | (46      | )      | (46      | )      | (46      | )      |
| Recognized net actuarial  losses   |   | —   |   | 82       |   | —   |   |
| Amortization of transition  asset  |   | 12       |   | 11       |   | 12       |   |
| Total costs recognized in  expense |   | $        | 779    |     | $      | 659      |   | $ | 420 |   |

 

The components in the balancesheet consist of:

 
|                                                              |   | **2003** |   | **2002** |   |
|-------------------------------------------------------------------|--------|----------|--------|----------|--------|
| (Accrued) prepaid benefit  cost                                   |   | $        | (194   | )        | $      | 87 |   |
| Accrued benefit liability                                         |   | (1,094   | )      | (1,093   | )      |
| Intangible asset                                                  |   | (9       | )      | (43      | )      |
| Accumulated other  comprehensive loss                             |   | 1,103    |   | 1,136    |   |
| Net asset (liability)  recorded in the consolidated balance sheet |   | $        | (194   | )        | $      | 87 |   |

 

The weighted-averagepost-retirement and pre-retirement discount rates used in determining the actuarialpresent value of the benefit obligations were 5.40% and 7.50% for fiscal year2003 and 5.45% and 7.50% for fiscal year 2002, respectively.  The rate of increase in future compensationlevels used to determine the actuarial present value of the benefit obligationswas 5.5% for both fiscal years 2003 and 2002. The expected long-term rate of return on plan assets was 8.0% for bothfiscal years 2003 and 2002.

 

88

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**Note 17.****                           RetirementPlan**

 

The Company had an employeestock ownership plan (ESOP) covering all full-time employees of the Company whohave attained age 21 and completed one year of service during which they workedat least 1,000 hours.  The ESOP includedan employee savings plan feature which provided for voluntary contributions byeligible employees on a tax-deferred basis with no matching contribution by theCompany.  All shares owned by the ESOPare included in earnings per share computations, with shares being allocated toeligible employees as the corresponding ESOP debt was repaid.  At June 30, 2003, the ESOP holds234,636 shares, all of which have been allocated to eligible employees.

 

For financial statementpurposes, expense for the ESOP is determined on the percentage of sharesallocated to participants each period (allocations are based on principal andinterest payments) times the original amount of the debt plus the interestincurred.

 

During fiscal year 2001, thefinal payment for the ESOP was made. Effective July 1, 2001, the ESOP wasamended and restated, and renamed the HF Financial Corp. Retirement SavingsPlan. The amended plan is intended to be a qualified profit sharing plan with acash or deferred arrangement pursuant to Code Section 401(k) andregulations issued thereunder. Participation and eligibility requirements aresimilar to the previous plan. The amended plan continues to allow voluntarycontributions by eligible employees, and also allows discretionarycontributions by the Company, as determined annually by the Board of Directors.  The total compensation cost charged toexpense related to the retirement plans mentioned above was $251, $216 and $113for 2003, 2002 and 2001, respectively.

 

**Note 18.****                           Stock-BasedCompensation Plans**

 

The Company has a 1991 StockOption and Incentive Plan (1991 Option Plan), in which awards for an aggregateamount of 828,000 common shares may be granted to directors and employees ofthe Bank.  Options granted under the1991 Option Plan may be either options that qualify as Incentive Stock Options,as defined in Section 422 of the Internal Revenue Code of 1986, as amended(the Code), or options that do not qualify. Options granted may have a maximum term of 10 years.  The 1991 Option Plan also provides for theaward of stock appreciation rights, limited stock appreciation rights andrestricted stock.

 

The 1991 Option Plan recentlyexpired.  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 750,000 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 of10 years.  The 2002 Option Plan alsoprovides for the award of stock appreciation rights, limited stock appreciationrights and restricted stock.  Duringfiscal year 2003, no awards were made under the 2002 Option Plan.

 

89

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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 years2003, 2002 and 2001, the Company met a performance level in the plan, andaccordingly, during fiscal year 2003 restricted stock with a value of $382 willbe issued in fiscal year 2004.  Duringfiscal years 2003 and 2002, 12,717 and 10,342 shares, respectively, ofrestricted stock were awarded under the 1991 Option Plan.  These shares vest 33 1/3% after 3 years, 662/3% after 4 years, and 100% after 5 years of continued employment.  The vesting period for these shares mayaccelerate based on the Company meeting certain performance criteria, in whichthe shares would vest 25% after year 1, 0% in year 2, and 25% in each of thenext 3 years.  The issuance value ofthese shares was $153 and $129 for 2003 and 2002, 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 2003 and2002, $30 and $21, respectively, was recorded as amortization expense.

