**UNITEDSTATES****SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.  20549**

 

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**FORM 10-K**

 

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

 

**For the Fiscal Year Ended June30, 2005**

 

**Commission File Number 0-19972**

 

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**HF FINANCIAL CORP.**

(Exact name of registrant as specified in itscharter)

 
| **Delaware**                                  |       | **46-0418532**                       |
|-----------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation |       | (I.R.S. Employer Identification No.) |
| or organization)                              |       |                                 |
|                                          |       |                                 |
| **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 RegisteredPursuant to Section 12(b) of the Act:

**None**

 

Securities RegisteredPursuant to Section 12(g) of the Act:

 

**Common Stock, par value $.01 per share**

(Title of class)

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such requirementsfor the past 90 days.

YES  ý  NO  o

 

Indicateby check mark if disclosure of delinquent filers pursuant to Item 405 ofRegulation S-K is not contained herein, and will not be contained, to the bestof registrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or any amendment tothis Form 10-K. o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act.)

YES  o  NO  ý

 

Indicateby check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange Act.)

YES  o  NO  ý

 

Asof September 23, 2005, there were 3,498,645 issued and outstanding shares ofthe registrant’s common stock.

 

Theaggregate market value of the common equity held by non-affiliates of theregistrant, computed by reference to the average of the bid and asked price ofsuch common equity as of December 31, 2004, the last business day of theregistrant’s most recently completed second fiscal quarter, was $66.2million.  (The exclusion from such amountof the market value of the common equity owned by any person shall not bedeemed an admission by the registrant that such person is an affiliate of theregistrant.)

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

PartIII of Annual Report on Form 10-K - Portions of the Proxy Statement for 2005Annual Meeting of Stockholders.

 

 

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**AnnualReport 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, Related Stockholder Matters  and Issuer Purchases of Equity Securities |   |
|         |                                                                                                                |   |
| Item 6.      | Selected  Financial Data                                                                                            |   |
|         |                                                                                                                |   |
| Item 7.      | Management’s  Discussion and Analysis of Financial Condition  and Results of Operations                        |   |
|         |                                                                                                                |   |
| Item 7A.     | Quantitative  and Qualitative Disclosures About Market Risk                                                         |   |
|         |                                                                                                                |   |
| Item 8.      | Financial  Statements and Supplementary Data                                                                        |   |
|         |                                                                                                                |   |
| Item 9.      | Changes in  and Disagreements with Accountants on Accounting  and Financial Disclosure                              |   |
|         |                                                                                                                |   |
| Item 9A.     | Controls and  Procedures                                                                                            |   |
|         |                                                                                                                |   |
| Item 9B.     | Other Information                                                                                                   |   |
|         |                                                                                                                |   |
| **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 and Related Stockholder  Matters                    |   |
|         |                                                                                                                |   |
| Item 13.     | Certain  Relationships and Related Transactions                                                                     |   |
|         |                                                                                                                |   |
| Item 14.     | Principal  Accounting Fees and Services                                                                             |   |
|         |                                                                                                                |   |
| **PART IV**  | ** **                                                                                                          |
|         |                                                                                                                |   |
| Item 15.     | Exhibits  and Financial Statement Schedules                                                                         |   |

 

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**Forward-Looking Statements**

 

This Annual Reporton Form 10-K (“Form 10-K”) and other reports issued by HF Financial Corp. (the “Company”),including reports filed with the Securities and Exchange Commission (the”SEC”),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 might includeone or more of the following:

 

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

•                  Descriptions of plans or objectivesof management for future operations, products or services, transactions,investments and use of subordinated debentures payable to trusts.

•      Forecastsof future economic performance.

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

 

Forward-lookingstatements can be identified by the fact that they do not relate strictly tohistorical or current facts.  They ofteninclude words such as “optimism,” “look-forward,” “bright,” “believe,” “expect,”“anticipate,” “intend,” “plan,” “estimate” or words of similar meaning, orfuture or conditional verbs such as “will,” “would,” “should,” “could” or “may.”

 

Forward-lookingstatements about the Company’s expected financial results and other plans aresubject to certain risks, uncertainties and assumptions.  These include, but are not limited to thefollowing: possible legislative changes and adverse economic, business andcompetitive conditions and developments (such as shrinking interest margins andcontinued short-term rate environments); deposit outflows; reduced demand forfinancial services and loan products; changes in accounting policies orguidelines, or in monetary and fiscal policies of the federal government;changes in credit and other risks posed by the Company’s loan portfolios; theability or inability of the Company to manage interest rate and other risks;unexpected or continuing claims against the Company’s self-insured health plan;the Company’s use of trust preferred securities; the ability or inability ofthe Company to successfully enter into a definitive agreement for and closeanticipated transactions; technological, computer-related or operationaldifficulties; adverse changes in securities markets; results of litigation; orother significant uncertainties.

 

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

 

**PART I**

 

**Item 1.  Business**

 

This sectionshould be read in conjunction with the following parts of this Form 10-K: PartII, Item 7, “Management’s Discussion and Analysis of Financial Condition andResults of Operations”, Part II, Item 7A, “Quantitative and QualitativeDisclosures About Market Risk” and Part II, Item 8, “FinancialStatements and Supplementary Data”.

 

**The Company**

 

HF Financial Corp., a unitary thrift holdingcompany, was formed in November 1991, for the purpose of owning all of theoutstanding stock of Home Federal Bank (the “Bank”) issued in the mutual tostock conversion of the Bank.  TheCompany acquired all of the outstanding stock of the Bank on April 8,1992.  The Company is incorporated underthe laws of the State of Delaware and generally is authorized to engage in anyactivity that 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 furtherinformation regarding the subsidiary operations of the Company and the Bank.

 

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The executive offices of the Company and itsdirect and indirect subsidiaries are located at 225 South Main Avenue, SiouxFalls, South Dakota, 57104.  The Company’stelephone number is (605) 333-7556.

 

**Website and Available Information**

 

Thewebsite for the Company and the Bank is located at www.homefederal.com.  Information on this website does not constitutepart of this Form 10-K.

 

TheCompany makes available, free of charge, its Form 10-K, its quarterly reportson Form 10-Q, its current reports on Form 8-K and amendments to such reportsfiled or furnished pursuant to Section 13(a) or 15(d) of the SecuritiesExchange Act of 1934, as amended (the “Exchange Act”) as soon as reasonablypracticable after such forms are filed with or furnished to the SEC.  Copies of these documents are available tostockholders upon request addressed to the Secretary of the Company at 225South Main Avenue, Sioux Falls, South Dakota, 57104.

 

**The Bank**

 

The Bank was founded in 1929 and is a federallychartered stock savings bank headquartered in Sioux Falls, South Dakota.  The Bank provides full-service consumer andcommercial business banking, including an array of financial products, to meetthe needs of its market place.  The Bankattracts deposits from the general public and uses such deposits, together withborrowings and other funds, to originate one- to four-family residential,commercial business, consumer, multi-family, commercial real estate,construction and agricultural loans.  TheBank’s consumer loan portfolio includes, among other things, automobile loans,home equity loans, loans secured by deposit accounts and student loans.  The Bank also purchases mortgage-backedsecurities and invests in U.S. Government and agency obligations and otherpermissible investments.  The Bank doesnot hold any non-investment grade bonds (i.e., “junk bonds”).  The Bank receives loan servicing income onloans serviced for others and commission income from credit-life insurance onconsumer loans.  The Bank, through itswholly-owned subsidiaries, offers annuities, mutual funds, life insurance andother financial products and equipment leasing services.

 

The Bank’s deposits are insured up to applicablelimits by the Savings Association Insurance Fund (“SAIF”), which isadministered 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 defined as components of anenterprise for which separate financial information is available that isevaluated regularly by the chief operating decision makers in deciding how toallocate resources and in assessing performance.  The Company’s reportable segments are “banking”(including leasing activities) and “other”. The “banking” segment is conducted through the Bank and Mid AmericaCapital Services, Inc. (“Mid America Capital”) and the “other” segment iscomposed of smaller nonreportable segments, the Company and inter-segmenteliminations.  For financial informationby segment see Note 1 of “Notes to Consolidated Financial Statements”, which isincluded in Part II, Item 8, “Financial Statements and Supplementary Data,” ofthis Form 10-K.

 

**SubsidiaryActivities**

 

In addition to theBank, the Company had six other wholly-owned subsidiaries as of June 30,2005:  HF Financial Group, Inc. (“HFGroup”), HF Financial Capital Trust I (“Trust I”), HF Financial Capital TrustII (“Trust II”), HF Financial Capital Trust III (“Trust III”), HF FinancialCapital Trust IV (“Trust IV”) and HomeFirst Mortgage Corp. (the “Mortgage Corp.”).

 

In August 2002, the Companyformed HF Group, a South Dakota corporation. Pursuant to a marketing license service agreement, HF Group hasthe exclusive right to market “Syben Services” for the Minneapolis-basedcorporation, Syben Holdings, Inc., to business customers within the three-stateterritory that includes South Dakota, Minnesota and Iowa.  “Syben Services” are internet based servicesthat utilize proprietary software developed to facilitate employee benefitsadministration, payroll processing and management and governmental reporting.Syben Services assists employers with the management of their employersponsored compensation and benefit programs. HF Group has an approved line of credit of $100,000, with no fundsadvanced by the Company as of June 30, 2005.

 

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Intercompany interest income and interest expense are eliminated in thepreparation of consolidated financial statements.

 

In November 2001,the Company formed Trust I for the sole purpose of issuing trustpreferred securities and investing the proceeds in subordinated debentures ofthe Company.  These subordinateddebentures constitute the sole asset of Trust I.

 

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

 

In December 2002,the Company formed Trust III 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.

 

In September 2003,the Company formed Trust IV for the sole purpose of issuing trust preferredsecurities and investing the proceeds in subordinated debentures of theCompany.  These subordinated debenturesconstitute the sole asset of Trust IV.

 

The MortgageCorp., a South Dakota corporation was previously engaged in the business oforiginating one- to four-family residential mortgage loans, which were sold intothe secondary market.  The Mortgage Corp.had no activity during fiscal year 2005.

 

As a federallychartered thrift institution, the Bank is permitted by OTS regulations toinvest up to 2.00% of its assets in the stock of, or loans to, service corporationsubsidiaries.  The Bank may invest anadditional 1.00% of its assets in service corporations where such additionalfunds are used for inner-city or community development purposes.  The Bank currently has less than 1.00% of itsassets in investments in its subsidiary service corporations as defined by theOTS.  In addition to investments inservice corporations, the Bank is permitted to invest an unlimited amount inoperating subsidiaries engaged solely in activities in which the Bank mayengage directly.

 

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

 

Hometown, a South Dakota corporation,provides financial and insurance products to customers of the Bank and membersof the general public in the Bank’s market area.  Insurance products offered by Hometownprimarily include annuities and life insurance products.  On August 8, 2003, the Company sold theproperty and casualty insurance book of business of Hometown to a third partyfor total proceeds of $375,000.  Thesales agreement included a “covenant not to compete” clause prohibitingHometown from directly or indirectly selling property or casualty insurance forthree years in the state of South Dakota. The transaction was effective as of July 31, 2003 and had an immaterialimpact on the Company’s financial position and results of operations.  Hometown obtains its funding via aline of credit from the Bank.  Bankingregulations do not limit the amount of funding provided to an operatingsubsidiary.  As of June 30, 2005, theBank had advanced no funds on an approved line of credit of $100,000.  Intercompany interest income and interest expenseare eliminated in the preparation of consolidated financial statements.

 

Mid America Capital, a SouthDakota corporation, specializes in equipment finance leasing.  Mid America Capital obtains itsfunding via a line of credit from the Bank. Banking regulations do not limit the amount of funding provided to anoperating subsidiary.  As of June 30,2005, the Bank had advanced $27.9 million on an approved line of credit of$35.0 million.  Intercompany interestincome and interest expense are eliminated in the preparation of consolidatedfinancial statements.

 

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HFSC, a Delaware corporation, exists for the solepurpose of buying motor vehicle installment loans from the Bank to besecuritized.  See Note 3 of “Notes toConsolidated Financial Statements”, which is included in Part II, Item 8, “FinancialStatements and Supplementary Data,” of this Form 10-K, and Part II, Item 7, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” ofthis Form 10-K for further discussion on consumer automobile loansecuritization.

 

Mid-America, a South Dakota corporation, previouslyprovided residential appraisal services to the Bank and other lenders in theBank’s market area until the third quarter of fiscal 2002.  The cessation of operations of Mid-Americahad no material effect on the consolidated financial statements.  Mid-America had no activity during fiscalyear 2005.

 

PMD, a South Dakota corporation, in the past was engagedin the business of buying, selling and managing repossessed real estateproperties.  PMD had no activity duringfiscal year 2005.

 

## **Market Area**

 

Based on total assets at June 30, 2005, the Bank is the largest savingsassociation headquartered in South Dakota. The Bank has a total of 34 banking centers in its market area and oneinternet branch located at www.homefederal.com. The Bank’s primary market area includes communities located in easternand central South Dakota, including the cities of Sioux Falls, Brandon, Pierre,Winner, Freeman, Dell Rapids, Hartford, Canton, Parker, Lennox, Mitchell,Aberdeen, Mobridge, Brookings, Redfield, Dakota Dunes, Colman, Crooks,Watertown and Yankton.  The Bank also hasa branch in Marshall, Minnesota, which serves customers located in southwesternMinnesota, and its banking center located in Dakota Dunes, South Dakota whichserves customers located in northwestern Iowa. The Bank’s primary market area features a variety of agri-business,banking, financial services, health care and light manufacturing firms.  The internet branch allows access tocustomers beyond traditional geographical areas.

 

Mid America Capital provides services to customers primarily in anine-state area in the upper Midwest, but originations can and have expanded nationwidebased on relationships developed with existing Bank customers and other vendorrelationships.

 

HF Group provides services to customers in the three-state region ofSouth Dakota, Minnesota and Iowa.

 

## **Lending Activities**

 

*General*.  The Bankoriginates a variety of loans including business banking loans, commercial andagricultural loans; mortgage lending, one- to four-family residentialmortgages; and consumer loans, including loans for automobile purchases, homeequity and home improvement loans and student loans.

 

**Business Banking**

 

*Commercial Business Lending*.  In order to serve the needs ofthe local business community and improve the interest rate sensitivity andyield of its assets, the Bank originates adjustable- and fixed-rate commercialloans.  Interest rates on commercialbusiness loans adjust or float with a designated national index plus aspecified margin.  The Bank’s commercialbusiness lending activities encompass loans with a variety of purposes andsecurity, including loans to finance accounts receivable, inventory andequipment and business expansion within the Bank’s market area.  The Bank originates commercial business loansdirectly and through programs sponsored by the Small Business Administration (“SBA”)of which a portion of such loans are also guaranteed in part by the SBA.  The Bank generally originates commercialbusiness loans for its portfolio and retains the servicing with respect to suchloans.  In the future, the Bankanticipates continued expansion and emphasis of its commercial businesslending, subject to market conditions and the Home Owners’ Loan Act (“HOLA”)restrictions.    See “Regulation–*Business Activities*” below for HOLArestrictions.

 

Commercial business loans typically are made on the basisof the borrower’s ability to make repayment from the cash flow of the borrower’sbusiness.  As a result, the availabilityof funds for the repayment of commercial business loans may be substantiallydependent on the success of the business itself (which, in turn, may be dependent

 

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upon the general economic environment). The Bank’s commercial business loans are occasionally secured by theassets of the business, such as accounts receivable, equipment andinventory.  However, the collateralsecuring the loans may depreciate over time, may be difficult to appraise andmay fluctuate in value based on the success of the business.  Whenever possible, the Bank’s commercialbusiness loans include personal guarantees of the borrowers.  In addition, the loan officer may, onoccasion, perform on-site visits, obtain financial statements and perform afinancial review of the loan.

 

*Multi-Family and Commercial Real Estate Lending*.  The Bank engages in multi-familyand commercial 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 commercial real estateproperties are generally larger and involve a greater degree of credit riskthan one- to four-family residential mortgage loans. Because payments on loanssecured by multi-family and commercial real estate properties are oftendependent 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 Bank’s primary market areamay contain a higher degree of risk due to the fact that the Bank may not be asfamiliar with market conditions where such property is located.  The Bank does not have a materialconcentration of multi-family or commercial real estate loans outside of SouthDakota and the adjoining Midwestern states.

 

The Bank presently originates adjustable-rate, short-termballoon payment, fixed-rate multi-family and commercial real estate loans.  The Bank’s multi-family and commercial realestate loan portfolio is secured primarily by apartment buildings and owneroccupied and non-owner occupied commercial real estate.  The terms of such loans are negotiated on a case-by-casebasis.  Commercial real estate loansgenerally have terms that do not exceed 25 years.  The Bank has a variety of rate adjustmentfeatures, call provisions and other terms in its multi-family and commercialreal estate loan portfolio.  Generally,the loans are made in amounts up to 80.00% of the appraised value of thecollateral property and with debt service coverage ratios of 115.00% orhigher.  The debt service coverage is theratio of net cash from operations before payment of debt service.  However, these percentages may vary dependingon the type of security and the guarantor. Such loans provide for a negotiated margin over a designated nationalindex.  The Bank analyzes the financialcondition of the borrower, the borrower’s credit history, the borrower’s priorrecord for producing sufficient income from similar loans, references and thereliability and predictability of the net income generated by the propertysecuring the loan.  The Bank generallyrequires personal 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 the limitationof Loans to One Borrower.  See “Regulation-*Loans to One Borrower*” for a discussion ofthe Loans to One Borrower regulations. In return for servicing these loans for the participants, the Bankgenerally receives a fee of 0.25% to 0.38%. Also, income is received at loan closing from loan fees and discountpoints.  Appraisals on propertiessecuring multi-family and commercial real estate loans originated by the Bankare performed by appraisers approved pursuant to the Bank’s appraisal policy.

 

The HOLA includes a provision that limits the Bank’s non-residentialreal estate lending to no more than four times its total capital.  This maximum limitation, which at June 30,2005 was $311.7 million, has not materially limited the Bank’s lendingpractices.

 

Under HOLA, the maximum amount which the Bank may lend toany one borrower is 15.00% of the Bank’s unimpaired capital and surplus or$11.7 million at June 30, 2005.  Loans inan amount equal to an additional 10.00% of unimpaired capital and surplus may bemade to the same borrower if such loans are fully secured by readily marketablecollateral.  The Bank may request awaiver from the OTS to exceed the 15.00% Loans to One Borrower limitation on acase by case basis.  The Bank is incompliance with the Loans to One Borrower limitation and had no borrowers inexcess of the Loans to One Borrower requirements at June 30, 2005.  See “Regulation-*Loans to One Borrower*” for a discussion of the Loans to OneBorrower regulations.

 

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

 

Construction loans to individuals for their residencesare structured to be converted to mortgage loans at the end of the constructionphase, which typically runs six to 12 months. These construction loans have rates and terms which match the one- tofour-family residential mortgage loans offered by the Bank.  Residential construction loans are generallyunderwritten pursuant to the same guidelines used for originating residentialmortgage loans.

 

The Bank also makes loans to developers for the purposeof developing one- to four-family lots. These loans typically have terms of one year and carry floating interestrates based on a national designated index. Loan commitment and partial release fees are charged.  These loans generally provide for the paymentof interest and loan fees from loan proceeds. The principal balance of these loans is typically paid down as lots aresold.  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 of multi-familyresidential properties.  Such loans aregenerally made at adjustable rates, which adjust periodically based on theappropriate Treasury Note maturity.

 

Construction loans are generally originated with amaximum loan-to-value ratio of 80.00% and land development loans are generallyoriginated with a maximum loan-to-value ratio of 60.00%, based upon anindependent appraisal.  Because of theuncertainties inherent in estimating development and construction costs and themarket for the project upon completion, it is relatively difficult to evaluateaccurately the total loan funds required to complete a project, the relatedloan-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 a construction loan,the Bank requires an appraisal of the property, or, for larger projects, bothan appraisal and a study of the feasibility of the proposed project.  The Bank’s construction loan policy providesfor the inspection of properties by independent in-house and outside inspectorsat the commencement of construction and prior to disbursement of funds duringthe term of the construction loan.

 

*Agricultural Loans.*  In order to serve the needs of the localbusiness community and improve the interest rate sensitivity and yield of itsassets, the Bank originates agricultural loans through its agriculturaldivision.  The agricultural division offersloans to its customers such as: (1) operating loans which are used to fundoperating expenses which typically have a one year term and are indexed to thenational prime rate; (2) term loans on machinery, equipment and breeding stockthat may have a term up to seven years and require annual payments; (3)agricultural farmland term loans which are used to fund land purchases orrefinances; (4) specialized livestock loans to fund facilities and equipmentfor confinement enterprises; and (5) loans to fund ethanol plantdevelopment.  Agriculture real estateloans typically will have personal guarantees of the borrowers, a first lien onthe real estate, interest rates adjustable to the national prime rate orTreasury Note rates, and annual, quarterly or monthly payments.  Operating and term loans are secured by farmchattels (crops, livestock, machinery, etc.), which are the operating assets ofthe borrower.  The Bank also originatesagricultural loans directly and through programs sponsored by the Farmers ServiceAgency (“FSA”) of which a portion of such loans are also guaranteed in part bythe FSA.

 

Loan customers are required to supply currentfinancial statements, tax returns for the past three to five years, and cashflow projections which are updated on an annual basis.  In addition, on major loans, the loan officerwill perform an annual farm visit, obtain financial statements and perform afinancial review of the loan.

 

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**MortgageLending**

 

*One- to Four-Family ResidentialMortgage Lending*.  One- to four-family residential mortgage loanoriginations are primarily generated by the Bank’s marketing efforts, itspresent customers, walk-in customers and referrals from real estate brokers andbuilders.  The Bank has focused itslending efforts primarily on the origination of loans secured by firstmortgages on owner-occupied, one- to four-family residences.

 

The Bank currently makes 10-, 15- and 30-year fixed- andadjustable-rate (“ARM”) one- to four-family residential mortgage loans inamounts up to 95.00% of the appraised value of the collateral property providedthat private mortgage insurance is obtained in an amount sufficient to reducethe Bank’s exposure at or below the 80.00% level.  The Bank generally offers an ARM loan havinga fixed rate for the initial three to five years, which then converts to a one-yearARM loan for the remainder of the life of the loan.  The Bank also offers a one-year ARM loan witha rate below the Bank’s then current fixed-rate loan for a comparable 15- or 30-yearterm loan.  These loans provide for anannual cap and a lifetime cap at a set percent over the fully-indexed rate.

 

The Bank also offers a 30-year balloon loan, which issold on the secondary market and has a fixed-rate for the first five or sevenyears of the loan.  At the end of thefive- or seven-year period, the loan converts to a 23- or 25-year fixed-rateloan at the then current market rate provided that the borrower qualifies atthe new rate.  If the borrower fails toqualify at the new rate, the loan becomes payable in full.  The Bank also offers a portfolio five- andseven-year balloon loan that is underwritten to secondary market standards butis fully payable at the end of the balloon term.

 

To meet the needs of the Bank’s borrowers and financialneeds of the communities it serves, the Bank has developed two distinct typesof loan programs.  The Integrity MortgageProgram is a limited documentation program that is generally available to theupper credit customer.  The Olympic PlusProgram is a program for individuals that do not meet secondary marketstandards but are eligible for private mortgage insurance.  The program underwriting guidelines matchthose as established by the private mortgage insurance company.  Borrowers may choose from either an ARM orballoon product as a financing option.

 

The Bank also offers fixed-rate 10- to 30-year mortgageloans that conform to secondary market standards. Interest rates charged onthese fixed-rate loans are competitively priced on a daily basis according tomarket conditions.  Residential loansgenerally do not include prepayment penalties.

 

The Bank also originates fixed-rate one- to four-familyresidential mortgage loans through the South Dakota Housing Development Authority(“SDHDA”) program.  These loans generallyhave terms not to exceed 30 years and are insured by the Federal HousingAdministration (“FHA”), Veterans Administration (“VA”), Rural Development orprivate mortgage insurance.  The Bankreceives an origination fee of 1.00% of the loan amount from the borrower and aservicing fee of generally 0.38% from the SDHDA for these services.  The Bank is the largest servicer of loans forthe SDHDA.  At June 30, 2005, the Bankserviced $465.3 million of mortgage loans for the SDHDA.  See Note 6 of “Notes to ConsolidatedFinancial Statements”, which is included in Part II, Item 8, “FinancialStatements and Supplementary Data,” in this Form 10-K for information on loanservicing.

 

In underwriting one- to four-family residential mortgageloans, the Bank evaluates both the borrower’s ability to make monthly paymentsand the value of the property securing the loan.  The property that secures the real estateloans made by the Bank is appraised by an appraiser approved under the Bank’sappraisal policy.  The Bank requiresborrowers to obtain title, fire and casualty insurance in an amount not lessthan the amount of the loan.  Real estateloans originated by the Bank contain a “due-on-sale” clause allowing the Bankto declare the unpaid principal balance due and payable upon the sale of thecollateral property.

 

In February 2005, the Bank introduced QuickClickTM OnlineMortgage Solutions, a service that allows customers to check rates, researchloan options and complete mortgage applications via the Bank’s website.  This service is currently available to ourbranch locations in South Dakota and Minnesota with plans to expand toneighboring states.

 

7

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**Consumer Lending**

 

*Other**Consumer Lending*.  The Bank’s management considersits consumer loan products to be an important component of its lendingstrategy.  Specifically, consumer loansgenerally have shorter terms to maturity and carry higher rates of interestthan do one- to four-family residential mortgage loans.  In addition, the Bank’s management believesthat the offering of consumer loan products helps to expand and create strongerties to its existing customer base by increasing the number of customerrelationships and providing cross-marketing opportunities.

 

The Bank currentlypurchases automobile conditional sales contracts from selected dealers withinits market area, as well as originating automobile loans directly.  The growth in indirect lending has providedsecuritization 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 were used in part to continue toservice the demand of the Bank’s dealer network.  Securitization is a source of funds at a ratelower than other sources of funds, and it reduces the Bank’s capitalrequirements and credit risk to the Bank from the loans sold.  See Note 3 of “Notes to Consolidated Financial Statements”, which is included in PartII, Item 8 “Financial Statements and Supplementary Data” of this Form 10-K, fordetails on the consumer automobile loan securitization.

 

Loans secured by second mortgages, together with loans securedby all prior liens, are limited to 100.00% or less of the appraised or assessedvalue of the property securing the loan and generally have maximum terms thatdo not exceed 10 to 15 years.

 

The student loans originated by the Bank are guaranteedas to principal and interest by the South Dakota Education AssistanceCorporation.  The Bank sells such studentloans with servicing rights released approximately 120 days after funds havebeen disbursed to the student.  The Bankreceives a market premium on the sale of the loan amount.

 

Consumer loan terms varyaccording to the type of collateral, length of contract and creditworthiness ofthe borrower.  The Bank offers both open-and closed-end credit.  Overdraft lendingis extended through lines of credit that are tied to a checking account.  The credit lines generally bear interest at18.00% and are generally limited to no more than $2,000.  Loans secured by deposit accounts at the Bankare currently originated for up to 90.00% of the account balance (althoughhistorically the Bank has loaned up to 100.00% of the account balance), with ahold placed on the account restricting the withdrawal of the accountbalance.  The interest rate on such loansis typically equal to 2.00% above the contract rate.

 

The underwriting standards employed by the Bank forconsumer loans include an application, a determination of the applicant’spayment history on other debts, and an assessment of the ability to meetexisting obligations and payments on the proposed loan.  Although creditworthiness of the applicant isa primary consideration, the underwriting process also includes a comparison ofthe value of the security, if any, in relation to the proposed loan amount.

 

Consumer loans may entail greatercredit risk than do residential mortgage loans, particularly in the case ofconsumer loans, which are unsecured or are secured by rapidly depreciableassets, such as 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 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.

 

8

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# **Leasing Activities**

 

*General.*Throughits wholly-owned subsidiary, Mid America Capital, the Bank originatescommercial and municipal leases.  Theseproducts have a fixed interest rate for the duration of the lease with termstypically ranging from 24 – 60 months. The leases generally are 100.00% financed with only the first or firstand last months’ payments due at lease inception.  As a result of the 100.00% financing andfixed interest rate, the yield on leases is higher than similar type lendingproducts.

 

Leases are originated generally in a nine-state areain the upper Midwest.  All leases aresecured by the equipment leased, with personal guarantees of the borrowersnormally obtained on commercial leases.

 

*Commercial Leases.*   In order to support the Bank and itscustomers and to improve the yield of its assets, Mid America Capitaloriginates commercial leases to customers primarily in the upper Midwest.  Mid America Capital offers three types ofcommercial leases: capital, tax and Terminal Rental Adjustment Clause (“TRAC”)leases.  TRAC leases are generally formedium- to heavy-duty titled equipment, such as semi-tractors and trailers andmedium- to heavy-duty trucks.  Leases maybe 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 typicallyare made on the basis of the borrower’s ability to make repayment from the cashflow of their business.  As a result, theavailability of funds for the repayment of commercial leases may besubstantially dependent on the success of the business itself.  The collateral securing the leases willgenerally depreciate over time, may be difficult to appraise and may fluctuatein value based on the success of the business.

 

*Municipal Leases.*   The Bank and Mid America Capital alsooriginates leases to municipal entities such as cities, counties, and publicschools.  The lessee must be a politicalsubdivision of the state in order to qualify as a municipal lease.   Because the interest income earned on thistype of lease is exempt from federal income taxes, the rate offered to themunicipality is usually substantially lower than a comparable commercial lease.  Repayment terms generally are on a monthly,semi-annual or annual basis.  Residualsare $1.00 for municipal leases.

 

Repayment is based on the municipality’s ability tolevy and collect taxes.  Assuming themunicipality has a bond rating, that bond rating, together with auditedfinancial statements are the basis for the lease.  On larger leases, bond ratings and financialstatements will be reviewed annually.

 

9

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Loan and Lease Portfolio Composition.  Thefollowing table sets forth information concerning the composition of theCompany’s loan and lease portfolio from continuing operations in dollar amountsand in percentages (before deductions for the undisbursed portion of loans inprocess, deferred fees and discounts and allowance for losses) as of the datesindicated.  Balances related todiscontinued credit card loan operations have been eliminated for all periodspresented.

 
| ** **                               | ** ** | **At June  30,**            | ** ** |
|------------------------------------------|------------|-----------------------------|------------|
| ** **                               | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                               | ** ** | **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)                 |       | $                           | 106,832    |   | 15.46 | % | $ | 104,492 |   | 15.80 | % | $ | 100,065 |   | 16.18 | % | $ | 79,074 |   | 13.78 | % | $ | 124,951 |   | 21.71 | % |
| Multi-family                             |       | 34,241                      |       | 4.95 |   | 42,721 |   | 6.46 |   | 49,364 |   | 7.98 |   | 56,952 |   | 9.92 |   | 44,378 |   | 7.71 |   |
| Commercial                               |       | 98,243                      |       | 14.22 |   | 89,538 |   | 13.54 |   | 93,405 |   | 15.10 |   | 89,111 |   | 15.53 |   | 73,720 |   | 12.81 |   |
| Agricultural                             |       | 23,954                      |       | 3.47 |   | 20,449 |   | 3.09 |   | 18,002 |   | 2.91 |   | 12,722 |   | 2.22 |   | 12,753 |   | 2.21 |   |
| Construction and  development            |       | 15,454                      |       | 2.24 |   | 15,044 |   | 2.28 |   | 9,083 |   | 1.47 |   | 12,738 |   | 2.22 |   | 28,419 |   | 4.94 |   |
| Total real estate  loans                 |       | 278,724                     |       | 40.34 |   | 272,244 |   | 41.17 |   | 269,919 |   | 43.64 |   | 250,597 |   | 43.67 |   | 284,221 |   | 49.38 |   |
|                                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Other Loans and  Leases:                 |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer Loans:                          |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Mobile home                              |       | 563                         |       | 0.08 |   | 848 |   | 0.13 |   | 1,468 |   | 0.24 |   | 2,365 |   | 0.41 |   | 3,920 |   | 0.68 |   |
| Automobiles                              |       | 108,621                     |       | 15.72 |   | 101,669 |   | 15.38 |   | 74,066 |   | 11.98 |   | 84,782 |   | 14.77 |   | 78,082 |   | 13.57 |   |
| Deposit account                          |       | 1,253                       |       | 0.18 |   | 1,489 |   | 0.22 |   | 1,463 |   | 0.24 |   | 1,597 |   | 0.28 |   | 1,917 |   | 0.33 |   |
| Student (2)                              |       | 400                         |       | 0.06 |   | 324 |   | 0.05 |   | 7,745 |   | 1.25 |   | 7,340 |   | 1.28 |   | 6,831 |   | 1.19 |   |
| Junior liens on  mortgages               |       | 87,243                      |       | 12.63 |   | 85,684 |   | 12.96 |   | 81,064 |   | 13.11 |   | 73,680 |   | 12.84 |   | 61,397 |   | 10.67 |   |
| Other                                    |       | 5,405                       |       | 0.78 |   | 4,900 |   | 0.74 |   | 6,035 |   | 0.98 |   | 8,529 |   | 1.49 |   | 10,939 |   | 1.90 |   |
| Total consumer  loans                    |       | 203,485                     |       | 29.45 |   | 194,914 |   | 29.48 |   | 171,841 |   | 27.80 |   | 178,293 |   | 31.07 |   | 163,086 |   | 28.34 |   |
|                                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Commercial  business (3)                 |       | 125,569                     |       | 18.17 |   | 124,158 |   | 18.78 |   | 113,570 |   | 18.36 |   | 95,462 |   | 16.63 |   | 97,362 |   | 16.92 |   |
| Equipment finance  leases (3)            |       | 33,090                      |       | 4.79 |   | 26,942 |   | 4.07 |   | 23,016 |   | 3.72 |   | 22,834 |   | 3.98 |   | 10,509 |   | 1.82 |   |
| Agricultural                             |       | 50,088                      |       | 7.25 |   | 42,953 |   | 6.50 |   | 40,109 |   | 6.48 |   | 26,707 |   | 4.65 |   | 20,370 |   | 3.54 |   |
|                                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total other loans  and leases            |       | 412,232                     |       | 59.66 |   | 388,967 |   | 58.83 |   | 348,536 |   | 56.36 |   | 323,296 |   | 56.33 |   | 291,327 |   | 50.62 |   |
|                                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total gross loans  and leases            |       | $                           | 690,956    |   | 100.00 | % | $ | 661,211 |   | 100.00 | % | $ | 618,455 |   | 100.00 | % | $ | 573,893 |   | 100.00 | % | $ | 575,548 |   | 100.00 | % |
|                                     |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed  portion of loans in process |       | (6,350                      | )          |   |   | (7,338 | ) |   |   | (3,576 | ) |   |   | (4,678 | ) |   |   | (3,853 | ) |   |   |
| Deferred fees and  discounts             |       | 1,289                       |       |   |   | 1,029 |   |   |   | 364 |   |   |   | 504 |   |   |   | (133 | ) |   |   |
| Allowance for  losses                    |       | (5,076                      | )          |   |   | (3,605 | ) |   |   | (3,842 | ) |   |   | (4,461 | ) |   |   | (5,509 | ) |   |   |
| Total loans and  leases receivable, net  |       | $                           | 680,819    |   |   |   | $ | 651,297 |   |   |   | $ | 611,401 |   |   |   | $ | 565,258 |   |   |   | $ | 566,053 |   |   |   |

 

----

(1)          Includes one- tofour-family loans held for sale

(2)          Includes student loansheld for sale

(3)          Includes tax-exemptleases

 

10

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The followingtable sets forth the composition of the Company’s loan and lease portfolio fromcontinuing operations by fixed- and adjustable-rate in dollar amounts and inpercentages (before deductions for the undisbursed portion of loans in process,deferred fees and discounts and allowance for losses) as of the datesindicated.  Balances related todiscontinued credit card loan operations have been eliminated for all periodspresented.  Variable loans are tied tovarious indices including prime rate and the treasury yield curve and havereset dates ranging from daily to several years.

 
| ** **                                   | ** ** | **At June  30,**            | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|
| ** **                                   | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                   | ** ** | **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)                     |       | $                           | 65,605     |   | 9.49 | % | $ | 70,895 |   | 10.72 | % | $ | 72,472 |   | 11.72 | % | $ | 45,804 |   | 7.98 | % | $ | 78,350 |   | 13.61 | % |
| Multi-family,  commercial & construction |       | 40,380                      |       | 5.84 |   | 44,065 |   | 6.66 |   | 41,231 |   | 6.67 |   | 44,842 |   | 7.81 |   | 39,752 |   | 6.91 |   |
| Agricultural                                 |       | 4,096                       |       | 0.59 |   | 2,609 |   | 0.39 |   | 4,760 |   | 0.77 |   | 1,305 |   | 0.23 |   | 3,433 |   | 0.60 |   |
| Total real estate  loans                     |       | 110,081                     |       | 15.92 |   | 117,569 |   | 17.77 |   | 118,463 |   | 19.16 |   | 91,951 |   | 16.02 |   | 121,535 |   | 21.12 |   |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer (2)                                 |       | 141,942                     |       | 20.54 |   | 133,012 |   | 20.12 |   | 110,037 |   | 17.79 |   | 127,488 |   | 22.21 |   | 125,955 |   | 21.88 |   |
| Agricultural                                 |       | 6,759                       |       | 0.98 |   | 3,905 |   | 0.59 |   | 5,285 |   | 0.85 |   | 5,596 |   | 0.98 |   | 6,007 |   | 1.04 |   |
| Equipment finance  leases (3)                |       | 33,090                      |       | 4.79 |   | 26,942 |   | 4.07 |   | 23,016 |   | 3.72 |   | 22,834 |   | 3.98 |   | 10,509 |   | 1.82 |   |
| Commercial  business (3)                     |       | 29,741                      |       | 4.30 |   | 26,631 |   | 4.03 |   | 23,839 |   | 3.85 |   | 21,463 |   | 3.74 |   | 25,983 |   | 4.52 |   |
| Total fixed-rate  loans and leases           |       | 321,613                     |       | 46.53 |   | 308,059 |   | 46.58 |   | 280,640 |   | 45.37 |   | 269,332 |   | 46.93 |   | 289,989 |   | 50.38 |   |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Adjustable-Rate  Loans:                      |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Real estate:                                 |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| One- to  four-family (1)                     |       | 41,227                      |       | 5.97 |   | 33,597 |   | 5.08 |   | 27,593 |   | 4.46 |   | 33,270 |   | 5.80 |   | 46,601 |   | 8.10 |   |
| Multi-family,  commercial & construction |       | 107,558                     |       | 15.57 |   | 103,238 |   | 15.61 |   | 110,621 |   | 17.89 |   | 113,959 |   | 19.86 |   | 106,765 |   | 18.55 |   |
| Agricultural                                 |       | 19,858                      |       | 2.87 |   | 17,840 |   | 2.70 |   | 13,242 |   | 2.14 |   | 11,417 |   | 1.99 |   | 9,320 |   | 1.62 |   |
| Total real estate  loans                     |       | 168,643                     |       | 24.41 |   | 154,675 |   | 23.39 |   | 151,456 |   | 24.49 |   | 158,646 |   | 27.65 |   | 162,686 |   | 28.27 |   |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Consumer (2) (4)                             |       | 61,543                      |       | 8.92 |   | 61,902 |   | 9.37 |   | 61,804 |   | 10.00 |   | 50,805 |   | 8.85 |   | 37,131 |   | 6.45 |   |
| Agricultural                                 |       | 43,329                      |       | 6.27 |   | 39,048 |   | 5.91 |   | 34,824 |   | 5.63 |   | 21,111 |   | 3.68 |   | 14,363 |   | 2.50 |   |
| Commercial  business                         |       | 95,828                      |       | 13.87 |   | 97,527 |   | 14.75 |   | 89,731 |   | 14.51 |   | 73,999 |   | 12.89 |   | 71,379 |   | 12.40 |   |
| Total  adjustable-rate loans                 |       | 369,343                     |       | 53.47 |   | 353,152 |   | 53.42 |   | 337,815 |   | 54.63 |   | 304,561 |   | 53.07 |   | 285,559 |   | 49.62 |   |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans and  leases                      |       | $                           | 690,956    |   | 100.00 | % | $ | 661,211 |   | 100.00 | % | $ | 618,455 |   | 100.00 | % | $ | 573,893 |   | 100.00 | % | $ | 575,548 |   | 100.00 | % |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less:                                        |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Undisbursed  portion of loans in process     |       | (6,350                      | )          |   |   | (7,338 | ) |   |   | (3,576 | ) |   |   | (4,678 | ) |   |   | (3,853 | ) |   |   |
| Deferred fees and  discounts                 |       | 1,289                       |       |   |   | 1,029 |   |   |   | 364 |   |   |   | 504 |   |   |   | (133 | ) |   |   |
| Allowance for  loan losses                   |       | (5,076                      | )          |   |   | (3,605 | ) |   |   | (3,842 | ) |   |   | (4,461 | ) |   |   | (5,509 | ) |   |   |
|                                         |       |                        |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total loans and  leases receivable, net      |       | $                           | 680,819    |   |   |   | $ | 651,297 |   |   |   | $ | 611,401 |   |   |   | $ | 565,258 |   |   |   | $ | 566,053 |   |   |   |

 

----

(1)          Includes one- tofour-family loans held for sale

(2)          Includes mobile homeloans

(3)          Includes tax-exemptleases

(4)          Includes student loansheld for sale

 

11

----

 

The following schedule illustrates the scheduledprincipal contractual repayments of the Company’s loan and lease portfolio fromcontinuing operations at June 30, 2005. Mortgages which have adjustable or renegotiable interest rates are shownas maturing at the contractual maturity date. The schedule does not reflect the effects of possible prepayments orenforcement of due-on-sale clauses.

 
| ** **             | ** ** | **Real  Estate**               | ** ** | **Non-Real  Estate** | ** ** |
|------------------------|------------|--------------------------------|------------|----------------------|------------|
| ** **             | ** ** | **One- to  Four-  Family (1)** | ** ** | **Multi-  Family**   | ** ** | **Commercial** | ** ** | **Agricultural** | ** ** | **Construction  &  Development** | ** ** | **Consumer  (2)** | ** ** | **Commercial  Business (3)** | ** ** | **Agricultural** | ** ** | **Total** | ** ** |
| ** **             | ** ** | **(Dollars  in Thousands)**    | ** ** |
| Due in 1 year or  less |       | $                              | 14,077     |                 | $          | 1,864 |   | $ | 14,005 |   | $ | 1,175 |   | $ | 12,454 |   | $ | 42,940 |   | $ | 76,040 |   | $ | 38,313 |   | $ | 200,868 |   |
| After 1 to 5  years    |       | 23,663                         |       | 9,859                |       | 38,256 |   | 4,613 |   | 3,000 |   | 157,661 |   | 64,044 |   | 8,296 |   | 309,392 |   |
| Greater than 5  years  |       | 69,092                         |       | 22,518               |       | 45,982 |   | 18,166 |   | — |   | 2,884 |   | 18,575 |   | 3,479 |   | 180,696 |   |
| Total                  |       | $                              | 106,832    |                 | $          | 34,241 |   | $ | 98,243 |   | $ | 23,954 |   | $ | 15,454 |   | $ | 203,485 |   | $ | 158,659 |   | $ | 50,088 |   | $ | 690,956 |   |

 

----

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

(2) Includes demand loans, loans having no stated maturity, studentloans held for sale and overdraft loans.

(3) Includes equipment finance leases and tax-exempt leases.

 

The total amount of loans due after June 30, 2006 whichhave predetermined interest rates is $244.0 million, while the total amount ofloans due after such date which have floating or adjustable interest rates is$246.1 million.

 

Scheduled contractual principal repayments of loans donot reflect the actual life of such assets. The average life of loans is substantially less than their averagecontractual terms because of prepayments. In addition, due-on-sale clauses on loans generally give the Bank theright 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.  Theaverage life of mortgage loans tends to increase when current mortgage loanrates are substantially higher than rates on existing mortgage loans anddecrease when rates on existing mortgages are substantially higher than currentmortgage loan rates.  The Company’s 2004Annual Report on Form 10-K schedule for payments due within 1 year or lesstotaled $183.8 million.  The Company’sConsolidated Statement of Cash Flows for fiscal year 2005 displays totalprincipal collected on loans and leases totaling $192.9 million.  The difference is due to prepayments of loansat June 30, 2004 and to contractual payments and prepayments for new loans infiscal year 2005.

 

12

----

 

The followingtable sets forth the composition of the Company’s deferred fees and discountson loans as of the dates indicated.

 
| ** **                                               | ** ** | **At June 30,**            | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|
| ** **                                               | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                               | ** ** | **(Dollars in Thousands)** | ** ** |
|                                                     |       |                       |       |   |   |   |   |   |   |   |   |
| One- to  four-family                                     |       | $                          | (576       | ) | $ | (561 | ) | $ | (510 | ) | $ | (554 | ) | $ | (939 | ) |
| Multi-family,  commercial real estate & construction |       | (278                       | )          | (334 | ) | (407 | ) | (508 | ) | (579 | ) |
| Consumer                                                 |       | 122                        |       | 113 |   | 65 |   | 5 |   | 3 |   |
| Agricultural                                             |       | (32                        | )          | (32 | ) | (16 | ) | (28 | ) | (20 | ) |
| Equipment  finance leases                                |       | 80                         |       | 77 |   | 54 |   | — |   | — |   |
| Commercial  business                                     |       | (15                        | )          | (125 | ) | (164 | ) | (16 | ) | (18 | ) |
| Dealer reserve                                           |       | 1,988                      |       | 1,891 |   | 1,342 |   | 1,605 |   | 1,420 |   |
| Total deferred  fees and discounts                       |       | $                          | 1,289      |   | $ | 1,029 |   | $ | 364 |   | $ | 504 |   | $ | (133 | ) |

 

Deferred fees anddiscounts on loans have trended from net deferred revenue to net deferred costsdue to several factors, including the following:

 

•                  Anincreasing amount of indirect automobile loans that include prepaid dealerreserves.  This increase was partiallyoffset as a result of the sale of $50.0 million of automobile loans in January2003, which resulted in a reduction of $1.0 million in prepaid dealer reservesat the time of the sale.

 

•                  Themortgage portfolio had a large turnover during 2002 through 2004 due to lowinterest rates and strong demand, which were booked with relatively higherorigination costs compared to the origination fees charged, than those bookedin prior years.

 

•                  Duringfiscal 2005, the Company experienced loan payoffs primarily inmulti-family, commercial real estate and commercial business.  These payoffs are due to competitive factors,both in price competition and new competitors entering the market.

 

13

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**Potential Problem Loans**

 

*Nonperforming Assets. *See “Asset Quality”under Part II, Item 7 “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” of this Form 10-K for discussion.

 

*Classified Assets*.  Federal regulations provide forthe classification of loans, leases and other assets, such as debt and equitysecurities considered by the OTS to be of lesser quality, as “substandard,” “doubtful”or “loss.” An asset is considered “substandard” if it is inadequately protectedby the current net worth and paying capacity of the obligor or of thecollateral pledged, if any.  “Substandard”assets include those characterized by the “distinct possibility” that theCompany will sustain “some loss” if the deficiencies are not corrected.  Assets classified as “doubtful” have all ofthe weaknesses inherent in those classified “substandard,” with the addedcharacteristic that the weaknesses present make “collection or liquidation infull,” on the basis of currently existing facts, conditions, and values, “highlyquestionable and improbable.”  Assetsclassified as “loss” are those considered “uncollectible” and of such littlevalue that their continuance as assets without the establishment of a specificloss reserve is not warranted.  Assetswhich do not currently expose the Company to sufficient risk to warrantclassification in one of the aforementioned categories, but possess weaknesses,are required to be designated “criticized” or “special mention” by management.

 

When the Company classifies problem assets as “loss, ” itis required either to establish a specific allowance for losses equal to100.00% of that portion of the asset so classified or to charge-off suchamount.  The Company’s determination asto the classification of its assets and the amount of its valuation allowancesis subject to review by the Bank’s Regional Director at the regional OTSoffice, who may order the establishment of additional general or specific lossallowances.

 

In connection with the filing of its periodic reportswith the OTS and in accordance with its classification of assets policy, theCompany regularly reviews problem loans and leases in its portfolio to determinewhether any loans or leases require classification in accordance withapplicable regulations.  On the basis ofmanagement’s monthly review of its assets, at June 30, 2005, theCompany had designated $10.6 million of its assets as special mention and $7.0million of its assets as classified. Other potential problem loans are included in criticized and classifiedassets.  See “Asset Quality” under PartII, Item 7 “Management’s Discussion and Analysis of Financial Condition andResults of Operations” of this Form 10-K for further discussion.

 

*Allowance for Loan and LeaseLosses*. See “Application of CriticalAccounting Policies” and “Asset Quality” under Part II, Item 7 “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” ofthis Form 10-K for discussion.

 

14

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**InvestmentActivities**

 

The Bank is required under OTS regulation to maintain asufficient amount of liquid assets. Liquidity may increase or decrease depending upon the availability offunds and comparative yields on investments in relation to the return on loans.

 

Federally chartered savings institutions have theauthority to invest in various types of liquid assets, including United StatesTreasury 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 Bank is to investfunds among various categories of investments and maturities based upon theBank’s asset/liability management policies, investment quality andmarketability, liquidity needs and performance objectives.

 

At June 30, 2005, the Company’s investments inmortgage-backed securities totaled $121.3 million, or 13.5% of its totalassets. As of such date, the Bank also had a $7.7 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.

 

The composition and maturities ofthe investment securities portfolio, excluding equity securities, are indicatedin the following table.

 
| ** **                                   | ** ** | **At June  30, 2005**       | ** ** |
|----------------------------------------------|------------|-----------------------------|------------|
| ** **                                   | ** ** | **1 Year or  Less**         | ** ** | **After 1  to 5 Years** | ** ** | **After 5  to 10 Years** | ** ** | **Greater  than 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 |       | $                           | —     |   | — |   | $ | 3,000 |   | 3.16 | % | $ | 2,000 |   | 3.99 | % | $ | — |   | — |   | $ | 5,000 |   | $ | 4,986 |   |
| Federal Home Loan  Bank                      |       |                        |       |   |   | 2,474 |   | 4.63 | % | 1,500 |   | 3.99 | % | — |   | — |   | 3,974 |   | 3,996 |   |
| Municipal bonds                              |       | 1,201                       |       | 2.18 | % | 1,784 |   | 2.34 | % | 100 |   | 3.65 | % | — |   | — |   | 3,085 |   | 3,069 |   |
| Preferred term  securities                   |       | —                      |       | — |   | — |   | — |   | — |   | — |   | 9,000 |   | 4.89 | % | 9,000 |   | 9,056 |   |
| Mortgage-backed  securities                  |       |                        |       |   |   | 23 |   | 7.03 | % | 7,528 |   | 4.62 | % | 115,116 |   | 4.54 | % | 122,667 |   | 121,251 |   |
| Total investment  securities                 |       | $                           | 1,201      |   |   |   | $ | 7,281 |   |   |   | $ | 11,128 |   |   |   | $ | 124,116 |   |   |   | $ | 143,726 |   | $ | 142,358 |   |

 

The effective maturities for the Bank’s mortgage-backedsecurities is much shorter due to the combination of prepayments and thevariable nature of $103.9 million of mortgage-backed securities.  The variable or hybrid (fixed for a period oftime and then variable thereafter) structure gives the Bank flexibility in riskmanagement of the balance sheet.

 

The Company’s investment securities portfolio did notcontain non-investment grade bonds (i.e., “junk bonds”) or other corporate debtsecurities.

 

The Bank’s investment security portfolio is managed inaccordance with a written investment policy adopted by the Board ofDirectors.  Investments may be made bythe Bank’s officers within specified limits and approved in advance by theBoard of Directors for transactions over these limits.  At the present time, the Bank does not haveany investments that are held for trading purposes.  At June 30, 2005, the Company had $142.4million of securities available for sale, including mortgage-backed securitiesof $121.3 million.  See Note 4 of “Notesto Consolidated Financial Statements,” which is included in Part II, Item 8 “FinancialStatements and Supplementary Data” of this Form 10-K, for further informationon the Company’s investment portfolio.

 

15

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**Sources ofFunds**

 

*General*.  The Company’s primary sourcesof funds are earnings, in-market deposits, FHLB advances and other borrowings,amortization and repayments of loan principal, mortgage-backed securities andcallable agency securities.  Secondarysources include sales of mortgage loans, sales and/or maturities of securities,out-of-market deposits and short-term investments.

 

Borrowings of the Bank are primarily from the FHLB of DesMoines, and may be used on a short-term basis to compensate for seasonalreductions in deposits or deposit inflows at less than projected levels, andmay be used on a longer-term basis to support expanded lending activities.  The Bank has established collateral at theFederal Reserve Bank (“FRB”) as a contingent source of funding.  See Note 9 of the “Notes to ConsolidatedFinancial Statements” which is included in Part II, Item 8 “FinancialStatements and Supplementary Data “ of this Form 10-K, for further detail ofthe Company’s borrowings.

 

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

 

The flow of deposits is influenced by general economicconditions, changes in money market and prevailing interest rates andcompetition.

 

The variety of deposit accounts offered by the Bank hasallowed it to be competitive in obtaining funds and to respond with flexibilityto changes in consumer demand.  In recentyears, the Bank has become more susceptible to short-term fluctuations indeposit flows as customers have become more interest rate conscious.  The Bank manages the pricing of its depositsin keeping with its asset/liability management and profitability objectives.  Based on its experience, the Bank believesthat its statement savings, money market, and checking accounts are stablesources of deposits.  However, theability of the Bank to attract and maintain certificates of deposit, and therates paid on these deposits, has been and will continue to be significantlyaffected by market conditions.

 

16

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Thefollowing table sets forth the dollar amount of deposits in the various typesof deposit accounts offered by the Bank as of the dates indicated.

 
| ** **                                                                                                                                | ** ** | **At June  30,**            | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------------|------------|
| ** **                                                                                                                                | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                                                | ** ** | **Amount**                  | ** ** | **Percent  of  Total** | ** ** | **Amount** | ** ** | **Percent  of  Total** | ** ** | **Amount** | ** ** | **Percent  of  Total** | ** ** |
| ** **                                                                                                                                | ** ** | **(Dollars  in Thousands)** | ** ** |
| Transaction  Accounts:                                                                                                                    |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Noninterest  bearing accounts                                                                                                             |       | $                           | 85,705     |   | 12.58 | % | $ | 75,251 |   | 11.42 | % | $ | 77,004 |   | 12.39 | % |
| Interest bearing  accounts weighted average rates of 0.52%, 0.18%, and 0.16% at June 30, 2005,  2004 and 2003                             |       | 50,120                      |       | 7.36 |   | 45,738 |   | 6.95 |   | 43,699 |   | 7.03 |   |
| Savings accounts  weighted average rates of 1.93%, 0.72% and   0.68% at June 30, 2005, 2004 and 2003                                 |       | 63,235                      |       | 9.28 |   | 63,670 |   | 9.67 |   | 54,462 |   | 8.77 |   |
| Money market  accounts(1) weighted average rates of 2.80%, 1.40% and 1.41% at June 30,  2005, 2004 and 2003                               |       | 209,116                     |       | 30.70 |   | 211,928 |   | 32.17 |   | 178,113 |   | 28.66 |   |
|                                                                                                                                      |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Total transaction  accounts                                                                                                               |       | 408,176                     |       | 59.92 |   | 396,587 |   | 60.21 |   | 353,278 |   | 56.85 |   |
|                                                                                                                                      |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| In-Market  Certificates of Deposit:                                                                                                       |       |                        |       |   |   |   |   |   |   |   |   |   |   |
|                                                                                                                                      |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| 0.00 - 3.99%                                                                                                                              |       | 216,461                     |       | 31.78 |   | 206,552 |   | 31.36 |   | 174,662 |   | 28.11 |   |
| 4.00 - 4.99%                                                                                                                              |       | 19,356                      |       | 2.84 |   | 16,102 |   | 2.44 |   | 21,112 |   | 3.40 |   |
| 5.00 - 5.99%                                                                                                                              |       | 7,322                       |       | 1.07 |   | 10,312 |   | 1.57 |   | 17,711 |   | 2.85 |   |
| 6.00 - 6.99%                                                                                                                              |       | 1,605                       |       | 0.24 |   | 12,335 |   | 1.87 |   | 18,040 |   | 2.90 |   |
| 7.00 - 7.99%                                                                                                                              |       | —                      |       | — |   | 1,006 |   | 0.15 |   | 985 |   | 0.16 |   |
| Total in-market  certificates of deposit                                                                                                  |       | 244,744                     |       | 35.93 |   | 246,307 |   | 37.39 |   | 232,510 |   | 37.42 |   |
|                                                                                                                                      |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Out-of-market  certificates of deposit weighted average rate of    3.09%, 2.23% and 2.11% at June 30, 2005,  2004 and 2003 |       | 28,296                      |       | 4.15 |   | 15,825 |   | 2.40 |   | 35,593 |   | 5.73 |   |
|                                                                                                                                      |       |                        |       |   |   |   |   |   |   |   |   |   |   |
| Total  certificates of deposit                                                                                                            |       | 273,040                     |       | 40.08 |   | 262,132 |   | 39.79 |   | 268,103 |   | 43.15 |   |
| Total deposits                                                                                                                            |       | $                           | 681,216    |   | 100.00 | % | $ | 658,719 |   | 100.00 | % | $ | 621,381 |   | 100.00 | % |

 

----

(1)     Includes out-of-market money market accounts in the amount of $1.9million, $18.4 million and $14.1 million at June 30, 2005, 2004 and 2003,respectively.

 

17

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The following tablesets forth the amount of the Company’s certificates of deposit and otherdeposits by time remaining until maturity as of June 30, 2005.

 
| ** **                                     | ** ** | **Maturity**               | ** ** | ** ** | ** ** |
|------------------------------------------------|------------|----------------------------|------------|------------|------------|
| ** **                                     | ** ** | **3 Months**               | ** ** | **3 to 6** | ** ** | **6 to 12** | ** ** | **Over** | ** ** | ** ** | ** ** |
| ** **                                     | ** ** | **or Less**                | ** ** | **Months** | ** ** | **Months** | ** ** | **12 Months** | ** ** | **Total** | ** ** |
| ** **                                     | ** ** | **(Dollars in Thousands)** | ** ** |
|                                           |       |                       |       |       |       |   |   |   |   |   |   |
| Certificates of  deposit less than $100,000    |       | $                          | 22,246     |       | $          | 15,640 |   | $ | 40,483 |   | $ | 100,484 |   | $ | 178,853 |   |
|                                           |       |                       |       |       |       |   |   |   |   |   |   |
| Certificates of  deposit of $100,000 or more   |       | 3,196                      |       | 3,419      |       | 7,097 |   | 25,120 |   | 38,832 |   |
|                                           |       |                       |       |       |       |   |   |   |   |   |   |
| Out-of-market  certificates of deposit (1) (2) |       | 15,961                     |       | 14,139     |       | 2,220 |   | 3,332 |   | 35,652 |   |
|                                           |       |                       |       |       |       |   |   |   |   |   |   |
| Public funds (3)  (4)                          |       | 10,041                     |       | 4,256      |       | 4,099 |   | 1,307 |   | 19,703 |   |
|                                           |       |                       |       |       |       |   |   |   |   |   |   |
| Total  certificates of deposit                 |       | $                          | 51,444     |       | $          | 37,454 |   | $ | 53,899 |   | $ | 130,243 |   | $ | 273,040 |   |

 

----

(1)                                  Includesfunds from the Certificate of Deposit Account Registry Service (“CDARS”)certificate of deposit program of $7,356.

(2)                                  Includescertificates of deposit of $100,000 or greater of $25,953.

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

(4)                                  Includescertificates of deposit of $100,000 or greater of $18.1 million.

 

The Bank solicits certificates of deposit of $100,000 orgreater from various state, county and local government units which carry rateswhich are negotiated at the time of deposit. See Note 8 of “Notes to Consolidated Financial Statements,” whichis included in Part II, Item 8 “Financial Statements and Supplementary Data” ofthis Form 10-K.  Deposits at June 30,2005 and 2004 included $51.6 million and $53.0 million, respectively, ofdeposits from one local governmental entity, the majority of which are savingsaccounts.

 

*Borrowings*.  Although deposits are the Bank’sprimary source of funds, the Bank’s policy has been to utilize borrowings whenthey are a less costly source of funds or can be invested at a positive rate ofreturn.

 

The Bank’s borrowings consistprimarily of advances from the FHLB of Des Moines upon the security of itscapital stock of the FHLB of Des Moines and certain pledgable loans, includingbut not limited to, its mortgage related loans, mortgage-backed securities andU.S. Government and other agency securities. Such advances can be made pursuant to several different credit programs,each of which has its own interest rate and range of maturities.  At June 30, 2005, the Bank’s FHLB advancestotaled $119.0 million, representing 14.1% of total Company liabilities.  See Note 9 of “Notes to Consolidated Financial Statements,” which is included in PartII, Item 8 “Financial Statements and Supplementary Data” of this Form 10-K, forfurther detail of the Company’s borrowings.

 

18

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The followingtable sets forth the maximum month-end balances and average balances of FHLBand FRB advances and other borrowings at the dates indicated.

 

| ** **                  | ** ** | **Years Ended June 30,**   | ** ** |
|-----------------------------|------------|----------------------------|------------|
| ** **                  | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                  | ** ** | **(Dollars in Thousands)** | ** ** |
| Maximum  Month-End Balance: |       |                       |       |   |   |   |   |
| FHLB and FRB  advances      |       | $                          | 140,590    |   | $ | 92,985 |   | $ | 134,503 |   |
| Other borrowings            |       | 760                        |       | 817 |   | 5,321 |   |
|                        |       |                       |       |   |   |   |   |
| Average Balance:            |       |                       |       |   |   |   |   |
| FHLB and FRB  advances      |       | $                          | 110,398    |   | $ | 79,038 |   | $ | 99,064 |   |
| Other borrowings            |       | 934                        |       | 1,831 |   | 1,201 |   |

 

The following table sets forth certain information as tothe Bank’s FHLB and FRB advances and other borrowings of the Company at thedates indicated.

 

| ** **                                               | ** ** | **June 30,**               | ** ** |
|----------------------------------------------------------|------------|----------------------------|------------|
| ** **                                               | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                               | ** ** | **(Dollars in Thousands)** | ** ** |
|                                                     |       |                       |       |   |   |   |   |
| FHLB and FRB  advances                                   |       | $                          | 118,959    |   | $ | 92,985 |   | $ | 84,498 |   |
| Other borrowings                                         |       | 705                        |       | 765 |   | 5,321 |   |
| Total borrowings                                         |       | $                          | 119,664    |   | $ | 93,750 |   | $ | 89,819 |   |
|                                                     |       |                       |       |   |   |   |   |
| Weighted average  interest rate of FHLB and FRB advances |       | 4.13                       | %          | 3.96 | % | 4.70 | % |

 

*ConsumerAutomobile Loan Securitization. *Thegrowth in indirect lending has previously provided securitization opportunitiesin the capital markets.  On January 31,2003, the Bank sold approximately $40.1 million principal of indirect and $9.9million principal of direct automobile receivables in a securitizationtransaction.  See Note 3 of  “Notes to Consolidated Financial Statements,”which is included in Part II, Item 8 “Financial Statements and SupplementaryData” of this Form 10-K, for details on the consumer automobile loansecuritization.  The Bank will continueto review opportunities to securitize automobile production in the future.

 

**Competition**

 

The Bank faces strong competition, both in originatingreal estate, commercial and consumer loans and in attracting deposits.Competition in originating real estate loans comes primarily from othercommercial banks, credit unions and mortgage bankers making loans secured byreal 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 its deposits throughits retail banking offices, primarily from the communities in which thoseretail banking offices are located.  Assuch, competition for those deposits is principally from other commercial banksand credit unions located in the same communities.  The Bank competes for these deposits byoffering a variety of deposit accounts at competitive rates, convenientbusiness hours, and convenient branch locations with interbranch deposit andwithdrawal privileges at each.

 

**Employees**

 

At June 30, 2005, the Bank had a total of 309 full-timeequivalent employees (“FTEs”) including nine FTEs of the Bank’s subsidiarycorporations.  The Bank’s employees arenot represented by any collective bargaining group.  Management considers its relations with itsemployees to be good.

 

19

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**Regulation**

 

*General*.  The Bank is a federallychartered thrift institution, the deposits of which are federally insured bythe SAIF of the FDIC.  Accordingly, theBank is subject to broad federal regulation and oversight extending to all itsoperations, by its primary federal regulator, the OTS.  The Bank is a member of the FHLB of DesMoines and is subject to certain limited regulation by the Federal ReserveBoard.  As the unitary thrift holdingcompany of the Bank, the Company also is subject to federal regulation andoversight by the OTS.  The purpose of theregulation of the Company and other holding companies is to protect subsidiarysavings associations where deposits are federally insured.

 

Certain of these regulatory requirements and restrictionsare 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 OTS has extensive authorityover the operations of federal savings associations, such as the Bank.  Pursuant to this authority, the Bank isrequired to file periodic reports with the OTS and is subject to periodicexaminations primarily by the OTS and to a lesser extent by the FDIC.  The last examination of the Bank by the OTSconcluded on February 7, 2005.  Examinersmay require a federal savings association to provide for higher general orspecific loan loss reserves.

 

*Assessments.*  The OTS has established aschedule for the assessment of fees upon all savings associations to fund theoperations of the OTS.  The generalassessment, paid on a semiannual basis, is computed by totaling threecomponents:  the Bank’s total assets,supervisory condition, and complexity of operations. ** **TheBank’s OTS assessment (standard assessment) for the fiscal year ended June 30,2005, was approximately $173,000.

 

*Enforcement.*  The OTS has primary enforcementresponsibility over savings associations, including the Bank.  This enforcement authority includes, amongother things, the ability to assess civil money penalties, to issue cease anddesist orders and to remove directors and officers.  In general, these enforcement actions may beinitiated in response to violations of laws and regulations and to unsafe orunsound practices.  Under the FDI Act,the FDIC has the authority to recommend to the Director of the OTS thatenforcement action be taken with respect to a particular savingsassociation.  If action is not taken bythe OTS, the FDIC may take action under certain circumstances.

 

*Safety and SoundnessStandards.*  Under federal law, the OTS has adopted a setof guidelines prescribing safety and soundness standards.  The guidelines establish general standardsrelating to internal controls, information systems, internal audit systems,loan documentation, credit underwriting, interest rate exposure, asset growth,asset quality, earnings and compensation, fees and benefits.  In general, the guidelines require, amongother things, appropriate systems and practices to identify and manage therisks and exposures specified in the 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 OTS adoptedregulations that authorize, but do not require, the OTS to order an institutionthat has been given notice by the OTS that it is not satisfying any of suchsafety 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 other actions of the types to which an undercapitalized associationis subject under the “prompt corrective action” provisions of FDICIA.  If an institution fails to comply with suchan order, the OTS may seek to enforce such order in judicial proceedings and toimpose civil money penalties.

 

20

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*Prompt Corrective ActionStandards.* The OTS and the FDIC are authorized and, under certain circumstances,required to take certain actions against any association that fails to meet itscapital requirements.  For this purpose,a savings bank is placed in one of the following four categories based on theassociations capital:  (a)well-capitalized, (b) adequately capitalized, (c) undercapitalized or (d)critically undercapitalized.

 

AtJune 30, 2005, the Bank met the criteria for being well-capitalized.  When appropriate, the OTS can requirecorrective action by a savings association holding company under the “promptcorrective action” provision of federal law.

 

*Business Activities.*  The Bank derives its lending and investmentpowers from the HOLA, and the regulations of the OTS thereunder.  Under these laws and regulations, the Bankmay invest in mortgage loans secured by residential and commercial real estate,commercial and consumer loans, certain types of debt securities and certainother assets.  The Bank may alsoestablish 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 residential property.  In addition, the HOLA and the OTS regulationsprovide that a federal savings association may invest up to 10.00% of itsassets in tangible personal property for leasing purposes.  At June 30, 2005, the Bank met the 10.00%leasing limitation with 3.56% of total Bank assets.  Such general leases, however, do not have tobe aggregated with the institution’s loans for purposes of the HOLA’sinvestment and lending limitations.  AtJune 30, 2005, the Bank met the 20.00% limitation with 16.49% of total Bankassets.

 

*Loan- To-One Borrower*.  Under the HOLA, the Bank isgenerally subject to the same limits on loans-to-one borrower as are imposed onnational banks.  With specifiedexceptions, the Bank may not make a loan or extend credit to a single or relatedgroup of borrowers in excess of 15.00% of the association’s unimpaired capitaland surplus.  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.  At June 30, 2005, the Bank’slending limit under this restriction was $11.7 million.  The Bank is in compliance with theloans-to-one borrower limitation and had no borrowers in excess of theloans-to-one borrower requirements at June 30, 2005.

 

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

 

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

 

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category and supervisorysubcategory to which it is assigned. Under the regulation, there are nine assessment risk classifications(i.e., combinations of capital groups and supervisory subgroups) to whichdifferent assessment rates are applied. Assessment rates currently range from 0.00% of deposits for aninstitution in the highest category (i.e., well capitalized and financiallysound, with no more than a few minor weaknesses) to 0.27% of deposits for aninstitution in the lowest category (i.e., undercapitalized and substantialsupervisory concern).  The FDIC isauthorized to raise the assessment rates as necessary to maintain the requiredreserve ratio of 1.25%.

 

The 1996 Act also provides that the FDIC cannot assessregular insurance assessments for an insurance fund unless required to maintainor to achieve the designated reserve ratio of 1.25%, except on those of itsmember institutions that are not classified as “well capitalized” or that havebeen found to have “moderately severe” or “unsatisfactory” financial,operational or compliance weaknesses.  AtJune 30, 2005, the Bank has not been so classified by the FDIC or the OTS.

 

In addition, all FDIC-insured institutions arerequired to pay assessments to the FDIC at an annual rate of approximately..0144% of insured deposits to fund interest payments on bonds issued by theFinancing Corporation (“FICO”), an agency of the federal government establishedin 1987 to recapitalize the predecessor to the SAIF.  These assessments, which are adjustedquarterly, will continue until the FICO bonds mature in 2017.

 

The Bank’s assessment rate for the fiscal year endingJune 30, 2005, was .0144% and the premium paid for this period was $93,000, ofwhich was all paid towards the FICO bonds. The FDIC has authority to increase insurance assessments.  A significant increase in SAIF insurancepremiums would have an adverse effect on the operating expenses and results ofoperations of the Bank.  Managementcannot predict what the insurance assessment rate will be in the future.

 

Under the FDI Act, insurance of deposits may beterminated by the FDIC upon a finding that the institution has engaged inunsafe or unsound practices, is in an unsafe or unsound condition to continueoperations or has violated any applicable law, regulation, rule, order orcondition imposed by the FDIC or the OTS. The management of the Bank does not know of any practice, condition orviolation that might lead to termination of deposit insurance.

 

*Regulatory Capital Requirements*.  OTSregulations require the Bank to meet three minimum capital standards:

 

•                  Atangible capital ration requirement of 1.50% of total assets, as adjusted underthe OTS regulations;

•                  Aleverage ratio requirement of 3.00% of core capital to such adjusted totalassets, if a savings association has been assigned the highest composite ratingof 1 under the Uniform Financial Institutions Ratings System; and

•                  Arisk-based capital ratio requirement of 8.00% of core and supplementary capitalto total risk-based assets.

 

The minimum leverage capital ratio for any otherdepository institution that does not have a composite rating of 1 will be4.00%, unless a higher leverage capital ratio is warranted by the particular circumstancesor risk profile of the depository institution. In determining the amount of risk-based assets for the purpose of therisk-based capital requirement, the Bank must compute its risk-based assets bymultiplying its assets and certain off-balance sheet items by risk-weights,which range from 0% for cash and obligations issued by the United StatesGovernment or its agencies to 100% for consumer and commercial loans, asassigned by the OTS capital regulation based on the risks found by the OTS to beinherent in the type of asset.

 

Tangible capital generally includes common stockholders’equity and retained earnings, and certain noncumulative perpetual preferredstock and related earnings on withdrawable accounts and deposits that qualifyas core capital.  In addition, allintangible assets, other than a limited amount of mortgage servicing rights andother categories must be deducted from tangible capital.  At June 30, 2005, the Bank had $5.2 millionof unamortized loan servicing rights. Included in total unamortized loan servicing was $9,000 of nonmortgageservicing rights which was required to be deducted from tangible capital.

 

The OTS regulations establish special capitalizationrequirements for savings associations that own subsidiaries.  Under these regulations certain subsidiariesare consolidated for capital purposes and others are excluded from assets andcapital.  In determining compliance withthe capital requirements, all subsidiaries engaged solely in

 

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activities permissible for national banks or engaged incertain other activities solely as agent for its customers such as mortgagebanking activities are “includable” subsidiaries that are consolidated forcapital purposes in proportion to the association’s level of ownership,including the assets of includable subsidiaries in which the association has aminority interest that is not consolidated for U.S. generally acceptedaccounting principals (“GAAP”) purposes. All subsidiaries of the Bank are includable subsidiaries.

 

Core capital generally consists of tangible capital pluscertain intangible assets, and up to 25.00% of other intangibles which meetcertain separate salability and market valuation tests.  At June 30, 2005, the Bank had $5.0 millionin 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, 2005, the Bank had Tier I (core)capital equal to $73.8 million, or 8.28%, of adjusted total assets, which is$38.8 million above the minimum leverage ratio requirement of 4.00% as ineffect on that date.

 

Total capital consists of core capital, as defined above,and supplementary capital.  Supplementarycapital consists of certain permanent and maturing capital instruments that donot qualify as core capital and general valuation loan and lease lossallowances up to a maximum of 1.25% of risk-weighted assets.  Supplementary capital may be used to satisfythe risk-based requirement only to the extent of core capital up to 100.00% ofcore capital.  At June 30, 2005, theBank had no capital instruments that qualified as supplementary capital and$3.3 million of general loss reserves, which was not in excess of 1.25% of risk-weightedassets.

 

Certain exclusions from capital and assets are requiredto be made for the purpose of calculating total capital, in addition to theadjustments required for calculating core capital.  Such exclusions consist of equity investments(as defined by regulation) and that portion of land loans and nonresidentialconstruction loans in excess of an 80.00% loan-to-value ratio, retainedinterest on securitizations and reciprocal holdings of qualifying capitalinstruments.  The Bank had $1.7 millionin dollar for dollar exclusions from capital and assets at June 30, 2005, forthe retained interest from securitized automobile loans.

 

On June 30, 2005, the Bank had total risk-based capitalof $75.4 million (including $73.8 million in core capital, $3.3 million in qualifyingsupplementary capital and dollar for dollar exclusions for the retainedinterest from securitized automobile loans of $1.7 million) and risk-weightedassets of $707.6 million (including $27.9 million in converted off-balancesheet assets), or total capital of 10.66% of risk-weighted assets.  This amount was $18.8 million above the 8.00%requirement in effect on that date.

 

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Thefollowing table sets forth the Bank’s compliance with its capital requirementsat June 30, 2005.

 
| ** **               | ** ** | ** **                 | ** ** | **Percent of Applicable** | ** ** |
|--------------------------|------------|----------------------------|------------|---------------------------|------------|
| ** **               | ** ** | **Amount (2)**             | ** ** | **Assets(1)**             | ** ** |
| ** **               | ** ** | **(Dollars in Thousands)** | ** ** |
| ** **               | ** ** | ** **                 | ** ** | ** **                | ** ** |
| GAAP capital             |       | $                          | 77,930     |                      | 8.71       | % |
| ** **               | ** ** | ** **                 | ** ** | ** **                | ** ** |
| Tier I (core)  capital   |       | $                          | 73,815     |                      | 8.28       | % |
| Required                 |       | 35,046                     |       | 4.00                      |       |
| Excess over  requirement |       | $                          | 38,769     |                      | 4.28       | % |
|                     |       |                       |       |                      |       |
| Risk-based  capital(3)   |       | $                          | 75,423     |                      | 10.66      | % |
| Required                 |       | 56,610                     |       | 8.00                      |       |
| Excess over  requirement |       | $                          | 18,813     |                      | 2.66       | % |

 

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(1)                                Tier I (core) capital figures are determined as a percentage of totaladjusted assets; risk-based capital figures are determined as a percentage ofrisk-weighted assets.

(2)                                The Bank’s investment in its subsidiaries is included for purposes ofcalculating regulatory capital.

(3)                                Includes qualifying supplementary capital of $3.3 million and dollar fordollar exclusion for the retained interest from securitized automobile loans of$1.7 million.

 

*Limitations on Dividends and Other CapitalDistributions*.  The OTS regulations impose variousrestrictions or requirements on associations with respect to their ability to paydividends or make other distributions of capital.  The OTS regulations prohibit an associationfrom declaring or paying any dividends or from repurchasing any of its stockif, as a result, the regulatory capital of the association would be reducedbelow the amount required to be maintained for the liquidation accountestablished in connection with its mutual to stock conversion.

 

The OTS imposes various restrictions or requirements onthe Bank’s ability to make capital distributions, including cash dividends.  A savings institution that is the subsidiaryof a savings and loan holding company must file a notice with the OTS at least30 days before making a capital distribution. The Bank must file an application for prior approval if the total amountof its capital distributions, including the proposed distribution, for theapplicable calendar year would exceed an amount equal to the Bank’s net incomefor that year plus retained net income for the previous two years.

 

The OTS may disapprove of a notice or application if:

 

•                  the Bank would be undercapitalized following the distribution;

•                  the proposed capital distribution raises safety and soundness concerns;or

•                  the capital distribution would violate a prohibition contained in anystatute, regulation or agreement.

 

During the fiscal year ended June 30, 2005, the Bank paidcash dividends to the Company totaling $3.7 million.

 

*Liquidity*.  All savings associations,including the Bank, are required to maintain a sufficient amount of liquidassets to ensure its safe and sound operation. For a discussion of what the Bank includes in liquid assets, see PartII, Item 7 “Management’s Discussion and Analysis of Financial Condition andResults of Operations” of this Form 10-K.

 

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*Branching.*  Subject to certain limitations,the HOLA and the OTS regulations permit federally chartered savingsassociations to establish branches in any state of the United States.  The authority to establish such branches isavailable (a) in states that expressly authorize branches of savingsassociations located in another state or (b) to an association that qualifiesas a “domestic building and loan association” under the Internal Revenue Codeof 1986, as amended, which imposes qualification requirements similar to thosefor a “qualified thrift lender” under the HOLA. See the section below entitled “Qualified Thrift Lender Test.”  This authority under the HOLA and the OTSregulations preempts any state law purporting to regulate branching by federalsavings associations.

 

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

 

The CRA regulations rate an institution based on itsactual 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*.  All savings associations,including the Bank, are required to meet a qualified thrift lender (“QTL”) testto avoid certain restrictions on their operations.  This test requires a savings association tohave at least 65.00% of its portfolio assets (which consists of goodwill andother intangible assets, properties used to conduct the savings association’sbusiness and specified liquid assets not exceeding 20.00% of total assets) inqualified thrift investments on a monthly average for nine out of every 12months on a rolling basis.  At June 30,2005, the Bank maintained 77.47% of its portfolio assets in qualified thriftinvestments, and thus met the test.  TheBank has met the QTL test since its inception.

 

*Transactions with Affiliates*.  The Bank’s authority to engagein transactions with its “affiliates” is limited by the OTS regulations and bySections 23A and 23B of the Federal Reserve Act (the “FRA”).  In general, an affiliate of the Bank is anycompany that controls the Bank or any other company that is controlled by acompany that controls the Bank, excluding the Bank’s subsidiaries other thanthose that are insured depository institutions. The OTS regulations prohibit a savings association (a) from lending toany of its affiliates that is engaged in activities that are not permissiblefor bank holding companies under Section 4(c) of the BHC Act and (b) frompurchasing the securities of any affiliate other than a subsidiary.  Section 23A of the FRA limits the aggregateamount of transactions with any individual affiliate to 10.00% of the capitaland surplus of the savings association and also limits the aggregate amount oftransactions with all affiliates to 20.00% of the savings association’s capitaland surplus.  Extensions of credit toaffiliates are required to be secured by collateral in an amount and of a typedescribed in Section 23A of the FRA, and the purchase of low quality assetsfrom affiliates is generally prohibited. Section 23B of the FRA provides that certain transactions withaffiliates, including loans and asset purchases, must be on terms and undercircumstances, including credit standards, that are substantially the same orat least as favorable to the association as those prevailing at the time forcomparable transactions with non-affiliated companies.  In the absence of comparable transactions,such transactions may only occur under terms and circumstances, includingcredit standards, that in good faith would be offered to or would apply tonon-affiliated companies.

 

Effective April 1, 2003, the Federal Reserve Boardrescinded its interpretations of Sections 23A and 23B of the FRA and replacedthese interpretations with Regulation W. In addition, Regulation W makes various changes to existing law regardingSections 23A and 23B of the FRA, including expanding the definition of whatconstitutes an affiliate subject to Sections 23A and 23B of the FRA.  The Federal Reserve Board’s final rule doesnot by its terms apply to savings associations. However, because the OTS incorporates Regulation W and applies it tosavings associations, Sections 23A and 23B of the FRA apply to the Bank in thesame manner and to the same extent as if

 

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the Bank were a memberbank.  The OTS rules incorporate allapplicable provisions and exceptions prescribed by the Federal Reserve Board inRegulation W, provide guidance regarding the additional prohibitions on savingsassociations with respect to transactions with affiliates under HOLA, and setout the additional restrictions that the OTS imposes on savings associationsunder HOLA with regard to transactions with affiliates.

 

Under Regulation W, all transactions entered into onor before December 12, 2002, which either became subject to Sections 23A and23B of the FRA solely because of Regulation W, and all transactions covered bySections 23A and 23B of the FRA, the treatment of which will change solelybecause of Regulation W, became subject to Regulation W on July 1, 2003.  All other covered affiliate transactions becamesubject to Regulation W on April 1, 2003. The Federal Reserve Board expects each depository institution that issubject to Sections 23A and 23B of the FRA to implement policies and proceduresto ensure compliance with Regulation W.