 

Also in connection with meetinga performance level of the long-term incentive plan, 39,094 stock options willbe issued in fiscal year 2004 under the plan.

 

During fiscal year 2001, theCompany created a pool of 10,000 restricted shares (Pool), which was increasedto 17,000 restricted shares in fiscal year 2003.  Awards from the Pool are at the discretion of the Chairman of theBoard of Directors on a spot basis to employees and are provided for under the1991 Option Plan.  The restricted sharesvest 33 1/3% after 3 years, 66 2/3% after 4 years, and 100% after 5 years ofcontinued employment.  Key provisions ofthe Pool include: outright grant of shares with restrictions as to sale,transfer, and pledging; during the restriction period, the grantee receivesdividends and has voting rights related to the shares awarded; and allnonvested shares are forfeited upon termination.  During 2001, no restricted shares were issued from the Pool.  During fiscal years 2003 and 2002, 10,741and 3,475 restricted shares, respectively, were awarded under the Pool.  The issuance value of these restrictedshares was $123 and $40 in 2003 and 2002, respectively, and is being amortizedover the vesting period of five years, with the unamortized balance included indeferred compensation in the consolidated balance sheet.  During fiscal years 2003 and 2002, $36 and$7, respectively, was recorded as amortization expense.

 

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

 
|                              |   | **2003**   |   | **2002**                               |   | **2001**   |    |
|-----------------------------------|--------|------------|--------|----------------------------------------|--------|------------|---------|
| **Fixed  Options**                |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   | **Shares** |    | **Weighted  Average  Exercise  Price** |   | **Shares** |   | **Weighted  Average  Exercise  Price** |   |
| Outstanding at beginning  of year |   | 283,919    |   | $                                      | 12.06  |       | 342,671 |   | $ | 10.33 |   | 262,047 |   | $ | 10.66 |   |
| Granted                           |   | 68,753     |   | 12.00                                  |   | 73,725     |    | 12.50 |   | 96,655 |   | 9.38 |   |
| Forfeited                         |   | (20,312    | )      | 11.75                                  |   | (52,285    | )       | 12.57 |   | (10,589 | ) | 13.52 |   |
| Exercised                         |   | (12,306    | )      | 11.15                                  |   | (80,192    | )       | 4.73 |   | (5,442 | ) | 3.33 |   |
| Outstanding at end of year        |   | 320,054    |   | $                                      | 12.10  |       | 283,919 |   | $ | 12.06 |   | 342,671 |   | $ | 10.33 |   |

 

Options for 231,047, 183,374and 232,005 shares were exercisable at June 30, 2003, 2002 and 2001,respectively.  The weighted average fairvalue of options granted was $2.86 and $2.78 for the fiscal years endedJune 30, 2003 and 2002, respectively.

 

90

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Fixed options outstanding atJune 30, 2003 are summarized as follows:

 
| **Options Outstanding** |   | **Options Exercisable** |   |
|-------------------------|--------|-------------------------|--------|
| **Number  Outstanding** |   | **Number  Exercisable** |   | **Remaining  Contractual  Life** |   | **Exercise  Price** |   |
| 4,773                   |   | 4,773                   |   | 1 year |   | $ | 7.33 |   |
| 23,556                  |   | 23,556                  |   | 2 years |   | 8.17 |   |
| 65,199                  |   | 37,394                  |   | 8 years |   | 9.38 |   |
| 300                     |   | 300                     |   | 3 years |   | 9.92 |   |
| 22,752                  |   | 22,752                  |   | 4 years |   | 10.21 |   |
| 336                     |   | 336                     |   | 3 years |   | 11.17 |   |
| 65,847                  |   | 21,935                  |   | 10 years |   | 12.00 |   |
| 49,561                  |   | 32,271                  |   | 9 years |   | 12.50 |   |
| 45,784                  |   | 45,784                  |   | 6 years |   | 15.38 |   |
| 41,946                  |   | 41,946                  |   | 5 years |   | 16.25 |   |
| 320,054                 |   | 231,047                 |   |   |   |   |   |
|                         |        |                         |        |  |  |  |  |  |

 

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 the inclusionof an annual cost of living adjustment based on the Consumer Price Index.  Each outside director is entitled to allvoting, dividend and distribution rights during the restriction period.  The effective date of the plan wasJuly 1, 1997.  The plan has 75,000shares allocated to it and is in effect for a period of ten years.  During fiscal years 2003, 2002 and 2001,7,164, 7,560 and 11,249 shares were awarded and $90, $103 and $100 of expensewas incurred under the plan as the annual retainer for the Company’s Board ofDirectors for the years ending June 30, 2003, 2002 and 2001, respectively.