 

The Bank’s authority to extendcredit to its directors, executive officers and 10.00% stockholders, as well asto entities controlled by such persons, is currently governed by therequirements of Sections 22(g) and 22(h) of the FRA and Regulation O of theFederal Reserve Board thereunder.  Amongother things, these provisions require that extensions of credit to insiders(a) be made on terms that are substantially the same as, and follow creditunderwriting procedures that are not less stringent than, those prevailing forcomparable transactions with unaffiliated persons and that do not involve morethan the normal risk of repayment or present other unfavorable features and (b)not exceed certain limitations on the amount of the association’s capital.  In addition, extensions of credit in excessof certain limits must be approved by the Bank’s board of directors.  Section 402 of the Sarbanes-Oxley Actof 2002 (the “Sarbanes-Oxley Act”) prohibits the extension of personal loans todirectors and executive officers of issuers (as defined in the Sarbanes-OxleyAct).  The prohibition, however, does notapply to mortgages advanced by an insured depository institution, such as theBank, that are subject to the insider lending restrictions of Section 22(h) ofthe FRA.

 

Certain transactions with directors, officers orcontrolling 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 OTS and the other federalbanking agencies adopted regulations to prescribe standards for extensions ofcredit that (a) are secured by real estate or (b) are made for the purpose offinancing the construction of improvements on real estate.  The OTS regulations require the Bank toestablish and maintain written internal real estate lending standards that areconsistent with safe and sound banking practices and appropriate to the size ofthe association and the nature and scope of its real estate lendingactivities.  The standards also must beconsistent with accompanying OTS guidelines, which include loan-to-value ratiosfor the different types of real estate loans. The Bank is also permitted to make a limited amount of loans that do notconform to the proposed loan-to-value limitations so long as such exceptionsare reviewed and justified appropriately. The guidelines also list a number of lending situations in whichexceptions to the loan-to-value standards are justified.

 

*Privacy Regulations.*  Under the OTS regulations adopted pursuant tothe Gramm-Leach-Bliley Act of 1999 (“GLBAct”), the Bank is required to adopt procedures to protect customers’ “nonpublicpersonal information.”  The regulationsgenerally require that the Bank disclose its privacy policy, includingidentifying with whom it shares a customer’s “nonpublic personal information,”to customers at the time of establishing the customer relationship and annuallythereafter.  In addition, the Bank isrequired to provide its customers with the ability to “opt-out” of having itshare their personal information with unaffiliated third parties and not todisclose account numbers or access codes to nonaffiliated third parties formarketing purposes.  The Bank currentlyhas a privacy protection policy in place, which has been reviewed, for compliancewith the regulations.

 

*Federal Reserve System*.  Under FRB regulations, the Bankis required to maintain noninterest-earning reserves against its transactionaccounts.  FRB regulations generallyrequire that (a) reserves of 3.00% must be maintained against aggregatetransaction accounts of $47.6 million or less, subject to adjustment by theFRB, and (b) a reserve of $1.2 million plus 10.00% must be maintained againstthat portion of total transaction accounts in excess of $47.6 million.  The first $7.0 million of otherwisereservable balances are exempted from the reserve requirements.  The Bank is in compliance with these reserverequirements at June 30, 2005.  Becauserequired reserves must be maintained in the form of either vault cash, anoninterest bearing account at a FRB, or a passthrough account as defined bythe FRB, the effect of this reserve requirement is to reduce the Bank’sinterest-earning assets to the extent that the requirement exceeds vault cash.

 

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*Federal Home Loan Bank System*.  The Bank is a member of theFHLB of Des Moines, which is one of 12 regional FHLBs that administers the homefinancing credit function of savings associations.  Each FHLB serves as a reserve or central bankfor 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 to befully secured by sufficient collateral as determined by the FHLB.  The Bank, as a member of the FHLB of Des Moines,is required to acquire and hold shares of capital stock in the FHLB of DesMoines equal to 0.12% of the total assets of the Bank at December 31annually.  The Bank is also required toown activity-based stock, which is based on 4.45% of the Bank’s outstandingadvances.  These percentages are subjectto change at the discretion of the FHLB Board of Directors.

 

At June 30, 2005, the Bank had$7.7 million in FHLB stock, which was in compliance with this requirement.  The Bank receives dividends on its FHLBstock, subject to approval by the FHLB. For the fiscal year ended June 30, 2005, dividends paid by the FHLB ofDes Moines to the Bank totaled approximately $152,000, which constitutes a$45,000 increase in the amount of dividends received in fiscal year 2004.  This increase was primarily due to anincrease in the dividend rate approved by the FHLB Board of Directors.

 

*TrustActivities Regulation*. The Bank derives its trust powers from Section 5(n) of the HOLA and theregulations and policies of the OTS. Under these laws, regulations and policies, the trust activities offederal savings banks are governed by both federal and state laws.  Generally, the scope of trust activities thatthe Bank can provide will be governed by the laws of the states in which theBank is “located” (as such term is defined under the regulations of the OTS),while other aspects of the trust operations of the Bank are governed by federallaws and regulations.  If the trustactivities of a federal savings bank are located in more than one state,however, then the scope of fiduciary services the federal savings bank canprovide will vary depending on the laws of each state.

 

The Bank, throughits trust department, acts as trustee, executor, administrator, guardian,custodian, record keeper, agent, registrar, advisor and manager for variousaccounts.  As of June 30, 2005, the trustdepartment of the Bank maintained approximately $100.5 million in assets undermanagement.

 

*USAPatriot Act*.  The Bankis subject to the USA Patriot Act, which gives the federal government newpowers to address terrorist threats through enhanced domestic securitymeasures, expanded surveillance powers, increased information sharing, andbroadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USAPatriot Act takes measures intended to encourage information-sharing among bankregulatory agencies and law enforcement bodies. Further, certain provisions of Title III of the USA Patriot Act imposeaffirmative obligations on a broad range of financial institutions, includingbanks, thrifts, brokers, dealers, credit unions, money transfer agents andparties registered under the Commodity Exchange Act.

 

Among other requirements,Title III of the USA Patriot Act imposes the following requirements withrespect to financial institutions:

 

•                  Pursuantto Section 352, *all* financialinstitutions must establish anti-money laundering programs that include, atminimum: (a) internal policies, procedures, and controls, (b) specificdesignation of an anti-money laundering compliance officer, (c) ongoingemployee training programs, and (d) an independent audit function to test theanti-money laundering program.

 

•                  Pursuantto Section 326, on May 9, 2003, the OTS, in conjunction with other bankregulators, issued a Joint Final Rule that provides for minimum standards withrespect to customer identification and verification.  This rule, which became effective October 1,2003, requires each financial institution to implement a written customeridentification program appropriate for its size, location and type of businessthat includes certain minimum requirements.

 

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•                  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 detect andreport money laundering.

 

•                  Section318, which become effective December 25, 2001, prohibits financial institutionsfrom establishing, maintaining, administering or managing correspondentaccounts for foreign shell banks (foreign banks that do not have a physicalpresence in any country), and requires financial institutions to takereasonable steps to ensure that correspondent accounts provided to foreignbanks are not being used to indirectly provide banking services to foreignshell banks.

 

•                  Bankregulators are directed to consider a holding company’s effectiveness incombating money laundering when ruling on FRA and Bank Merger Act applications.

 

*The Sarbanes-Oxley Act*. As a public company, we are subject to the Sarbanes-Oxley Act.  The Sarbanes-Oxley Act implements a broadrange of corporate governance and accounting measures for public companiesdesigned to promote honesty and transparency in corporate America and to betterprotect investors from corporate wrongdoing.

 

The Sarbanes-Oxley Act’s principal legislationincludes:

 

•                  the creation of an independent accounting oversight board;

 

•                  auditor independence provisions which restrict non-audit services thataccountants may provide to their audit clients;

 

•                  additional corporate governance and responsibility measures, includingthe requirement that the chief executive officer and chief financial officercertify financial statements;

 

•                  a requirement that companies establish and maintain a system ofinternal control over financial reporting and that a company’s managementprovide an annual report regarding its assessment of the effectiveness of suchinternal control over financial reporting to the company’s independentaccountants and that such accountants provide an attestation report withrespect to management’s assessment of the effectiveness of the company’sinternal control over financial reporting;

 

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

 

•                  an increase in the oversight of, and enhancement of certainrequirements relating to audit committees of public companies and how theyinteract with the Company’s independent auditors;

 

•                  a requirement that audit committee members must be independent and areabsolutely barred from accepting consulting, advisory or other compensatoryfees from the issuer;

 

•                  a requirement that companies disclose whether at least one member ofthe committee is an “audit committee financial expert” (as such term is definedby the SEC) and if not, why not;

 

•                  expanded disclosure requirements for corporate insiders, includingaccelerated reporting of stock transactions by insiders and a prohibition oninsider trading during pension blackout periods;

 

•                  a prohibition on personal loans to directors and officers, exceptcertain loans made by insured financial institutions;

 

•                  disclosure of a code of ethics and filing a Current Report on Form 8-Kfor a change or waiver of such code;

 

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•                  mandatory disclosure by analysts of potential conflicts of interest;and

 

•                  a range of enhanced penalties for fraud and other violations.

 

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

 

The Companyanticipates additional expenses in complying with the provisions of theSarbanes-Oxley Act and the resulting regulation.  Management presently anticipates that theassociated internal costs and third party expenses may be significant.

 

*Holding Company Regulation*.  The Company is a unitary thrift holdingcompany subject to regulatory oversight by the OTS.  As such, the Company is registered with andfiles reports with the OTS and is subject to regulation and examination by theOTS.  Under the GLBAct, any company which becomes a unitary savings and loan holding company pursuantto a charter application filed with the OTS after May 4, 1999, is prohibitedfrom engaging in non-financial activities or affiliating with non-financialcompanies.  All unitary savings and loanholding companies in existence prior to May 4, 1999, such as the Company, are “grandfathered”under the GLB Act and may continue to operate as a unitary savings and loanholding company without any limitations in the types of business activities inwhich it can engage at the holding company level, provided the Bank continuesto satisfy the QTL Test.  Inaddition, the OTS has enforcement authority over the Company and its non-savingsassociation subsidiaries which also permits the OTS to restrict or prohibitactivities that are determined to be a serious risk to the subsidiary savingsassociation.

 

As a “grandfathered” unitary thrift holding company, theCompany generally is not subject to activity restrictions.  If the Company acquires control of anothersavings association as a separate subsidiary, it would become a multiplesavings and loan holding company, and the activities of the Company and any ofits subsidiaries (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 Company must obtainthe approval of the OTS prior to continuing after such failure, directly orthrough its other subsidiaries, any business activity other than those approvedfor multiple savings and loan holding companies or their subsidiaries.  In addition, within one year of such failurethe Company must register as, and will become subject to, the restrictions applicableto bank holding companies.  Theactivities authorized for a bank holding company are more limited than are theactivities authorized for a unitary or multiple savings and loan holdingcompany.  See the section above entitled “QualifiedThrift Lender Test.”

 

In addition, for grandfathered savings andloan holding companies, such as the Company, the GLB Act also prohibits thesale of such entities to nonfinancial companies.  This prohibition is intended to restrict thetransfer of grandfathered rights to other entities and, thereby, preventevasion of the limitation on the creation of new unitary savings and loanholding companies.

 

*Federal Securities Law*.  The common stock of the Companyis 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 are affiliates(generally officers, directors and principal stockholders) of the Company maynot be resold without registration or unless sold in accordance with certainresale restrictions.  If the Companymeets specified current public information requirements, each affiliate of theCompany is able to sell in the public market, without registration, a limitednumber of shares in any three-month period.

 

29

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**Federal and State Taxation**

 

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

 

In addition to the regular income tax, corporations,including savings associations such as the Bank, generally are subject to aminimum tax.  An alternative minimum taxis imposed at a minimum tax rate of 20.00% on alternative minimum taxableincome, which is the sum of a corporation’s regular taxable income (withcertain adjustments) and tax preference items, less any availableexemption.  The alternative minimum taxis imposed to the extent it exceeds the corporation’s regular income tax andnet operating losses can offset no more than 90.00% of alternative minimumtaxable income.

 

To the extent earnings appropriated to a savingsassociation’s bad debt reserves for “qualifying real property loans” anddeducted for federal income tax purposes exceed the allowable amount of suchreserves 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 30,2005, the Bank’s Excess for tax purposes totaled approximately $4.8 million.

 

*South Dakota Taxation*.  The Bank is subject to theSouth Dakota Franchise tax to the extent that such corporations are engaged inbusiness in the state of South Dakota. South Dakota does not have a corporateincome tax.  The franchise tax will beimposed at a rate of 6.00% on franchise taxable income which is computed in thesame manner as federal taxable income with some minor variations to comply withSouth Dakota law, other than the carryover of net operating losses which is notpermitted under South Dakota law.  ASouth Dakota return of franchise tax must be filed annually.

 

*Minnesota Taxation.*  The Bank is subject to theMinnesota Corporate Income tax to the extent that such corporations are engagedin business in the state of Minnesota. The Corporate Income tax is imposed at a rate of 9.8% on corporatetaxable income, which is computed in the same manner as federal taxable incomewith some minor variations to comply with Minnesota law.  A Minnesota return of Corporate Income taxmust be filed annually.

 

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

 

**Taxation in Other States. **Mid America Capital isrequired to file state income tax returns in those states which lessees haveoperations.  The total taxes paid in the year ended June 30, 2005 were notmaterial to the operation of Company.

 

**Executive Officers of the Company**

 

Informationregarding the executive officers of the Company and the Bank is set forthbelow.

 

*Curtis L. Hage*- Mr. Hage, age 59, is Chairman, President and Chief Executive Officer of theCompany.  He was elected to the positionof Chairman of the Board of Directors of the Company in September 1996 and hasheld the positions of President and Chief Executive Officer since February1991.  Prior to such time, Mr. Hageserved as Executive Vice President of the Bank since 1986.  Since joining the Bank in 1968, he served in variouscapacities prior to being elected Executive Vice President.  Mr. Hage received his M.B.A. from theUniversity of South Dakota and attended the Graduate School of SavingsInstitution Management at the University of Texas.

 

*DarrelL. Posegate* — Mr. Posegate, age 47, has served asExecutive Vice President, Chief Financial Officer and Treasurer of the Companyand the Bank since January 2002.  He wasemployed as Chief Financial Officer for West Des Moines State Bank, Des Moines,IA, a state banking institution, from 1998 until joining the Bank.  Prior to that time, he was employed in seniorleadership roles for community banking organizations in Iowa from 1983 to1998.  Mr. Posegate received his B.A.degree from Luther College, Decorah, IA, and is a Certified Public Accountant.

 

30

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*David A. Brown* – Mr. Brown, age 43,has served as the Senior Vice President/Business Banking of the Bank since November 1999.  Prior to joining the Bank, Mr. Brownserved as Vice President/Manager Commercial Banking of Firstar Bank, SiouxCity, Iowa, a national banking institution, a position he held since December 1998.  Mr. Brown received his M.B.A. and a B.S.in Business Administration from University of South Dakota.

 

*Mary F. Hitzemann* - Ms. Hitzemann,age 52, has served as the Senior Vice President/Human Resources of the Banksince October 1993.  Ms. Hitzemannjoined the Bank in January 1993. Prior to that time, she was employed as Vice President of HumanResources for Rapid City Regional Hospital from May 1989 to May 1992.  Ms. Hitzemann received her B.A. degreefrom Augustana College.

 

*Mark S. Sivertson*- Mr. Sivertson,age 47, has served as the Senior Vice President/Trust Officer of the Bank sinceJuly 1996.  He joined the Bank in February 1995as Vice President/Trust Officer.  Priorto joining the Bank, Mr. Sivertson was Vice President and Trust Officer incharge of the Investment Management and Trust Department at Western Bank.  He holds a law degree from the University ofNorth Dakota and his Certified Trust Financial Advisor designation from the AmericanBankers Association.

 

*Natalie A. Solberg –*Ms. Solberg, age 42, has served as the Senior Vice President/Service &Support of the Bank since October 2002. She joined the Bank in February 1994 as manager of the phonebanking center and was promoted to Vice President/In-Touch Banking in October 1995.  Prior to joining the Bank, she was employedby the Bank of New York from October 1989 to October 1993.  Ms. Solberg received her B.S. fromNorthern State University.

 

*Raymond C. Wilson*– Mr. Wilson, age 47, has served as the Vice President/Senior Controllerof the Bank since September 2003. Prior to joining the Bank, Mr. Wilson was the Corporate FinanceDirector for Interactive Information Service, Inc., a software developmentcompany, located in Cleveland, Ohio, from June 1999 to December 2002.  Prior to that time, he held senior financialand accounting management positions with two community banks.  Mr. Wilson received his B.B.A. degree inFinance and a MAFIS from Cleveland State University, Cleveland, Ohio.

 

**Item 2.  Properties**

 

TheCompany and its direct and indirect subsidiaries conduct their business at themain office located at 225 South Main Avenue, Sioux Falls, South Dakota,57104.  Currently, the Bank also conductsbusiness from 33 other offices located in its primary market area.  Of such 34 total business offices, theCompany owns 20 and leases 14 others.

 

Thetotal net book value of the Company’s premises and equipment (including land,building, leasehold improvements and furniture, fixtures and equipment) at June 30,2005 was $13.0 million.  Managementbelieves that the Company’s existing properties are adequate for its currentneeds.

 

**Item 3.  Legal Proceedings**

 

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

 

**Item4.  Submission of Matters to a Vote ofSecurity Holders**

 

Nomatter was submitted to a vote of stockholders, through the solicitation ofproxies or otherwise, during the quarterly period ended June 30, 2005.

 

31

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**PART II**

 

**Item 5.  Marketfor Registrant’s Common Equity and Related Stockholder Matters**

 

**StockListing**

 

TheCompany’s common stock is traded under the symbol “HFFC” on the NASDAQ NationalMarket System.  On July 28, 2005,the Company announced it will be included in the new Russell Microcap Index.

 

Thefollowing table sets forth the range of high and low sale prices for theCompany’s common stock for each of the fiscal quarters of the two years ended June 30,2005 and 2004.  Quotations for suchperiods are as reported by the NASDAQ National Market System and have beenretroactively adjusted for the 10% stock dividend paid on December 31,2003 to shareholders of record as of December 3, 2003.

 

| **FISCAL  2005** | ** ** | **HIGH** | ** ** | **LOW** | ** ** |
|------------------|------------|----------|------------|---------|------------|
| 1st Quarter      |       | $        | 17.45      |    | $          | 14.05 |   |
| 2nd Quarter      |       | $        | 19.25      |    | $          | 16.12 |   |
| 3rd Quarter      |       | $        | 24.74      |    | $          | 18.00 |   |
| 4th Quarter      |       | $        | 25.65      |    | $          | 19.25 |   |

 

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

 

Asof September 23, 2005, the Company had 508 holders of record of its commonstock.

 

Thetransfer agent for the Company’s common stock is Mellon Investor Services, POBox 3315, South Hackensack, New Jersey, 07606-1915.

 

**Dividends**

 

TheCompany paid cash dividends on a quarterly basis of $0.11 per share throughoutfiscal 2005.  The Company paid cashdividends on a quarterly basis of $0.1068, $0.1075, $0.1075 and $0.1075,respectively, per share in fiscal 2004. The Board of Directors intends to continue the payment of quarterly cashdividends, dependent on the results of operations and financial condition ofthe Company, tax considerations, industry standards, economic conditions,general business practices and other factors the Board of Directors deemsrelevant.  On July 20, 2005, theBoard of Directors approved a cash dividend of $0.11 per share and the Companypaid the respective cash dividends on August 17, 2005 to shareholders ofrecord on August 3, 2005.  TheCompany’s ability to pay dividends is dependent on the dividend payments itreceives from its subsidiary, the Bank, which are subject to OTSregulations.  The ability of the Companyto pay dividends is also subject to the terms of the agreements on subordinateddebentures payable to trusts, should the Company elect to defer interestpayments.  In addition, the Company’s abilityto pay dividends is subject to the terms of its line of credit with FirstTennessee Bank, NA.  See Item 7,“Management’s Discussion and Analysis of Financial Condition and Results ofOperations – Liquidity and Capital Resources” of this Form 10-K.

 

**Salesof Unregistered Stock**

 

TheCompany had no sales of unregistered stock during the fiscal year ended June 30,2005.

 

32

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**IssuerPurchases of Equity Securities**

 

Thefollowing table sets forth the purchases by the Company of its common stockduring the quarterly period ended June 30, 2005.

 
| ** **              | ** ** | **Total**     | ** ** | ** **     | ** ** | **Total Number**             | ** ** | **Maximum Number of**        | ** ** |
|-------------------------|------------|---------------|------------|----------------|------------|------------------------------|------------|------------------------------|------------|
| ** **              | ** ** | **Number**    | ** ** | **Average**    | ** ** | **of Shares Purchased**      | ** ** | **Shares that May Yet** | ** ** |
| ** **              | ** ** | **of Shares** | ** ** | **Price Paid** | ** ** | **as Part of Publicly** | ** ** | **Be Purchased Under**       | ** ** |
| **Period**              | ** ** | **Purchased** | ** ** | **per Share**  | ** ** | **Announced Programs**       | ** ** | **the Current Program**      | ** ** |
| April 1 - 30, 2005 |       | 5,600         |       | $              | 22.16      |                         | 5,600      |                         | 237,481    |   |
| May 1 - 31, 2005   |       | 44,900        |       | $              | 22.76      |                         | 44,900     |                         | 306,014    |   |
| June 1 - 30, 2005  |       | 2,400         |       | $              | 22.06      |                         | 2,400      |                         | 303,614    |   |
|                    |       |          |       |           |       |                         |       |                         |       |
| 4th Quarter Total       |       | 52,900        |       | $              | 22.67      |                         | 52,900     |                         |       |   |

 

Therepurchases made during the fiscal year ended June 30, 2005 were madeunder the Company’s publicly announced stock buy back programs.  A total of 115,500 shares of common stockwere purchased pursuant to the program which was publicly announced on April 26,2004, under which up to 10% of the common stock of the Company that wasoutstanding on May 1, 2004, which equals 352,981 shares, may be acquiredthrough April 30, 2005.  Thisprogram expired on April 30, 2005.

 

TheCompany approved a new stock buy back program effective as of  May 1, 2005, which was publiclyannounced on April 25, 2005.  Underthis program, the Company may repurchase up to 10% of the common stock of theCompany outstanding on May 1, 2005, which equals 350,914 shares, through April 30,2006.  A total of 47,300 shares stockwere purchased pursuant to this program during May and June 2005.  All of the 162,800 shares repurchased duringthe fiscal year ended June 30, 2005 were purchased in the open-market.

 

33

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**Item6.  Selected Financial Data**

 

Thefollowing table sets forth selected consolidated financial statement andoperations data with respect to the Company for the periods indicated.  This information should be read inconjunction with the Financial Statements and related notes appearing inPart II, Item 8 “Financial Statements and Supplementary Data,” of thisForm 10-K and with Part II, Item 7 “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” of this AnnualReport on Form 10-K.  TheCompany’s selected financial statement and operations data for each of thefiscal years 2001 through 2004 have been derived from audited consolidatedfinancial statements, which have been audited by McGladrey & Pullen,LLP, independent public accountants.  Forfiscal 2005, the financial statements have been audited by Eide Bailly, LLP,independent public accountants.

 
| ** **                                           | ** ** | **At June 30,**       | ** ** |
|------------------------------------------------------|------------|----------------------------|------------|
| ** **                                           | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                           | ** ** | **(Dollars in Thousands)** | ** ** |
| **Selected  Statement of Financial Condition Data:** |       |                       |       |   |   |   |   |   |   |   |   |
| Total assets                                         |       | $                          | 897,874    |   | $ | 847,070 |   | $ | 801,103 |   | $ | 723,227 |   | $ | 784,002 |   |
| Securities available for sale                        |       | 142,429                    |       | 122,715 |   | 88,527 |   | 82,804 |   | 87,387 |   |
| FHLB stock                                           |       | 7,699                      |       | 5,469 |   | 7,025 |   | 6,332 |   | 6,332 |   |
| Loans and leases receivable                          |       | 670,581                    |       | 640,946 |   | 595,417 |   | 559,814 |   | 563,836 |   |
| Loans held for sale                                  |       | 10,238                     |       | 10,351 |   | 15,984 |   | 6,559 |   | 7,270 |   |
| Deposits                                             |       | 681,216                    |       | 658,719 |   | 621,381 |   | 562,596 |   | 601,207 |   |
| Advances from FHLB and other borrowings              |       | 119,664                    |       | 93,750 |   | 89,819 |   | 84,308 |   | 108,376 |   |
| Subordinated debentures payable to trusts            |       | 27,837                     |       | 27,837 |   | 20,620 |   | 10,310 |   | — |   |
| Stockholders’ equity                            |       | 53,635                     |       | 51,649 |   | 49,358 |   | 48,536 |   | 52,525 |   |
|                                                      |            |                            |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 
| ** **                                                                    | ** ** | **Years Ended June 30,**                     | ** ** |
|-------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                    | ** ** | **2005**                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                    | ** ** | **(Dollars in Thousands, Except Per Share Data)** | ** ** |
| **Selected  Statement of Income Data:**                                       |       |                                              |       |   |   |   |   |   |   |   |   |
| Interest and dividend income                                                  |       | $                                                 | 44,946     |   | $ | 40,260 |   | $ | 44,262 |   | $ | 48,185 |   | $ | 58,463 |   |
| Interest expense                                                              |       | 18,747                                            |       | 15,188 |   | 17,997 |   | 23,573 |   | 35,051 |   |
| Net interest income                                                           |       | 26,199                                            |       | 25,072 |   | 26,265 |   | 24,612 |   | 23,412 |   |
| Provision for losses on loans and leases                                      |       | 2,681                                             |       | 2,020 |   | 3,173 |   | 1,905 |   | 1,482 |   |
| Net interest income after provision for  losses on loans and leases           |       | 23,518                                            |       | 23,052 |   | 23,092 |   | 22,707 |   | 21,930 |   |
| Loan servicing income                                                         |       | 1,446                                             |       | 1,578 |   | 1,610 |   | 1,858 |   | 1,567 |   |
| Gain on sale of loans, net                                                    |       | 726                                               |       | 1,311 |   | 1,629 |   | 1,464 |   | 745 |   |
| Gain on sale of securities, net                                               |       | 20                                                |       | 43 |   | 352 |   | 135 |   | — |   |
| Other noninterest income                                                      |       | 6,822                                             |       | 6,896 |   | 6,895 |   | 6,369 |   | 6,032 |   |
| Noninterest expense                                                           |       | (24,936                                           | )          | (24,773 | ) | (26,048 | ) | (24,806 | ) | (22,750 | ) |
| Income from continuing operations before  income taxes                        |       | 7,596                                             |       | 8,107 |   | 7,530 |   | 7,727 |   | 7,524 |   |
| Income tax expense                                                            |       | 2,431                                             |       | 2,891 |   | 2,584 |   | 2,856 |   | 2,929 |   |
| Income from continuing operations                                             |       | 5,165                                             |       | 5,216 |   | 4,946 |   | 4,871 |   | 4,595 |   |
| Discontinued Operations:                                                      |       |                                              |       |   |   |   |   |   |   |   |   |
| Income (loss) from operations of  discontinued segment  (net of income taxes) |       | —                                            |       | — |   | 253 |   | (246 | ) | 12 |   |
| (Loss) on discontinued segment  (net of income taxes)                         |       | —                                            |       | — |   | (224 | ) | (1,440 | ) | — |   |
| Income (loss) from discontinued operations                                    |       | —                                            |       | — |   | 29 |   | (1,686 | ) | 12 |   |
|                                                                          |       |                                              |       |   |   |   |   |   |   |   |   |
| Net income                                                                    |       | $                                                 | 5,165      |   | $ | 5,216 |   | $ | 4,975 |   | $ | 3,185 |   | $ | 4,607 |   |

 

34

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| ** **                                                                                                  | ** ** | **Years Ended June 30,**                     | ** ** |
|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------|------------|
| ** **                                                                                                  | ** ** | **2005**                                          | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                                  | ** ** | **(Dollars in Thousands, Except Per Share Data)** | ** ** |
| Basic earnings (loss) per share:                                                                            |       |                                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                                                                           |       | $                                                 | 1.46       |   | $ | 1.47 |   | $ | 1.36 |   | $ | 1.27 |   | $ | 1.14 |   |
| Income (loss) from discontinued operations                                                                  |       | —                                            |       | — |   | 0.01 |   | (0.44 | ) | — |   |
| Net income                                                                                                  |       | 1.46                                              |       | 1.47 |   | 1.37 |   | 0.83 |   | 1.14 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Diluted earnings (loss) per share:                                                                          |       |                                              |       |   |   |   |   |   |   |   |   |
| Income from continuing operations                                                                           |       | 1.42                                              |       | 1.43 |   | 1.34 |   | 1.24 |   | 1.12 |   |
| Income (loss) from discontinued operations                                                                  |       | —                                            |       | — |   | 0.01 |   | (0.43 | ) | — |   |
| Net income                                                                                                  |       | 1.42                                              |       | 1.43 |   | 1.35 |   | 0.81 |   | 1.12 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Dividends declared per share                                                                                |       | 0.44                                              |       | 0.43 |   | 0.42 |   | 0.40 |   | 0.38 |   |
| Dividend payout ratio from continuing  operations (1)                                                       |       | 30.03                                             | %          | 29.33 | % | 30.81 | % | 31.92 | % | 33.62 | % |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| **Other  data from continuing operations: (2)**                                                             |       |                                              |       |   |   |   |   |   |   |   |   |
| Interest rate spread (average during  period)                                                               |       | 3.05                                              | %          | 3.18 | % | 3.42 | % | 3.25 | % | 2.83 | % |
| Net interest margin (3)                                                                                     |       | 3.31                                              |       | 3.41 |   | 3.72 |   | 3.66 |   | 3.37 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Average interest-earning assets to average  interest-bearing liabilities                                    |       | 1.11                                              |       | 1.11 |   | 1.12 |   | 1.12 |   | 1.11 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Equity to total assets (end of period)                                                                      |       | 5.97                                              |       | 6.10 |   | 6.16 |   | 6.71 |   | 6.70 |   |
| Equity-to-assets ratio (ratio of average  equity to average total assets)                                   |       | 6.25                                              |       | 6.36 |   | 6.52 |   | 7.17 |   | 6.77 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Nonperforming assets to total assets (end  of period)                                                       |       | 0.78                                              |       | 0.27 |   | 0.77 |   | 1.59 |   | 0.76 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses to  nonperforming loans and leases (end of period) (4)                  |       | 73.24                                             |       | 174.75 |   | 65.89 |   | 40.02 |   | 97.73 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Allowance for loan and lease losses to  total loans and leases (end of period)                              |       | 0.74                                              |       | 0.55 |   | 0.62 |   | 0.78 |   | 0.96 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Nonperforming loans and leases to total  loans and leases (end of period) (4)                               |       | 1.01                                              |       | 0.32 |   | 0.95 |   | 1.96 |   | 0.99 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Noninterest expense to average total assets                                                                 |       | 2.91                                              |       | 3.11 |   | 3.42 |   | 3.42 |   | 3.06 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Net interest income after provision for  losses for loans and leases to noninterest expense (end of period) |       | 94.31                                             |       | 93.05 |   | 88.65 |   | 91.54 |   | 96.40 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Return on assets (ratio of income from  continuing operations to average total assets)                      |       | 0.60                                              |       | 0.66 |   | 0.65 |   | 0.67 |   | 0.62 |   |
| Return on assets (ratio of net income to  average total assets)                                             |       | 0.60                                              |       | 0.66 |   | 0.65 |   | 0.44 |   | 0.62 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Return on equity (ratio of income from  continuing operations to average equity)                            |       | 9.66                                              |       | 10.30 |   | 9.96 |   | 9.37 |   | 9.14 |   |
| Return on equity (ratio of net income to  average equity)                                                   |       | 9.66                                              |       | 10.30 |   | 10.02 |   | 6.13 |   | 9.16 |   |
|                                                                                                        |       |                                              |       |   |   |   |   |   |   |   |   |
| Operating Efficiency Ratio (5)                                                                              |       | 67.68                                             |       | 68.57 |   | 69.08 |   | 71.29 |   | 71.64 |   |
| Efficiency Ratio (6)                                                                                        |       | 70.81                                             |       | 70.98 |   | 70.88 |   | 72.03 |   | 71.64 |   |
| Number of full-service offices                                                                              |       | 34                                                |       | 34 |   | 34 |   | 33 |   | 31 |   |
|                                                                                                             |            |                                                   |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1) Dividends declared per share divided by net income per sharefrom continuing operations.

(2) All periods presented have been restated to eliminate effectof discontinued operations.

(3) Net interest income divided by average interest-earningassets.

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

(5) Total noninterest expense divided by the sum of net interestincome plus total noninterest income and interest expense on trust preferredsecurities.

(6) Total noninterest expense divided by the sum of net interestincome plus total noninterest income.

 

35

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

 

This section should be read in conjunction with the followingparts of this Form 10-K: Part II, Item 8 “Financial Statementsand Supplementary Data”, Part II, Item 7A, “Quantitative and QualitativeDisclosures About Market Risk,” and Part I, Item 1 “Business”.

 

## **Executive Summary**

 

The Company’s net income for fiscal 2005 was $5.2 million, or $1.42 perdiluted share, compared to $5.2 million, or $1.43 per diluted share for fiscal2004.  Return on average equity was 9.66%at June 30, 2005, compared to 10.30% at June 30, 2004.

 

Financial performance of the Company was adversely impacted in thefourth quarter of fiscal 2005 due to a downgrade of a $4.1 million commercialbusiness participation loan that was placed on nonaccrual status as of June 30,2005.  In addition, the Companycharged-off $224,000 in direct leases associated with the same customer as of June 30,2005.  Furthermore, a provision for loanand lease losses charge of $2.0 million, including a $1.8 million impaired loanvaluation allowance, was recorded as of June 30, 2005.

 

Net interest income for fiscal 2005 was $26.2 million, an increase of$1.1 million or 4.5% over the same period a year ago.  The change in net interest income for thefiscal year ended June 30, 2005 as compared to the same period a year agowas due in part to a 7.7% increase in average interest-earning assets.  The flattening of the treasury yield curvecaused by increasing short-term rates and lagging long-term rates continued toaffect the Company’s net interest margin ratio during fiscal 2005.  The net interest margin was 3.31%, comparedto 3.41% for the same period a year ago, a decline of 10 basis points.  Variability of the net interest margin ratiomay be affected by many aspects, including Federal Reserve policies forshort-term interest rates, competitive and economic factors and customerpreferences for various products and services. Trust preferred securities issued are variable rated tied to LIBOR.  The increase in interest rates caused anincrease in this funding cost causing a decrease in margin of 6 basis points.

 

The transformation from a traditional thrift balance sheet to a fullservice Community Bank operation is complete. The diversification of product lines and services helps the Company togrow and compete in an ever-changing financial services landscape.  The Company experienced growth in totalyear-end balance outstandings of 4.7% in fiscal 2005, compared to fiscal 2004,as well as in the major product lines of business banking, real estate andconsumer loans.  Funding for this loangrowth was comprised primarily of in-market deposits.  Total deposits grew at an increase of 3.4% infiscal 2005, compared to fiscal 2004. This growth consisted of balanced contributions from each depositline.  The Company believes the need forlong-term growth of loans will be funded by in-market generated deposits.

 

Total deposits at June 30, 2005 were at $681.2 million, anincrease of $22.5 million, or 3.4%, from June 30, 2004.  Interest expense on these deposits was $12.7million for fiscal 2005, which is an increase of $2.5 million, or 24.0%, overthe same period a year ago.  A primaryfactor affecting interest expense has been money market accounts.  The volume of money market accounts decreasedby $2.8 million, or 1.3%, from June 30, 2004 to June 30, 2005.  Interest expense for these accounts hasincreased by $1.9 million, or 76.3%, compared to the same period in the priorfiscal year.  At June 30, 2005,approximately 70% of all money market accounts were indexed with a monthlyreset, tied to the 91-day Treasury bill, compared to approximately 33% atJune 30, 2004.  From June 30,2004 to June 30, 2005, the Federal Reserve increased short-term interestrates nine times at 25 basis points each or a total of 225 basis points.  With the actions taken by the FederalReserve, the 91-day Treasury bill has risen significantly from 1.26% at June 30,2004 to 3.12% at June 30, 2005, an increase of 186 basis points.

 

In April 2005, the Company announced the renewal of its annualstock buyback program for the period of May 2005 through April 2006with a maximum purchase of 350,914 shares. During the previous annual stock buyback program that expired on April 30,2005, the Company acquired 115,500 shares or 32.7% of the authorized purchaseagainst a pool maximum of 352,981. During the fourth quarter ended June 30, 2005, the Company acquired5,600 shares under the previous stock buyback program and 47,300 shares underthe current stock buyback program.

 

36

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The total risk-based capital ratio of 10.66% at June 30, 2005 isabove the 10.54% at June 30, 2004, an increase of 12 basis points.  This continues to place the Bank in the “wellcapitalized” category within OTS regulation at June 30, 2005 and isconsistent within the “well capitalized” OTS category in which the Companyplans to operate.  The Companyhistorically has been able to manage the size of its assets through secondarymarket loan sales of single-family mortgages and student loans and a loansecuritization.

 

Nonperforming assets at June 30, 2005 were $7.0 million incomparison to $2.3 million a year ago, an increase of $4.7 million or208.6%.  The ratio of nonperformingassets to total assets increased to 0.78% at June 30, 2005, compared to0.27% at June 30, 2004.  Theallowance for loan and lease losses increased to $5.1 million at June 30,2005 compared to $3.6 million at June 30, 2004, an increase of $1.5million or 40.8%.  As a result ofincreases in nonperforming assets and the allowance for loan and lease losses,the ratio of allowance for loan and lease losses to nonperforming loans andleases decreased from 174.75% at June 30, 2004 to 73.24% at June 30,2005.

 

Notwithstanding the downgrade of the aforementioned participation loan,asset quality is and continues to be a primary focus for the Company.  Asset quality has generally improved over thelast two years as a result of a combination of disciplined underwritingstandards and good economic health of the region.  The allowance for loan and lease losses iscalculated based on loan and lease levels, loan and lease loss history, creditquality of the loan and lease portfolio, and environmental factors such aseconomic health of the region and management experience.  This risk rating analysis is well advancedand gives the Company a consistent and systematic methodology to determineproper levels for the allowance at a given time.

 

Noninterest expense for fiscal 2005 was $24.9 million, compared to $24.8million a year ago, an increase of $163,000 or 0.7%.  Compensation and employee benefits expensefor fiscal 2005 accounted for a decrease of $49,000 from the same period a yearago.  Net healthcare costs, inclusive ofself-funded health claims, administration fees and fully-insured dentalpremiums offset by stop loss insurance receivable and employee reimbursementsfor fiscal 2005 were $1.3 million, compared to $1.8 million for the same perioda year ago, a decrease of $533,000 or 29.8%. This change is due to lower health claims expense and additionalemployee responsibility for reimbursements. Other expenses were $3.3 million for fiscal 2005, compared to $3.2million for the same period a year ago. Marketing and advertising expenses increased by $263,000 or 35.1% to$1.0 million in fiscal 2005 from the same period a year ago.

 

Noninterest income for fiscal 2005 was $9.0 million, compared to $9.8million for the same period a year ago, a decrease of $814,000 or 8.3%.  This shortfall was driven primarily by adecline in single-family mortgage production as a result of an overall decreasein housing market refinancing activity. Gain on sale of loans was $726,000 for fiscal 2005, compared to $1.3million for the same a period a year ago, a decline of $585,000 or 44.6%.

 

The operating efficiency ratio for fiscal 2005 was 67.68%, compared to68.57% for the same time period a year ago, a decrease of 89 basis points.  The operating efficiency ratio excludes theimpact of net interest expense on the variable priced trust preferredsecurities issued by the Company.  Netinterest expense on the $27.8 million of variable priced trust preferredsecurities outstanding, increased to $1.6 million for the fiscal 2005, comparedto $1.2 million for the same period a year ago, an increase of $403,000 or32.9%.  The total efficiency ratio was70.81% for fiscal 2005, compared to 70.98% for fiscal 2004, an improvement of17 basis points.  It is the Company’sgoal to continue to move the operating efficiency ratio towards the 50% levelover the long term.  Management believesthat this can be accomplished through steady growth of the balance sheet andthe containment of incremental operating expenses.

 

**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 thenet interest margin,

 

37

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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 byregulatory, economic and competitive factors that influence interest rates,loan demand and deposit flows.  Feesearned include charges for deposit services, trust services and loan services.  Personnel costs are the primary expensesrequired to deliver the services to customers. Other costs include occupancy and equipment and general andadministrative expenses.

 

During thefourth quarter of fiscal 2002, management committed to a plan to sell thesubprime credit card operations, which were previously reported in the creditcard segment of the Company.  At June 30,2002, the Company estimated the net realizable value based on estimates from athird party and reclassified the net realizable value of $1.1 million at thattime from loans receivable to loans held for sale.  The Bank ceased processing subprime creditcard applications in March 1999 and managed the portfolio from a balance of$18.1 million at June 30, 1999, to the sale of the receivables as of January31, 2003.  On December 31, 2002, theCompany, through the Bank, entered into an agreement to sell the discontinuedcredit card operations to an independent third party.  The sale of the receivables took place onJanuary 31, 2003, and the Company dissolved the operations of HF Card Services,LLC during the third quarter of fiscal 2003. See Note 2 of “Notes to Consolidated Financial Statements” which isincluded in Part II, Item 8 “Financial Statements and Supplementary Data” ofthis Form 10 K for further discussion on discontinued operations.

 

**Financial Condition Data**

 

At June 30, 2005, the Company had total assets of $897.9 million,an increase of $50.8 million from the level at June 30, 2004.  The increase in assets was due primarily toincreases in loans and leases receivable of $29.6 million, investmentsecurities available for sale of $19.7 million and FHLB Stock of $2.2 millionoffset by a decrease in cash and cash equivalents of $2.2 million.  The increase in liabilities of $48.8 millionwas due to increases in deposits of $22.5 million and advances from the FHLBand other borrowings of $25.9 million from the levels at June 30,2004.  In addition, stockholders’ equityincreased to $53.6 million at June 30, 2005 from $51.6 million at June 30,2004 primarily due to net income of $5.2 million offset by the cost of treasurystock acquired of $3.2 million and cash dividends paid of $1.6 million.

 

The increase in net loans and leases receivable of $29.6 million wasdue primarily to an increase in purchases and originations over sales, amortizationand repayments of principal.  Inaddition, deferred fees and discounts increased by $260,000, or 25.3%,primarily due to an increase of $110,000 for deferred fees and discounts oncommercial business loans, reflecting early payoffs.  Also, there was anincrease of $97,000 for deferred fees and discounts on indirect automobileloans that include prepaid dealer reserves.

 

The increase in securities available for sale of $19.7 million wasprimarily the result of purchases of $70.9 million exceeding sales, maturitiesand repayments of $51.1 million.  Thepurchases of $70.9 million included variable-rate, mortgage-backed securitiesof $64.4 million.  Included in the $51.1million of sales, maturities and repayments was approximately $30.9 million ofmortgage backed securities principal repayments.

 

The net increase in FHLB stock of $2.2 million wasprimarily the result of the Company’s redemption of $3.7 million of stockoffset by purchases of FHLB stock of $5.9 million.

 

The decrease in cash and cash equivalents of $2.2million was primarily due to the timing of items in clearing.

 

The $22.5 million increase in deposits was primarilydue to increases in out-of-market certificates of deposit of $12.5 million,noninterest bearing checking accounts of $10.4 million and interest bearingchecking accounts of $4.4 million, offset by decreases in in-marketcertificates of deposit of $1.6 million, money market accounts of $2.8 millionand savings accounts of $435,000.

 

Advances from the FHLB and other borrowings increased $25.9 million forthe year ended June 30, 2005 primarily due to the Company increasing itsovernight Fed Funds advances by $3.1 million, in addition to a net increase of $22.8million in short and long-term advances during the fiscal year ended June 30,2005.  

 

38

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**Analysis of Net Interest Income**

 

Net interest income represents the differencebetween income on interest-earning assets and expense on interest-bearingliabilities.  Net interest income dependsupon the volume of interest-earning assets and interest-bearing liabilities andthe interest rates 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.  Average balances consist of daily averagebalances for the Bank with simple average balances for all othercompanies.  The average balances includenonaccruing loans and leases.  The yieldson loans and leases include origination fees, net of costs, which areconsidered adjustments to yield. Balances related to discontinued credit card loan operations have beenreclassified to noninterest-earning assets for all periods presented.  

 
| ** **                                 | ** ** | **Years  Ended June 30,** | ** ** |
|--------------------------------------------|------------|--------------------------------|------------|
| ** **                                 | ** ** | **2005**                       | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **Average**                    | ** ** | **Interest** | ** ** | ** ** | ** ** | **Average** | ** ** | **Interest** | ** ** | ** ** | ** ** | **Average** | ** ** | **Interest** | ** ** | ** ** | ** ** |
| ** **                                 | ** ** | **Outstanding**                | ** ** | **Earned/** | ** ** | **Yield/** | ** ** | **Outstanding** | ** ** | **Earned/** | ** ** | **Yield/** | ** ** | **Outstanding** | ** ** | **Earned/** | ** ** | **Yield/** | ** ** |
| ** **                                 | ** ** | **Balance**                    | ** ** | **Paid** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Paid** | ** ** | **Rate** | ** ** | **Balance** | ** ** | **Paid** | ** ** | **Rate** | ** ** |
| ** **                                 | ** ** | **(Dollars  in Thousands)**    | ** ** |
| Interest-earning  assets:                  |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Loans  and leases receivable (1) (3)  |       | $                              | 662,661    |   | $ | 40,489 |   | 6.11 | % | $ | 621,548 |   | $ | 36,935 |   | 5.94 | % | $ | 594,873 |   | $ | 40,240 |   | 6.76 | % |
| Investment  securities (2) (3)        |       | 121,824                        |       | 4,256 |   | 3.49 | % | 107,942 |   | 3,218 |   | 2.98 | % | 103,902 |   | 3,801 |   | 3.66 | % |
| FHLB  stock                                |       | 6,248                          |       | 201 |   | 3.22 | % | 4,726 |   | 107 |   | 2.26 | % | 6,854 |   | 221 |   | 3.22 | % |
| Total  interest-earning assets             |       | 790,733                        |       | $ | 44,946 |   | 5.68 | % | 734,216 |   | $ | 40,260 |   | 5.49 | % | 705,629 |   | $ | 44,262 |   | 6.27 | % |
| Noninterest-earning  assets                |       | 64,839                         |       |   |   |   |   | 61,381 |   |   |   |   |   | 55,921 |   |   |   |   |   |
| Total  assets                              |       | $                              | 855,572    |   |   |   |   |   | $ | 795,597 |   |   |   |   |   | $ | 761,550 |   |   |   |   |   |
|                                       |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Interest-bearing  liabilities:             |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Deposits:                                  |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Checking  and money market                 |       | $                              | 263,037    |   | $ | 4,845 |   | 1.84 | % | $ | 238,774 |   | $ | 2,704 |   | 1.13 | % | $ | 195,394 |   | $ | 2,647 |   | 1.35 | % |
| Savings                                    |       | 49,204                         |       | 578 |   | 1.17 | % | 50,791 |   | 303 |   | 0.60 | % | 39,998 |   | 298 |   | 0.75 | % |
| Certificates  of deposit                   |       | 260,579                        |       | 7,236 |   | 2.78 | % | 261,982 |   | 7,198 |   | 2.75 | % | 278,397 |   | 9,566 |   | 3.44 | % |
| Total  interest-bearing deposits           |       | 572,820                        |       | 12,659 |   | 2.21 | % | 551,547 |   | 10,205 |   | 1.85 | % | 513,789 |   | 12,511 |   | 2.44 | % |
| FHLB  advances and other borrowings        |       | 111,332                        |       | 4,409 |   | 3.96 | % | 80,869 |   | 3,753 |   | 4.64 | % | 100,200 |   | 4,565 |   | 4.56 | % |
| Subordinated  debentures payable to trusts |       | 27,837                         |       | 1,679 |   | 6.03 | % | 26,172 |   | 1,230 |   | 4.70 | % | 17,844 |   | 921 |   | 5.16 | % |
| Total  interest-bearing liabilities        |       | 711,989                        |       | $ | 18,747 |   | 2.63 | % | 658,588 |   | $ | 15,188 |   | 2.31 | % | 631,833 |   | $ | 17,997 |   | 2.85 | % |
| Noninterest-bearing  deposits              |       | 72,627                         |       |   |   |   |   | 66,807 |   |   |   |   |   | 60,201 |   |   |   |   |   |
| Other  liabilities                         |       | 17,465                         |       |   |   |   |   | 19,586 |   |   |   |   |   | 19,869 |   |   |   |   |   |
| Total  liabilities                         |       | 802,081                        |       |   |   |   |   | 744,981 |   |   |   |   |   | 711,903 |   |   |   |   |   |
| Equity                                     |       | 53,491                         |       |   |   |   |   | 50,616 |   |   |   |   |   | 49,647 |   |   |   |   |   |
| Total  liabilities and equity              |       | $                              | 855,572    |   |   |   |   |   | $ | 795,597 |   |   |   |   |   | $ | 761,550 |   |   |   |   |   |
|                                       |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest income; interest rate spread |       |                           |       | $ | 26,199 |   | 3.05 | % |   |   | $ | 25,072 |   | 3.18 | % |   |   | $ | 26,265 |   | 3.42 | % |
|                                       |       |                           |       |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Net  interest margin (4)                   |       |                           |       |   |   | 3.31 | % |   |   |   |   | 3.41 | % |   |   |   |   | 3.72 | % |

 

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

(2) Includes federal funds sold

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

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

 

39

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**Rate/Volume Analysis of 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 ofinterest-earning assets and interest-bearing liabilities, information isprovided on changes attributable to (i) changes in volume (i.e., changesin volume multiplied by old rate) and (ii) changes in rate (i.e., changesin rate multiplied by old volume).  Forpurposes of this table, changes attributable to both rate and volume, whichcannot be segregated, have been allocated proportionately to the change due tovolume and the change due to rate.

 
| ** **                                | ** ** | **Years Ended June 30,**            | ** ** | **Years Ended June 30,**          | ** ** |
|-------------------------------------------|------------|------------------------------------------|------------|----------------------------------------|------------|
| ** **                                | ** ** | **2005 vs. 2004**                        | ** ** | **2004 vs. 2003**                      | ** ** |
| ** **                                | ** ** | **(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)           |       | $                                        | 2,443      |                                   | $          | 1,111 |   | $ | 3,554 |   | $ | 1,804 |   | $ | (5,109 | ) | $ | (3,305 | ) |
| Investment securities (2)                 |       | 414                                      |       | 624                                    |       | 1,038 |   | 148 |   | (731 | ) | (583 | ) |
| FHLB stock                                |       | 34                                       |       | 60                                     |       | 94 |   | (69 | ) | (45 | ) | (114 | ) |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Total interest-earning assets             |       | $                                        | 2,891      |                                   | $          | 1,795 |   | $ | 4,686 |   | $ | 1,883 |   | $ | (5,885 | ) | $ | (4,002 | ) |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Interest-bearing liabilities:             |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Deposits:                                 |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Checking and money market                 |       | $                                        | 275        |                                   | $          | 1,866 |   | $ | 2,141 |   | $ | 588 |   | $ | (531 | ) | $ | 57 |   |
| Savings                                   |       | (9                                       | )          | 284                                    |       | 275 |   | 80 |   | (75 | ) | 5 |   |
| Certificates of deposit                   |       | (39                                      | )          | 77                                     |       | 38 |   | (564 | ) | (1,804 | ) | (2,368 | ) |
| Total interest-bearing deposits           |       | 227                                      |       | 2,227                                  |       | 2,454 |   | 104 |   | (2,410 | ) | (2,306 | ) |
| FHLB advances and other borrowings        |       | 1,414                                    |       | (758                                   | )          | 656 |   | (881 | ) | 69 |   | (812 | ) |
| Subordinated debentures payable to trusts |       | 78                                       |       | 371                                    |       | 449 |   | 430 |   | (121 | ) | 309 |   |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Total interest-bearing liabilities        |       | $                                        | 1,719      |                                   | $          | 1,840 |   | $ | 3,559 |   | $ | (347 | ) | $ | (2,462 | ) | $ | (2,809 | ) |
|                                      |       |                                     |       |                                   |       |   |   |   |   |   |   |   |   |
| Net interest income increase (decrease)   |       |                                     |       |                                   |       | $ | 1,127 |   |   |   |   |   | $ | (1,193 | ) |

 

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

(2) Includes federal funds sold

 

40

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# **Applicationof Critical Accounting Policies**

 

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

 

*Allowance forLoan and Lease Losses* –GAAP requires the Company to set aside reserves or maintain an allowanceagainst probable loan and lease losses in the loan and lease portfolio.  Management must develop a consistent andsystematic approach to estimate the appropriate balances that will cover theprobable losses.  Due to the uncertaintyof future events, the approach includes a process that may differ significantlyfrom other methodologies and still produce an estimate that is in accordancewith GAAP.

 

The allowance is compiled by utilizing the Company’s loan and leaserisk rating system, which is structured to identify weaknesses in the loan andlease portfolio.  The risk rating systemhas evolved to a process whereby management believes the system will properlyidentify the credit risk associated with the loan and lease portfolio.  Due to the stratification of loans and leasesfor the allowance calculation, the estimate of the allowance for loan and leaselosses could change materially if the loan and lease risk rating system wouldnot properly identify the strength of a large or a few large loan and leasecustomers.  Although management believesthat it uses the best information available to determine the allowance,unforeseen market or borrower conditions could result in adjustments and netearnings being significantly affected if circumstances differ substantiallyfrom the assumptions used in making the final determinations.

 

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

 

At each balance sheet date, the MSRs are analyzed for impairment, whichoccurs when the fair value of the MSRs is lower than the amortized book value.The Company’s MSRs are primarily servicing rights acquired on SDHDA first timehome buyers program.  Due to the lack ofquoted markets for the Company’s servicing portfolio, the Company estimates thefair value of the MSRs using present value of future cash flow analysis.  If the analysis produces a fair value that isgreater than or equal to the amortized book value of the MSRs, no impairment isrecognized.  If the fair value is lessthan the book value, an expense for the difference is charged to earnings byinitiating a MSR valuation account.  Ifthe Company determines this impairment is temporary, any future changes  in 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 ratesduring the last several fiscal years, the Company has included MSRs as acritical accounting policy because the use of estimates for determining fairvalue using present value concepts may produce results which may significantlydiffer from other fair value analysis perhaps even to the point of recordingimpairment.  The risk to earnings is whenthe underlying mortgages payoff significantly faster than the assumptions usedin the previously recorded amortization. Estimating future cash flows on the underlying mortgages is a difficultanalysis and requires judgment based on the best information available.  The Company looks at alternative assumptionsand projections when preparing a reasonable and supportable analysis.  Based on the Company’s quarterly analysis ofMSRs, there was no impairment to the MSRs at June 30, 2005.

 

*Retained Interest fromSecuritization*– The Company recorded an asset as a result of the automobilesecuritization.  See Note 3 of “Notes toConsolidated Financial Statements” which is included in Part II, Item 8“Financial Statements and Supplementary Data” of this Form 10-K.  This asset is recorded based on present valueconcepts of future expected cash flows. The assumptions used to calculate the initial retained interest valueand subsequent assumptions are based on the best information available.  The value of the retained interest may changesignificantly if actual cash flows differ from expected cash flows.

 

*Self-Insurance*- The Company has aself-insured healthcare plan for its employees up to certain limits.  To mitigate a portion of these risks, theCompany has a stop-loss insurance policy through a commercial insurance

 

41

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carrier forcoverage in excess of $60,000 per individual occurrence with a maximumaggregate limitation of $1.0 million. The estimate of self-insurance liability is based upon known claims andan estimate of incurred, but not reported (“IBNR”) claims.  IBNR claims are estimated using historicalclaims lag information received by a third party claims administrator.  Due to the uncertainty of health claims, theapproach includes a process that may differ significantly from othermethodologies and still produce an estimate that is in accordance withGAAP.  Although management believes thatit uses the best information available to determine the accrual, unforeseenhealth claims could result in adjustments to the accrual.  These adjustments could significantly affectnet earnings if circumstances differ substantially from the assumptions used inestimating the accrual.

 

**Asset Quality**

 

Whena borrower fails to make a required payment on a loan within 10 to 15 daysafter the payment is due, the Bank generally institutes collection proceduresby issuing a late notice.  The customeris contacted again when the payment is between 17 and 40 days past due.  In most cases, delinquencies are curedpromptly; however, if a loan has been delinquent for more than 40 days, theBank attempts additional written as well as verbal contacts and, if necessary,personal contact with the borrower in order to determine the reason for thedelinquency and to effect a cure, and, where appropriate, reviews the conditionof the property and the financial circumstances of the borrower.  Based upon the results of any suchinvestigation, the Bank may: (i) accept a repayment program which underappropriate circumstances could involve an extension in the case of consumerloans for the arrearage from the borrower, (ii) seek evidence, in the formof a listing 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.

 

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.

 

Leases are generally classified as nonaccrual when there are reasonabledoubts as to the collectibility of principal and/or interest.  Leases may be placed on nonaccrual when thelease has experienced either four consecutive months with no payments or oncethe account is five months in arrears. Interest collections on nonaccrual leases, for which the ultimatecollectibility of principal is uncertain, are applied as principal reductions.

 

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

 

Nonperforming assets (nonaccrual loans and leases, accruing loans andleases delinquent more than 90 days and foreclosed assets) increased to $7.0million at June 30, 2005 from $2.3 million at June 30, 2004, anincrease of $4.7 million.  In addition,the ratio of nonperforming assets to total assets, which is one indicator ofcredit risk exposure, increased to 0.78% at June 30, 2005 as compared to0.27% at June 30, 2004.

 

Nonaccruing loans and leases increased $3.8 million to $5.3 million at June 30,2005 compared to $1.6 million at June 30, 2004.  Included in nonaccruing loans and leases at June 30,2005 were four loans totaling $263,000 secured by one- to four-family realestate, one loan in the amount of $70,000 secured by commercial real estate, 13commercial business loans totaling $4.5 million, six equipment finance leasestotaling $130,000 and 28 consumer loans totaling $341,000.  During the fourth quarter of fiscal 2005, theBank downgraded a $4.1 million participation loan and charged off $224,000 indirect leases based on information received about the customer before and afterthe end of the fiscal year.  The Companywill continue to analyze information regarding the participation loan as it isreceived from the lead bank and make adjustments to the reserve for loan lossesaccordingly.

 

42

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The Company’s nonperforming loans and leases, which represent nonaccrualand past due 90 days and still accruing, have increased $4.9 million from thelevels at June 30, 2004.  The riskrating system in place is designed to identify and manage the nonperformingloans and leases.  Commercial andagricultural loans and equipment finance leases will have specific reserveallocations based on collateral values or based on the present value ofexpected cash flows if the loans or leases are deemed impaired.  Loans and leases that are not performing donot necessarily result in a loss.

 

As of June 30, 2005, the Company had $89,000 of foreclosedassets.  The balance of foreclosed assetsat June 30, 2005 consisted of $50,000 in consumer collateral and $39,000in single-family residences.  The Companydid not have any foreclosed assets secured by mobile homes at June 30,2005.

 

At June 30, 2005, the Company had designated $10.6 million of itsassets as special mention and classified $7.0 million of its assets thatmanagement has determined need to be closely monitored because of possiblecredit problems of the borrowers or the cash flows of the securedproperties.  At June 30, 2005, theCompany had $26.3 million in multi-family, commercial real estate andagricultural participation loans purchased, of which none were classified at June 30,2005.  These loans and leases wereconsidered in determining the adequacy of the allowance for loan and leaselosses.  The allowance for loan and leaselosses is established based on management’s evaluation of the risks probable inthe loan and lease portfolio and changes in the nature and volume of loan andlease activity.  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 the underlyingcollateral, present value of expected principal and interest payments, economicconditions, historical loss experience and other factors that warrantrecognition in providing for an adequate loan and lease loss allowance.

 

Although the Company’s management believes that the June 30, 2005recorded 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, 2005 will be adequate in the future.

 

43

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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 the Company’snonperforming assets from continuing operations for the periods indicated.  Balances related to discontinued credit cardloan operations have been eliminated for all periods presented.

 
| ** **                                                            | ** ** | **At June 30,**       | ** ** |
|-----------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                            | ** ** | **2005**                   | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                            | ** ** | **(Dollars in Thousands)** | ** ** |
| Nonaccruing loans and leases:                                         |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                   |       | $                          | 263        |   | $ | 86 |   | $ | 103 |   | $ | 886 |   | $ | 723 |   |
| Commercial real estate                                                |       | 70                         |       | 75 |   | 310 |   | 3,678 |   | 385 |   |
| Multi-family                                                          |       | —                     |       | — |   | — |   | 290 |   | — |   |
| Commercial business                                                   |       | 4,518                      |       | 795 |   | 472 |   | 1,872 |   | 3,223 |   |
| Equipment finance leases                                              |       | 130                        |       | 21 |   | 30 |   | — |   | — |   |
| Consumer(1)                                                           |       | 341                        |       | 564 |   | 875 |   | 690 |   | 518 |   |
| Agricultural                                                          |       | —                     |       | 20 |   | 2,541 |   | 2,801 |   | 373 |   |
| Mobile homes                                                          |       | —                     |       | — |   | 34 |   | 25 |   | 88 |   |
| Total                                                                 |       | 5,322                      |       | 1,561 |   | 4,365 |   | 10,242 |   | 5,310 |   |
|                                                                  |       |                       |       |   |   |   |   |   |   |   |   |
| Accruing loans and leases delinquent more  than 90 days               |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                   |       | 98                         |       | — |   | 330 |   | — |   | — |   |
| Commercial real estate                                                |       | 292                        |       | — |   | 42 |   | — |   | — |   |
| Multi-family                                                          |       | —                     |       | — |   | — |   | — |   | 304 |   |
| Commercial business                                                   |       | 1,052                      |       | 221 |   | 779 |   | 512 |   | — |   |
| Equipment finance leases                                              |       | 71                         |       | 281 |   | 313 |   | 229 |   | — |   |
| Consumer(1)                                                           |       | —                     |       | — |   | 2 |   | — |   | — |   |
| Agricultural                                                          |       | 96                         |       | — |   | — |   | 165 |   | 23 |   |
| Total                                                                 |       | 1,609                      |       | 502 |   | 1,466 |   | 906 |   | 327 |   |
|                                                                  |       |                       |       |   |   |   |   |   |   |   |   |
| Foreclosed assets:                                                    |       |                       |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                   |       | 39                         |       | 100 |   | 258 |   | 239 |   | 203 |   |
| Consumer(1)                                                           |       | 50                         |       | 112 |   | 77 |   | 132 |   | 105 |   |
| Mobile homes                                                          |       | —                     |       | — |   | — |   | 3 |   | 2 |   |
| Total (2)                                                             |       | 89                         |       | 212 |   | 335 |   | 374 |   | 310 |   |
|                                                                  |       |                       |       |   |   |   |   |   |   |   |   |
| Total nonperforming assets(3)                                         |       | $                          | 7,020      |   | $ | 2,275 |   | $ | 6,166 |   | $ | 11,522 |   | $ | 5,947 |   |
| Ratio of nonperforming assets to total  assets(4)                     |       | 0.78                       | %          | 0.27 | % | 0.77 | % | 1.59 | % | 0.76 | % |
| Ratio of nonperforming loans and leases to  total loans and leases(5) |       | 1.01                       | %          | 0.32 | % | 0.95 | % | 1.96 | % | 0.99 | % |

 

----

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

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

(3)             Nonperformingassets include nonaccruing loans and leases, accruing loans and leasesdelinquent more than 90 days and foreclosed assets.

(4)             Percentageis calculated based upon total assets of the Company and its direct andindirect subsidiaries on a consolidated basis.

(5)             Nonperformingloans and leases include both nonaccruing and accruing loans and leasesdelinquent more than 90 days.

 

44

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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,** | ** ** |
|----------------------------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                               | ** ** | **2005**                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                                                                               | ** ** | **(Dollars in Thousands)**    | ** ** |
| Balance at beginning of period                                                                           |       | $                             | 3,605      |   | $ | 3,842 |   | $ | 4,461 |   | $ | 5,509 |   | $ | 5,499 |   |
|                                                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Charge-offs:                                                                                             |       |                          |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                                                      |       | —                        |       | (7 | ) | (9 | ) | (38 | ) | (21 | ) |
| Commercial real estate                                                                                   |       | (31                           | )          | (92 | ) | — |   | (76 | ) | (361 | ) |
| Commercial business                                                                                      |       | (187                          | )          | (457 | ) | (1,234 | ) | (1,484 | ) | (253 | ) |
| Equipment finance leases                                                                                 |       | (269                          | )          | (30 | ) | (124 | ) | (323 | ) | (131 | ) |
| Consumer                                                                                                 |       | (1,044                        | )          | (1,143 | ) | (1,164 | ) | (1,323 | ) | (1,106 | ) |
| Agricultural                                                                                             |       | (14                           | )          | (835 | ) | (1,429 | ) | (108 | ) | — |   |
| Mobile homes                                                                                             |       | —                        |       | — |   | (41 | ) | (55 | ) | (51 | ) |
| Total charge-offs                                                                                        |       | (1,545                        | )          | (2,564 | ) | (4,001 | ) | (3,407 | ) | (1,923 | ) |
| Recoveries:                                                                                              |       |                          |       |   |   |   |   |   |   |   |   |
| One- to four-family                                                                                      |       | 9                             |       | 4 |   | 3 |   | 2 |   | — |   |
| Commercial real estate                                                                                   |       | —                        |       | 1 |   | — |   | 2 |   | — |   |
| Commercial business                                                                                      |       | 31                            |       | 3 |   | 5 |   | 59 |   | — |   |
| Equipment finance leases                                                                                 |       | 2                             |       | 64 |   | 41 |   | 45 |   | 16 |   |
| Consumer                                                                                                 |       | 215                           |       | 232 |   | 319 |   | 296 |   | 325 |   |
| Agricultural                                                                                             |       | 78                            |       | 3 |   | 100 |   | 28 |   | — |   |
| Mobile homes                                                                                             |       | —                        |       | — |   | 5 |   | 22 |   | 13 |   |
| Total recoveries                                                                                         |       | 335                           |       | 307 |   | 473 |   | 454 |   | 354 |   |
|                                                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Net (charge-offs)                                                                                        |       | (1,210                        | )          | (2,257 | ) | (3,528 | ) | (2,953 | ) | (1,569 | ) |
|                                                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Additions charged to operations                                                                          |       | 2,681                         |       | 2,020 |   | 3,173 |   | 1,905 |   | 1,482 |   |
| Allowance related to assets acquired  (sold), net                                                        |       | —                        |       | — |   | (264 | ) | — |   | 97 |   |
| Balance at end of period                                                                                 |       | $                             | 5,076      |   | $ | 3,605 |   | $ | 3,842 |   | $ | 4,461 |   | $ | 5,509 |   |
|                                                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Ratio of net (charge-offs) during the period  to average loans and leases outstanding during the period  |       | (0.18                         | )%         | (0.36 | )% | (0.59 | )% | (0.54 | )% | (0.28 | )% |
|                                                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Ratio of allowance for loan and lease  losses to total loans and leases at end of period                 |       | 0.74                          | %          | 0.55 | % | 0.62 | % | 0.78 | % | 0.96 | % |
|                                                                                                     |       |                          |       |   |   |   |   |   |   |   |   |
| Ratio of allowance for loan and lease  losses to nonperforming loans and leases at end of period(1) |       | 73.24                         | %          | 174.75 | % | 65.89 | % | 40.02 | % | 97.73 | % |

____________________

(1)             Nonperformingloans and leases include both nonaccruing and accruing loans and leasesdelinquent more than 90 days.

 

45

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Thedistribution of the Company’s allowance for loan and lease losses and impairedloss summary as required by the Financial Accounting Standards Board, (“FASB”) StatementNo. 114, “Accounting by Creditors for Impairment of a Loan” are summarizedin the following tables.  Balancesrelated to discontinued credit card loan operations have been eliminated forall periods presented.

 
| ** **                                  | ** ** | **At June 30,**        | ** ** |
|---------------------------------------------|------------|-----------------------------|------------|
| ** **                                  | ** ** | **2005**                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                  | ** ** | **Amount  (3)**             | ** ** | **Percent  of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount  (3)** | ** ** | **Percent  of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount(3)** | ** ** | **Percent  of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount** | ** ** | **Percent  of  Loans in  Each  Category to  Total Loans** | ** ** | **Amount** | ** ** | **Percent  of  Loans in  Each  Category to  Total Loans** | ** ** |
| ** **                                  | ** ** | **(Dollars  in Thousands)** | ** ** |
| One-to  four-family(1)                      |       | $                           | 186        |   | 17.21 | % | $ | 15 |   | 17.51 | % | $ | 28 |   | 17.39 | % | $ | 81 |   | 16.00 | % | $ | 1,196 |   | 26.65 | % |
| Commercial  and multi-family real estate(1) |       | 261                         |       | 19.66 |   | 220 |   | 20.57 |   | 241 |   | 23.34 |   | 606 |   | 25.45 |   | 1,402 |   | 20.52 |   |
| Commercial  business(2)                     |       | 2,953                       |       | 22.96 |   | 1,270 |   | 22.85 |   | 1,033 |   | 22.09 |   | 1,460 |   | 20.61 |   | 1,033 |   | 18.74 |   |
| Consumer                                    |       | 1,343                       |       | 29.45 |   | 1,736 |   | 29.48 |   | 1,538 |   | 27.55 |   | 1,889 |   | 30.66 |   | 1,524 |   | 27.66 |   |
| Agricultural                                |       | 333                         |       | 10.72 |   | 364 |   | 9.59 |   | 945 |   | 9.39 |   | 375 |   | 6.87 |   | 317 |   | 5.75 |   |
| Mobile  homes                               |       | —                      |       | — |   | — |   | — |   | 57 |   | 0.24 |   | 50 |   | 0.41 |   | 37 |   | 0.68 |   |
| Total                                       |       | $                           | 5,076      |   | 100.00 | % | $ | 3,605 |   | 100.00 | % | $ | 3,842 |   | 100.00 | % | $ | 4,461 |   | 100.00 | % | $ | 5,509 |   | 100.00 | % |

 

----

(1) Includesconstruction and development loans.

(2) Includesequipment finance leases.

(3) The Companymigrated its allocation methodology of allowances by type in fiscal 2002 toreflect a more systematic method based in part on the Company’s historicalcharge-offs by each loan type as compared to primarily a pro rata allocationbased on loan balances in prior years.

 

46

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| ** **               | ** ** | **FASB 5**                 | ** ** | **FASB 114**              | ** ** | **FASB 5**       | ** ** | **FASB 114**      | ** ** |
|--------------------------|------------|----------------------------|------------|---------------------------|------------|------------------|------------|-------------------|------------|
| ** **               | ** ** | **Allowance**              | ** ** | **Impaired Loan**         | ** ** | **Allowance**    | ** ** | **Impaired Loan** | ** ** |
| ** **               | ** ** | **for Loan and**           | ** ** | **Valuation**             | ** ** | **for Loan and** | ** ** | **Valuation**     | ** ** |
| ** **               | ** ** | **Lease Losses**           | ** ** | **Allowance**             | ** ** | **Lease Losses** | ** ** | **Allowance**     | ** ** |
| **Loan  Type**           | ** ** | **At June 30, 2005**  | ** ** | **At June 30, 2004** | ** ** |
| ** **               | ** ** | **(Dollars in Thousands)** | ** ** |
|                     |       |                       |       |                      |       |             |       |              |       |
| One- to four-family      |       | $                          | 186        |                      | $          | —           |       | $                 | 15         |   | $ | — |   |
| Commercial real estate   |       | 200                        |       | —                    |       | 135              |       | —            |       |
| Multi-family real estate |       | 61                         |       | —                    |       | 85               |       | —            |       |
| Commercial business      |       | 844                        |       | 1,750                     |       | 970              |       | —            |       |
| Equipment finance leases |       | 359                        |       | —                    |       | 300              |       | —            |       |
| Consumer (1)             |       | 1,343                      |       | —                    |       | 1,736            |       | —            |       |
| Agricultural             |       | 333                        |       | —                    |       | 364              |       | —            |       |
| Total                    |       | $                          | 3,326      |                      | $          | 1,750            |       | $                 | 3,605      |   | $ | — |   |

 

----

(1)  Includes mobile home loans.

 

**FASB 114 Impaired Loan Summary**

 
| ** **             | ** ** | ** **                 | ** ** | ** **                 | ** ** | **Impaired**  | ** ** | ** **    | ** ** | ** **  | ** ** | **Impaired**  | ** ** |
|------------------------|------------|----------------------------|------------|----------------------------|------------|---------------|------------|---------------|------------|-------------|------------|---------------|------------|
| ** **             | ** ** | **Number**                 | ** ** | ** **                 | ** ** | **Loan**      | ** ** | **Number**    | ** ** | ** **  | ** ** | **Loan**      | ** ** |
| ** **             | ** ** | **of Loan**                | ** ** | **Loan**                   | ** ** | **Valuation** | ** ** | **of Loan**   | ** ** | **Loan**    | ** ** | **Valuation** | ** ** |
| ** **             | ** ** | **Customers**              | ** ** | **Balance**                | ** ** | **Allowance** | ** ** | **Customers** | ** ** | **Balance** | ** ** | **Allowance** | ** ** |
| **Loan  Type**         | ** ** | **At June 30, 2005**  | ** ** | **At June 30, 2004**  | ** ** |
| ** **             | ** ** | **(Dollars in Thousands)** | ** ** | **(Dollars in Thousands)** | ** ** |
|                   |       |                       |       |                       |       |          |       |          |       |        |       |          |       |
| Commercial real estate |       | 1                          |       | $                          | 61         |          | $          | —        |       | 1           |       | $             | 73         |   | $ | — |   |
| Commercial business    |       | 4                          |       | 4,152                      |       | 1,750         |       | 5             |       | 175         |       | —        |       |
| Total                  |       | 5                          |       | $                          | 4,213      |          | $          | 1,750         |       | 6           |       | $             | 248        |   | $ | — |   |

 

The allowance for loan and lease losses was $5.1 million at June 30,2005 as compared to $3.6 million at June 30, 2004.    The ratio of the allowance for loan andlease losses to total loans and leases was 0.74% at June 30, 2005 comparedto 0.55% at June 30, 2004, an increase of 34.5%.  The Company’s management has considerednonperforming assets and other assets of concern in establishing the allowancefor loan and lease losses.  The Companycontinues to monitor its allowance for possible loan and lease losses and makefuture additions or reductions in light of the level of loans and leases in itsportfolio and as economic conditions dictate. The current level of the allowance forloan and lease losses is a result of management’s assessment of the riskswithin the portfolio based on the information revealed in credit reportingprocesses. The Company utilizes a risk-rating system on all commercialbusiness, agricultural, construction, multi-family and commercial real estateloans, including purchased loans.  Aperiodic credit review is performed on all types of loans and

 

47

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leases to establish the necessary reservebased on the estimated risk within the portfolio. This assessment of risk takesinto account the composition of the loan and lease portfolio, historical lossexperience for each loan and lease category, previous loan and leaseexperience, concentrations of credit, current economic conditions and otherfactors that in management’s judgment deserve recognition. OTS regulators havereviewed the Company’s methodology for determining allowance requirements onthe Company’s loan and lease portfolio and have made no requiredrecommendations for increases in the allowances during the three year periodended June 30, 2005.

 

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

 

Althoughmanagement believes that it uses the best information available to determinethe allowances, unforeseen market conditions could result in adjustments andnet earnings being significantly affected if circumstances differ substantiallyfrom the assumptions used in making the final determinations.  Future additions to the Company’s allowancesresult from periodic loan, property and collateral reviews and thus cannot bepredicted in advance.  See Note 1 of“Notes to Consolidated Financial Statements,” which is included inPart II, Item 8 “Financial Statements and Supplementary Data” of thisForm 10-K, for a description of the Company’s policy regarding theprovision for losses on loans and leases.

 

48

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**Comparisonof the Years Ended June 30, 2005 and June 30, 2004**

 

**Continuing Operations**

 

*General*.  The Company’s income from continuingoperations was $5.2 million or $1.46 and $1.42 for basic and diluted earningsper share, respectively, for the year ended June 30, 2005, a $51,000decrease in earnings compared to $5.2 million or $1.47 and $1.43 for basic anddiluted earnings per share, respectively, for the prior year.  For the year ended June 30, 2005, thereturn on average equity from continuing operations was 9.66%, a 6.2% decreasecompared to 10.30% in the prior year. For the year ended June 30, 2005, the return on average assets fromcontinuing operations was 0.60%, a 9.1% decrease compared to 0.66% in the prioryear.  As discussed in more detail below,the decreases were due to a variety of key factors, including increases inprovision for losses on loans and leases of $661,000 and noninterest expense of$163,000 and a decrease in noninterest income of $814,000 offset by an increasein net interest income of $1.1 million and a decrease in income tax expense of$460,000.

 

*Interest and Dividend Income.*  Interest and dividend income was $44.9million for the year ended June 30, 2005 as compared to $40.3 million forthe prior year, an increase of $4.7 million, or 11.6%.  A $2.9 million increase in interest, dividendand loan fee income was the result of a 7.7% increase in the average volume oftotal interest-earning assets and a $1.8 million increase in interest anddividend income was the result of a 3.5% increase in the average yield oninterest-earning assets.   The averagevolume of loans and leases receivable increased 6.6% from $621.5 million forthe year ended June 30, 2004 to $662.7 million for the year ended June 30,2005.  The average yield oninterest-earning assets was 5.68% for the year ended June 30, 2005 as comparedto 5.49% for the prior year.  For theyear ended June 30, 2005, the average yield on loans and leases receivablewas 6.11%, an increase of 2.9% from 5.94% in the prior year.  The overall increase in interest and dividendincome was due in part to the repricing of loans and investments that generallyreflected national interest rates.  From June 30,2004 to June 30, 2005, the prime rate increased from 4.00% to 6.00%.

 

*Interest Expense.*  Interest expense was $18.7 million for theyear ended June 30, 2005 as compared to $15.2 million for the prior year,an increase of $3.6 million or 23.4%.  A$2.2 million increase was the result of a 19.5% increase in the average ratepaid on interest-bearing deposits.  Theaverage rate on interest-bearing deposits was 2.21% for the year ended June 30,2005 as compared to 1.85% for the prior year. A $1.4 million increase in interest expense was the result of a 37.7%increase in the average balance of FHLB advances and other borrowings offset bya decrease of $758,000 as a result of the average yield on FHLB advances andother borrowings decreasing from 4.64% for the year ended June 30, 2004 to3.96% for the year ended June 30, 2005.

 

*Net Interest Income.*The Company’s net interest income from continuing operations for the year endedJune 30, 2005 increased $1.1 million, or 4.5%, to $26.2 million comparedto $25.1 million for the prior year.  Theincrease in net interest income was due to an increase in the average balanceof interest earning assets and gradual increases in average interest rates overthe prior year.  The Company’s netinterest margin decreased to 3.31% for the year ended June 30, 2005 ascompared to 3.41% for the prior year.  The Company continues to have a diversified loan portfoliocomprised of a mix of consumer and business type lending.  This mix helpsthe Company manage the net interest margin and interest rate risk by taking theproduction and keeping the loans on balance sheet or looking at alternativesthrough secondary markets.

 

*Provision for Losses on Loans and Leases.*The allowance for loan and lease losses is maintained at a level which isconsidered by management to be adequate to absorb probable losses on existingloans and leases that may become uncollectible, based on an evaluation of the collectabilityof the loans and leases and prior loan and lease loss experience.  The evaluation takes into consideration suchfactors as changes in the nature and volume of the loan and lease portfolio,overall portfolio quality, review of specific problem loans and leases, andcurrent economic conditions that may affect the borrower’s ability to pay.  The allowance for loan and lease losses isestablished through a provision for losses on loans and leases charged toexpense.

 

Provision for losses on loans and leases increased $661,000, or 32.7%,to $2.7 million for the year ended June 30, 2005 as compared to $2.0million in the prior year.  The increasereflects the impairment of a participation loan and direct leases, whichresulted in a $2.0 million provision for loan and lease losses charge as of June 30,2005.  Net charge-offs decreased from$2.3 million during fiscal year 2004 to $1.2 million during fiscal year2005.  In addition, nonperforming assetsincreased $4.7 million as compared to the prior fiscal year primarily due tothe downgrade to doubtful as of June 30, 2005, of a $4.1 millionparticipation loan.   See “Asset Quality”above for further discussion.

 

The allowance for loan and lease losses at June 30, 2005 was $5.1million.  The allowance increased fromthe June 30, 2004 balance of $3.6 million primarily as a result ofcharge-offs exceeding recoveries by $1.2 million offset by the provision forlosses on loans and leases of $2.7 million. The ratio of allowance for loan and lease losses to nonperforming

 

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loans and leases at June 30, 2005 was 73.24% compared to 174.75%at June 30, 2004.  The allowance forloan and lease losses to total loans and leases at June 30, 2005 was 0.74%compared to 0.55% at June 30, 2004. The Bank’s management believes that the June 30, 2005 recordedallowance for loan and lease losses was adequate to provide for probable losseson the related loans and leases, based on its evaluation of the collectabilityof loans and leases and prior loss experience.

 

*Noninterest Income.*  Noninterest income was $9.0 million for theyear ended June 30, 2005 as compared to $9.8 million for the year ended June 30,2004, a decrease of $814,000, or 8.3%. The decrease in noninterest income was due primarily to decreases in netgain on sale of loans of $585,000, loan servicing income of $132,000, earningson cash value of life insurance of $58,000, commission and insurance income of$53,000 and other noninterest income of $268,000 offset by increases in fees ondeposits of $172,000 and trust income of $133,000.

 

Net gain on sale of loans decreased $585,000 for the year ended June 30,2005 as compared to the prior year.  Thedecrease was primarily due to a decrease in the amount of residential mortgageloans sold into the secondary market during the fiscal year ended June 30,2005 as compared to the prior fiscal year. During the fiscal year ended June 30, 2005, the total number ofsingle family loans sold was 705 with principal balances of $76.7 million.  This compares to 1,288 loans sold withprincipal balances of $127.4 million for the prior fiscal year.

 

Loan servicing income decreased $132,000, to $1.4 million for the yearended June 30, 2005 compared to $1.6 million primarily due to the numberof loans serviced (excluding South Dakota Housing loans) by the Bank decreasingfrom 498 loans with a total balance of $40.6 million at June 30, 2004 to402 loans with a total balance of $35.3 million at June 30, 2005.