 

**Note 19.****                           AccumulatedOther Comprehensive Income**

 

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

 
|                                                                                                  |   | **2003** |   | **2002** |   |
|-------------------------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|
| Unrealized gain (loss) on  securities available for sale, net of related tax effect of $(34) and $305 |   | $        | (56    | )        | $      | 498 |   |
| Fair value change in  retained interest, net of related deferred tax effect of $3                     |   | 5        |   | —   |   |
| Unrecognized pension  costs, net of related deferred tax effect of $(419) and $(432)                  |   | (684     | )      | (704     | )      |
|                                                                                                  |   | $        | (735   | )        | $      | (206 | ) |

 

91

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**Note 20.****                           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,**    |   |
|-----------------------------------------------------------------------------|--------|----------------------|--------|
|                                                                        |   | **2003**             |   | **2002** |   |
|                                                                        |   | **Carrying  Amount** |   | **Fair Value** |   | **Carrying  Amount** |   | **Fair Value** |   |
| Financial Assets                                                            |   |                 |   |   |   |   |   |   |   |
| Cash and cash equivalents                                                   |   | $                    | 44,214 |   | $ | 44,214 |   | $ | 27,546 |   | $ | 27,546 |   |
| Securities                                                                  |   | 88,527               |   | 88,527 |   | 82,804 |   | 82,804 |   |
| Federal Home Loan Bank  stock                                               |   | 7,025                |   | 7,025 |   | 6,332 |   | 6,332 |   |
| Loans and leases                                                            |   | 611,401              |   | 634,195 |   | 566,373 |   | 575,490 |   |
| Accrued interest  receivable                                                |   | 4,298                |   | 4,298 |   | 4,410 |   | 4,410 |   |
| Servicing rights                                                            |   | 4,003                |   | 8,725 |   | 3,467 |   | 5,275 |   |
| Retained interest asset                                                     |   | 3,468                |   | 3,468 |   | — |   | — |   |
|                                                                        |   |                 |   |   |   |   |   |   |   |
| Financial Liabilities                                                       |   |                 |   |   |   |   |   |   |   |
| Deposits                                                                    |   | 621,381              |   | 626,850 |   | 562,596 |   | 567,323 |   |
| Preferred securities of  subsidiary trusts                                  |   | 20,000               |   | 20,000 |   | 10,000 |   | 10,000 |   |
| Borrowed funds                                                              |   | 89,819               |   | 94,287 |   | 84,308 |   | 84,938 |   |
| Accrued interest payable  and advances by borrowers for taxes and insurance |   | 10,999               |   | 10,999 |   | 10,187 |   | 10,187 |   |
|                                                                             |        |                      |        |  |  |  |  |  |  |  |  |  |  |

 

92

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**Note 21.****                           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 30,2003 and 2002, the Bank has approximately $55 and $74 of loans sold withrecourse to the 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 $92,995and $68,369 at June 30, 2003 and 2002, respectively.  Unused letters of credit amounted to $5,359and $1,221 at June 30, 2003 and 2002, respectively.  The lines of credit and letters of creditare collateralized in substantially the same manner as loans receivable.

 

The Bank had outstandingcommitments to originate or purchase loans of $91,645 and to sell loans ofapproximately $43,293 and to purchase investment securities of $260 atJune 30, 2003.  The portion ofcommitments to originate or purchase fixed rate loans totaled $73,502 with arange in interest rates of 4.61% to 6.00%. No losses are expected to be sustained in the fulfillment of any ofthese commitments.

 

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 22.****                           CashFlow Information**

 

Changes in other assets andliabilities for the years ended June 30, 2003, 2002 and 2001 consist of:

 
|                                                           |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| (Increase) decrease in  accrued interest receivable            |   | $        | 112    |     | $      | 1,002    |   | $ | (59 | ) |
| Increase (decrease) in  deferred loan fees                     |   | 140      |   | (637     | )      | (223     | )      |
| Earnings on cash value of  life insurance                      |   | (431     | )      | —   |   | —   |   |
| (Increase) in other assets                                     |   | (6,121   | )      | (485     | )      | (403     | )      |
| Increase (decrease) in  accrued expenses and other liabilities |   | 1,016    |   | (4,609   | )      | 1,485    |   |
|                                                           |   | $        | (5,284 | )        | $      | (4,729   | )      | $ | 800 |   |

 

93

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**Note 23.****                           SubsequentEvent**

 

The Company sold the propertyand casualty book of business of Hometown to a third party as of July 31,2003 for total proceeds of $375.  Thetransaction had an immaterial impact on the Company’s financial position andresults of operations.