 

The Bank recorded a decrease of $58,000, to $561,000 for the year ended June 30, 2005 compared to$619,000 in the prior year for earnings on cash value of bank owned lifeinsurance (“BOLI”), which is tax-exempt.

 

Commission and insurance income was $454,000 for the year ended June 30,2005 compared to $507,000 in the prior year, a decrease of $53,000.  Hometown’s personal and commercial insurancelines are down compared to the prior year primarily due to the sale of theproperty and casualty book of business in August 2003.  See Note 1 of “Notes to ConsolidatedFinancial Statements” which is included in Part II, Item 8 “FinancialStatements and Supplementary Data” of this Form 10-K.

 

Fees on deposits increased $172,000 from $4.2 million for the yearended June 30, 2004 to $4.4 million for the year ended June 30, 2005,primarily due to an increase of $152,000 in income from point-of-sale purchasesby customers.

 

Trust income increased by $133,000 to $701,000 during the year ended June 30,2005 as compared to the prior year primarily due to assets under managementincreasing from $83.8 million to $100.5 million.

 

Other noninterest income decreased from $976,000 for the year ended June 30,2004 to $708,000 for the year ended June 30, 2005 primarily due to thedecrease of $179,000 income on the retained interest obtained through thesecuritization of automobile loans.  SeeNote 3 of  “Notes to ConsolidatedFinancial Statements” which is included in Part II, Item 8 “FinancialStatements and Supplementary Data” of this Form 10-K.

 

*Noninterest Expense.*  Noninterest expense was $24.9 million for theyear ended June 30, 2005 as compared to $24.8 million for the prior year,an increase of $163,000.  The increase innoninterest expense was due primarily to increases in advertising of $263,000,check and data processing of $74,000 and other noninterest expenses of $80,000offset by decreases in occupancy and equipment of $109,000, foreclosed realestate and other properties of $96,000 and compensation and employee benefitsof $49,000.

 

Advertisingexpense increased 35.1% to $1.0 million for the year ended June 30, 2005as compared to $749,000 for the prior year primarily due to additionaladvertising expenses to strengthen the Company’s position in the marketplace.

 

Checkand data processing increased $74,000 to $1.9 million for the year ended June 30,2005, primarily due to increases in data communications expense of $52,000 andcomputer service expense of $39,000.

 

Occupancyand equipment decreased 3.4% to $3.1 million for the year ended June 30,2005 as compared to $3.2 million for the prior year.  The decrease was primarily due to a decreasein furniture and fixture depreciation expense of $111,000.

 

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Compensation and employee benefits decreased $49,000 during the yearended June 30, 2005 as compared to the prior fiscal year primarily due todecreases in net healthcare costs of $533,000 and mortgage incentive pay of$192,000 offset by increases in employee compensation of $344,000 and deferredcompensation related to loan origination fees and costs of $448,000.  Net healthcare costs, inclusive of healthclaims and administration fees offset by stop loss and employee reimbursementunder the Company’s self-insured health plan was $1.3 million for the fiscalyear ended June 30, 2005, a decrease of $533,000, or 29.8% compared to theprior fiscal year.  The Company has had aself-insured health plan since January 1994.  Management believes the current structure isa reasonable alternative to traditional health care plans over the longterm.  This is a challenging area for allcompanies and the Company continues to review its health care plans in aneffort to provide its employees with affordable health care.

 

*Income tax expense.*  The Company’s income tax expense decreased$460,000, or 15.9%, for the year ended June 30, 2005 to $2.4 millioncompared to $2.9 million for the prior year. The decrease was primarily due to the decrease in the Company’seffective tax rate due to changes in permanent tax differences.  The effective rate was 32.00% and 35.66% forthe years ended June 30, 2005 and June 30, 2004, respectively.

 

**Comparison of the Years Ended June 30, 2004 and June 30, 2003**

 

**Continuing Operations**

 

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

 

*Interest and Dividend Income.*  Interest and dividend income was $40.3million for the year ended June 30, 2004 as compared to $44.3 million forthe prior year, a decrease of $4.0 million, or 9.0%.  A $5.9 million decrease in interest anddividend income was the result of a 12.4% decrease in the average yield oninterest-earning assets.  The averageyield on interest-earning assets was 5.49% for the year ended June 30,2004 as compared to 6.27% for the prior year. For the year ended June 30, 2004, the average yield on loans andleases receivable was 5.94%, a decrease of 12.1% from 6.76% in the prioryear.  The Company continues to manageyields by changing the types of loans that comprise the portfolio to loans thathave a higher yield than single-family real estate loans.  Commercial business loans, agriculturalbusiness loans and equipment finance leases comprise 29.3% of the total loanand lease portfolio at June 30, 2004 as compared to 28.6% at June 30,2003.  The percentages of business loansare expected to remain stable at these levels due to restrictions imposed byHOLA at 20.00% of total Bank assets.  Asof June 30, 2004, the Bank met the 20.00% limitation at 16.39% of totalBank assets.  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 30,2004, the prime rate dropped from 6.75% to 4.00%.

 

*Interest Expense.*  Interest expense was $15.2 million for theyear ended June 30, 2004 as compared to $18.0 million for the prior year,a decrease of $2.8 million or 15.6%.  A$2.5 million decrease was the result of a 18.9% decrease in the average ratepaid on interest-bearing liabilities. The average rate on interest-bearing liabilities was 2.31% for the yearended June 30, 2004 as compared to 2.85% for the prior year.  For the year ended June 30, 2004, theaverage rate paid on interest-bearing deposits was 1.85%, a decrease of 24.2%from 2.44% in the prior year.  Theaverage rate paid on FHLB advances and other borrowings increased 1.8% to 4.64%at June 30, 2004 from 4.56% at June 30, 2003.  An average volume decrease of $19.3 millionfor FHLB advances and other borrowings contributed to a decrease in interestexpense of $881,000 for the for the year ended June 30, 2004 as comparedto the prior year.

 

*Net Interest Income.*The Company’s net interest income from continuing operations for the year endedJune 30, 2004 decreased $1.2 million, or 4.5%, to $25.1 million comparedto $26.3 million for the prior year.  Thedecrease in net interest income was due primarily to declining asset yields anda slower decrease in the cost of funds throughout fiscal years 2003 and2004.  The Company’s net interest margindecreased to 3.41% for the year ended June 30, 2004 as compared to

 

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3.72% for the prior year.  Inaddition, the Company has increased its investment portfolio composition inhigh quality GNMA adjustable rate securities in order to enhance its netinterest margin.

 

*Provision for Losses on Loans and Leases.*The allowance for loan and lease losses is maintained at a level which isconsidered by management to be adequate to absorb probable losses on existingloans and leases that may 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.

 

Provision for losses on loans and leases decreased $1.2 million, or36.3%, to $2.0 million for the year ended June 30, 2004 as compared to$3.2 million in the prior year.  Thedecrease was due to charge-offs decreasing from $4.5 million during fiscal year2003 to $2.5 million during fiscal year 2004. In the fourth quarter of fiscal 2003, a $1.4 million agriculture realestate participation loan was modified as a troubled debt restructuring withspecific reserve allowance which resulted in a fiscal 2003 charge to provisionin the amount of $893,000.  In addition,recoveries fell from $473,000 during fiscal year 2003 compared to $307,000during fiscal year 2004.   See “AssetQuality” for further discussion.

 

The allowance for loan and lease losses at June 30, 2004 was $3.6million.  The allowance decreased fromthe June 30, 2003 balance of $3.8 million primarily as a result ofcharge-offs exceeding recoveries by $2.3 million offset by the provision forlosses on loans and leases of $2.0 million. The ratio of allowance for loan and lease losses to nonperforming loansand leases at June 30, 2004 was 174.75% compared to 65.89% at June 30,2003.  The allowance for loan and leaselosses to total loans and leases at June 30, 2004 was 0.55% compared to0.62% at June 30, 2003.  The Bank’smanagement believes that the June 30, 2004 recorded allowance for loan andlease losses was adequate to provide for probable losses on the related loansand leases, based on its evaluation of the collectability of loans and leasesand prior loss experience.

 

*Noninterest Income.*  Noninterest income was $9.8 million for theyear ended June 30, 2004 as compared to $10.5 million for the year ended June 30,2003, a decrease of $658,000, or 6.3%. The decrease in noninterest income was due primarily to decreases incommission and insurance income of $525,000, net gain on sale of loans of$318,000 and net gain on sale of securities of $309,000 offset by increases inearnings on cash value of life insurance of $188,000, trust income of $97,000and other noninterest income of $309,000.

 

Commission and insurance income was $507,000 for the year ended June 30,2004 compared to $1.1 million in the prior year, a decrease of 50.9%.  Hometown’s personal and commercial insurancelines are down compared to the prior year primarily due to the sale of theproperty and casualty book of business in August 2003.  See Note 1 of “Notes to ConsolidatedFinancial Statements”.  The decrease incommission and insurance income was offset by an increase in income fromfinancial products of $59,000 for the year ending June 30, 2004 ascompared to the prior year.

 

Net gain on sale of loans decreased $318,000 for the year ended June 30,2004 as compared to the prior year.  Thedecrease was primarily due to a decrease in the amount of residential mortgageloans sold into the secondary market during the fiscal year ended June 30,2004 as compared to the prior fiscal year. During the fiscal year ended June 30, 2004, the total number ofsingle family loans sold was 1,288 with principal balances of $127.4million.  This compares to 1,609 loanssold with principal balances of $161.1 million for the prior fiscal year.  As is the case with the industry, residentialmortgage loan pipelines decreased back to more historical levels and was reflectedin fiscal year earnings.

 

Net gain on sale of securities decreased $309,000 for the year ended June 30,2004 as compared to the prior year due to a $8.9 million decrease in proceedsfrom the sale of securities to $6.3 million for the year ended June 30,2004 compared to $15.2 million for the year ended June 30, 2003.  Sales of securities for the year ended June 30,2004 consisted primarily of variable mortgage-backed securities.

 

The Bank recorded an increase of 43.6%, or $188,000, to $619,000 forthe year ended June 30, 2004 compared to $431,000 in the prior year forearnings on cash value of bank owned life insurance (“BOLI”), which istax-exempt.

 

Trust income increased by $97,000 to $568,000 during the fiscal yearended June 30, 2004 as compared to the prior year primarily due to assetsunder management increasing from $70.9 million to $83.8 million.

 

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Other noninterest income increased 46.3% to $976,000 for the year endedJune 30, 2004 compared to $667,000 in the prior year primarily due to anincrease of $135,000 recorded on the retained interest obtained through thesecuritization of automobile loans.  SeeNote 3 of  “Notes to ConsolidatedFinancial Statements,” which is included in Part II, Item 8, “FinancialStatements and Supplementary Data,” of this Form 10-K.

 

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

 

Occupancyand equipment decreased 9.5% to $3.2 million for the year ended June 30,2004 as compared to $3.5 million for the prior year.  The decrease was primarily due to recording avaluation impairment of $200,000 during the year ended June 30, 2003.

 

Compensation and employee benefits decreased 2.1% to $15.5 million forthe year ended June 30, 2004 as compared to $15.9 million for the prioryear.  This decrease was primarily due toa reduction in variable compensation (performance incentives) to $579,000 forthe fiscal year ended June 30, 2004 from $970,000 during the prior fiscalyear.  In addition, annual employeebonuses decreased $265,000 and pension plan costs decreased $245,000.   Employee staffing levels decreased from 329at June 30, 2003 to 306 at June 30, 2004 due in part to the sale ofHometown’s property and casualty book of business.  The Company has had a self-insured healthplan since January 1994.  Althoughhealth claims expense net of the stop loss receivable increased to $1.7 millionfor the year ended June 30, 2004 as compared to $1.6 million for the priorfiscal year, the Company does not believe the claim level will continue at thecurrent rate.  Management believes thecurrent structure is a reasonable alternative to traditional health care plansover the long run.  This is a challengingarea for all companies and the Company continues to review its health careplans in an effort to provide its employees with affordable health care.

 

Advertisingexpense decreased 18.3% to $749,000 for the year ended June 30, 2004 ascompared to $917,000 for the prior year primarily due to a reduction inextensive advertising campaigns and more emphasis on existing programs tostrengthen the Company’s position in the marketplace.

 

*Income tax expense.*  The Company’s income tax expense increased$307,000, or 11.9%, for the year ended June 30, 2004 to $2.9 millioncompared to $2.6 million for the prior year. The increase was primarily due to the increase in the Company’seffective tax rate due to changes in permanent tax differences.  The effective rate was 35.66% and 34.32% forthe years ended June 30, 2004 and June 30, 2003, respectively.

 

**Liquidityand Capital Resources**

** **

The Company’s liquidity is comprised of three primaryclassifications:  cash flows fromoperating activities, cash flows from investing activities and cash flows fromfinancing activities.  Net cash providedby operating activities was $10.0 million for the fiscal year ended June 30,2005, which was primarily due to proceeds from the sale of loans of $81.1million offset by loans originated for resale of $80.2 million.  For the fiscal year ended June 30, 2004,net cash provided by operating activities was $17.1 million primarily due toproceeds from the sale of loans of $131.6 million offset by loans originatedfor resale of $124.6 million.  Net cashused in investing activities was $56.7 million for the fiscal year ended June 30,2005 primarily due to loans and leases originated and held of $208.7 millionoffset by principal collected on loans and leases of $192.9 million.  For the fiscal year ended June 30, 2004,net cash used in investing activities was $84.9 million primarily due to loansand leases originated and held of $266.5 million offset by principal collectedon loans and leases of $221.2 million. Net cash provided by financing activities for the fiscal year ended June 30,2005 was $44.5 million primarily due to a net increase in deposit accounts of$22.5 million.  This compares to net cashprovided by financing activities in the prior fiscal year of $44.0 millionprimarily due to a net increase in deposit accounts of $37.3 million.

 

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,out-of-market deposits and short-term investments.  While scheduled loan payments and maturingsecurities are relatively predictable, deposit flows and loan and securityprepayments are more influenced by interest rates, general economic conditionsand competition. The Bank attempts to price its deposits to meet itsasset/liability objectives consistent with local market conditions.  Excess balances are invested in overnightfunds.

 

Liquidity management is both a daily and long-term responsibility ofmanagement.  The Bank adjusts its

 

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investments 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) theobjectives of its asset/liability management program. Excess liquidity isinvested generally in interest-bearing overnight deposits and other short-termgovernment and agency obligations.  At June 30,2005, the Bank had no funds invested in federal funds sold. During the yearended June 30, 2005, the Bank increased its borrowings with the FHLB andFRB by $25.9 million.

 

The Bank anticipates that it will have sufficient funds available tomeet current loan commitments.  At June 30,2005, the Bank had outstanding commitments to originate and purchase mortgageand commercial loans of $80.2 million and to sell mortgage loans of $34.9million.  Commitments by the Bank to originateloans are not necessarily executed by the customer. The Bank monitors the ratioof commitments to funding for use in liquidity management. At June 30,2005, the Bank had no outstanding commitments to purchase investment securitiesavailable for sale or commitments to sell investment securities available forsale.

 

The growth in indirect lending has providedsecuritization 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 were used in part to continue toservice the demand of the Bank’s dealer network.  The securitization is a source of funds at arate lower than other sources of funds, which reduces the Bank’s capitalrequirements and the credit risk from the loans sold.  See Note 3 of “Notes to Consolidated Financial Statements” which is included inPart II, Item 8 “Financial Statements and Supplementary Data” of this Form 10-Kfor additional information on the consumer automobile securitization.

 

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.  The Bankcurrently has $10.0 million and $15.0 million in unsecured lines of federalfunds with correspondent banks. There were no funds drawn on either line ofcredit at June 30, 2005.  Also, theBank has implemented arrangements to acquire out-of-market certificates ofdeposit and money market accounts as an additional source of funding.  As of June 30, 2005, the Bank had $28.3million in out-of-market certificates of deposit and $1.9 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 FRB.

 

The Company has a line of credit for $6.0 million with First TennesseeBank, NA for liquidity needs in the Company. The note is short-term in duration and is subject to annual review.  In case of default on the notes, the Company’sability to pay cash dividends may be restricted.  At June 30, 2005 no funds were advancedon the line of credit.  See Note 9of  “Notes to Consolidated FinancialStatements” and “Financial Condition Data” and Exhibit 10.17 of this Form 10-Kfor additional information.

 

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.

 

Most of the Company’s stock repurchases made duringthe year ended June 30, 2005 were made under the Company’s stock buy backprogram which was publicly announced on April 26, 2004 in which theCompany was permitted to repurchase up to 10% of the common stock of theCompany that was outstanding on May 1, 2004.  This stock buy back program expired on April 30,2005.  A total of 115,500 shares ofcommon stock were purchased pursuant to the program during the fiscal yearended June 30, 2005.

 

TheCompany approved a new stock buy back program which began on May 1, 2005and was publicly announced on April 25, 2005.  Under this program, the Company mayrepurchase up to 10% of the common stock of the Company outstanding on May 1,2005, which equals 350,914 shares, through April 30, 2006.  A total of 47,300 were purchased pursuant tothis program during the fiscal year ended June 30, 2005.   All of the 162,800 shares repurchased duringthe fiscal year ended June 30, 2005 were purchased in the open-market.

 

Savings institutions insured by the FDIC arerequired to meet three regulatory capital requirements.  If a requirement is not met, regulatoryauthorities may take legal or administrative actions, including restrictions ongrowth 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 June 30,2005, 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 forwell-capitalized institutions is 5.00% of total adjusted assets.  The Bank had

 

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tier 1 (core) capital of 8.28% at June 30, 2005.  The minimum OTS risk-based capitalrequirement for well capitalized institutions is 10.00% of risk-weightedassets.  The Bank had risk-based capitalof 10.66% at June 30, 2005.

 

# **Off-BalanceSheet Financing Arrangements**

 

**Duringfiscal 2003, the Bank securitized and sold consumer automobile loans in theamount of $50.0 million through HFSC and Home Federal Automobile SecuritizationTrust 2003-A.  As a result of thissecuritization transaction, the Bank had off-balance sheet automobile loans inthe amount of $35.5 million at June 30, 2003.  At June 30, 2005, the outstandingbalance was $6.6 million.  As part of thesales transaction, the Bank retains servicing responsibilities and a retainedinterest in the interest payments from the receivables, which is subordinatedto third party investors’ interests.  Thereceivables were sold without legal recourse to third party conduits.  The sale provided the Bank with an additionalsource of liquidity at interest rates more favorable than it could receivethrough other forms of financing.  Italso assisted in reducing capital requirements and credit risk to the Bank, inaddition to giving the Bank access to the national capital markets.  The Bank has the optionto execute a clean-up call when the remaining balance of the loans outstandingis at 10% of the original balance.  See Notes 1 and 3 of “Notes to ConsolidatedFinancial Statements” which are included in part II, Item 8 “FinancialStatements and Supplementary Data” of this Form 10-K for furtherdetail.**

 

**Impact of Inflation and Changing Prices**

 

The Consolidated Financial Statements and Notes thereto presented inPart II, Item 8 “Financial Statements and Supplementary Data” of thisForm 10-K have been prepared in accordance with GAAP, which requirethe measurement of financial position and operating results in terms ofhistorical dollars without considering the change in the relative purchasingpower of money over time due to inflation. The impact of inflation is reflected in the increased cost of the Bank’soperations.  Unlike most industrialcompanies, nearly all the assets and liabilities of the Bank are monetary innature.  As a result, interest rates havea greater impact on the Bank’s performance than do the effects of generallevels of inflation.  Interest rates donot necessarily move in the same direction or to the same extent as the pricesof goods and services.

 

**Effectof New Accounting Standards**

 

The Company accountsfor stock-based compensation in accordance with Accounting Principles Board(“APB”) Opinion No. 25, “*Accounting forStock Issued to Employees”*, and related interpretations. Nostock-based employee compensation cost has been recognized for grants under theCompany’s fixed stock option plans, as all options granted under those planshad an exercise price equal to the market value of the underlying common stockon the date of grant.

 

In December 2004,FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123R,*“Share-Based Payment”,*whichrequires all companies to measure compensation cost for all share-basedpayments (including stock options) at fair value.  This will be effective for the Company forthe interim reporting period ending September 30, 2005.

 

SFASNo. 123R provides two alternatives for adoption: (1) a “modifiedprospective” method in which compensation costs is recognized for all awardsgranted subsequent to the effective date of this statement as well as for theunvested portion of awards outstanding as of the effective date and (2) a“modified retrospective” method which follows the approach in the “modifiedprospective” method, but also permits entities to restate prior periods toreflect compensation cost calculated under SFAS No. 123 for pro formaamounts disclosure.  The Company adoptedSFAS No. 123R on July 1, 2005, using the modified prospectivemethod.  The adoption of SFASNo. 123R is not expected to have a significant impact on the Company’sconsolidated financial statements.

 

In May 2005,FASB issued SFAS No. 154, “Accounting Changes and Error Corrections”,which requires that a voluntary change in accounting principle be appliedretrospectively with all prior period financial statements presented, unless itis impracticable to do so.  The newstandard is effective for accounting changes and correction of errors made infiscal years beginning after December 15, 2005.  The Company has not determined the effect theadoption of SFAS No. 154 will have on its consolidated financialstatements.

 

55

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**Asset/Liability and Risk Management**

 

Interest rate risk is the most significant marketrisk affecting the Company.  Other typesof market risk, such as foreign currency exchange rate risk and commodity pricerisk, do not arise in the normal course of the Company’s businessactivities.  The Bank, like otherfinancial institutions, is subject to interest rate risk to the extent that itsinterest-bearing liabilities with short- and medium-term maturities mature orreprice more rapidly than its interest-earning assets. The Company does notcurrently engage in trading activities or use derivative instruments to controlinterest rate risk although it may in the future, if necessary, to manageinterest 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, thisanalysis calculates the difference between the present value of the liabilitiesand the present value of expected cash flows from assets and off-balance sheetcontracts.  The following table setsforth, at June 30, 2005 and June 30, 2004, an analysis of the Company’sinterest rate risk as measured by the estimated changes in NPV resulting frominstantaneous and sustained parallel shifts in the yield curve (+ 300 or –100basis points, measured in 100 basis point increments).  Due to the abnormally low prevailing interestrate environment, -200 and –300 NPV were not estimated by the OTS.

 

The data in the following tables is based onassumptions utilized by the OTS in assessing interest rate risk of thriftinstitutions and published in “Selected Asset and Liability Price Tables as of June 30,2005” and “Selected Asset and Liability Price Tables as of June 30,2004”.  Even if interest rates change inthe designated amounts, there can be no assurance that the Company’s assets andliabilities would perform as set forth below. In addition, a change in U.S. Treasury rates in the designated amountsaccompanied by a change in the shape of the Treasury yield curve would causesignificantly different changes to the NPV than indicated below.

 

June 30, 2005

 

| **Change  in  Interest Rates** | ** ** | **Estimated  NPV  Amount** | ** ** | **Estimated Increase** | ** ** |
|--------------------------------|------------|----------------------------|------------|------------------------|------------|
| **(Decrease) in NPV**          |
| **Amount**                     | ** ** | **Percent**                |
| **Basis  Points**              | ** ** | **(Dollars in Thousands)** | ** ** | ** **             | ** ** |
|                           |       |                       |       |                   |       |   |   |
| +300                           |       | $                          | 93,517     |                   | $          | (10,726 | ) | (10 | )% |
| +200                           |       | 99,208                     |       | (5,035                 | )          | (5 | ) |
| +100                           |       | 102,459                    |       | (1,784                 | )          | (2 | ) |
| —                         |       | 104,243                    |       | —                 |       | — |   |
| -100                           |       | 101,818                    |       | (2,425                 | )          | (2 | ) |
| -200                           |       | 94,213                     |       | (10,031                | )          | (10 | ) |
|                                |            |                            |            |                        |            |  |  |  |  |

 

56

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June 30, 2004

 

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

 

**Contractual Obligations**

 

Thefollowing table sets forth information with respect to the Company’scontractual obligations as of June 30, 2005.  Operating lease obligations are primarilyrelated to the lease of certain branch offices and purchase obligations are primarilyrelated to various smaller purchases, which the Company has committed to as of June 30,2005.

 
| ** **                                       | ** ** | **Payments due by period** | ** ** |
|--------------------------------------------------|------------|----------------------------|------------|
| ** **                                       | ** ** | **1 Year**                 | ** ** | ** ** | ** ** | ** ** | ** ** | **Greater than** | ** ** | ** ** | ** ** |
| ** **                                       | ** ** | **or Less**                | ** ** | **1 to 3 Years** | ** ** | **3 to 5 Years** | ** ** | **5 Years** | ** ** | **Total** | ** ** |
| Federal Funds and Security Repurchase Agreements |       | $                          | 18,959     |   | $ | 5,000 |   | $ | 40,000 |   | $ | 55,000 |   | $ | 118,959 |   |
|                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Deposits without a stated maturity               |       | 408,246                    |       | — |   | — |   | — |   | 408,246 |   |
|                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Certificates of Deposit                          |       | 142,797                    |       | 111,752 |   | 18,491 |   | — |   | 273,040 |   |
|                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Short-Term Debt Obligations                      |       | 705                        |       | — |   | — |   | — |   | 705 |   |
|                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Long-Term Debt Obligations                       |       | —                     |       | — |   | — |   | 27,837 |   | 27,837 |   |
|                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Operating Lease Obligations                      |       | 517                        |       | 920 |   | 704 |   | — |   | 2,141 |   |
|                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Purchase Obligations                             |       | 474                        |       | — |   | — |   | — |   | 474 |   |
|                                             |       |                       |       |   |   |   |   |   |   |   |   |
| Total Contractual Obligations                    |       | $                          | 571,698    |   | $ | 117,672 |   | $ | 59,195 |   | $ | 82,837 |   | $ | 831,402 |   |

 

57

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**Item 7A.****  Quantitativeand Qualitative Disclosures About Market Risk**

 

*Interest Rate Risk Management*

 

The Company’s net income is largely dependent on its net interestincome.  Net interest income issusceptible to interest rate risk to the degree that interest-bearingliabilities with short- and medium-term maturities mature or reprice morerapidly than its interest-earning assets. When interest-bearing liabilities mature or reprice more quickly thaninterest-earning assets in a given period, a significant increase in marketrates of interest could adversely affect net interest income.  Similarly, when interest-earning assetsmature or reprice more quickly than interest-bearing liabilities, fallinginterest rates could result in a decrease in net income.

 

In an attempt to manage its exposure to change ininterest rates, management monitors the Company’s interest rate risk.  The Asset-Liability Committee meetsperiodically to review the Company’s interest rate risk position andprofitability, and to recommend adjustments for consideration by executivemanagement. Management also reviews the Bank’s securities portfolio, formulatesinvestment strategies, and oversees the timing and implementation oftransactions to assure attainment of the Board ‘s objectives in the mosteffective manner.  In managing marketrisk and the asset/liability mix, the Bank has placed its emphasis ondeveloping a portfolio in which, to the extent practicable, assets andliabilities reprice within similar periods. Notwithstanding the Company’s interest rate risk management activities,the potential for changing interest rates is an uncertainty that can have anadverse effect on net income.  TheCompany does not currently engage in trading activities or use derivativeinstruments to control interest rate risk although it may in the future, ifnecessary, to manage interest rate risk.

 

In adjusting the Company’s asset/liability position, managementattempts to manage the Company’s interest rate risk while enhancing netinterest margins.  At times, depending onthe level of general interest rates, the relationship between long andshort-term interest rates, market conditions and competitive factors,management may determine to increase the Company’s interest rate risk positionsomewhat in order to increase its net interest margin.  The Company’s results of operations and netportfolio values remain vulnerable to increases in interest rates and tofluctuations in the difference between long- and short-term interest rates.

 

Consistent with the asset/liability management philosophy describedabove, the Company has taken several steps to manage its interest raterisk.  The Company has structured itssecurity portfolio to shorten the repricing of its interest-earningassets.  The Company’s mortgage-backedsecurities and securities available for sale typically have either short ormedium terms to maturity or adjustable interest rates.  At June 30, 2005, the Company’sadjustable-rate securities had a weighted-average time to coupon reset ofapproximately 20.3 months.  At June 30,2005, the Company had investment securities available for sale of $8.5 millionwith contractual maturities of five years or less.  Variable-rate mortgage-backed securitiestotaled $105.3 million at June 30, 2005. Mortgage-backed securities amortize and experience prepayments ofprincipal.  The Company has receivedaverage cash flows from principal paydowns, maturities, sales and calls of allsecurities available for sale of $48.8 million annually over the past threefiscal years.  The Company also managesinterest rate risk reduction by utilizing non-certificate depositor accountsfor certain liquidity purposes.  TheBoard 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 June 30, 2005, the Company had $63.2million of savings accounts, $209.1 million of money market accounts and $135.9million of checking accounts, representing 60.0% of total depositor accounts.

 

One approach used to quantify interest rate risk is the NPVanalysis.  In essence, this analysiscalculates the difference between the present value of liabilities and thepresent value of expected cash flows from assets and off-balance sheetcontracts.  See Item 7, “Management’sDiscussion and Analysis of Financial Condition and Results of Operations –Asset/Liability and Risk Management” of this Form 10-K for furtherdiscussion regarding the NPV analysis and an analysis of the Company’s interestrate risk as measured by the estimated changes in NPV resulting frominstantaneous and sustained parallel shifts in the yield curve.

 

58

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**Item 8.  FinancialStatements and Supplementary Data**

 

**HF FINANCIAL CORP.**

 

Tableof Contents

 
| **INDEPENDENT REGISTERED  PUBLIC ACCOUNTING FIRM’S REPORT ON THE FINANCIAL STATEMENTS – SUCCESSOR FIRM**    | ** ** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------|------------|------------|
|                                                                                                                  |       |       |
| **INDEPENDENT  REGISTERED PUBLIC ACCOUNTING FIRM’S REPORT ON THE FINANCIAL STATEMENTS –  PREDECESSOR FIRM** | ** ** | ** ** |
|                                                                                                                  |       |       |
| **CONSOLIDATED  FINANCIAL STATEMENTS**                                                                                | ** ** | ** ** |
| Statements  of Financial Condition                                                                                    |       |       |
| Statements of  Income                                                                                                 |       |       |
| Statements  of Stockholders’ Equity                                                                              |       |       |
| Statements  of Cash Flows                                                                                             |       |       |
| Notes  to Consolidated Financial Statements                                                                           |       |       |

 

59

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**Report ofIndependent Registered Public Accounting Firm – Successor Firm**

 

 

To the Board of Directorsand Stockholders

HF Financial Corp.

Sioux Falls, South Dakota

 

We have audited theconsolidated statements of financial condition of HF Financial Corp. and subsidiariesas of June 30, 2005, and the related consolidated statements of income,stockholders’ equity and cash flows for the year then ended. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audit.

 

We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of HF Financial Corp. and subsidiariesas of June 30, 2005, and the results of their operations and their cashflows for the year then ended in conformity with accounting principles generallyaccepted in the United States of America. 

 

Sioux Falls, South Dakota

July 29, 2005

 

PEOPLE. PRINCIPLES. POSSIBILITIES.

www.eidebailly.com

200 E. 10th Street, Suite 500 • PO Box 5126 •Sioux Falls, South Dakota 57117-5126 • Phone 605.339.1999 • Fax605.339.1306• EOE

 

60

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**Report ofIndependent Registered Public Accounting Firm – PredecessorFirm**

 

 

To the Board of Directorsand Stockholders

HF Financial Corp.

Sioux Falls, South Dakota

 

We have audited theconsolidated statement of financial condition of HF Financial Corp. as of June30, 2004, and the related consolidated statements of income, stockholders'equity and cash flows for each of the two years in the period ended June 30,2004.  These financial statements are theresponsibility of the Company's management. Our responsibility is to express an opinion on these financialstatements based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States).  Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement.  An audit includes examining, on a test basis,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 statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

In our opinion, theconsolidated financial statements referred to above present fairly, in allmaterial respects, the financial position of HF Financial Corp. as of June 30,2004, and the results of its operations and its cash flows for each of the twoyears in the period ended June 30, 2004, in conformity with U.S. generallyaccepted accounting principles.

 
|   | /s/ McGladrey  & Pullen, LLP |   |
|--------|----------------------------------|--------|

 

Sioux Falls, South Dakota

July 30, 2004

 

 

McGladrey & Pullen, LLP is a member firm of RSM International,

an affiliation of separate and independent legal entities.

 

61

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**HFFINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF FINANCIALCONDITION**

**JUNE 30,2005 AND 2004**

**(DOLLARSIN THOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                                                                                                                                     | ** ** | **2005**    | ** **  | **2004**   | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------|-------------|------------|------------|
| **ASSETS**                                                                                                                                                     |       |        | ** **  |       |       |
| ** **                                                                                                                                                     |       |        | ** **  |       |       |
| Cash and cash  equivalents                                                                                                                                     | ** ** | **$**       | **18,248**  | ** ** | $          | 20,474 |   |
| Securities  available for sale (Note 4)                                                                                                                        | ** ** | **142,429** | ** **  | 122,715    |       |
| Federal Home  Loan Bank stock (Note 9)                                                                                                                         | ** ** | **7,699**   | ** **  | 5,469      |       |
| Loans held for  sale (Note 5)                                                                                                                                  | ** ** | **10,238**  | ** **  | 10,351     |       |
| Loans and leases  receivable (Notes 5 and 9)                                                                                                                   | ** ** | **670,581** | ** **  | 640,946    |       |
| Accrued interest  receivable                                                                                                                                   | ** ** | **5,087**   | ** **  | 4,056      |       |
| Office  properties and equipment, net of accumulated depreciation (Note 7)                                                                                     | ** ** | **12,978**  | ** **  | 12,555     |       |
| Foreclosed real  estate and other properties                                                                                                                   | ** ** | **1,387**   | ** **  | 1,689      |       |
| Cash value of  life insurance                                                                                                                                  | ** ** | **12,530**  | ** **  | 12,051     |       |
| Servicing rights  (Note 6)                                                                                                                                     | ** ** | **5,211**   | ** **  | 4,620      |       |
| Goodwill, net                                                                                                                                                  | ** ** | **4,951**   | ** **  | 4,951      |       |
| Other assets  (Note 3 and 11)                                                                                                                                  | ** ** | **6,535**   | ** **  | 7,193      |       |
| ** **                                                                                                                                                     |       | **$**       | **897,874** |       | $          | 847,070 | ** ** |
| ** **                                                                                                                                                     |       |        | ** **  |       |       |
| **LIABILITIES  AND STOCKHOLDERS’ EQUITY**                                                                                                                 |       |        | ** **  |       |       |
| ** **                                                                                                                                                     |       |        | ** **  |       |       |
| Liabilities                                                                                                                                                    |       |        | ** **  |       |       |
| Deposits (Note 8)                                                                                                                                              | ** ** | **$**       | **681,216** | ** ** | $          | 658,719 |   |
| Advances from Federal Home Loan Bank and other  borrowings (Note 9)                                                                                            | ** ** | **119,664** | ** **  | 93,750     |       |
| Subordinated debentures payable to trusts (Note 10)                                                                                                            | ** ** | **27,837**  | ** **  | 27,837     |       |
| Advances by borrowers for taxes and insurance                                                                                                                  | ** ** | **6,446**   | ** **  | 6,391      |       |
| Accrued expenses and other liabilities (Note 15)                                                                                                               | ** ** | **9,076**   | ** **  | 8,724      |       |
| Total liabilities                                                                                                                                              | ** ** | **844,239** | ** **  | 795,421    |       |
| Commitments and  contingencies (Note 7 and 20)                                                                                                                 |       |        | ** **  |       |       |
|                                                                                                                                                           |       |        | ** **  |       |       |
| Stockholders’  equity (Notes 11, 12 and 13)                                                                                                               |       |        | ** **  |       |       |
| Preferred stock, $.01 par value, 500,000 shares  authorized, none outstanding                                                                                  | ** ** | **—**  | ** **  | —     |       |
| Series A Junior Participating Preferred Stock,  $1.00 stated value, 50,000 shares authorized, none outstanding                                            | ** ** | **—**  | ** **  | —     |       |
| Common stock, $.01 par value, 10,000,000 shares authorized,  5,462,066 and 5,347,686 shares issued at June 30, 2005 and June 30,  2004, respectively | ** ** | **55**      | ** **  | 53         |       |
| Common stock subscribed for but not issued shares, 66,644  and 40,244 at June 30, 2005 and June 30, 2004, respectively                               | ** ** | **1,266**   | ** **  | 698        |       |
| Additional paid-in capital                                                                                                                                     | ** ** | **19,190**  | ** **  | 17,680     |       |
| Retained earnings, substantially restricted                                                                                                                    | ** ** | **65,267**  | ** **  | 61,653     |       |
| Deferred compensation (Note 17)                                                                                                                                | ** ** | **(2,140**  | **)**       | (1,147     | )          |
| Accumulated other comprehensive (loss), net of  related deferred tax effect (Note 18)                                                                          | ** ** | **(836**    | **)**       | (1,327     | )          |
| Less cost of treasury stock, 1,977,836 and 1,815,036  shares at June 30, 2005 and 2004, respectively                                                      | ** ** | **(29,167** | **)**       | (25,961    | )          |
| ** **                                                                                                                                                     |       | **53,635**  | ** **  | 51,649     |       |
| ** **                                                                                                                                                     |       | **$**       | **897,874** | ** ** | $          | 847,070 |   |

 

See Notes to Consolidated Financial Statements

 

62

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**HFFINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF INCOME**

**YEARSENDED JUNE 30, 2005, 2004 AND 2003**

**(DOLLARSIN THOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                                                   | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------|------------|------------|------------|----------|------------|----------|------------|
| Interest,  dividend and loan fee income:                                     |       |       |       |     |       |     |       |
| Loans and leases receivable                                                  | ** ** | **$**      | **40,489** |     | $          | 36,935   |       | $ | 40,240 |   |
| Investment securities and interest-bearing deposits                          | ** ** | **4,457**  |       | 3,325    |       | 4,022    |       |
| ** **                                                                   |       | **44,946** |       | 40,260   |       | 44,262   |       |
| Interest  expense:                                                           |       |       |       |     |       |     |       |
| Deposits                                                                     | ** ** | **12,659** |       | 10,205   |       | 12,511   |       |
| Advances from Federal Home Loan Bank and other  borrowings                   | ** ** | **6,088**  |       | 4,983    |       | 5,486    |       |
| ** **                                                                   |       | **18,747** |       | 15,188   |       | 17,997   |       |
| Net interest income                                                          | ** ** | **26,199** |       | 25,072   |       | 26,265   |       |
| Provision for  losses on loans and leases                                    | ** ** | **2,681**  |       | 2,020    |       | 3,173    |       |
| Net interest income after provision for losses on  loans and leases          | ** ** | **23,518** |       | 23,052   |       | 23,092   |       |
|                                                                         |       |       |       |     |       |     |       |
| Noninterest  income:                                                         |       |       |       |     |       |     |       |
| Fees on deposits                                                             | ** ** | **4,398**  |       | 4,226    |       | 4,294    |       |
| Loan servicing income                                                        | ** ** | **1,446**  |       | 1,578    |       | 1,610    |       |
| Gain on sale of loans, net                                                   | ** ** | **726**    |       | 1,311    |       | 1,629    |       |
| Earnings on cash value of life insurance                                     | ** ** | **561**    |       | 619      |       | 431      |       |
| Trust income                                                                 | ** ** | **701**    |       | 568      |       | 471      |       |
| Commission and insurance income                                              | ** ** | **454**    |       | 507      |       | 1,032    |       |
| Gain on sale of securities, net                                              | ** ** | **20**     |       | 43       |       | 352      |       |
| Other                                                                        | ** ** | **708**    |       | 976      |       | 667      |       |
| ** **                                                                   |       | **9,014**  |       | 9,828    |       | 10,486   |       |
| Noninterest  expense:                                                        |       |       |       |     |       |     |       |
| Compensation and employee benefits                                           | ** ** | **15,493** |       | 15,542   |       | 15,876   |       |
| Occupancy and equipment                                                      | ** ** | **3,100**  |       | 3,209    |       | 3,547    |       |
| Check and data processing expense                                            | ** ** | **1,893**  |       | 1,819    |       | 1,741    |       |
| Advertising                                                                  | ** ** | **1,012**  |       | 749      |       | 917      |       |
| Foreclosed real estate and other properties, net                             | ** ** | **200**    |       | 296      |       | 371      |       |
| Other                                                                        | ** ** | **3,238**  |       | 3,158    |       | 3,596    |       |
| ** **                                                                   |       | **24,936** |       | 24,773   |       | 26,048   |       |
| Income from continuing operations before income  taxes                       | ** ** | **7,596**  |       | 8,107    |       | 7,530    |       |
| Income tax  expense (Note 11)                                                | ** ** | **2,431**  |       | 2,891    |       | 2,584    |       |
| Income from continuing operations before                                     | ** ** | **5,165**  |       | 5,216    |       | 4,946    |       |
| Discontinued  operations (Note 2):                                           |       |       |       |     |       |     |       |
| Income from operations of discontinued segment, net  of income taxes of $131 | ** ** | **—** |       | —   |       | 253      |       |
| (Loss) on discontinued segment, net of income taxes  of $(116)               | ** ** | **—** |       | —   |       | (224     | )          |
| Income from discontinued operations                                          | ** ** | **—** |       | —   |       | 29       |       |
| Net income                                                                   | ** ** | **$**      | **5,165**  |     | $          | 5,216    |       | $ | 4,975 |   |

 

See Notes to ConsolidatedFinancial Statements

 