 

**Note 24.****                           FinancialInformation of HF Financial Corp. (Parent Only)**

 

The Company’s condensed balancesheets as of June 30, 2003 and 2002 and related condensed statements ofincome and cash flows for each of the years in the three year period endedJune 30, 2003 are as follows:

 

Condensed Balance Sheets

 
|                                |   | **2003** |   | **2002** |   |
|-------------------------------------|--------|----------|--------|----------|--------|
| Assets                              |   |     |   |     |   |
| Cash, primarily with the  Bank      |   | $        | 730    |     | $      | 238 |   |
| Note receivable, HF Card            |   | —   |   | 8,327    |   |
| Investments, marketable  securities |   | —   |   | 282      |   |
| Investments in  subsidiaries        |   | 71,368   |   | 48,727   |   |
| Land held for sale                  |   | 1,298    |   | 1,298    |   |
| Other                               |   | 2,104    |   | 1,240    |   |
|                                |   | $        | 75,500 |     | $      | 60,112 |   |
|                                |   |     |   |     |   |
| Liabilities                         |   |     |   |     |   |
| Other borrowings                    |   | $        | 25,941 |     | $      | 11,184 |   |
| Other liabilities                   |   | 201      |   | 392      |   |
| Stockholders’ equity           |   | 49,358   |   | 48,536   |   |
|                                |   | $        | 75,500 |     | $      | 60,112 |   |

 

Condensed Statements of Income

 
|                                                                 |   | **2003** |   | **2002** |   | **2001** |   |
|----------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Dividends from  subsidiaries                                         |   | $        | 2,551  |     | $      | 5,317    |   | $ | 2,703 |   |
| Interest and other income                                            |   | 80       |   | 633      |   | 769      |   |
| Income from operations of  discontinued segment, net of income taxes |   | 72       |   | —   |   | —   |   |
| Expenses                                                             |   | (1,415   | )      | (850     | )      | (574     | )      |
| Income tax benefit                                                   |   | 546      |   | 1,067    |   | 88       |   |
| Equity in undistributed  income of subsidiaries                      |   | 3,141    |   | (2,982   | )      | 1,621    |   |
| Net income                                                           |   | $        | 4,975  |     | $      | 3,185    |   | $ | 4,607 |   |

 

94

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Condensed Statements of Cash Flows

 
|                                                                               |   | **2003** |   | **2002** |   | **2001** |   |
|------------------------------------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Cash Flows From Operating  Activities                                              |   |     |   |     |   |     |   |
| Net income                                                                         |   | $        | 4,975  |     | $      | 3,185    |   | $ | 4,607 |   |
| Adjustments to reconcile  net income to net cash provided by operating activities: |   |     |   |     |   |     |   |
| Realized (gain) on sale of  securities, net                                        |   | (1       | )      | —   |   | —   |   |
| Amortization                                                                       |   | 20       |   | 7        |   | 113      |   |
| Equity in (earnings) of  subsidiaries                                              |   | (5,692   | )      | (2,335   | )      | (4,324   | )      |
| Cash dividends received  from subsidiaries                                         |   | 2,551    |   | 5,317    |   | 2,703    |   |
| Increase (decrease) in  liabilities                                                |   | (191     | )      | 262      |   | (47      | )      |
| Other, net                                                                         |   | (335     | )      | (757     | )      | 4        |   |
| Net cash provided by  operating activities                                         |   | 1,327    |   | 5,679    |   | 3,056    |   |
|                                                                               |   |     |   |     |   |     |   |
| Cash Flows From Investing  Activities                                              |   |     |   |     |   |     |   |
| Disbursements on note  receivable from HF Card                                     |   | (2,476   | )      | (1,505   | )      | (1,383   | )      |
| Repayments on note  receivable from HF Card                                        |   | 225      |   | 540      |   | 720      |   |
| Proceeds from maturities  and sales of securities                                  |   | 283      |   | 101      |   | —   |   |
| Capital contribution to  the Bank                                                  |   | (9,000   | )      | (5,300   | )      | (1,650   | )      |
| Capital contribution to HF  Group                                                  |   | (600     | )      | —   |   | —   |   |
| Capital contribution to  the Mortgage Corp.                                        |   | —   |   | —   |   | (2,950   | )      |
| Net cash (used in) investing  activities                                           |   | (11,568  | )      | (6,164   | )      | (5,263   | )      |
|                                                                               |   |     |   |     |   |     |   |
| Cash Flows From Financing  Activities                                              |   |     |   |     |   |     |   |
| Purchase of treasury stock                                                         |   | (2,403   | )      | (5,571   | )      | —   |   |
| Cash dividends paid                                                                |   | (1,524   | )      | (1,555   | )      | (1,545   | )      |
| Proceeds from issuance of  common stock                                            |   | 513      |   | 637      |   | 118      |   |
| Proceeds from issuance of  preferred securities                                    |   | 10,000   |   | 10,000   |   | —   |   |
| Proceeds from other  borrowings                                                    |   | 4,500    |   | —   |   | 3,000    |   |
| Payments on other  borrowings                                                      |   | (53      | )      | (3,048   | )      | (46      | )      |
| Payment of debt issue  costs                                                       |   | (300     | )      | (350     | )      | —   |   |
| Net cash provided by  financing activities                                         |   | 10,733   |   | 113      |   | 1,527    |   |
| Increase (decrease) in  cash                                                       |   | 492      |   | (372     | )      | (680     | )      |
|                                                                               |   |     |   |     |   |     |   |
| Cash at beginning of  period                                                       |   | 238      |   | 610      |   | 1,290    |   |
| Cash at end of period                                                              |   | $        | 730    |     | $      | 238      |   | $ | 610 |   |

 

95

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**Note 25.****                           QuarterlyFinancial Information (Unaudited)**

 

(Dollars in thousands exceptper share data)

 
| **(1) Fiscal  year 2003**                   |   | **1st Quarter** |   | **2nd Quarter** |   | **3rd Quarter** |   | **4th Quarter** |   |
|---------------------------------------------|--------|-----------------|--------|-----------------|--------|-----------------|--------|-----------------|--------|
| Total interest income                       |   | $               | 11,506 |            | $      | 11,324          |   | $               | 10,513 |   | $ | 10,217 |   |
| Net interest income                         |   | 6,735           |   | 6,587           |   | 6,133           |   | 6,108           |   |
| 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          |   | $               | 0.43   |            | $      | 0.46            |   | $               | 0.46   |   | $ | 0.13 |   |
| Discontinued operations,  net of tax        |   | 0.02            |   | (0.03           | )      | 0.03            |   | —          |   |
| Net income                                  |   | $               | 0.45   |            | $      | 0.43            |   | $               | 0.49   |   | $ | 0.13 |   |
|                                        |   |            |   |            |   |            |   |            |   |
| Earnings per share -  diluted:              |   |            |   |            |   |            |   |            |   |
| Income from continuing  operations          |   | $               | 0.43   |            | $      | 0.45            |   | $               | 0.45   |   | $ | 0.13 |   |
| Discontinued operations,  net of tax        |   | 0.02            |   | (0.03           | )      | 0.03            |   | —          |   |
| Net income                                  |   | $               | 0.45   |            | $      | 0.42            |   | $               | 0.48   |   | $ | 0.13 |   |

 
| **(1) Fiscal year 2002**                    |   | **1st  Quarter** | ** ** | **2nd  Quarter** | ** ** | **3rd  Quarter** | ** ** | **4th  Quarter  (2)** |   |
|---------------------------------------------|--------|------------------|------------|------------------|------------|------------------|------------|-----------------------|--------|
| Total interest income                       |   | $                | 13,494     |             | $          | 12,111           |       | $                     | 11,067 |   | $ | 11,345 |   |
| Net interest income                         |   | 5,773            |       | 5,778            |       | 6,196            |       | 6,697                 |   |
| Provision for losses on  loans and leases   |   | 523              |       | 543              |       | 354              |       | 485                   |   |
| Income from continuing  operations          |   | 1,124            |       | 1,175            |       | 1,212            |       | 1,360                 |   |
| Income (loss) from  discontinued operations |   | 143              |       | (183             | )          | (103             | )          | (1,543                | )      |
| Net income (loss)                           |   | 1,267            |       | 992              |       | 1,109            |       | (183                  | )      |
|                                        |   |             |       |             |       |             |       |                  |   |
| Earnings per share - basic:                 |   |             |       |             |       |             |       |                  |   |
| Income from continuing  operations          |   | $                | 0.30       |             | $          | 0.32             |       | $                     | 0.36   |   | $ | 0.41 |   |
| Discontinued operations,  net of tax        |   | 0.04             |       | (0.05            | )          | (0.03            | )          | (0.46                 | )      |
| Net income (loss)                           |   | $                | 0.34       |             | $          | 0.27             |       | $                     | 0.33   |   | $ | (0.05 | ) |
|                                        |   |             |       |             |       |             |       |                  |   |
| Earnings per share - diluted:               |   |             |       |             |       |             |       |                  |   |
| Income from continuing  operations          |   | $                | 0.30       |             | $          | 0.31             |       | $                     | 0.36   |   | $ | 0.40 |   |
| Discontinued operations,  net of tax        |   | 0.04             |       | (0.05            | )          | (0.03            | )          | (0.45                 | )      |
| Net income (loss)                           |   | $                | 0.34       |             | $          | 0.26             |       | $                     | 0.33   |   | $ | (0.05 | ) |