63

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| ** **                             | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------|------------|------------|------------|----------|------------|----------|------------|
|                                   |       |       |       |     |       |     |       |
| Basic earnings  per share (Note 14):   |       |       |       |     |       |     |       |
| Income from continuing operations      | ** ** | **$**      | **1.46**   |     | $          | 1.47     |       | $ | 1.36 |   |
| Income from discontinued operations    | ** ** | **—** |       | —   |       | 0.01     |       |
| Net income                             | ** ** | **1.46**   |       | 1.47     |       | 1.37     |       |
|                                   |       |       |       |     |       |     |       |
| Diluted earnings  per share (Note 14): |       |       |       |     |       |     |       |
| Income from continuing operations      | ** ** | **1.42**   |       | 1.43     |       | 1.34     |       |
| Income from discontinued operations    | ** ** | **—** |       | —   |       | 0.01     |       |
| Net income                             | ** ** | **1.42**   |       | 1.43     |       | 1.35     |       |
|                                   | ** ** | ** ** |       |     |       |     |       |
| Dividend  declared per share           | ** ** | **0.44**   |       | 0.43     |       | 0.42     |       |
|                                        |            |            |            |          |            |          |            |  |  |  |

 

See Notes to ConsolidatedFinancial Statements

 

64

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**HFFINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF STOCKHOLDERS’EQUITY**

**YEARSENDED JUNE 30, 2005, 2004 AND 2003**

**(DOLLARSIN THOUSANDS, EXCEPT PER SHARE DATA)**

 
| ** **                                                                                     | ** ** | **Common  Stock** | ** ** | **Common  Stock  Subscribed** | ** ** | **Additional  Paid-in  Capital** | ** ** | **Retained  Earnings** | ** ** | **Deferred  Compensation** | ** ** | **Accumulated  Other  Comprehensive  (Loss)** | ** ** | **Treasury  Stock** | ** ** | **Total** | ** ** |
|------------------------------------------------------------------------------------------------|------------|-------------------|------------|-------------------------------|------------|----------------------------------|------------|------------------------|------------|----------------------------|------------|-----------------------------------------------|------------|---------------------|------------|-----------|------------|
| 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 stock and exercise of stock options                                                |       | —            |       | —                        |       | 513                              |       | —                 |       | (287                       | )          | —                                        |       | —              |       | 226       |       |
| Common stock subscribed for but not issued                                                     |       | —            |       | 382                           |       | —                           |       | —                 |       | (382                       | )          | —                                        |       | —              |       | —    |       |
| Cash dividends paid on common stock                                                            |       | —            |       | —                        |       | —                           |       | (1,524                 | )          | —                     |       | —                                        |       | —              |       | (1,524    | )          |
| Purchase of treasury stock                                                                     |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | (2,403              | )          | (2,403    | )          |
| Amortization of deferred compensation                                                          |       | —            |       | —                        |       | —                           |       | —                 |       | 77                         |       | —                                        |       | —              |       | 77        |       |
| Balance, June 30,  2003                                                                   |       | 49                |       | 382                           |       | 16,527                           |       | 57,967                 |       | (733                       | )          | (735                                          | )          | (24,099             | )          | 49,358    |       |
| Comprehensive income                                                                           |       |              |       |                          |       |                             |       |                   |       |                       |       |                                          |       |                |       |      |       |
| Net income                                                                                     |       | —            |       | —                        |       | —                           |       | 5,216                  |       | —                     |       | —                                        |       | —              |       |      |       |
| Net changes in unrealized gain (loss) on securities  available for sale, net of deferred taxes |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | (1,298                                        | )          | —              |       |      |       |
| Net change in retained interest, net of deferred  taxes                                        |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 22                                            |       | —              |       |      |       |
| Net change in unrecognized pension costs, net of  deferred taxes                               |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 684                                           |       | —              |       |      |       |
| Comprehensive income                                                                           |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | —              |       | 4,624     |       |
| Issuance of stock and exercise of stock options (Note  17)                                     |       | 4                 |       | (382                          | )          | 1,153                            |       | —                 |       | 166                        |       | —                                        |       | —              |       | 941       |       |
| Common stock subscribed for but not issued                                                     |       | —            |       | 698                           |       | —                           |       | —                 |       | (698                       | )          | —                                        |       | —              |       | —    |       |
| Cash dividends paid on common stock                                                            |       | —            |       | —                        |       | —                           |       | (1,530                 | )          | —                     |       | —                                        |       | —              |       | (1,530    | )          |
| Purchase of treasury stock                                                                     |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | (1,862              | )          | (1,862    | )          |
| Amortization of deferred compensation                                                          |       | —            |       | —                        |       | —                           |       | —                 |       | 118                        |       | —                                        |       | —              |       | 118       |       |
| Balance, June 30,  2004                                                                   |       | 53                |       | 698                           |       | 17,680                           |       | 61,653                 |       | (1,147                     | )          | (1,327                                        | )          | (25,961             | )          | 51,649    |       |
| Comprehensive income                                                                           |       |              |       |                          |       |                             |       |                   |       |                       |       |                                          |       |                |       |      |       |
| Net income                                                                                     |       | —            |       | —                        |       | —                           |       | 5,165                  |       | —                     |       | —                                        |       | —              |       | —    |       |
| Net changes in unrealized gain (loss) on securities  available for sale, net of deferred taxes |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | 516                                           |       | —              |       | —    |       |
| Net change in retained interest, net of deferred  taxes                                        |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | (25                                           | )          | —              |       | —    |       |
| Net change in unrecognized pension costs, net of  deferred taxes                               |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | —              |       | —    |       |
| Comprehensive income                                                                           |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | —              |       | 5,656     |       |
| Issuance of stock and exercise of stock options (Note  17)                                     |       | 2                 |       | (698                          | )          | 1,510                            |       | —                 |       | 49                         |       | —                                        |       | —              |       | 863       |       |
| Common stock subscribed for but not issued                                                     |       | —            |       | 1,266                         |       | —                           |       | —                 |       | (1,266                     | )          | —                                        |       | —              |       | —    |       |
| Cash dividends paid on common stock                                                            |       | —            |       | —                        |       | —                           |       | (1,551                 | )          | —                     |       | —                                        |       | —              |       | (1,551    | )          |
| Purchase of treasury stock                                                                     |       | —            |       | —                        |       | —                           |       | —                 |       | —                     |       | —                                        |       | (3,206              | )          | (3,206    | )          |
| Amortization of deferred compensation                                                          |       | —            |       | —                        |       | —                           |       | —                 |       | 224                        |       | —                                        |       | —              |       | 224       |       |
| Balance, June 30,  2005                                                                   |       | $                 | 55         |                          | $          | 1,266                            |       | $                      | 19,190     |                       | $          | 65,267                                        |       | $                   | (2,140     | )         | $          | (836 | ) | $ | (29,167 | ) | $ | 53,635 |   |

 

SeeNotes to Consolidated Financial Statements

 

65

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**HF FINANCIAL CORP.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**YEARS ENDED JUNE 30, 2005,2004 AND 2003**

**(DOLLARS IN THOUSANDS, EXCEPT PERSHARE DATA)**

 
| ** **                                                                                    | ** ** | **2005**     | ** ** | **2004**   | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------------------|------------|--------------|------------|------------|------------|----------|------------|
| Cash Flows From  Operating Activities                                                         |       |         | ** ** |       |       |     |       |
| Net income                                                                                    | ** ** | **$**        | **5,165**  | ** ** | $          | 5,216    |       | $ | 4,975 |   |
| Adjustments to reconcile net income to net cash  provided by (used in) operating activities   |       |         | ** ** |       |       |     |       |
| Provision for losses on loans and leases                                                      | ** ** | **2,681**    | ** ** | 2,020      |       | 3,173    |       |
| Depreciation                                                                                  | ** ** | **1,417**    | ** ** | 1,518      |       | 1,659    |       |
| Amortization of discounts and premiums on securities  and other                               | ** ** | **1,566**    | ** ** | 1,616      |       | 1,549    |       |
| Stock based compensation                                                                      | ** ** | **331**      | ** ** | 234        |       | 166      |       |
| Deferred income taxes (credits)                                                               | ** ** | **(836**     | **)**      | 976        |       | 2,629    |       |
| Loans originated for resale                                                                   | ** ** | **(80,212**  | **)**      | (124,615   | )          | (219,671 | )          |
| Proceeds from the sale of loans                                                               | ** ** | **81,051**   | ** ** | 131,559    |       | 211,461  |       |
| Gain on sale of loans, net                                                                    | ** ** | **(726**     | **)**      | (1,311     | )          | (1,664   | )          |
| Realized gain on sale of securities, net                                                      | ** ** | **(20**      | **)**      | (43        | )          | (352     | )          |
| Losses and provision for losses on sales of  foreclosed real estate and other properties, net | ** ** | **53**       | ** ** | 114        |       | 150      |       |
| Loss on disposal of office properties and equipment,  net                                     | ** ** | **6**        | ** ** | 1          |       | 243      |       |
| Change in other assets and liabilities (Note 21)                                              | ** ** | **(490**     | **)**      | (175       | )          | (5,284   | )          |
|                                                                                          | ** ** | ** **   | ** ** |       |       |     |       |
| Net cash  provided by (used in) operating activities                                          | ** ** | **9,986**    | ** ** | 17,110     |       | (966     | )          |
|                                                                                          | ** ** | ** **   | ** ** |       |       |     |       |
| Cash Flows From  Investing Activities                                                         |       |         | ** ** |       |       |     |       |
| Loans and leases purchased                                                                    | ** ** | **(16,835**  | **)**      | (2,212     | )          | (1,466   | )          |
| Loans and leases originated and held                                                          | ** ** | **(208,651** | **)**      | (266,519   | )          | (203,562 | )          |
| Principal collected on loans and leases                                                       | ** ** | **192,945**  | ** ** | 221,173    |       | 164,911  |       |
| Securities available for sale                                                                 |       |         | ** ** |       |       |     |       |
| Sales, maturities and repayments                                                              | ** ** | **51,106**   | ** ** | 41,010     |       | 54,398   |       |
| Purchases                                                                                     | ** ** | **(70,941**  | **)**      | (78,508    | )          | (61,641  | )          |
| Purchases of other assets                                                                     | ** ** | **—**   | ** ** | (240       | )          | —   |       |
| Purchase of Federal Home Loan Bank stock                                                      | ** ** | **(5,958**   | **)**      | (3,458     | )          | (693     | )          |
| Redemption of Federal Home Loan Bank stock                                                    | ** ** | **3,729**    | ** ** | 5,014      |       | —   |       |
| Purchase of cash value of life insurance                                                      | ** ** | **—**   | ** ** | —     |       | (5,000   | )          |
| Proceeds from sale of office properties and  equipment                                        | ** ** | **2**        | ** ** | —     |       | 14       |       |
| Purchase of office properties and equipment                                                   | ** ** | **(1,848**   | **)**      | (936       | )          | (1,531   | )          |
| Purchase of servicing rights                                                                  | ** ** | **(959**     | **)**      | (892       | )          | (569     | )          |
| Proceeds from sale of foreclosed real estate and  other properties                            | ** ** | **733**      | ** ** | 684        |       | 1,102    |       |
|                                                                                          | ** ** | ** **   | ** ** |       |       |     |       |
| Net cash (used  in) investment activities                                                     | ** ** | **(56,677**  | **)**      | (84,884    | )          | (54,037  | )          |
|                                                                                               |            |              |            |            |            |          |            |  |  |  |

 

See Notes to ConsolidatedFinancial Statements

 

66

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| ** **                                                                   | ** ** | **2005**     | ** ** | **2004**   | ** ** | **2003** | ** ** |
|------------------------------------------------------------------------------|------------|--------------|------------|------------|------------|----------|------------|
|                                                                         |       |         | ** ** |       |       |     |       |
| Cash Flows From  Financing Activities                                        |       |         | ** ** |       |       |     |       |
| Net increase in deposit accounts                                             | ** ** | **$**        | **22,497** | ** ** | $          | 37,338   |       | $ | 58,785 |   |
| Proceeds of advances from Federal Home Loan Bank and  other borrowings       | ** ** | **548,976**  | ** ** | 277,211    |       | 565,250  |       |
| Payments on advances from Federal Home Loan Bank and  other borrowings       | ** ** | **(523,062** | **)**      | (273,280   | )          | (559,739 | )          |
| Payment of debt issue costs                                                  | ** ** | **—**   | ** ** | (158       | )          | (300     | )          |
| Proceeds from issuance of subordinated debentures                            | ** ** | **—**   | ** ** | 7,000      |       | 10,000   |       |
| Increase (decrease) in advances by borrowers                                 | ** ** | **55**       | ** ** | (1,510     | )          | 1,465    |       |
| Purchases of treasury stock                                                  | ** ** | **(3,206**   | **)**      | (1,862     | )          | (2,403   | )          |
| Proceeds from issuance of common stock                                       | ** ** | **756**      | ** ** | 825        |       | 137      |       |
| Cash dividends paid                                                          | ** ** | **(1,551**   | **)**      | (1,530     | )          | (1,524   | )          |
|                                                                         | ** ** | ** **   | ** ** |       |       |     |       |
| Net cash  provided by financing activities                                   | ** ** | **44,465**   | ** ** | 44,034     |       | 71,671   |       |
|                                                                         | ** ** | ** **   | ** ** |       |       |     |       |
| Increase  (decrease) in cash and cash equivalents                            | ** ** | **(2,226**   | **)**      | (23,740    | )          | 16,668   |       |
|                                                                         | ** ** | ** **   | ** ** |       |       |     |       |
| Cash and Cash  Equivalents                                                   |       |         | ** ** |       |       |     |       |
| Beginning                                                                    | ** ** | **20,474**   | ** ** | 44,214     |       | 27,546   |       |
|                                                                         | ** ** | ** **   | ** ** |       |       |     |       |
| Ending                                                                       | ** ** | **$**        | **18,248** | ** ** | $          | 20,474   |       | $ | 44,214 |   |
|                                                                         |       |         | ** ** |       |       |     |       |
| Supplemental  Disclosure of Cash Flows Information                           |       |         | ** ** |       |       |     |       |
| Cash payments for interest                                                   | ** ** | **$**        | **18,554** | ** ** | $          | 15,441   |       | $ | 18,650 |   |
| Cash payments (receipts) for income and franchise  taxes, net                | ** ** | **1,704**    | ** ** | (159       | )          | 2,487    |       |
|                                                                         |       |         | ** ** |       |       |     |       |
| Supplemental  Disclosure of Noncash Investing and Financing Activities       |       |         | ** ** |       |       |     |       |
| Foreclosed real estate and other properties acquired  in settlement of loans | ** ** | **$**        | **783**    | ** ** | $          | 713      |       | $ | 1,201 |   |
| Loans receivable reclassified as held for sale                               | ** ** | **—**   | ** ** | —     |       | —   |       |
| Office property reclassified as held for sale                                | ** ** | **—**   | ** ** | —     |       | 191      |       |

 

See Notes to ConsolidatedFinancial Statements

 

67

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**HFFINANCIAL CORP.**

**NOTES TO CONSOLIDATED FINANCIALSTATEMENTS**

**(DOLLARSIN THOUSANDS, EXCEPT PER SHARE DATA)**

 

**NOTE 1 -     SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

The accounting andreporting policies of HF Financial Corp. and subsidiaries (the Company) conformto accounting principles generally accepted in the United States of America andto general practice within the industry. The following is a description of themore significant of those policies that the Company follows in preparing and presentingits consolidated financial statements.

 

*Principlesof Consolidation*

 

The accompanyingconsolidated financial statements include the accounts of the Company, theCompany’s wholly-owned subsidiaries, HomeFirst Mortgage Corp. (the MortgageCorp.), HF Financial Group, Inc. (HF Group), and Home Federal Bank (theBank) and the Bank’s wholly-owned subsidiaries, Hometown Insurors, Inc.(Hometown), Mid America Capital Services, Inc. (Mid America Capital), HomeFederal Securitization Corp. (HFSC), Mid-America Service Corporation and PMD, Inc. HF Card, a wholly-owned subsidiary ofthe Company, was dissolved during the year 2003 (Note 2). All intercompanybalances and transactions have been eliminated in consolidation.

 

*Basis ofFinancial Statement Presentation*

 

In preparing the consolidatedfinancial statements, management is required to make estimates and assumptionsthat affect the reported amounts of assets and liabilities as of the date ofthe statement of financial condition and revenues and expenses for the fiscal year.Actual results could differ significantly from those estimates. Materialestimates that are particularly susceptible to significant change in thenear-term related to the determination of the allowance for loan and leaselosses, the retained interest asset and servicing rights.

 

*Cash andCash Equivalents*

 

For purposes ofreporting the statements of cash flows, the Company includes as cashequivalents all cash accounts which are not subject to withdrawal restrictionsor penalties and time deposits with original maturities of 90 days or less.

 

*TrustAssets*

 

Assets of thetrust department, other than trust cash on deposit at the Bank, are notincluded in these consolidated financial statements because they are not assetsof the Bank.

 

*Securities*

 

Managementdetermines the appropriate classification of securities at the date individualsecurities are acquired and evaluates the appropriateness of suchclassifications at each statement of financial condition date.

 

Securitiesavailable for sale are those debt securities that the Company intends to holdfor an indefinite period of time, but not necessarily to maturity, and allequity securities. Any decision to sell a security classified as available forsale would be based on various factors, including significant movements ininterest rates, changes in the maturity mix of the Company’s assets andliabilities, liquidity needs, regulatory capital considerations, and othersimilar 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.

 

68

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

 

*RetainedInterest Asset*

 

When the Banksells receivables in securitizations of automobile loans, it retains aninterest-only strip and a cash reserve account, which is combined and includedin other assets. The retained interest asset is initially recognized based uponan allocation of the carrying value of the assets which are securitized inproportion to the relative fair values of the assets sold and interestsretained. After the securitization, these interests are treated as availablefor sale and are adjusted to fair value with the adjustment reflected as anunrealized gain or loss in the accumulated other comprehensive income categoryin stockholders’ equity, unless a decline in fair value is determined to beother than temporary, in which case the loss is charged to expense.

 

The retainedinterest asset is initially recorded as an asset at fair value. Fair value isbased upon estimating future cash flows paid to the Bank from the Home FederalAutomobile Securitization Trust 2003-A (“Automobile Securitization Trust”) sometimescalled the “cash-out” method. The cash flows are modeled to reflect certainassumptions for prepayment speeds, discount rates and charge off rates as wellas cash reserve balances reflecting the required credit enhancements.

 

The value of theretained interest asset will fluctuate over the life of the securitization toreflect income recorded on the amortized balance of the retained interest, cashreceived from the trust and changes in assumptions. The amortized balance iscomprised of the initial allocated retained interest plus the interest accruedon the outstanding amortized balance less excess cash payments received fromthe Automobile Securitization Trust and less any recognized impairment on thesecuritization asset. The income recorded on the retained interest asset isclassified as noninterest income and not interest income, which is consistentwith the Office of Thrift Supervision (“OTS”) guidelines.

 

Impairment occurswhenever the current fair value of the retained interest is lower than itscurrent amortized cost. If this occurs, a test must take place to determine ifan impairment charge for the deficiency is required to be taken through currentearnings. If there has been an adverse change in estimated cash flowsconsidering both the timing and amount of flows, the retained interest must bewritten down to fair value, which becomes the new amortized cost basis forfuture amortization. No impairment losses were recorded during fiscal year 2005.

 

*LoansHeld for Sale*

 

Loans receivablewhich the Bank may sell or intends to sell prior to maturity are carried at thelower of net book value or fair value on an aggregate basis. Such loans heldfor sale include loans receivable that management intends to use as part of itsasset/liability strategy, or that may be sold in response to changes ininterest rates, changes in prepayment risk or other similar factors.

 

69

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*Loans andLeases Receivable*

 

Loans receivableare stated at unpaid principal balances, less the allowance for loan losses,and net of deferred loan origination fees, costs and discounts.

 

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

 

Loans and leasesare generally classified as nonaccrual when there are reasonable doubts as tothe collectibility of principal and/or interest and/or when payment becomes 90days past due, except loans which are well secured and in the process of collection.Uncollectible interest on loans and leases that are impaired or contractuallypast due is charged off based on management’s periodic evaluation. The chargeto interest 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 leasesreceivable are classified as direct finance leases. Under the direct financingmethod of accounting for leases, the total net payments receivable under thelease contracts 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.

 

The allowance forloan and lease losses is established as losses are estimated to have occurredthrough a provision for loan losses charged to earnings. Loan losses arecharged against the allowance when management believes the uncollectibility ofa loan balance is confirmed.

 

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

 

A loan isconsidered impaired when, based on current information and events, it isprobable that the Company will be unable to collect the scheduled payments ofprincipal or interest when due according to the contractual terms of the loanagreement. Factors considered by management in determining impairment includepayment status, collateral value, and the probability of collecting scheduledprincipal and interest payments when due. Loans that experience insignificantpayment delays and payment shortfalls generally are not classified as impaired.Management determines the significance of payment delays and payment shortfallson a case-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 ismeasured on a loan by loan basis for commercial and construction loans byeither the present value of expected future cash flows discounted at the loan’seffective interest rate, the loan’s obtainable market price, or the fair valueof the collateral if the loan is collateral dependent.

 

Large groups ofsimilar balance homogeneous loans are collectively evaluated for impairment. Accordingly,the Company does not separately identify individual consumer and residentialloans for impairment disclosures.

 

70

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*LoanOrigination Fees and Related Discounts*

 

Loan fees andcertain direct loan origination costs are deferred, and the net fee or cost isrecognized as an adjustment to interest income using the interest method overthe contractual life of the loans, adjusted for prepayments.

 

Commitment feesand costs relating to commitments, the likelihood of exercise of which isremote, are recognized during the commitment period. If the commitment issubsequently exercised during the commitment period, the remaining unamortizedcommitment fee at the time of exercise is recognized over the life of the loanas an adjustment of yield.

 

*LoanServicing*

 

The cost allocatedto servicing rights purchased or retained has been recognized as a separateasset and is being amortized in proportion to and over the period of estimatednet servicing income. Servicing rights are periodically evaluated forimpairment based on the fair value of those rights. Fair values are estimatedusing discounted cash flows based on current market rates of interest. Forpurposes of measuring impairment, the rights are stratified by one or morepredominant risk characteristics of the underlying loans. The Bank stratifiesits capitalized servicing rights based on loan type. The amount of impairmentrecognized is the amount, if any, by which the amortized cost of the rights foreach loan type exceeds their fair value. As of June 30, 2005, there was noimpairment to loan servicing rights purchased and retained servicing rights.

 

*Goodwill*

 

Goodwill is thedifference between the purchase price and the amounts assigned to the netassets acquired and accounted for under the purchase method of accounting. Priorto July 2002, goodwill was amortized over 10 years.

 

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

 

In October 2002,the FASB issued Statement No. 147, Acquisitions of Certain FinancialInstitutions, which provides guidance on the accounting for the acquisition ofa financial institution. The provisions of FASB Statement No. 147 reflectthe conclusion that the excess of the fair value of liabilities assumed overthe fair value of tangible and identifiable intangible assets acquired in abusiness combination represents goodwill that should be accounted for underFASB Statement No. 142. Thus, the specialized accounting guidance inparagraph 5 of FASB Statement No. 72 does not apply after September 30,2003 for those acquisitions that meet the definition of a business combination.The Company adopted FASB Statement No. 147, effective October 1,2002, and accordingly, reclassified FASB Statement No. 72 unidentifiableintangible assets of $416 to goodwill and no longer amortizes these assetsafter October 1, 2002.

 

At June 30,2005, the Company had $4,951 of goodwill that is not being amortized. TheCompany performs annual testing to determine if goodwill is impaired. As of June 30,2005, management believes there is no impairment with respect to intangibleassets. The impact of FASB Statement No. 142 on the Company’s net incomeis shown in the following table for the periods presented:

 

71

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| ** **                                   | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|----------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                   | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Reported net  income                         | ** ** | **$**      | **5,165**  |       | $          | 5,216      |       | $ | 4,975 |   |
| Add back goodwill amortization, net of taxes | ** ** | **—** |       | —     |       | —     |       |
|                                         | ** ** | ** ** |       |       |       |       |       |
| Adjusted net income                          | ** ** | **$**      | **5,165**  |       | $          | 5,216      |       | $ | 4,975 |   |
|                                         |       |       |       |       |       |       |       |
| Basic earnings  per share                    |       |       |       |       |       |       |       |
| Reported net income                          | ** ** | **$**      | **1.46**   |       | $          | 1.47       |       | $ | 1.37 |   |
| Goodwill amortization, net of taxes          | ** ** | **—** |       | —     |       | —     |       |
|                                         | ** ** | ** ** |       |       |       |       |       |
| Adjusted net income                          | ** ** | **$**      | **1.46**   |       | $          | 1.47       |       | $ | 1.37 |   |
|                                         |       |       |       |       |       |       |       |
| Diluted earnings  per share                  |       |       |       |       |       |       |       |
| Reported net income                          | ** ** | **$**      | **1.42**   |       | $          | 1.43       |       | $ | 1.35 |   |
| Goodwill amortization, net of taxes          | ** ** | **—** |       | —     |       | —     |       |
|                                         | ** ** | ** ** |       |       |       |       |       |
| Adjusted net income                          | ** ** | **$**      | **1.42**   |       | $          | 1.43       |       | $ | 1.35 |   |

 

*IntangibleAsset*

 

The intangibleasset related to insurance customer lists. The original cost of this asset was$350, and it was being amortized over seven years. Amortization expense was $0,$4 and $68 in 2005, 2004 and 2003, respectively. The Company sold the propertyand casualty book of business of Hometown to a third party effective July 31,2003 for total proceeds of $375, of which the disposal of $69 of goodwill isincluded in the net gain of $116 on the sale of the casualty book of businessduring fiscal 2004.

 

*ForeclosedReal Estate and Other Properties*

 

Real estate andother properties acquired through, or in lieu of, loan foreclosure areinitially recorded at lower of cost or fair value less estimated costs to sellat the date of foreclosure. Costs relating to improvement of property arecapitalized, whereas costs relating to the holding of 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 saleis carried at the lower of cost, including cost of improvements and amenitiesincurred subsequent to acquisition, or fair value less cost to sell. Costsrelating to the development and improvement of property are capitalized,whereas costs relating to holding property are expensed. The carrying amount ofland held for sale was $1,298 at June 30, 2005 and 2004.

 

72

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*OfficeProperties and Equipment*

 

Land is carried atcost. All other properties and equipment are carried at cost, less accumulateddepreciation and amortization. Buildings and improvements and leaseholdimprovements are depreciated primarily on the straight-line method over theestimated useful lives of the assets which are five to fifty years. Furniture,fixtures, equipment and automobiles are depreciated using both thestraight-line and declining balance methods over the estimated useful lives ofthe assets which are three to twelve years.

 

*IncomeTaxes*

 

Deferred taxes areprovided on an asset and liability method whereby deferred tax assets arerecognized for deductible temporary differences and operating loss and taxcredit carryforwards and deferred tax liabilities are recognized for taxabletemporary differences. Temporary differences are the differences between thereported amounts of assets and liabilities and their tax bases. Deferred taxassets are reduced by a valuation allowance when, in the opinion of management,it is more likely than not that some portion or all of the deferred tax assetswill not be realized. Deferred tax assets and liabilities are adjusted for theeffects of changes in tax laws and rates on the date of enactment.

 

*EarningsPer Share (EPS)*

 

Basic EPSrepresents income available to common stockholders divided by theweighted-average number of common shares outstanding during the period. DilutedEPS reflects additional common shares that would have been outstanding ifdilutive potential common shares had been issued.

 

During the secondquarter of fiscal 2004, the Company declared a 1-1/10-for-1 stock split of allof the common stock of the Company outstanding, payable in the form of a 1/10-for-1stock dividend. The 10% stock dividend was paid on December 31, 2003 toshareholders of record as of December 3, 2003. All per share data andnumber of common shares outstanding have been retroactively adjusted for allperiods presented as a result of the stock split.

 

*SegmentReporting*

 

Operating segmentsare defined as components of an enterprise for which separate financialinformation is available that is evaluated regularly by the chief operatingdecision makers in deciding how to allocate resources and in assessingperformance. The Company’s reportable segments are “banking” (including leasingactivities) and “other.”  The “banking”segment is conducted through the Bank and Mid America Capital and the “other”segment is composed of smaller nonreportable segments, the Company andinter-segment eliminations.

 

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

 

73

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| ** **                                                    | ** ** | **Banking** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------|------------|-------------|------------|-----------|------------|-----------|------------|
| 2005                                                          |       |        |       |      |       |      |       |
|                                                          |       |        |       |      |       |      |       |
| Net interest  income                                          |       | $           | 29,081     |      | $          | (2,882    | )          | $ | 26,199 |   |
| Intersegment  interest income                                 |       | (1,233      | )          | 1,233     |       | —    |       |
| Provision for  losses on loans and leases                     |       | (2,681      | )          | —    |       | (2,681    | )          |
| Noninterest  income                                           |       | 8,873       |       | 141       |       | 9,014     |       |
| Intersegment  noninterest income                              |       | (124        | )          | 124       |       | —    |       |
| Noninterest  expense                                          |       | (23,950     | )          | (986      | )          | (24,936   | )          |
| Intersegment  noninterest expense                             |       | 4           |       | (4        | )          | —    |       |
| Income (loss) from continuing operations before  income taxes |       | $           | 9,970      |      | $          | (2,374    | )          | $ | 7,596 |   |
|                                                          |       |        |       |      |       |      |       |
| Total assets                                                  |       | $           | 892,404    |      | $          | 5,470     |       | $ | 897,874 |   |
|                                                          |       |        |       |      |       |      |       |
| 2004                                                          |       |        |       |      |       |      |       |
|                                                          |       |        |       |      |       |      |       |
| Net interest  income                                          |       | $           | 27,239     |      | $          | (2,167    | )          | $ | 25,072 |   |
| Intersegment  interest income                                 |       | (854        | )          | 854       |       | —    |       |
| Provision for  losses on loans and leases                     |       | (2,020      | )          | —    |       | (2,020    | )          |
| Noninterest  income                                           |       | 9,915       |       | (87       | )          | 9,828     |       |
| Intersegment  noninterest income                              |       | (398        | )          | 398       |       | —    |       |
| Noninterest  expense                                          |       | (23,822     | )          | (951      | )          | (24,773   | )          |
| Intersegment  noninterest expense                             |       | 4           |       | (4        | )          | —    |       |
| Income (loss) from continuing operations before  income taxes |       | $           | 10,064     |      | $          | (1,957    | )          | $ | 8,107 |   |
|                                                          |       |        |       |      |       |      |       |
| Total assets                                                  |       | $           | 844,783    |      | $          | 2,287     |       | $ | 847,070 |   |
|                                                          |       |        |       |      |       |      |       |
| 2003                                                          |       |        |       |      |       |      |       |
|                                                          |       |        |       |      |       |      |       |
| Net interest  income                                          |       | $           | 27,256     |      | $          | (991      | )          | $ | 26,265 |   |
| Intersegment  interest income                                 |       | (892        | )          | 892       |       | —    |       |
| Provision for  losses on loans and leases                     |       | (3,173      | )          | —    |       | (3,173    | )          |
| Noninterest  income                                           |       | 11,790      |       | (1,304    | )          | 10,486    |       |
| Intersegment  noninterest income                              |       | (548        | )          | 548       |       | —    |       |
| Noninterest  expense                                          |       | (26,056     | )          | 8         |       | (26,048   | )          |
| Intersegment  noninterest expense                             |       | (3          | )          | 3         |       | —    |       |
| Income (loss) from continuing operations before  income taxes |       | $           | 8,374      |      | $          | (844      | )          | $ | 7,530 |   |
|                                                          |       |        |       |      |       |      |       |
| Total assets                                                  |       | $           | 796,027    |      | $          | 5,076     |       | $ | 801,103 |   |

 

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*FairValue of Financial Instruments*

 

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

 

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

 

Securities – Fairvalues for investment securities are based on quoted market prices, except forstock in the Federal Home Loan Bank for which fair value is assumed to equalcost.

 

Retained interestasset – Fair values are estimated using discounted cash flows based on currentmarket rates of interest.

 

Loans and leases –Approximately 59% of loans are variable-rate loans that reprice at variousfrequencies and have no significant change in interest rate risk. Fair valueson these loans are based on carrying values. The fair values for fixed-rateloans and leases are estimated using discounted cash flow analyses, usinginterest rates currently being offered for loans and leases with similar termsto borrowers with similar credit quality or from quoted market prices of similarloans and leases sold, adjusted for differences in loan and leasecharacteristics.

 

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

 

Servicing rights –Fair values are estimated using discounted cash flows based on current marketrates 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 – Thefair values for deposits with no defined maturities equal their carryingamounts, which represent the amount payable on demand. Fair values forfixed-rate certificates of deposit are estimated using a discounted cash flowcalculation that applies interest rates currently being offered on certificatesto a schedule of aggregated expected monthly maturities on certificates ofdeposit.

 

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

 

Subordinateddebentures payable to trusts – The carrying amounts for subordinated debenturespayable to trusts approximate their fair values.

 

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

 

75

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Stock-basedcompensation – The Company accounts for stock-based compensation in accordancewith Accounting Principles Board (APB) Opinion No. 25., Accounting forStock Issued to Employees, and related interpretations. No stock-based employeecompensation cost has been recognized for grants under the fixed stock optionplans, as all options granted under those plans had an exercise price equal tothe market value of the underlying common stock on the date of grant. Thefollowing table illustrates the effect on net income and earnings per share ifthe Company had applied the fair value recognition provisions of FASB StatementNo. 123, Accounting for Stock-Based Compensation, to stock-based employeecompensation.

 
| ** **                                                                                                                                            | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net income, as  reported                                                                                                                              | ** ** | **$**    | **5,165**  |     | $          | 5,216    |       | $ | 4,975 |   |
| Add stock-based employee compensation expense  included in reported net income, net of related tax effects                                            | ** ** | **214**  |       | 154      |       | 110      |       |
| Deduct total stock-based employee compensation  expense determined under fair value based method for all awards, net of  related tax effects (1) | ** ** | **(442** | **)**      | (289     | )          | (246     | )          |
|                                                                                                                                                  |       |     |       |     |       |     |       |
| Pro forma net  income                                                                                                                                 | ** ** | **$**    | **4,937**  |     | $          | 5,081    |       | $ | 4,839 |   |
|                                                                                                                                                  |       |     |       |     |       |     |       |
| Basic earnings  per share;                                                                                                                            |       |     |       |     |       |     |       |
| As reported                                                                                                                                           | ** ** | **$**    | **1.46**   |     | $          | 1.47     |       | $ | 1.37 |   |
| Pro forma                                                                                                                                             | ** ** | **1.40** |       | 1.43     |       | 1.34     |       |
|                                                                                                                                                  |       |     |       |     |       |     |       |
| Diluted earnings  per share:                                                                                                                          |       |     |       |     |       |     |       |
| As reported                                                                                                                                           | ** ** | **$**    | **1.42**   |     | $          | 1.43     |       | $ | 1.35 |   |
| Pro forma                                                                                                                                             | ** ** | **1.36** |       | 1.39     |       | 1.31     |       |

 

----

(1) Includesexpenses related to restricted stock reported in net income.

 

The fair value ofeach incentive stock option grant is estimated at the grant date using theBlack-Scholes option-pricing model. The following weighted average assumptionswere used for grants in fiscal years 2005, 2004 and 2003, respectively:  a dividend rate as a percentage of stockprice of 2.69%, 2.79%, and 2.59%; price volatility of 24.00%, 24.00% and25.00%; risk-free interest rates of 3.73%, 4.26% and 3.64% and expected livesof seven years for all three years.

 

In December, 2004,FASB issued Statement of Financial Accounting Standards (“SFAS”) No. 123R,*“Share-Based Payment,”* which requiresthe measurement of all employee share-based payments to employees, includinggrants of employee stock options, using a fair-value based method and therecording of such expense in the Company’s consolidated financial statements.This will be effective for the Company for the interim reporting period ending September 30,2005. The pro forma disclosures previously permitted under SFAS No. 123 nolonger will be an alternative to financial statement recognition.

 

Self-insurance –The Company has a self-insured health plan for its employees. The accrualestimate for pending and incurred but not reported health claims is based upona pending claims lag report provided by a third party provider. Althoughmanagement believes that it uses the best information available to determinethe accrual, unforeseen health claims could result in adjustments and netearnings being significantly affected if circumstances differ substantiallyfrom the assumptions used in estimating the accrual. Amounts charged to expenserelated to the self-insured health plan during fiscal years 2005, 2004, and2003 were $1,213, $1,662 and $1,575, respectively. 

 

76

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Reclassification – Duringfiscal year 2004, the Company reclassified certain deferred loan originationfees and other loan fees and costs. This process was done upon a fullerinterpretation of Statement No. 91 as issued by the FASB and RegulationS-X (“Reg S-X”) as issued by the Securities and Exchange Commission. Allperiods presented have been revised in presentation to reflect thisreclassification and there was no change to net income or earnings per share asa result of this reclassification.

 

**NOTE 2 -     DISCONTINUED OPERATIONS AND SALE**

 

During the fourthquarter of fiscal year 2002, management committed to a plan to sell thesubprime credit card operations which were previously reported in the creditcard segment of the Company. At June 30, 2002, the Company estimated thenet realizable value based on estimates from a third party and reclassified thenet realizable value of $1,115 at that time from loans receivable to loans heldfor sale. The Bank ceased processing subprime credit card applications in March 1999and had been managing the portfolio from a balance of $18,062 at June 30,1999, to the sale of the receivables as of January 31, 2003. On December 31,2002, the Company, through the Bank, entered into an agreement to sell thediscontinued credit card operations to an independent third party. Amounts ofrevenue (including interest income on loans and noninterest income) and pretaxprofit reported in discontinued operations for the fiscal year ended June 30,2003, were $818 and $44, respectively. The Company dissolved the operations ofHF Card during the third quarter of fiscal 2003.

 

**NOTE 3 -     CONSUMER AUTOMOBILE LOAN SECURITIZATION**

 

On January 31,2003, the Bank securitized and sold motor vehicle installment loans withprincipal balances totaling $50,002 for a gain of $308 through HFSC and theAutomobile Securitization Trust. As part of the sales transaction, the Bankretains servicing responsibilities. In addition, the Bank retains the rights tocash flows remaining after investors in the Automobile Securitization Trusthave receive their contractual payments and has pledged a $1,500 reserve fundto the Automobile Securitization Trust. These retained interests aresubordinated to investors’ interests. The investors and AutomobileSecuritization Trust have no recourse to the Bank’s other assets for failure ofdebtors to pay when due.

 

The gainrecognized on the sale of these loans was determined by allocating the carryingamount of the loans between the loans sold and the interests retained. The Bankdetermined that 50 basis points of the 100 basis points servicing contractrepresented was excess servicing and was capitalized as part of the transactionutilizing a market discount rate of 10.0%. This asset is amortized inproportion to, and over the period of, estimated net servicing income.

 

Key economicassumptions used in measuring the fair value of retained interests at the dateof securitization resulting from securitization completed during fiscal year2003 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% CPR and 721.61 PSA.

 

77

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Key economicassumptions used and the sensitivity of fair value of the retained interest asof June 30, 2005 are as follows:

 
| ** **                                 | ** ** | **Retained  Interest** | ** ** | **Servicing  Rights** | ** ** |
|--------------------------------------------|------------|------------------------|------------|-----------------------|------------|
|                                       |       |                   |       |                  |       |
| Fair values                                |       | $                      | 1,713      |                  | $          | 12 |   |
| Weighted average life (in years)           |       | 1.86                   |       | 1.86                  |       |
| Prepayment speed  (ABS annual rate)        |       | 20.40                  | %          | 20.40                 | %          |
| Impact on fair value of 10% adverse change |       | $                      | (8         | )                     | $          | (2 | ) |
| Impact on fair value of 20% adverse change |       | $                      | (9         | )                     | $          | (2 | ) |
| Credit losses  (annual rate)               |       | 1.13                   | %          | 1.13                  | %          |
| Impact on fair value of 10% adverse change |       | $                      | (4         | )                     | $          | — |   |
| Impact on fair value of 20% adverse change |       | $                      | (7         | )                     | $          | — |   |
| Discount rate                              |       | 6.35                   | %          | 10.00                 | %          |
| Impact on fair value of 10% adverse change |       | $                      | (4         | )                     | $          | — |   |
| Impact on fair value of 20% adverse change |       | $                      | (9         | )                     | $          | — |   |

 

Thesesensitivities are hypothetical and should be used with caution. Changes in fairvalue based on a 10 percent variation in assumptions generally cannot beextrapolated because the relationship of the change in assumption to the changein fair value may not be linear. Also, in this table, the effect of a variationin a particular assumption on the fair value of the retained interest iscalculated without changing any other assumption; in reality, changes in onefactor may result in changes in another (for example, increases in market interestrates may result in lower prepayments and increased credit losses), which mightmagnify or counteract the sensitivities.

 

Static pool lossesare calculated by summing the actual credit losses and dividing the total bythe original balance of the pool of loans. The expected static pool losses ofthe loans securitized in fiscal 2003 is 1.13%.