 

----

(1)          Certainamounts for all periods presented have been reclassified to discontinuedoperations (Note 2).

(2)          Duringthe fourth quarter of fiscal year 2002, the Company recorded a provision of$2,073 and reclassified $577 from the allowance for loan and lease lossesdirectly against credit card loans receivable and transferred the loans fromloans receivable to loans held for sale at their estimated net realizable value(Note 2).

 

96

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**Item 9.  Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

During the Company’s two most recent fiscalyears there have been no disagreements with our independent accountant on anymatter of accounting principle or financial statement disclosure.

 

**Item 9A. Controls and Procedures**

 

As of June 30, 2003 an evaluation wasperformed by the Company’s management, including the Company’s Chairman,President and Chief Executive Officer and the Chief Financial Officer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the ExchangeAct).  Based upon, and as of the date ofthat evaluation, the Chairman, President and Chief Executive Officer and the ChiefFinancial Officer concluded that the Company’s disclosure controls andprocedures were effective, in all material respects, to ensure that informationrequired to be disclosed in the reports the Company files and submits under theExchange Act is recorded, processed, summarized and reported as and whenrequired.

 

**PART III**

 

**Item 10.  Directors and Executive Officers of theRegistrant**

 

Information regarding untimely filingspursuant to Section 16 of the Securities Exchange Act of 1934, as amended, isincorporated in this Form 10-K by reference from the Company’s definitive ProxyStatement for the Annual Meeting of Stockholders to be held in 2003, a copy ofwhich will be filed not later than 120 days after June 30, 2003.

 

**Directors**

 

Information concerning Directors of theCompany is incorporated in this Form 10-K by reference from the definitiveProxy Statement for the Annual Meeting of Stockholders to be held in 2003, acopy of which will be filed not later than 120 days after June 30, 2003.

 

**Executiveofficers**

 

Information required by this item regardingthe business experience of the executive officers of the Company and the Bankis contained in Part I, Item 1 of this Form 10-K pursuant to Instruction 3 andItem 401(b) of Regulation S-K is incorporated herein by reference.

 

**Item 11.  Executive Compensation**

 

Information concerning executive compensationis incorporated in this Form 10-K by reference from the definitive ProxyStatement for the Annual Meeting of Stockholders to be held in 2003, a copy ofwhich will be filed not later than 120 days after June 30, 2003.  Information contained under the headings“Board Compensation Committee Report on Executive Compensation” and“Stockholder Return Performance Presentation” is not incorporated in this Form10-K.

 

97

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**Item 12.  Security Ownership of Certain BeneficialOwners and Management**

 

Except for the Equity Compensation Planinformation set forth below, information concerning security ownership ofcertain beneficial owners, directors and certain executive officers isincorporated in this Form 10-K by reference from the definitive Proxy Statementfor the Annual Meeting of Stockholders to be held in 2003, a copy of which willbe filed not later than 120 days after June 30, 2003.

 

The following table sets forth certaininformation about the Common Stock that may be issued upon exercise of options,warrants and rights under all of the existing equity compensation plans as ofJune 30, 2003, including the 1996 Director Restricted Stock Plan and 2002 StockOption 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     |   | 320,054                                                                                        |   | $                                                                                  | 12.10  |                                                                                                                                              | 750,000 |   |
| Equity  plan compensation plans not approved by stockholders |   | N/A                                                                                            |   | N/A                                                                                |   | N/A                                                                                                                                               |    |
|                                                         |   |                                                                                           |   |                                                                               |   |                                                                                                                                              |    |
| Total                                                        |   | 320,054                                                                                        |   | $                                                                                  | 12.10  |                                                                                                                                              | 750,000 |   |

 

**Item 13.  Certain Relationships and RelatedTransactions**

 

Information concerning certain relationshipsand related transactions is incorporated in this Form 10-K by reference fromthe definitive Proxy Statement for the Annual Meeting of Stockholders to beheld in 2003, a copy of which will be filed not later than 120 days after theclose of the fiscal year.  Informationcontained under the headings “Board Compensation Committee Report on ExecutiveCompensation” and “Stockholder Return Performance Presentation” is notincorporated in this Form 10-K.

 

**PART IV**

 

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

 
| (a)    |   | The following 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 Statements and  Supplementary Data” of this report.                                       |
|   | (2)    | All supplemental schedules are omitted  because of the absence of conditions under which they are required or because  the information is shown in the Consolidated Financial Statements or notes  thereto. |

 

98

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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 Contracts between the Bank and  Curtis L. Hage                                         |   | (1) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.2                                |   | Amendment to Employment Contract between  the Bank and Curtis L. Hage                                       |   | (3) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.3                                |   | 1991 Stock Option and Incentive Plan                                                                        |   | (2) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.4                                |   | Articles of Incorporation of HF Card  Services LLC                                                          |   | (3)                                                                  |
|                                |   |                                                                                                        |   |                                                                 |
| 10.5                                |   | Amendment to 1991 Stock Option and  Incentive Plan                                                          |   | (5) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.6                                |   | 1996 Director Restricted Stock Plan                                                                         |   | (5) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.7                                |   | Employment Contract between the Bank and  Mark S. Sivertson                                                 |   | (6) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.8                                |   | Employment Contract between the Bank and  Michael H. Zimmerman                                              |   | (6) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.9                                |   | Change in Control Contract between the Bank  and Mark S. Sivertson                                          |   | (6) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.10                               |   | Change in Control Contract between the Bank  and Michael H. Zimmerman                                       |   | (6) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.11                               |   | Employment Contract between the Bank and  David A. Brown                                                    |   | (8) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.12                               |   | Change in Control Contract between the Bank  and David A. Brown                                             |   | (8) #                                                                |
|                                |   |                                                                                                        |   |                                                                 |
| 10.13                               |   | Guarantee Agreement dated November 28, 2001  by and between HF Financial Corp. and Wilmington Trust Company |   | (9)                                                                  |
|                                |   |                                                                                                        |   |                                                                 |
| 10.14                               |   | Indenture Agreement dated November 28, 2001  by and between HF Financial Corp. and Wilmington Trust Company |   | (9)                                                                  |
|                                |   |                                                                                                        |   |                                                                 |
| 10.15                               |   | Guarantee Agreement dated July 11, 2002 by  and between HF Financial Corp. and Wilmington Trust Company     |   | (10)                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 10.16                               |   | Indenture Agreement dated July 11, 2002 by  and between HF Financial Corp. and Wilmington Trust Company     |   | (10)                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 10.17                               |   | Guarantee Agreement dated December 19, 2002  by and between HF Financial Corp. and Wilmington Trust Company |   | (11)                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 10.18                               |   | Indenture Agreement dated December 19, 2002  by and between HF Financial Corp. and Wilmington Trust Company |   | (11)                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 10.19                               |   | Letter Agreement dated June 3, 2003 between  HF Financial Corp. and First Tennessee Bank, NA                |   | (12)                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 10.20                               |   | $ 3.0 Million Promissory Note between HF  Financial Corp. and First Tennessee Bank, NA                      |   | (12)                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 10.21                               |   | $ 1.5 Million Promissory Note between HF  Financial Corp. and First Tennessee Bank, NA                      |   | (12)                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 21.1                                |   | Subsidiaries of Registrant                                                                                  |   | 21.1                                                                 |
|                                |   |                                                                                                        |   |                                                                 |
| 23.1                                |   | Consents of Experts and Counsel                                                                             |   | 23.1                                                                 |

 

99

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| **Regulation  S-K Exhibit  Number** |   | **Document**                                                                                                                      |   | **Reference to  Prior Filing  or Exhibit  Number  Attached  Hereto** |
|-------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------|--------|----------------------------------------------------------------------|
|                                |   |                                                                                                                              |   |                                                                 |
| 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  and Chief Financial Officer 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  and Chief Financial Officer Pursuant to Section 906 of the Sarbanes-Oxley Act  of 2002 |   | 32.2                                                                 |

 

----

(1)    Filedas exhibits to the Company’s Form S-1 registration statement filed onDecember 6, 1991 (File No. 33-44383)

 pursuant to Section 5 of theSecurities Act of 1933.

(2)    Filedas an exhibit to the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 1993.

(3)    Filedas exhibits to the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 1996.

(4)    Filedas an exhibit to the Company’s filing on Form 8-A, filed on October 28, 1996.