 

The table belowsummarizes certain cash flows received from and paid to the securitizationtrust during fiscal years 2005 and 2004:

 
| ** **                                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------------|------------|----------|------------|----------|------------|
| Servicing fees  received                        | ** ** | **$**    | **118**    |     | $          | 263 |   |
| Other cash flows  received on retained interest | ** ** | **316**  |       | 1,998    |       |
|                                                 |            |          |            |          |            |  |  |

 

78

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The followingtable presents delinquencies, net credit losses, and components of securitizedfinancial assets and other loans managed together with them as of June 30,2005 and 2004:

 
| ** **                                                             | ** ** | **2005**   | ** **  | **2004**   | ** ** |
|------------------------------------------------------------------------|------------|------------|-------------|------------|------------|
| ** **                                                             | ** ** | ** ** | ** **  | ** ** | ** ** |
| Automobile loans  held in portfolio                                    | ** ** | **$**      | **108,621** |       | $          | 101,669 |   |
| Automobile loans  serviced for others                                  | ** ** | **6,635**  |        | 17,180     |       |
|                                                                   | ** ** | ** ** |        |       |       |
| Total managed  automobile loans                                        | ** ** | **$**      | **115,256** |       | $          | 118,849 |   |
|                                                                   |       |       |        |       |       |
| Principal amount  of managed automobile loans 60 days or more past due | ** ** | **$**      | **286**     |       | $          | 306 |   |
|                                                                   | ** ** | ** ** |        |       |       |
| Net credit  losses for automobile loans for the year                   | ** ** | **$**      | **428**     |       | $          | 511 |   |

 

The Company hasthe option to execute a cleanup call when the total outstanding balance is at10.0% or less of the original pool balance, or $5,000. Based on management’sestimates, this cleanup call could be executed in the second quarter of thefiscal year ending June 30, 2006.

 

**NOTE 4 -     INVESTMENTS IN SECURITIES**

 

The amortized cost andfair values of investments in securities, all of which are classified asavailable for sale according to management’s intent, are as follows:

 
| ** **                                | ** ** | **June 30, 2005** | ** ** |
|-------------------------------------------|------------|------------------------|------------|
| ** **                                | ** ** | **Amortized  Cost**    | ** ** | **Gross  Unrealized  Gains** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Fair  Value** | ** ** |
|                                      |       |                   |       |   |   |   |   |   |   |
| Debt securities                           |       |                   |       |   |   |   |   |   |   |
| U.S. government agencies and corporations |       | $                      | 5,000      |   | $ | — |   | $ | (14 | ) | $ | 4,986 |   |
| Federal Home Loan Bank                    |       | 3,974                  |       | 27 |   | (5 | ) | 3,996 |   |
| Municipal bonds                           |       | 3,085                  |       | 2 |   | (18 | ) | 3,069 |   |
| Preferred term securities                 |       | 9,000                  |       | 56 |   | — |   | 9,056 |   |
|                                      |       | 21,059                 |       | 85 |   | (37 | ) | 21,107 |   |
|                                      |       |                   |       |   |   |   |   |   |   |
| Equity  securities                        |       |                   |       |   |   |   |   |   |   |
| FNMA                                      |       | 8                      |       | 15 |   | — |   | 23 |   |
| Federal agricultural mortgage             |       | 7                      |       | 2 |   | — |   | 9 |   |
| Other                                     |       | 39                     |       | — |   | — |   | 39 |   |
|                                      |       | 54                     |       | 17 |   | — |   | 71 |   |
|                                      |       |                   |       |   |   |   |   |   |   |
| Mortgage-backed  securities               |       | 122,667                |       | 30 |   | (1,446 | ) | 121,251 |   |
|                                      |       |                   |       |   |   |   |   |   |   |
|                                      |       | $                      | 143,780    |   | $ | 132 |   | $ | (1,483 | ) | $ | 142,429 |   |

 

79

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

 

The following tablespresent the age of gross unrealized losses and fair value by investmentcategory in accordance with Emerging Issues Task Force Issue No. 03-1, TheMeaning of Other-Than-Temporary Impairment and Its Application to CertainInvestments.

 
| ** **                                | ** ** | **June 30, 2005**  | ** ** |
|-------------------------------------------|------------|-------------------------|------------|
| ** **                                | ** ** | **Less than 12 Months** | ** ** | **12 Months or More** | ** ** | **Total** | ** ** |
| ** **                                | ** ** | **Fair  Value**         | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Losses)** | ** ** | **Fair  Value** | ** ** | **Gross  Unrealized  (Losses)** | ** ** |
|                                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Debt securities                           |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| U.S. government agencies and corporations |       | $                       | 6,480      |   | $ | (19 | ) | $ | — |   | $ | — |   | $ | 6,480 |   | $ | (19 | ) |
| Municipal bonds                           |       | 1,715                   |       | (9 | ) | 717 |   | (9 | ) | 2,432 |   | (18 | ) |
|                                      |       | 8,195                   |       | (28 | ) | 717 |   | (9 | ) | 8,912 |   | (37 | ) |
|                                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |
| Mortgage-backed  securities               |       | 65,083                  |       | (656 | ) | 48,542 |   | (790 | ) | 113,625 |   | (1,446 | ) |
|                                      |       |                    |       |   |   |   |   |   |   |   |   |   |   |
|                                      |       | $                       | 73,278     |   | $ | (684 | ) | $ | 49,259 |   | $ | (799 | ) | $ | 122,537 |   | $ | (1,483 | ) |

 

80

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

 

Management does notbelieve any individual unrealized losses as of June 30, 2005 and June 30,2004, represent an other-than-temporary impairment. The unrealized lossesreported for mortgage-backed securities relate primarily to securities issuedby FNMA, GNMA and FHLMC. These unrealized losses in total are primarilyattributable to changes in interest rates. As a group, the unrealized losses,were less than 1.2% and 2.1% of its respective amortized cost basis for June 30,2005 and June 20, 2004, respectively. The Company has the ability to holdthe securities to maturity contained in this table for a time necessary torecover the amortized cost.

 

The amortized cost andfair values of debt securities as of June 30, 2005, by contractualmaturity, are shown below. Expected maturities will differ from contractualmaturities because the borrowers may have the right to call or prepayobligations with or without call or prepayment penalties.

 
| ** **                              | ** ** | **Amortized  Cost** | ** ** | **Fair  Value** | ** ** |
|-----------------------------------------|------------|---------------------|------------|-----------------|------------|
|                                    |       |                |       |            |       |
| Due in one year  or less                |       | $                   | 1,201      |            | $          | 1,199 |   |
| Due after one  year through five years  |       | 7,258               |       | 7,262           |       |
| Due after five  years through ten years |       | 3,600               |       | 3,590           |       |
| Due after ten  years                    |       | 9,000               |       | 9,056           |       |
|                                    |       | 21,059              |       | 21,107          |       |
| Mortgage-backed  securities             |       | 122,667             |       | 121,251         |       |
|                                    |       |                |       |            |       |
|                                    |       | $                   | 143,726    |            | $          | 142,358 |   |

 

Equity securities havebeen excluded from the maturity table above because they do not havecontractual maturities associated with debt securities.

 

81

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The components of othercomprehensive income (loss) – net change in unrealized gain (loss) onsecurities available for sale are as follows:

 
| ** **                                                                       | ** ** | **Years Ended June 30,** | ** ** |
|----------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                      | ** ** | **2004** | ** ** | **2003** | ** ** |
|                                                                             | ** ** | ** **                    | ** ** |   |   |   |   |   |   |   |
| Unrealized  holding gain (loss) arising during the year                          | ** ** | **$**                         | **853**    |   | $ | (2,051 | ) | $ | (541 | ) |
| Less  reclassification adjustment for net gains realized in net income           | ** ** | **(20**                       | **)**      | (43 | ) | (352 | ) |
|                                                                             | ** ** | ** **                    | ** ** |   |   |   |   |
| Net change in unrealized gain (loss) before income  taxes                        | ** ** | **833**                       | ** ** | (2,094 | ) | (893 | ) |
|                                                                             | ** ** | ** **                    | ** ** |   |   |   |   |
| Income (taxes)  benefit                                                          | ** ** | **(317**                      | **)**      | 796 |   | 339 |   |
|                                                                             | ** ** | ** **                    | ** ** |   |   |   |   |
| Other comprehensive income - net change in  unrealized gain (loss) on securities | ** ** | **$**                         | **516**    | ** ** | $ | (1,298 | ) | $ | (554 | ) |

 

Proceeds from the sale ofsecurities available for sale in fiscal 2005 were $17,174 and resulted in grossgains of $20. Proceeds from the sale of securities available for sale in fiscal2004 were $6,324 and resulted in gross gains of $43. Proceeds from the sale ofsecurities available for sale in fiscal 2003 were $15,210 and resulted in grossgains of $352.

 

At June 30, 2005 and2004, securities with a fair value of $130,233 and $109,029, respectively, werepledged as collateral for public deposits and other purposes.

 

82

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**NOTE 5 -     LOANS AND LEASES RECEIVABLE**

 

Loans and leasesreceivable at June 30, 2005 and 2004 consist of the following:

 
| ** **                                                      | ** ** | **2005**    | ** **  | **2004** | ** ** |
|-----------------------------------------------------------------|------------|-------------|-------------|----------|------------|
| Loans secured by  real estate                                   |       |        |        |     |       |
| Residential                                                     |       |        |        |     |       |
| One-to-four family                                              | ** ** | **$**       | **96,994**  |     | $          | 94,465 |   |
| Multi-family                                                    | ** ** | **34,241**  |        | 42,721   |       |
| Commercial                                                      | ** ** | **98,243**  |        | 89,538   |       |
| Agriculture                                                     | ** ** | **23,954**  |        | 20,449   |       |
| Construction and development                                    | ** ** | **15,454**  |        | 15,044   |       |
| Business,  consumer and other                                   |       |        |        |     |       |
| Commercial business                                             | ** ** | **125,569** |        | 124,158  |       |
| Automobile                                                      | ** ** | **108,621** |        | 101,669  |       |
| Junior liens on real estate                                     | ** ** | **87,243**  |        | 85,684   |       |
| Agriculture                                                     | ** ** | **50,088**  |        | 42,953   |       |
| Equipment financing leases                                      | ** ** | **33,090**  |        | 26,942   |       |
| Other loans                                                     | ** ** | **5,405**   |        | 4,900    |       |
| Loans on savings accounts                                       | ** ** | **1,253**   |        | 1,489    |       |
| Mobile home                                                     | ** ** | **563**     |        | 848      |       |
| ** **                                                      |       | **680,718** |        | 650,860  |       |
| Add (less)                                                      |       |        |        |     |       |
| Undisbursed portion of loans in process                         | ** ** | **(6,350**  | **)**       | (7,338   | )          |
| Deferred loan fees and unamortized discounts and  premiums, net | ** ** | **1,289**   | ** **  | 1,029    |       |
| Allowance for loan and lease losses                             | ** ** | **(5,076**  | **)**       | (3,605   | )          |
|                                                            | ** ** | ** **  | ** **  |     |       |
| ** **                                                      |       | **$**       | **670,581** |     | $          | 640,946 |   |

 

Loans held for saletotaling $10,238 at June 30, 2005 consist of $9,838 one-to-four family residentialmortgage loans and $400 of student loans. Loans held for sale totaling $10,351 at June 30, 2004 consist of$10,027 one-to-four family fixed-rate loans and $324 of student loans. 

 

Activity in the allowancefor loan losses included in continuing operations is summarized as follows forthe fiscal years ended June 30:

 
| ** **                                       | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                       | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Balance,  beginning                              | ** ** | **$**      | **3,605**  |       | $          | 3,842      |       | $ | 4,461 |   |
|                                             | ** ** | ** ** |       |       |       |       |       |
| Provision charged to income                      | ** ** | **2,681**  |       | 2,020      |       | 3,173      |       |
| Allowance related to assets acquired (sold), net | ** ** | **—** |       | —     |       | (264       | )          |
| Other charge offs                                | ** ** | **(1,545** | **)**      | (2,564     | )          | (4,001     | )          |
| Recoveries                                       | ** ** | **335**    |       | 307        |       | 473        |       |
|                                             | ** ** | ** ** |       |       |       |       |       |
| Balance, ending                                  | ** ** | **$**      | **5,076**  |       | $          | 3,605      |       | $ | 3,842 |   |

 

83

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The following is asummary of information pertaining to impaired loans and nonaccrual loans as ofand for the fiscal years ended June 30, 2005, 2004, and 2003:

 
| ** **                                              | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|---------------------------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                                              | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Impaired loans  without a valuation allowance           | ** ** | **$**      | **98**     |       | $          | 248        |       | $ | 27 |   |
| Impaired loans  with a valuation allowance              | ** ** | **4,115**  |       | —     |       | 2,647      |       |
|                                                    |       |       |       |       |       |       |       |
| Total impaired loans                                    | ** ** | **$**      | **4,213**  |       | $          | 248        |       | $ | 2,674 |   |
|                                                    |       |       |       |       |       |       |       |
| Valuation  allowance related to impaired loans          | ** ** | **$**      | **1,750**  |       | $          | —     |       | $ | 846 |   |
|                                                    |       |       |       |       |       |       |       |
| Nonaccruing loans  and leases                           | ** ** | **$**      | **5,322**  |       | $          | 1,561      |       | $ | 4,365 |   |
| Accruing loans  and leases delinquent more than 90 days | ** ** | **1,609**  |       | 502        |       | 1,466      |       |
| Average  investment in impaired loans                   | ** ** | **529**    |       | 1,702      |       | 5,199      |       |
| Interest income  recognized on impaired loans           | ** ** | **16**     |       | 505        |       | 17         |       |

 

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

 

**NOTE 6 -     LOAN SERVICING**

 

Mortgage loans servicedfor others (primarily the South Dakota Housing Development Authority) are notincluded in the accompanying consolidated statements of financial condition. Theunpaid principal balances of mortgage loans serviced for others was $499,064 and$462,708 at June 30, 2005 and 2004, respectively.

 

Custodial balancesmaintained in connection with mortgage loan servicing, and included in advancesby borrowers for taxes and insurance, were approximately $876, and $1,015 at June 30,2005 and 2004, respectively.

 

The carrying values ofmortgage and consumer servicing rights were $5,211 and $4,620 at June 30,2005 and 2004, respectively. The fair values of these rights were $6,453 and $7,763at June 30, 2005 and 2004, respectively. The fair values of the servicingrights were estimated as the present value of the expected future cash flowsusing a discount rate of 10%. During fiscal years 2005 and 2004, servicingrights of $1,157 and $1,136, respectively, were capitalized. The Companyrecognized expense for amortization of the cost of servicing rights in theamount of $566, $519 and $482 for the fiscal years ended June 30, 2005,2004 and 2003, respectively.

 

No valuation allowanceswere provided for servicing rights capitalized during the fiscal years ended June 30,2005 and 2004.

 

84

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**NOTE 7 -     OFFICE PROPERTIES AND EQUIPMENT**

 
| ** **                                      | ** ** | **2005**    | ** ** | **2004**   | ** ** |
|-------------------------------------------------|------------|-------------|------------|------------|------------|
| ** **                                      | ** ** | ** **  | ** ** | ** ** | ** ** |
| Land                                            | ** ** | **$**       | **1,832**  |       | $          | 1,832 |   |
| Buildings and  improvements                     | ** ** | **16,898**  |       | 15,802     |       |
| Leasehold  improvements                         | ** ** | **1,475**   |       | 1,475      |       |
| Furniture,  fixtures, equipment and automobile  | ** ** | **13,530**  |       | 12,868     |       |
| ** **                                      |       | **33,735**  |       | 31,977     |       |
| Less accumulated  depreciation and amortization | ** ** | **(20,757** | **)**      | (19,422    | )          |
|                                            | ** ** | ** **  |       |       |       |
| ** **                                      |       | **$**       | **12,978** |       | $          | 12,555 |   |

 

In addition, the Companyleases several branch facilities under operating lease agreements which requireminimum rentals totaling $2,030 through the year ending June 30, 2010.

 

**NOTE 8 -     DEPOSITS**

 

Deposits at June 30,2005 and 2004 consist of the following:

 
| ** **                             | ** ** | **2005**    | ** **  | **2004**   | ** ** |
|----------------------------------------|------------|-------------|-------------|------------|------------|
| ** **                             | ** ** | ** **  | ** **  | ** ** | ** ** |
| Noninterest  bearing checking accounts | ** ** | **$**       | **85,705**  |       | $          | 75,251 |   |
| Interest bearing  accounts             | ** ** | **50,120**  |        | 45,738     |       |
| Money market  accounts                 | ** ** | **209,116** |        | 211,928    |       |
| Savings accounts                       | ** ** | **63,235**  |        | 63,670     |       |
| Certificates of  deposit               | ** ** | **273,040** |        | 262,132    |       |
|                                   | ** ** | ** **  |        |       |       |
| ** **                             |       | **$**       | **681,216** |       | $          | 658,719 |   |

 

Scheduled maturities ofcertificates of deposit are as follows:

 

Maturing in fiscal year:

 
| 2006       |   | $      | 142,797 |   |
|------------|--------|--------|---------|--------|
| 2007       |   | 78,108 |    |
| 2008       |   | 33,645 |    |
| 2009       |   | 9,245  |    |
| 2010       |   | 9,245  |    |
| Thereafter |   | — |    |
|       |   |   |    |
|       |   | $      | 273,040 |   |

 

Deposit accounts areinsured up to $100 by the Savings Association Insurance Fund (SAIF) undermanagement of the Federal Deposit Insurance Corporation (FDIC). The aggregateamount of jumbo certificates of deposit with a minimum denomination of $100 wasapproximately $82,900 and $74,574 at June 30, 2005 and 2004, respectively.Deposits at June 30, 2005 and 2004 include $51,640 and $53,008,respectively, of deposits from one local governmental entity, the majority ofwhich are savings accounts.

 

85

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**NOTE 9 -     ADVANCES FROM FEDERAL HOME LOAN BANK ANDOTHER BORROWINGS**

 

Advances from theFederal Home Loan Bank of Des Moines (FHLB) and the Federal Reserve Bank ofMinneapolis at June 30, 2005 and 2004, are summarized as follows:

 
| ** **                                                     | ** ** | **2005**  | ** **  | **2004** | ** ** |
|----------------------------------------------------------------|------------|-----------|-------------|----------|------------|
|                                                           |       |      |        |     |       |
| Fixed-rate  advances (with rates ranging from 1.9% to 6.4%)    | ** ** | **$**     | **110,077** |     | $          | 77,223 |   |
| Variable-rate  advances (with rates ranging from 1.2% to 3.6%) | ** ** | **8,882** |        | 15,762   |       |
|                                                           |       |      |        |     |       |
| ** **                                                     |       | **$**     | **118,959** |     | $          | 92,985 |   |

 

Aggregatematurities of advances, computed based on call date, are as follows:  2006 - $98,459; 2007 - $20,000; 2008 - $0; 2009- $500 and 2010 - $0. Prepayment of the callable advances results in aprepayment fee as negotiated between the Bank and the FHLB.

 

Advances with theFHLB are secured by stock in the FHLB, one-to-four family first mortgage loans,multi-family first mortgage loans and investment securities. In order toprovide additional borrowing collateral, commercial real estate first mortgageloans, home equity line of credit loans and home equity second mortgage havealso been pledged with the FHLB. 

 

Advances with theFederal Reserve Bank are secured by commercial business loans.

 

Convertibleadvances without a strike rate are subject to be called at the FHLB’sdiscretion. Convertible advances tied to LIBOR strike rates may only be calledif the three month LIBOR rate is equal to or greater than the indicated strikerate.

 

The Bank currentlyhas $10,000 and $15,000 unsecured lines of federal funds with correspondentbanks. There were no funds drawn on either line of credit at June 30, 2005.

 

The Company has aline of credit for $6,000 with First Tennessee Bank, NA for liquidity needs ofthe Company. At June 30, 2005, no funds were advanced on the line ofcredit.

 

Other borrowingsconsist of the following:

 

The Company has acontract for deed which requires monthly payments of $9, plus interest at 7.0%,to October 2013. The contract for deed, which is secured by land held forsale with a carrying value of $1,298, had a balance of $705 and $765 at June 30,2005 and 2004, respectively. 

 

On December 31,2004, the Company entered into a Real Estate Purchase Agreement, secured by thecontract for deed as described above, that provides for the sale by the Companyof approximately 211.44 acres of real property located in Minnehaha County,South Dakota (the “Property”), for a per acre purchase price of $23 and anaggregate purchase price of approximately $4,900. The purchase price for theProperty is payable as follows: upon full execution of the Agreement, $100 inearnest money escrowed in an interest bearing account with the title company,with the remaining balance payable on the date of and at the closing. Theclosing for such sale will occur on December 15, 2005, subject to certainconditions.

 

86

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**NOTE 10 -     SUBORDINATED DEBENTURES PAYABLE TO TRUSTS**

 

On November 28,2001, the Company issued 10,000 shares totaling $10,000 of Company ObligatedMandatorily Redeemable Preferred Securities of Trust I. Trust I exists for thesole purpose of issuing trust preferred securities and investing the proceedsin subordinated debentures of the Company. These subordinated debentures constitutethe sole asset of Trust I. The securities provide for cumulative cashdistributions calculated at a rate based on six-month LIBOR plus 3.75% adjustedsemi-annually. The Company may, at one or more times, defer interest paymentson the capital securities for up to 10 consecutive semi-annual periods, but notbeyond December 8, 2031. At the end of the deferral period, allaccumulated and unpaid distributions must be paid. The capital securities mustbe redeemed on December 8, 2031; however, the Company has the option toshorten the maturity date to a date not earlier 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, the Company issued 5,000 shares totaling $5,000 of Company ObligatedMandatorily Redeemable Preferred Securities of Trust II. Trust II wasestablished and exists for the sole purpose of issuing trust preferredsecurities and investing the proceeds in subordinated debentures of theCompany. These subordinated debentures constitute the sole asset of Trust II.The securities provide for cumulative cash distributions calculated at a ratebased 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. Thecapital securities must be redeemed on October 7, 2032; however, theCompany has the option to shorten the maturity date to a date not earlier than July 7,2007. Holders of the capital securities have no voting rights, are unsecured,and rank junior in priority of the payment to all of the Company’s indebtednessand senior to the Company’s capital stock.

 

On December 19,2002, the Company issued 5,000 shares totaling $5,000 of Company ObligatedMandatorily Redeemable Preferred Securities of Trust III. Trust III exists forthe sole purpose of issuing trust preferred securities and investing theproceeds in subordinated debentures of the Company. These subordinateddebentures constitute the sole asset of Trust III. The securities provide forcumulative cash distributions calculated at a rate based on three-month LIBORplus 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 deferralperiod, all accumulated and unpaid distributions 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 than January 7,2008. Holders of the capital securities have no voting rights, are unsecured,and rank junior in priority of the payment to all of the Company’s indebtednessand senior to the Company’s capital stock. 

 

87

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On September 25,2003, the Company issued 7,000 shares totaling $7,000 of Company ObligatedMandatorily Redeemable Preferred Securities of Trust IV. Trust IV exists forthe sole purpose of issuing trust preferred securities and investing theproceeds in subordinated debentures of the Company. These subordinateddebentures constitute the sole asset of Trust IV. The securities provide forcumulative cash distributions calculated at a rate based on three-month LIBORplus 3.10% adjusted quarterly. The Company may, at one or more times, deferinterest payments on the capital securities for up to 20 consecutive quarterlyperiods, but not beyond October 8, 2033. At the end of the deferralperiod, all accumulated and unpaid distributions must be paid. The capitalsecurities must be redeemed on October 8, 2003; however, the Company has theoption to shorten the maturity date to a date not earlier than October 8,2008. Holders of the capital securities have no voting rights, are unsecured,and rank junior in priority of the payment to all of the Company’s indebtednessand senior to the Company’s capital stock.

 

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

 

The subordinatedtrust entities of the Company were deconsolidated during 2004 and the June 30,2003 balance sheet was restated as provided by FIN 46R. As a result, the fiscal2005, 2004 and 2003 balance sheets include $27,837, $27,837, and $20,620 ofsubordinated debentures to these trusts, which was previously included on thebalance sheet at June 30, 2003, as $20,000 of Company obligatedmandatorily redeemable preferred securities of subsidiary trusts that solelyhold subordinated debentures after a consolidation elimination of $620. Theterms of the subordinated debentures correspond to the related preferredsecurities. The overall effect on the Company’s financial position andoperating results of the deconsolidation was not material, and did not affectreported equity or net income.

 

**NOTE 11 -     INCOME TAX MATTERS**

 

The Company andsubsidiaries file a consolidated federal income tax return on a fiscal yearbasis. The Bank is allowed bad debt deductions based on actual charge-offs. 

 

The consolidatedprovision for income taxes from continuing operations consists of the followingfor the years ended June 30, 2005, 2004 and 2003:

 
| ** **       | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------|------------|----------|------------|----------|------------|----------|------------|
|             |       |     |       |     |       |     |       |
| Current          |       |     |       |     |       |     |       |
| Federal          | ** ** | **$**    | **2,786**  |     | $          | 1,485    |       | $ | 412 |   |
| State            | ** ** | **481**  |       | 430      |       | 463      |       |
| Deferred expense | ** ** | **(836** | **)**      | 976      |       | 1,709    |       |
|             |       |     |       |     |       |     |       |
| ** **       |       | **$**    | **2,431**  |     | $          | 2,891    |       | $ | 2,584 |   |

 

88

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Income tax expenseis different from that calculated at the statutory federal income tax rate topretax income from continuing operations. The reasons for this difference inthe tax expense are as follows:

 
| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                |       |     |       |     |       |     |       |
| Computed “expected”  tax expense          | ** ** | **$**    | **2,659**  |     | $          | 2,837    |       | $ | 2,636 |   |
| Increase  (decrease) in income taxes resulting from |       |     |       |     |       |     |       |
| Tax exempt income                                   | ** ** | **(172** | **)**      | (116     | )          | (224     | )          |
| State taxes, net of federal benefit                 | ** ** | **331**  | ** ** | 320      |       | 331      |       |
| Increase in cash surrender value of life insurance  | ** ** | **(168** | **)**      | (184     | )          | (16      | )          |
| Benefit of income taxed at lower rates              | ** ** | **(61**  | **)**      | (67      | )          | (65      | )          |
| Change in valuation allowance                       | ** ** | **(1**   | **)**      | (76      | )          | —   |       |
| Other, net                                          | ** ** | **(157** | **)**      | 177      |       | (78      | )          |
|                                                |       |     |       |     |       |     |       |
| ** **                                          |       | **$**    | **2,431**  |     | $          | 2,891    |       | $ | 2,584 |   |

 

The components ofthe net deferred tax asset (liability) as of June 30, 2005 and 2004, areas follows:

 
| ** **                                           | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                           | ** ** | ** ** | ** ** | ** ** | ** ** |
| Deferred tax  assets                                 |       |       |       |       |       |
| Allowance for loan and lease losses                  | ** ** | **$**      | **1,738**  |       | $          | 1,181 |   |
| Accrued expenses                                     | ** ** | **377**    |       | 399        |       |
| Net unrealized loss on securities available for sale | ** ** | **513**    |       | 830        |       |
| Other                                                | ** ** | **392**    |       | 542        |       |
|                                                 | ** ** | **3,020**  |       | 2,952      |       |
| Less valuation allowance                             | ** ** | **(5**     | **)**      | (6         | )          |
|                                                 | ** ** | ** ** | ** ** |       |       |
|                                                 | ** ** | **3,015**  |       | 2,946      |       |
| Deferred tax  liabilities                            |       |       |       |       |       |
| Property and equipment                               | ** ** | **2,072**  |       | 2,626      |       |
| Mortgage servicing rights                            | ** ** | **309**    |       | 235        |       |
| Other assets                                         | ** ** | **175**    |       | 155        |       |
| Other                                                | ** ** | **12**     |       | 18         |       |
|                                                 | ** ** | **2,568**  |       | 3,034      |       |
|                                                 | ** ** | ** ** |       |       |       |
|                                                 | ** ** | **$**      | **447**    |       | $          | (88 | ) |

 

Retained earningsat June 30, 2005 and 2004, include approximately $4,805 related to the pre-1987allowance for loan losses for which no deferred federal income tax liabilityhas been recognized. These amounts represent an allocation of income to baddebt deductions for tax purposes only. If the Bank no longer qualifies as abank, or in the event of a liquidation of the Bank, income would be created fortax purposes only, which would be subject to the then current corporate incometax rate. The unrecorded deferred income tax liability on the above amount forfinancial statement purposes was approximately $1,634.

 

89

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**NOTE 12 -     REGULATORY CAPITAL**

 

The Bank issubject to various regulatory capital requirements administered by federalbanking agencies. Failure to meet minimum capital requirements can initiatecertain mandatory – and possibly additional discretionary – actions byregulators that, if undertaken, could have a direct material effect on the Bank’sfinancial statements. Under capital adequacy guidelines and the regulatoryframework for prompt corrective action, the Bank must meet specific capitalguidelines that involve quantitative measures of the Bank’s assets,liabilities, and certain off-balance sheet items as calculated under regulatoryaccounting practices. The Bank’s capital amounts and classification are alsosubject to qualitative judgments by the regulators about components, riskweightings, and other factors.

 

Quantitativemeasures established by regulation to ensure capital adequacy require the Bankto maintain minimum amounts and ratios (set forth in the following table) oftotal and Tier I capital (as defined in the regulations) to risk-weightedassets (as defined) and of Tier I capital (as defined) to adjusted total assets(as defined). Management believes, as of June 30, 2005 and 2004, that theBank meets all capital adequacy requirements to which it is subject. 

 

As of June 30,2005, the Office of Thrift Supervision (OTS) categorized the Bank as “wellcapitalized” under the regulatory framework. 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. Thereare no conditions or events since that notification that management believeshave unfavorably changed the Bank’s category.

 

The followingtable summarizes the Bank’s compliance with its regulatory capital requirementsat June 30, 2005 and 2004:  

 
| ** **                                         | ** ** | ** ** | ** ** | ** **      | ** ** | ** **            | ** ** | ** **  | ** ** | **To Be Well Capitalized  Under Prompt Corrective** | ** ** |
|----------------------------------------------------|------------|------------|------------|-----------------|------------|-----------------------|------------|-------------|------------|-----------------------------------------------------|------------|
| ** **                                         | ** ** | **Actual** | ** ** | **Requirement** | ** ** | **Action Provisions** | ** ** |
| ** **                                         | ** ** | **Amount** | ** ** | **Percent**     | ** ** | **Amount**            | ** ** | **Percent** | ** ** | **Amount**                                          | ** ** | **Percent** | ** ** |
| As of June 30,  2005                          |       |       |       |            |       |                  |       |        |       |                                                |       |   |   |
| Tier I (core) capital (to adjusted total assets)   |       | $          | 73,815     |            | 8.28       | %                     | $          | 35,046      |       | 4.00                                                | %          | $ | 44,577 |   | 5.00 | % |
| Total risk-based capital (to risk-weighted assets) |       | 75,423     |       | 10.66           | %          | 56,610                |       | 8.00        | %          | 70,763                                              |       | 10.00 | % |
| Tangible capital (to tangible assets)              |       | 73,815     |       | 8.28            | %          | 13,373                |       | 1.50        | %          | N/A                                                 |       | N/A |   |
| Tier I (core) capital (to risk-weighted assets)    |       | 73,815     |       | 10.43           | %          | N/A                   |       | N/A         |       | 42,458                                              |       | 6.00 | % |
|                                               |       |       |       |            |       |                  |       |        |       |                                                |       |   |   |
| As of June 30,  2004                          |       |       |       |            |       |                  |       |        |       |                                                |       |   |   |
| Tier I (core) capital (to adjusted total assets)   |       | $          | 69,762     |            | 8.28       | %                     | $          | 33,689      |       | 4.00                                                | %          | $ | 42,112 |   | 5.00 | % |
| Total risk-based capital (to risk-weighted assets) |       | 71,502     |       | 10.54           | %          | 54,270                |       | 8.00        | %          | 67,838                                              |       | 10.00 | % |
| Tangible capital (to tangible assets)              |       | 69,762     |       | 8.28            | %          | 12,633                |       | 1.50        | %          | N/A                                                 |       | N/A |   |
| Tier I (core) capital (to risk-weighted assets)    |       | 69,762     |       | 10.28           | %          | N/A                   |       | N/A         |       | 40,703                                              |       | 6.00 | % |

 

90

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**NOTE 13 -     STOCKHOLDERS’ EQUITY**

 

The Companycurrently has in effect a publicly announced stock buy-back program in which upto 10% of the common stock of the Company outstanding on May 1, 2005, maybe acquired through April 30, 2006. A total of 162,800 shares of commonstock were purchased pursuant to this current program and the previous publiclyannounced program in effect during fiscal year 2005. Pursuant to a series ofstock buy-back programs initiated by the Company since 1996, the Company haspurchased an aggregate of 1,977,836 shares of common stock through June 30,2005. The aggregate purchases include two blocks of 11,000 and 340,021 sharesof common stock repurchased in private transactions in February 2004 and January 2002,respectively. As of June 30, 2005, the maximum number of shares that mayyet be purchased under the current program was 303,614 shares.

 

The Company hasauthorized 50,000 shares of Preferred Stock, designated as “Series AJunior Participating Preferred Stock” with a stated value of $1.00 per share.Outstanding shares of the Junior Preferred Stock are entitled to cumulativedividends. Such shares have voting rights of 100 votes per share and apreference in liquidation. The shares are not redeemable after issuance.

 

The Company alsohas preferred share purchase rights (Rights). Each Right entitles theregistered holder to purchase from the Company one one-hundredth of a share of Series AJunior Participating Preferred Stock at a price of $65 per one-hundredth of apreferred share, subject to the complete terms as stated in the RightsAgreement. The Rights become exercisable immediately after the earlier of (i) tenbusiness days following a public announcement that a person or group hasacquired beneficial ownership of 20% or more of the outstanding common sharesof 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 on October 22, 2006, which date may beextended subject to certain additional conditions. There were no outstandingRights as of June 30, 2005.

 

Under currentregulations, the Bank is not permitted to pay dividends on its stock if itsregulatory capital would reduce below (i) the amount required for theliquidation account established to provide a limited priority claim to theassets of the Bank to qualifying depositors (Eligible Account Holders) at March 31,1992, who continue to maintain deposits at the Bank after its conversion from afederal mutual savings and loan association to a federal stock savings bankpursuant to its Plan of Conversion adopted August 21, 1991, or (ii) theBank’s regulatory capital requirements. Capital distributions are limited tothe greater of 100% of net income for the year to date plus 50% of the amountof which the lesser of the institution’s tangible core or risk-based capitalexceeds its capital requirement for such capital commitment, as measured at thebeginning of the calendar year or up to 75% of net income over the most recentfour quarter period. Subsequent to June 30, 2005, the Bank sent writtennotification to the OTS of its intention to pay up to 50% of the Bank’s netincome for each quarter in the year ending June 30, 2006, to the Company.

 

91

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**NOTE 14 -     EARNINGS PER SHARE**

 

A reconciliationof the income and common stock share amounts used in the calculation of basicand diluted EPS for the fiscal years ended June 30, 2005, 2004, and 2003,follow:

 
| ** **                                                                                     | ** ** | **2005**      | ** ** | **2004**  | ** ** | **2003**  | ** ** |
|------------------------------------------------------------------------------------------------|------------|---------------|------------|-----------|------------|-----------|------------|
| Earnings                                                                                       |       |          |       |      |       |      |       |
| Income from continuing operations                                                              | ** ** | **$**         | **5,165**  |      | $          | 5,216     |       | $ | 4,946 |   |
| Discontinued operations, net of tax                                                            | ** ** | **—**    |       | —    |       | 29        |       |
|                                                                                           |       |          |       |      |       |      |       |
| Net income                                                                                     | ** ** | **$**         | **5,165**  |      | $          | 5,216     |       | $ | 4,975 |   |
|                                                                                           |       |          |       |      |       |      |       |
| Basic EPS                                                                                      |       |          |       |      |       |      |       |
| Weighted average number of common shares outstanding                                           | ** ** | **3,532,088** |       | 3,557,860 |       | 3,631,431 |       |
|                                                                                           |       |          |       |      |       |      |       |
| Earnings per  common share                                                                     |       |          |       |      |       |      |       |
| Income from continuing operations                                                              | ** ** | **$**         | **1.46**   |      | $          | 1.47      |       | $ | 1.36 |   |
| Discontinued operations, net of tax                                                            | ** ** | **—**    |       | —    |       | 0.01      |       |
|                                                                                           |       |          |       |      |       |      |       |
| Net income                                                                                     | ** ** | **$**         | **1.46**   |      | $          | 1.47      |       | $ | 1.37 |   |
|                                                                                           |       |          |       |      |       |      |       |
| Diluted EPS                                                                                    |       |          |       |      |       |      |       |
| Weighted average number of common shares outstanding                                           | ** ** | **3,532,088** |       | 3,557,860 |       | 3,631,431 |       |
| Common share equivalents - stock options and stock  issuable under employee compensation plans | ** ** | **105,266**   |       | 98,292    |       | 67,873    |       |
| Weighted average number of common shares and common  share equivalents                         | ** ** | **3,637,354** |       | 3,656,152 |       | 3,699,304 |       |
|                                                                                           |       |          |       |      |       |      |       |
| Earnings per  common share                                                                     |       |          |       |      |       |      |       |
| Income from continuing operations                                                              | ** ** | **$**         | **1.42**   |      | $          | 1.43      |       | $ | 1.34 |   |
| Discontinued operations, net of tax                                                            | ** ** | **—**    |       | —    |       | 0.01      |       |
|                                                                                           |       |          |       |      |       |      |       |
| Net income                                                                                     | ** ** | **$**         | **1.42**   |      | $          | 1.43      |       | $ | 1.35 |   |

 

All optionsoutstanding were included in the computation for the year ended June 30,2005. Options outstanding of approximately 43,000 and 99,000 shares of commonstock at weighted average share prices of $16.23 and $14.20 during the yearsended June 30, 2004 and 2003, respectively, were not included in thecomputation of diluted earnings per share because the exercise prices of thoseinstruments exceeded the average market prices of the common shares during theyears. 

 

92

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**NOTE 15 -     DEFINED BENEFIT 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 21 and have completed 1,000 hours in a plan year. The benefits arebased on 6% of each eligible participant’s annual compensation, plus incomeearned in the accounts at a rate determined annually based on 30-year treasurynote rates. The Company’s funding policy is to make the minimum annual requiredcontribution plus such amounts as the Company may determine to be appropriatefrom time to time. One hundred percent vesting occurs after five years with aretirement age of 65. Information relative to the components of net periodicbenefit cost for the Company’s defined benefit plan is presented below.

 
| ** **                                    | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                    | ** ** | ** ** | ** ** | ** ** | ** ** |
| Changes in  benefit obligations               |       |       |       |       |       |
| Benefit obligations, beginning                | ** ** | **$**      | **4,476**  |       | $          | 4,473 |   |
| Service cost                                  | ** ** | **454**    |       | 431        |       |
| Interest cost                                 | ** ** | **366**    |       | 324        |       |
| Benefits paid                                 | ** ** | **(359**   | **)**      | (169       | )          |
| Actuarial loss (gain)                         | ** ** | **84**     |       | (583       | )          |
|                                          |       |       |       |       |       |
| Benefit obligations, ending                   | ** ** | **$**      | **5,021**  |       | $          | 4,476 |   |
|                                          |       |       |       |       |       |
| Changes in plan  assets                       |       |       |       |       |       |
| Fair value of plan assets, beginning          | ** ** | **$**      | **3,675**  |       | $          | 2,793 |   |
| Actual return on plan assets                  | ** ** | **262**    |       | 381        |       |
| Company contributions                         | ** ** | **662**    |       | 670        |       |
| Benefits paid                                 | ** ** | **(359**   | **)**      | (169       | )          |
|                                          |       |       |       |       |       |
| Fair value of plan assets, ending             | ** ** | **$**      | **4,240**  |       | $          | 3,675 |   |
|                                          |       |       |       |       |       |
| Funded status at  end of year                 |       |       |       |       |       |
| Plan assets (deficient) of obligations        | ** ** | **$**      | **(782**   | **)**      | $          | (801 | ) |
| Unrecognized losses                           | ** ** | **880**    |       | 721        |       |
| Unrecognized transition asset                 | ** ** | **12**     |       | 22         |       |
|                                          |       |       |       |       |       |
| (Accrued) prepaid benefit cost at end of year | ** ** | **$**      | **110**    |       | $          | (58 | ) |

 

93

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The components ofpension cost for the fiscal years ended June 30, consist of the following:

 
| ** **                          | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003**   | ** ** |
|-------------------------------------|------------|------------|------------|------------|------------|------------|------------|
| ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Service cost                        | ** ** | **$**      | **454**    |       | $          | 431        |       | $ | 622 |   |
| Interest cost                       | ** ** | **366**    |       | 324        |       | 282        |       |
| Expected return  on plan assets     | ** ** | **(370**   | **)**      | (244       | )          | (204       | )          |
| Amortization of  prior losses       | ** ** | **33**     |       | 55         |       | 113        |       |
| Amortization of  prior service cost | ** ** | **—** |       | (44        | )          | (46        | )          |
| Amortization of  transition asset   | ** ** | **12**     |       | 12         |       | 12         |       |
|                                |       |       |       |       |       |       |       |
| Total costs recognized in expense   | ** ** | **$**      | **495**    |       | $          | 534        |       | $ | 779 |   |

 

The components inthe balance sheet consist of:

 
| ** **                                                        | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|-------------------------------------------------------------------|------------|------------|------------|------------|------------|
| ** **                                                        | ** ** | ** ** | ** ** | ** ** | ** ** |
| (Accrued) prepaid benefit cost                                    | ** ** | **$**      | **110**    |       | $          | (58 | ) |
|                                                              | ** ** | ** ** |       |       |       |
| Net asset (liability) recorded in the consolidated  balance sheet | ** ** | **$**      | **110**    |       | $          | (58 | ) |

 

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

 
| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|
|                            |       |     |       |     |       |
| Discount rate - preretirement   | ** ** | **7.50** | **%**      | 7.50     | %          |
| Discount rate -  postretirement | ** ** | **4.93** | **%**      | 4.93     | %          |
| Rate of  compensation increase  | ** ** | **5.50** | **%**      | 5.50     | %          |

 

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

 
| ** **                                | ** ** | **2005** | ** ** | **2004** | ** ** |
|-------------------------------------------|------------|----------|------------|----------|------------|
|                                      |       |     |       |     |       |
| Discount rate -  preretirement            | ** ** | **7.50** | **%**      | 7.50     | %          |
| Discount rate -  postretirement           | ** ** | **4.55** | **%**      | 4.81     | %          |
| Expected  long-term return on plan assets | ** ** | **8.00** | **%**      | 8.00     | %          |
| Rate of  compensation increase            | ** ** | **5.50** | **%**      | 5.50     | %          |

 

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

 

94

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Plan Assets:  The Company’s pension plan weighted-averageasset allocations at June 30, 2005 and 2004 by asset category are asfollows:

 
| ** **                 | ** ** | **June 30, 2005** | ** ** |
|----------------------------|------------|------------------------|------------|
| **Investment Category**    | ** ** | **Cost**               | ** ** | **Market  Value** | ** ** | **Unrealized  Gain** | ** ** | **Actual Asset  Mix as a % of  Market Value** | ** ** | **Target Asset  Mix as a % of  Market Value** | ** ** |
|                       |       |                   |       |   |   |   |   |   |   |   |   |
| Equities                   |       | $                      | 2,521      |   | $ | 2,871 |   | $ | 350 |   | 65.5 | % | 65.0 | % |
| Fixed                      |       | 1,282                  |       | 1,308 |   | 26 |   | 29.9 | % | 30.0 | % |
| Cash and cash  equivalents |       | 201                    |       | 201 |   | — |   | 4.6 | % | 5.0 | % |
|                       |       |                   |       |   |   |   |   |   |   |   |   |
| Total pension plan assets  |       | $                      | 4,004      |   | $ | 4,380 |   | $ | 376 |   | 100.0 | % | 100.0 | % |

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

 

The objective ofthe pension plan investment policy for equities is to pursue a growth strategythat results in capital appreciation. The objective of the pension planinvestment policy for fixed rate instruments and cash equivalents is to ensuresafety of principal and interest. 