(5)    Filedas exhibits to the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 1997.

(6)    Filedas exhibits to the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 1998.

(7)    Filedas an exhibit to the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 1999.

(8)    Filedas exhibits to the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 2001.

(9)    Filedas exhibits to the Company’s Quarterly Report on Form 10-Q for the quarterended December 31, 2001.

(10)  Filedas exhibits to the Company’s Quarterly Report on Form 10-Q for the quarterended September 30, 2002.

(11)  Filedas exhibits to the Company’s Quarterly Report on Form 10-Q for the quarterended December 31, 2002.

(12)  Filedas exhibits to the Company’s Annual Report on Form 10-K for the fiscal yearended June 30, 2003.

#       Managementor compensatory plan or arrangements required to be filed.

All of such previously filed documents arehereby incorporated in this Form 10-K by reference in accordance withItem 601 of Regulation S-K.

 

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

 

On April 29, 2003, the Company filed a Form8-K, reporting under Item 5, “Other Events,” announcing the approval by theCompany’s Board of Directors to repurchase up to 10% of its outstanding commonstock through April 30, 2004, and announcing the Company’s intent to pay itsregular cash dividend of 11.5 cents per share for the third quarter of the 2003fiscal year.

 

 **(c) Exhibits**

 

See Item15(a)(3) above.

 

100

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**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the Registrant has duly causedthis report to be signed on its behalf by the undersigned, thereunto dulyauthorized.

 

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

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this report has been signed below by thefollowing persons in the capacities and on the dates indicated.

 

 
|     /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 and  Chief Financial Officer *(Principal Financial and  Accounting Officer)* |
|                                                                                                            |               |                                                                                                                      |
|                                                                                                            |               |                                                                                                                      |
| Date:                                                                                                           | September 24, 2003 |                                                                                                                      | Date: | September 24, 2003 |
|                                                                                                            |               |                                                                                                                      |
|                                                                                                            |               |                                                                                                                      |
|     /s/ Thomas L. Van Wyhe                                                                  |               |     /s/ Robert L. Hanson                                                                              |
| Thomas L. Van Wyhe, Director                                                                                    |               | Robert L. Hanson, Director                                                                                                |
|                                                                                                            |               |                                                                                                                      |
|                                                                                                            |               |                                                                                                                      |
| Date:                                                                                                           | September 24, 2003 |                                                                                                                      | Date: | September 24, 2003 |
|                                                                                                            |               |                                                                                                                      |
|                                                                                                            |               |                                                                                                                      |
|     /s/ Jeffrey G. Parker                                                                   |               |     /s/ JoEllen G. Koerner                                                                            |
| Jeffrey G. Parker, Director                                                                                     |               | JoEllen G. Koerner, Ph.D., Director                                                                                       |
|                                                                                                            |               |                                                                                                                      |
|                                                                                                            |               |                                                                                                                      |
| Date:                                                                                                           | September 24, 2003 |                                                                                                                      | Date: | September 24, 2003 |
|                                                                                                            |               |                                                                                                                      |
|                                                                                                            |               |                                                                                                                      |
|     /s/ William G. Pederson                                                                 |               |     /s/ Steven R. Sershen                                                                             |
| William. G. Pederson, Director                                                                                  |               | Steven R. Sershen, Director                                                                                               |
|                                                                                                            |               |                                                                                                                      |
|                                                                                                            |               |                                                                                                                      |
| Date:                                                                                                           | September 24, 2003 |                                                                                                                      | Date: | September 24, 2003 |

 

101

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**Indexto Exhibits**

 
| **Exhibit  Number** |   |                                                                                                                                  |
|---------------------|--------|---------------------------------------------------------------------------------------------------------------------------------------|
|                |   |                                                                                                                                  |
| 10.19               |   | Letter Agreement dated June 3, 2003 between HF Financial Corp. and  First Tennessee Bank, NA                                     |
|                |   |                                                                                                                                  |
| 10.20               |   | $3.0 Million Promissory Note between HF Financial Corp. and First  Tennessee Bank, NA                                                 |
|                |   |                                                                                                                                  |
| 10.21               |   | $1.5 Million Promissory Note between HF Financial Corp. and First  Tennessee Bank, NA                                                 |
|                |   |                                                                                                                                  |
| 21.1                |   | Subsidiaries of Registrant                                                                                                            |
|                |   |                                                                                                                                  |
| 23.1                |   | Consents of Experts and Counsel                                                                                                       |
|                |   |                                                                                                                                  |
| 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 and Chief Financial Officer  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 and Chief Financial Officer  Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 |

 

102

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