 

The Companyexpects to contribute $610 to its pension plan in fiscal 2006.

 

Estimated FutureBenefit Payments:  The following benefitpayments which reflect expected future service, as appropriate, are expected tobe paid during the years ended June 30: 

 
| 2006             |   | $     | 372    |   |
|------------------|--------|-------|--------|--------|
| 2007             |   | 267   |   |
| 2008             |   | 244   |   |
| 2009             |   | 328   |   |
| 2010             |   | 495   |   |
| Years 2011 -2016 |   | 3,620 |   |

 

95

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**NOTE 16 -     RETIREMENT SAVINGS PLAN**

 

The Company has aretirement savings plan 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 plan is intended to be a qualified profit sharingplan with a cash or deferred arrangement pursuant to IRS Code Section 401(k)and regulations issued there under. The plan allows voluntary contributions byeligible employees, and also allows discretionary contributions by the Companyas determined annually by the Board of Directors. The total compensation costcharged to expense related to the plan was $275, $233, and $251 for 2005, 2004,and 2003, respectively.

 

**NOTE 17 -     STOCK-BASED COMPENSATION PLANS**

 

The Company has a1991 Stock Option and Incentive Plan (1991 Option Plan), in which awards for anaggregate amount of 910,800 common shares may be granted to directors andemployees of the Bank. Options granted had a maximum term of 10 years. The 1991Option Plan also provided for the award of stock appreciation rights, limitedstock appreciation rights, and restricted stock.

 

During fiscal year2003, the Company established the 2002 Stock Option and Incentive Plan (2002Option Plan), and ceased granting options under the 1991 Option Plan. Under the2002 Option Plan, awards for an aggregate amount of 825,000 common shares maybe granted to directors and employees of the Bank. Options granted under theOption Plan may be either options that qualify as Incentive Stock Options, asdefined in the Code, or options that do not qualify. Options granted may have amaximum term of 10 years. The 2002 Option Plan also provides for the award ofstock appreciation rights, limited stock appreciation rights and restrictedstock.

 

The Company has along-term incentive plan which provides for the grant of restricted stockawards and for stock options under the option plans if the Company achievescertain performance levels. During fiscal years 2005, 2004, and 2003, theCompany met a performance level in the plan and, accordingly, for fiscal year2005 restricted stock with a value of $1,266 will be issued in fiscal year2006. During fiscal years 2005 and 2004, 40,940 and 15,817 shares, respectivelyof restricted stock were issued under the 2002 Option Plan. These shares vest33 1/3% after 3 years, 66 2/3% after 4 years, and 100% after 5 years ofcontinued employment. The issuance value of these shares was $670 and $282 for2005 and 2004, respectively, and is being amortized over the vesting period offive years, with the unamortized balance included in deferred compensation inthe consolidated statements of financial condition. During fiscal years 2005, 2004,and 2003, $195, $89 and $50, respectively, were recorded as amortizationexpense.

 

Also in connectionwith meeting a performance level of the long-term incentive plan, 38,105 stockoptions and 66,644 shares of restricted stock will be issued in fiscal year2006 under the plan. 

 

96

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The Company has apool of 11,000 restricted shares (1991 Pool), which was increased to 18,700restricted shares in fiscal year 2003. Awards from the 1991 Pool are at thediscretion of the Chairman of the Board of Directors on a spot basis toemployees and were provided for under the 1991 Option Plan. The restrictedshares vest 33 1/3% after 3 years, 66 2/3% after 4 years, and 100% after 5years of continued employment. Key provisions of the 1991 Pool include:  outright grant of shares with restrictions asto sale, transfer, and pledging; during the restriction period, the granteereceives dividends and has voting rights related to the shares awarded; and allnonvested shares are forfeited upon termination. During fiscal year 2004, theCompany created a pool of 11,000 restricted shares for grants under the 2002Option Plan (2002 Pool). The provisions of the 2002 Pool are the same as the1991 Pool. During fiscal years 2005 and 2004, 1,543 and 1,005 restrictedshares, respectively, were awarded under the Pool. The issuance value of theserestricted shares was $25 and $16 in 2005 and 2004, respectively, and is beingamortized over the vesting period of five years, with the unamortized balanceincluded in deferred compensation in the consolidated balance sheet. Duringfiscal years 2005, 2004 and 2003, $29, $29, and $26, respectively, wererecorded as amortization expense.

 

A summary of thestatus of the plans and changes during the years ended June 30, are asfollows:

 
| ** **                        | ** ** | **2005**    | ** ** | **2004**                               | ** ** | **2003**   | ** ** |
|-----------------------------------|------------|-------------|------------|----------------------------------------|------------|------------|------------|
| **Fixed Options**                 | ** ** | **Shares**  | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                              |       |        |       |                                   |       |       |       |   |   |   |   |   |   |
| Outstanding at  beginning of year | ** ** | **301,743** | ** ** | **$**                                  | **11.22**  |       | 352,059    |   | $ | 11.00 |   | 312,311 |   | $ | 10.96 |   |
| Granted                           | ** ** | **84,560**  | ** ** | **16.37**                              |       | 42,987     |       | 16.23 |   | 75,628 |   | 10.91 |   |
| Forfeited                         | ** ** | **(20,773** | **)**      | **12.98**                              |       | (16,075    | )          | 9.99 |   | (22,343 | ) | 10.68 |   |
| Exercised                         | ** ** | **(69,647** | **)**      | **10.36**                              |       | (77,228    | )          | 10.69 |   | (13,537 | ) | 10.14 |   |
|                              |       |        |       |                                   |       |       |       |   |   |   |   |   |   |
| Outstanding at  end of year       | ** ** | **295,883** | ** ** | **$**                                  | **13.44**  |       | 301,743    |   | $ | 11.22 |   | 352,059 |   | $ | 11.00 |   |

 

Options for 235,603,238,389 and 254,152 shares were exercisable at June 30, 2005, 2004, and2003, respectively. The weighted average fair value of options granted in eachfiscal year was $3.73, $3.83, and $2.57 for the fiscal years ended June 30,2005, 2004, and 2003, respectively. 

 

97

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Fixed optionsoutstanding at June 30, 2005 are summarized as follows:

 
| ** ** | ** ** | **Options Outstanding** | ** ** | **Options Exercisable** | ** ** |
|------------|------------|-------------------------|------------|-------------------------|------------|
| ** ** | ** ** | **Number  Outstanding** | ** ** | **Number  Exercisable** | ** ** | **Remaining  Contractual  Life** | ** ** | **Exercise  Price** | ** ** |
|       |       |                    |       |                    |       |   |   |   |   |
|       |       | 41,567                  |       | 41,567                  |       | 6 years |   | $ | 8.52 |   |
|       |       | 3,723                   |       | 3,723                   |       | 2 years |   | 9.28 |   |
|       |       | 42,719                  |       | 42,719                  |       | 8 years |   | 10.91 |   |
|       |       | 29,136                  |       | 29,136                  |       | 7 years |   | 11.36 |   |
|       |       | 32,811                  |       | 32,811                  |       | 4 years |   | 13.98 |   |
|       |       | 31,989                  |       | 31,989                  |       | 3 years |   | 14.77 |   |
|       |       | 31,666                  |       | 26,243                  |       | 9 years |   | 16.23 |   |
|       |       | 82,272                  |       | 27,415                  |       | 10 years |   | 16.37 |   |
|       |       |                    |       |                    |       |   |   |   |   |
|       |       | 295,883                 |       | 235,603                 |       |   |   |   |   |
|            |            |                         |            |                         |            |  |  |  |  |  |

 

The Company has aDirector Restricted Stock Plan which provides that awards of restricted sharesof the Company’s common stock be made to outside directors of the Company. Theplan is designed to allow for payment of the annual retainer fee in shares ofthe Company’s common stock, with the inclusion of an annual cost of livingadjustment based on the Consumer Price Index. Each outside director is entitledto all voting, dividend and distribution rights during the restriction period.The effective date of the plan was July 1, 1997. The plan has 82,500shares allocated to it and is in effect for a period of ten years. Duringfiscal years 2005, 2004 and 2003, 5,974, 6,604, and 7,880 shares were awarded and$90, $116, and $90 of expense was incurred under the plan, respectively, as theannual retainer for the Company’s Board of Directors. 

 

**NOTE 18 -  ACCUMULATED OTHER COMPREHENSIVE LOSS**

 

The components ofaccumulated other comprehensive loss as of June 30, are as follows:

 
| ** **                                                                                        | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|
|                                                                                              |       |     |       |     |       |
| Unrealized loss  on securities available for sale net of related tax effect of $(513) and  $(830) | ** ** | **$**    | **(838**   | )        | $          | (1,354 | ) |
| Fair value  change in retained interest, net of related deferred tax effect of $1 and $17         | ** ** | **2**    |       | 27       |       |
|                                                                                              |       |     |       |     |       |
| ** **                                                                                        |       | **$**    | **(836**   | **)**    | $          | (1,327 | ) |

 

98

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**NOTE 19 -  FINANCIAL INSTRUMENTS**

 

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

 

The Bank’sexposure to credit loss in the event of nonperformance by the other party tothe financial instrument for commitments to extend credit, standby letters ofcredit, and financial guarantees written is represented by the contractualnotional amount of those instruments. The Bank uses the same credit policies inmaking commitments and conditional obligations as it does for on-balance-sheetinstruments.

 

Unless notedotherwise, the Bank does not require collateral or other security to supportfinancial instruments with credit risk.

 

Estimated fairvalues of the Company’s financial instruments are as follows at June 30:

 
| ** **                                                                  | ** ** | **June 30,**    | ** ** |
|-----------------------------------------------------------------------------|------------|----------------------|------------|
| ** **                                                                  | ** ** | **2005**             | ** ** | **2004** | ** ** |
| ** **                                                                  | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** | **Carrying  Amount** | ** ** | **Fair  Value** | ** ** |
| ** **                                                                  | ** ** | ** **           | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Financial assets                                                            |       |                 |       |   |   |   |   |   |   |
| Cash and cash equivalents                                                   | ** ** | **$**                | **18,248** | ** ** | **$** | **18,248** |   | $ | 20,474 |   | $ | 20,474 |   |
| Securities                                                                  | ** ** | **142,429**          | ** ** | **142,429** |   | 122,715 |   | 122,715 |   |
| Federal Home Loan Bank stock                                                | ** ** | **7,699**            | ** ** | **7,699** |   | 5,469 |   | 5,469 |   |
| Loans and leases                                                            | ** ** | **680,819**          | ** ** | **676,842** |   | 651,297 |   | 661,214 |   |
| Accrued interest receivable                                                 | ** ** | **5,087**            | ** ** | **5,087** |   | 4,056 |   | 4,056 |   |
| Servicing rights                                                            | ** ** | **5,211**            | ** ** | **6,453** |   | 4,620 |   | 7,763 |   |
| Retained interest asset                                                     | ** ** | **1,713**            | ** ** | **1,713** |   | 1,878 |   | 1,878 |   |
|                                                                        | ** ** | ** **           | ** ** | ** ** |   |   |   |   |   |
| Financial  liabilities                                                      |       |                 |       |   |   |   |   |   |   |
| Deposits                                                                    | ** ** | **681,216**          | ** ** | **679,277** |   | 658,719 |   | 659,944 |   |
| Borrowed funds                                                              | ** ** | **119,664**          | ** ** | **119,364** |   | 93,750 |   | 92,922 |   |
| Subordinated debentures payable to trusts                                   | ** ** | **27,837**           | ** ** | **27,837** |   | 27,837 |   | 27,837 |   |
| Accrued interest payable and advances by borrowers  for taxes and insurance | ** ** | **9,484**            | ** ** | **9,484** |   | 9,236 |   | 9,236 |   |
|                                                                             |            |                      |            |  |  |  |  |  |  |  |  |  |  |

 

99

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**NOTE 20 -  COMMITMENTS, CONTINGENCIES AND CREDIT RISK**

 

The Bankoriginates first mortgage, consumer and other loans primarily in eastern SouthDakota and holds residential and commercial real estate loans which werepurchased from other originators of loans located throughout the United States.Collateral for substantially all consumer loans are security agreements and/orUniform Commercial Code (UCC) filings on the purchased asset. At June 30,2005 and 2004, the Bank has approximately $5 and $24 of loans sold withrecourse to the Federal National Mortgage Association (FNMA). The collateralsecuring these loans are one-to-four family mortgage loans, which are seasoned.Unused lines of credit amounted to $119,080 and $113,279 at June 30, 2005and 2004, respectively. Unused letters of credit amounted to $4,721 and $5,423at June 30, 2005 and 2004, respectively. The lines of credit and lettersof credit are collateralized in substantially the same manner as loanreceivable.

 

The Bank hadoutstanding commitments to originate or purchase loans of $80,217 and to sellloans of approximately $34,894 at June 30, 2005. The portion ofcommitments to originate or purchase fixed rate loans totaled $33,716 with arange in interest rates of 4.63% to 8.63%. No losses are expected to besustained in the fulfillment of any of these commitments. 

 

The Company isinvolved in various claims and legal actions arising in the ordinary course ofbusiness. In the opinion of management, based upon consultation with legalcounsel, the ultimate disposition of these matters will not have a materialadverse effect on the Company’s consolidated financial position.

 

**NOTE 21 -  CASH FLOW INFORMATION**

 

Changes in otherassets and liabilities for the years ended June 30, 2005, 2004 and 2003,consist of:

 
| ** **                                                     | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
|                                                           |       |     |       |     |       |     |       |
| (Increase)  decrease in accrued interest receivable            | ** ** | **$**    | **(1,031** | **)**    | $          | 242      |       | $ | 112 |   |
| Increase  (decrease) in net deferred loan fees                 | ** ** | **259**  | ** ** | 666      |       | 140      |       |
| Earnings on cash  value of life insurance                      | ** ** | **(561** | **)**      | (619     | )          | (431     | )          |
| (Increase)  decrease in other assets                           | ** ** | **491**  | ** ** | 2,836    |       | (6,121   | )          |
| Increase  (decrease) in accrued expenses and other liabilities | ** ** | **352**  | ** ** | (3,300   | )          | 1,016    |       |
|                                                           |       |     | ** ** |     |       |     |       |
| ** **                                                     |       | **$**    | **(490**   | **)**    | $          | (175     | )          | $ | (5,284 | ) |

 

100

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**NOTE 22 -  FINANCIAL INFORMATION OF HF FINANCIAL CORP.(PARENT ONLY)**

 

The Company’scondensed balance sheets as of June 30, 2005 and 2004 and relatedcondensed statements of income and cash flows for each of the years in the three-yearperiod ended June 30, 2005, are as follows:

 

Condensed Balance Sheets

 
| ** **                   | ** ** | **2005**   | ** ** | **2004**   | ** ** |
|------------------------------|------------|------------|------------|------------|------------|
| ** **                   | ** ** | ** ** | ** ** | ** ** | ** ** |
| Assets                       |       |       |       |       |       |
| Cash primarily with the Bank | ** ** | **$**      | **1,003**  |       | $          | 2,557 |   |
| Investments in subsidiaries  | ** ** | **77,968** |       | 73,596     |       |
| Land held for sale           | ** ** | **1,298**  |       | 1,298      |       |
| Investment securities        | ** ** | **39**     |       |       |       |
| Other                        | ** ** | **2,969**  |       | 3,449      |       |
|                         | ** ** | ** ** |       |       |       |
|                         | ** ** | **$**      | **83,277** |       | $          | 80,900 |   |
|                         |       |       |       |       |       |
| Liabilities                  |       |       |       |       |       |
| Other borrowings             | ** ** | **$**      | **28,542** |       | $          | 28,603 |   |
| Other liabilities            | ** ** | **1,100**  |       | 648        |       |
|                         |       |       |       |       |       |
| Stockholders’  equity   | ** ** | **53,635** |       | 51,649     |       |
|                         | ** ** | ** ** |       |       |       |
|                         | ** ** | **$**      | **83,277** |       | $          | 80,900 |   |

 

Condensed Statements ofIncome

 
| ** **                                                           | ** ** | **2005**   | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------------------|------------|------------|------------|----------|------------|----------|------------|
|                                                                 |       |       |       |     |       |     |       |
| Dividends from  subsidiaries                                         | ** ** | **$**      | **3,716**  |     | $          | 2,575    |       | $ | 2,551 |   |
| Interest and  other income                                           | ** ** | **98**     |       | 52       |       | 80       |       |
| Income from  operations of discontinued segment, net of income taxes | ** ** | **—** |       | —   |       | 72       |       |
| Expenses                                                             | ** ** | **(2,207** | **)**      | (1,752   | )          | (1,415   | )          |
| Income tax  benefit                                                  | ** ** | **736**    |       | 568      |       | 546      |       |
| Equity in  undistributed income of subsidiaries                      | ** ** | **2,822**  |       | 3,773    |       | 3,141    |       |
|                                                                 | ** ** | ** ** |       |     |       |     |       |
| Net income                                                           | ** ** | **$**      | **5,165**  |     | $          | 5,216    |       | $ | 4,975 |   |

 

101

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CondensedCash Flows

 
| ** **                                                                        | ** ** | **2005**   | ** ** | **2004**   | ** ** | **2003** | ** ** |
|-----------------------------------------------------------------------------------|------------|------------|------------|------------|------------|----------|------------|
| Cash Flows From  Operating Activities                                             |       |       | ** ** |       |       |     |       |
| Net income                                                                        | ** ** | **$**      | **5,165**  | ** ** | $          | 5,216    |       | $ | 4,975 |   |
| Adjustments to reconcile net income to net cash  provided by operating activities | ** ** | ** ** | ** ** |       |       |     |       |
| Realized (gain) on sale of securities, net                                        | ** ** | **—** | ** ** | —     |       | (1       | )          |
| Amortization                                                                      | ** ** | **27**     | ** ** | 26         |       | 20       |       |
| Equity in (earnings) of subsidiaries                                              | ** ** | **(6,538** | **)**      | (6,348     | )          | (5,692   | )          |
| Cash dividends received from subsidiaries                                         | ** ** | **3,716**  | ** ** | 2,575      |       | 2,551    |       |
| Increase (decrease) in liabilities                                                | ** ** | **452**    | ** ** | 447        |       | (191     | )          |
| Other, net                                                                        | ** ** | **892**    | ** ** | (354       | )          | (335     | )          |
| Net cash provided by operating activities                                         | ** ** | **3,714**  | ** ** | 1,562      |       | 1,327    |       |
|                                                                              |       |       | ** ** |       |       |     |       |
| Cash Flows From  Investing Activities                                             |       |       | ** ** |       |       |     |       |
| Purchase of investment securities                                                 | ** ** | **40**     | ** ** | —     |       | —   |       |
| Disbursements on note receivable from HF Card                                     | ** ** | **—** | ** ** | —     |       | (2,476   | )          |
| Repayments on note receivable from HF Card                                        | ** ** | **—** | ** ** | —     |       | 225      |       |
| Proceeds from maturities and sales of securities                                  | ** ** | **—** | ** ** | —     |       | 283      |       |
| Capital contribution to the Bank                                                  | ** ** | **(2,000** | **)**      | —     |       | (9,000   | )          |
| Capital contribution to HF Group                                                  | ** ** | **—** | ** ** | —     |       | (600     | )          |
| Net cash (used in) investment activities                                          | ** ** | **(1,960** | **)**      | —     |       | (11,568  | )          |
|                                                                              |       |       | ** ** |       |       |     |       |
| Cash Flows From  Financing Activities                                             |       |       | ** ** |       |       |     |       |
| Purchase of treasury stock                                                        | ** ** | **(3,206** | **)**      | (1,862     | )          | (2,403   | )          |
| Cash dividends paid                                                               | ** ** | **(1,551** | **)**      | (1,530     | )          | (1,524   | )          |
| Proceeds from issuance of common stock                                            | ** ** | **1,512**  | ** ** | 1,153      |       | 513      |       |
| Proceeds from issuance of subordinated debentures                                 | ** ** | **—** | ** ** | 7,000      |       | 10,000   |       |
| Proceeds from other borrowings                                                    | ** ** | **—** | ** ** | —     |       | 4,500    |       |
| Payments on other borrowings                                                      | ** ** | **(60**    | **)**      | (4,338     | )          | (53      | )          |
| Payments of debt issue costs                                                      | ** ** | **(3**     | **)**      | (158       | )          | (300     | )          |
| Net cash provided by (used in) financial activities                               | ** ** | **(3,308** | **)**      | 265        |       | 10,733   |       |
|                                                                              |       |       | ** ** |       |       |     |       |
| Increase (decrease) in cash                                                       | ** ** | **(1,554** | **)**      | 1,827      |       | 492      |       |
|                                                                              |       |       | ** ** |       |       |     |       |
| Cash at  beginning of period                                                      | ** ** | **2,557**  | ** ** | 730        |       | 238      |       |
|                                                                              | ** ** | ** ** | ** ** |       |       |     |       |
| Cash at end of  period                                                            | ** ** | **$**      | **1,003**  | ** ** | $          | 2,557    |       | $ | 730 |   |

 

102

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**NOTE 23 -  QUARTERLY FINANCIAL INFORMATION (UNAUDITED)**

 

(Dollars inthousands except per share data)

 
| ** **                                  | ** ** | **1st  Quarter** | ** ** | **2nd  Quarter** | ** ** | **3rd  Quarter** | ** ** | **4th  Quarter** | ** ** |
|---------------------------------------------|------------|------------------|------------|------------------|------------|------------------|------------|------------------|------------|
| Fiscal Year 2005                            | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** | ** **       | ** ** |
|                                        |       |             |       |             |       |             |       |             |       |
| Total interest  income                      |       | $                | 10,690     |             | $          | 11,249           |       | $                | 10,990     |   | $ | 12,017 |   |
| Net interest  income                        |       | 6,540            |       | 6,804            |       | 6,282            |       | 6,573            |       |
| Provision for  losses on loans and leases   |       | 179              |       | 196              |       | 129              |       | 2,177            |       |
| Income from  continuing operations          |       | 1,460            |       | 1,648            |       | 1,344            |       | 713              |       |
| Income (loss)  from discontinued operations |       | —           |       | —           |       | —           |       | —           |       |
| Net income                                  |       | 1,460            |       | 1,648            |       | 1,344            |       | 713              |       |
|                                        |       |             |       |             |       |             |       |             |       |
| Earnings per  share - basic                 |       |             |       |             |       |             |       |             |       |
| Income from continuing operations           |       | $                | 0.41       |             | $          | 0.46             |       | $                | 0.38       |   | $ | 0.20 |   |
|                                        |       |             |       |             |       |             |       |             |       |
| Net income                                  |       | $                | 0.41       |             | $          | 0.46             |       | $                | 0.38       |   | $ | 0.20 |   |
|                                        |       |             |       |             |       |             |       |             |       |
| Earnings per  share - diluted               |       |             |       |             |       |             |       |             |       |
| Income from continuing operations           |       | $                | 0.41       |             | $          | 0.45             |       | $                | 0.37       |   | $ | 0.20 |   |
| Discontinued operations, net of tax         |       | —           |       | —           |       | —           |       | —           |       |
|                                        |       |             |       |             |       |             |       |             |       |
| Net income                                  |       | $                | 0.41       |             | $          | 0.45             |       | $                | 0.37       |   | $ | 0.20 |   |
|                                        |       |             |       |             |       |             |       |             |       |
| Fiscal Year 2004                            |       |             |       |             |       |             |       |             |       |
|                                        |       |             |       |             |       |             |       |             |       |
| Total interest  income                      |       | $                | 10,284     |             | $          | 9,844            |       | $                | 9,837      |   | $ | 10,295 |   |
| Net interest  income                        |       | 6,369            |       | 6,120            |       | 6,171            |       | 6,412            |       |
| Provision for  losses on loans and leases   |       | 437              |       | 634              |       | 607              |       | 342              |       |
| Income from continuing  operations          |       | 1,322            |       | 1,269            |       | 973              |       | 1,652            |       |
| Net income                                  |       | 1,322            |       | 1,269            |       | 973              |       | 1,652            |       |
|                                        |       |             |       |             |       |             |       |             |       |
| Earnings per  share - basic                 |       |             |       |             |       |             |       |             |       |
| Income from continuing operations           |       | $                | 0.41       |             | $          | 0.35             |       | $                | 0.27       |   | $ | 0.47 |   |
| Discontinued operations, net of tax         |       | —           |       | —           |       | —           |       | —           |       |
|                                        |       |             |       |             |       |             |       |             |       |
| Net income                                  |       | $                | 0.41       |             | $          | 0.35             |       | $                | 0.27       |   | $ | 0.47 |   |
|                                        |       |             |       |             |       |             |       |             |       |
| Earnings per  share - diluted               |       |             |       |             |       |             |       |             |       |
| Income from continuing operations           |       | $                | 0.40       |             | $          | 0.34             |       | $                | 0.26       |   | $ | 0.46 |   |
| Discontinued operations, net of tax         |       | —           |       | —           |       | —           |       | —           |       |
|                                        |       |             |       |             |       |             |       |             |       |
| Net income                                  |       | $                | 0.40       |             | $          | 0.34             |       | $                | 0.26       |   | $ | 0.46 |   |

 

103

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**Item9.  Changes in and Disagreements withAccountants on Accounting and Financial Disclosures**

 

Notapplicable.

 

**Item9A.  Controls and Procedures**

 

As of June 30,2005 an evaluation was performed by the Company’s management, including theCompany’s Chairman, President and Chief Executive Officer and the Company’sExecutive Vice President, Chief Financial Officer and Treasurer, of theeffectiveness of the design and operation of the Company’s disclosure controlsand procedures (as defined in Rules 13a-15(e) and 15d-15(e) underthe Exchange Act).  Based upon, and as ofthe date of that evaluation, the Company’s Chairman, President and ChiefExecutive Officer and the Company’s Executive Vice President, Chief FinancialOfficer and Treasurer concluded that the Company’s disclosure controls andprocedures were effective, 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.  There were no significantchanges in the Company’s internal control over financial reporting oridentified in the above-referenced evaluation that materially affected, or isreasonably likely to materially effect, the Company’s internal control overfinancial reporting.

 

**Item9B.  Other Information**

 

LetterAgreement dated June 1, 2005 between HF Financial Corp. and FirstTennessee Bank, NA which renews and increases the revolving line of credit to$6.0 million from $3.0 million. Additionally, the federal funds accommodation was increased to $15.0million from $10.0 million.  See Exhibit 10.17in this Form 10-K.

 

**PART III**

 

**Item10.  Directors and Executive Officersof the Registrant**

 

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

 

Informationregarding compliance with Section 16(a) of the Securities ExchangeAct of 1934, as amended, is incorporated by reference from the discussion underthe heading “Section 16(a) Beneficial Ownership Reporting Compliance”in the Company’s definitive Proxy Statement for the Annual Meeting ofStockholders to be held in 2005, a copy of which will be filed not later than120 days after June 30, 2005 (The “2005 Proxy Statement”).

 

**Codeof Ethics**

 

Informationregarding the Company’s Code of Conduct and Ethics is incorporated by referenceto the discussion under the heading “Code of Conduct and Ethics” in the Company’s2005 Proxy Statement.

 

**Directors**

 

Informationregarding Directors of the Company is incorporated by reference to thediscussion under the heading “Information with Respect to Nominees andContinuing Directors” in Proposal 1 of the Company’s 2005 Proxy Statement.

 

**AuditCommittee and Audit Committee Financial Expert**

 

Informationregarding the Company’s Audit Committee, including identification of eachcommittee member and the audit committee financial expert is incorporated byreference to the discussion under the heading :meetings of the Board ofDirectors, Compensation of Directors, Committees of the Board of Directors andIndependent Directors” in Proposal 1 of the Company’s 2005 Proxy Statement.

 

104

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**DirectorNominations**

 

Informationregarding material changes, if any, to the procedures by which the Company’sstockholders may recommend nominees to the Company’s Board of Directors isincorporated by reference to the discussion under the heading “DirectorNominations” in Proposal 1 of the Company’s 2005 Proxy Statement.

 

**ExecutiveOfficers**

 

Informationregarding the executive officers of the Company and the Bank is contained in Part I,Item 1 “Business” of this Form 10-K pursuant to Instruction 3 and Item 401(b) ofRegulation S-K, and is incorporated by reference.

 

**Item11.  Executive Compensation**

 

Informationconcerning executive compensation is incorporated by reference to thediscussion under the heading “Executive Compensation” in the Company’s 2005Proxy Statement.  Information containedunder the headings “Report of the Board Compensation Committee on ExecutiveCompensation” and “Stockholder Return Performance Presentation” is notincorporated herein.

 

**Item12.  Security Ownership of CertainBeneficial Owners and Management**

 

Informationconcerning security ownership of certain beneficial owners, directors andcertain executive officers is incorporated by reference from the discussionunder the heading “Security Ownership of Certain Beneficial Owners andManagement” in the Company’s 2005 Proxy Statement.

 

Thefollowing table sets forth certain information about the Company’s common stockthat may be issued upon exercise of options, warrants and rights under all ofthe Company’s existing equity compensation plans as of June 30, 2005,including the 1996 Director Restricted Stock Plan and 2002 Stock OptionPlan.  The 1991 Stock Option Plan expiredon October 27, 2002.  As a result, although the column below entitled“Number of Shares to be Issued Upon Exercise of Outstanding Options, Warrantsand Rights” includes common stock to be issued upon unexpired options issuedunder the 1991 Stock Option Plan, no common stock remains available for futureissuance under the 1991 Stock Option Plan.

 

**EquityCompensation 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     |       | 295,883                                                                                        |       | $                                                                                  | 13.44      |                                                                                                                                              | 673,211    |   |
|                                                         |       |                                                                                           |       |                                                                               |       |                                                                                                                                              |       |
| Equity plan compensation plans not approved by  stockholders |       | N/A                                                                                            |       | N/A                                                                                |       | N/A                                                                                                                                               |       |
|                                                         |       |                                                                                           |       |                                                                               |       |                                                                                                                                              |       |
| Total                                                        |       | 295,883                                                                                        |       | $                                                                                  | 13.44      |                                                                                                                                              | 673,211    |   |

 

**Item13.  Certain Relationships and RelatedTransactions**

 

Informationconcerning certain relationships and related transactions is incorporated byreference from the discussion under the heading “Executive Compensation –Certain Transactions” in the Company’s 2005 Proxy Statement.

 

**Item14.  Principal Accounting Fees andServices**

 

Informationconcerning the fees for professional services rendered by the Company’sprincipal accountant is incorporated by reference from the discussion under theheading “Executive Compensation – Report of the Audit

 

105

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Committee – Audit Fees,Audit Related Fees, Tax Fees and All Other Fees” in the Company’s 2005 ProxyStatement.  Information concerning thepre-approval policies and procedures of the Company’s Audit Committee isincorporated by reference from the discussion under the heading “AuditCommittee Pre-Approval Policies” in Proposal 1 of the Company’s 2005 ProxyStatement.

 

**PART IV**

 

**Item15.  Exhibits and Financial StatementSchedules**

 

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

 

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

 

(2)   Allsupplemental schedules are omitted because of the absence of conditions underwhich they are required or because the information is shown in the ConsolidatedFinancial Statements or notes thereto.**        **(3) Exhibits

 

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

 

106

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| 10.14 |   |   | Indenture Agreement  dated December 19, 2002, by and between HF Financial Corp. and  Wilmington Trust Company                                |   | (10)  |   |
|-------|--------|--------|---------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------|--------|
| 10.15 |   |   | Guarantee  Agreement dated September 25, 2003, by and between HF Financial Corp.  and Wilmington Trust Company                               |   | (11)  |   |
| 10.16 |   |   | Indenture  Agreement dated September 25, 2003, by and between HF Financial Corp.  and Wilmington Trust Company                               |   | (11)  |   |
| 10.17 |   |   | Letter Agreement  dated June 1, 2005 between HF Financial Corp. and First Tennessee Bank,  NA                                                |   | 10.17 |   |
| 10.18 |   |   | $3.0 Million  Promissory Note between HF Financial Corp. and First Tennessee Bank, NA                                                             |   | (12)  |   |
| 10.19 |   |   | HF Financial  Corp. 2002 Stock Option and Incentive Plan                                                                                          |   | (13)  |   |
| 10.20 |   |   | Real Estate  Purchase Agreement dated December 21, 2004 by and between HF Financial  Corp. and MVB Properties, Inc.                     |   | (15)  |   |
| 10.21 |   |   | Home Federal  Bank Short Term Incentive Plan                                                                                                      |   | (16)# |   |
| 10.22 |   |   | Home Federal  Bank Third Amended and Restated Long-Term Incentive Plan                                                                            |   | (16)# |   |
| 21.1  |   |   | Subsidiaries of  Registrant                                                                                                                       |   | 21.1  |   |
| 23.1  |   |   | Consent of  Independent Registered Accounting Firm                                                                                                |   | 23.1  |   |
| 23.2  |   |   | Consent of  Independent Registered Accounting Firm                                                                                                |   | 23.2  |   |
| 31.1  |   |   | Certification of  Chairman, President and Chief Executive Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002                 |   | 31.1  |   |
| 31.2  |   |   | Certification of  Executive Vice President, Chief Financial Officer and Treasurer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |   | 31.2  |   |
| 32.1  |   |   | Certification of  Chairman, President and Chief Executive Officer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                 |   | 32.1  |   |
| 32.2  |   |   | Certification of  Executive Vice President, Chief Financial Officer and Treasurer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |   | 32.2  |   |

 

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| (1)  | Filed as  exhibits to the Company’s Registration Statement on Form S-1 filed with  the SEC on December 6, 1991 (File No. 33-44383). |
|------|---------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2)  | Filed as an  exhibit to the Company’s Annual Report on Form 10-K for the fiscal year  ended June 30, 1993.                               |
| (3)  | Filed as  exhibits to the Company’s Annual Report on Form 10-K for the fiscal year  ended June 30, 1996.                                 |
| (4)  | Filed as an  exhibit to the Company’s Registration Statement on Form 8-A, filed with  the SEC on October 29, 1996.                       |
| (5)  | Filed as  exhibits to the Company’s Annual Report on Form 10-K for the fiscal year  ended June 30, 1997.                                 |
| (6)  | Filed as  exhibits to the Company’s Annual Report on Form 10-K for the fiscal year  ended June 30, 1998.                                 |
| (7)  | Filed as  exhibits to the Company’s Annual Report on Form 10-K for the fiscal year  ended June 30, 2001.                                 |
| (8)  | Filed as  exhibits to the Company’s Quarterly Report on Form 10-Q for the quarter  ended December 31, 2001.                              |
| (9)  | Filed as  exhibits to the Company’s Quarterly Report on Form 10-Q for the quarter  ended September 30, 2002.                             |
| (10) | Filed as  exhibits to the Company’s Quarterly Report on Form 10-Q for the quarter  ended December 31, 2002.                              |
| (11) | Filed as  exhibits to the Company’s Quarterly Report on Form 10-Q for the quarter  ended September 30, 2003.                             |
| (12) | Filed as  exhibits to the Company’s Annual Report on Form 10-K for the fiscal year  ended June 30, 2003.                                 |
| (13) | Filed as  Appendix A to the Company’s definitive Proxy Statement on Schedule 14A,  filed with the SEC on October 15, 2002.               |
| (14) | Filed as an  exhibit to the Company’s Annual Report on Form 10-K for the fiscal year  ended June 30, 2004.                               |
| (15) | Filed as an  exhibit to the Company’s Quarterly Report on Form 10-Q for the quarter  ended December 31, 2004.                            |
| (16) | Filed as an  exhibit to the Company’s Current Report on Form 8-K dated July 26,  2005, and filed with the SEC on August 1, 2005.    |
| #    | Management or  compensatory plan or arrangements required to be filed.                                                                                  |

 

All ofsuch previously filed documents are hereby incorporated in this Annual Reporton Form 10-K by reference in accordance with Item 601 of RegulationS-K.

 

107

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**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned, thereunto duly authorized.

 

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

 

Pursuantto the requirements of the Securities Exchange Act of 1934, this report hasbeen signed below by the following persons in the capacities and on the datesindicated.

 

 
|   /s/  Curtis L. Hage                                                                                   |                     |   /s/  Darrel L. Posegate                                                                                                    |
|-------------------------------------------------------------------------------------------------------------------|--------------------------|----------------------------------------------------------------------------------------------------------------------------------------|
| Curtis L. Hage,  Chairman, President and  Chief Executive Officer *(Principal  Executive and  Operating Officer)* |                     | Darrel L.  Posegate, Executive Vice President, Chief  Financial Officer and Treasurer *(Principal  Financial  and Accounting Officer)* |
|                                                                                                              |                     |                                                                                                                                   |
|                                                                                                              |                     |                                                                                                                                   |
| Date:                                                                                                             | September 26,  2005 |                                                                                                                                   | Date: | September 26,  2005 |
|                                                                                                              |                     |                                                                                                                                   |   |   |
|                                                                                                              |                     |                                                                                                                                   |   |   |
|   /s/  Thomas L. Van Wyhe                                                                               |                     |   /s/  Robert L. Hanson                                                                                                      |
| Thomas L. Van  Wyhe, Director                                                                                     |                     | Robert L.  Hanson, Director                                                                                                            |
|                                                                                                              |                     |                                                                                                                                   |
|                                                                                                              |                     |                                                                                                                                   |
| Date:                                                                                                             | September 26,  2005 |                                                                                                                                   | Date: | September 26,  2005 |
|                                                                                                              |                     |                                                                                                                                   |
|                                                                                                              |                     |                                                                                                                                   |
|   /s/  Steven R. Sershen                                                                                |                     |   /s/  William G. Pederson                                                                                                   |
| Steven R.  Sershen, Director                                                                                      |                     | William. G.  Pederson, Director                                                                                                        |
|                                                                                                              |                     |                                                                                                                                   |
| Date:                                                                                                             | September 26,  2005 |                                                                                                                                   | Date: | September 26,  2005 |
|                                                                                                              |                     |                                                                                                                                   |
|                                                                                                              |                     |                                                                                                                                   |
|   /s/  Curtis J. Bernard                                                                                |                     |                                                                                                                                   |
| Curtis J. Bernard,  Director                                                                                      |                     | Christine E. Hamilton,  Director                                                                                                       |
|                                                                                                              |                     |                                                                                                                                   |
|                                                                                                              |                     |                                                                                                                                   |
| Date:                                                                                                             | September 26,  2005 |                                                                                                                                   | Date: |   |

 

108

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**Index to Exhibits**

 
| **Exhibit  Number** | ** ** | ** **                                                                                                                                        |
|---------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                              |
| 10.17               |       | Letter Agreement  dated June 1, 2005 between HF Financial Corp. and First Tennessee Bank,  NA                                                |
|                |       |                                                                                                                                              |
| 21.1                |       | Subsidiaries of  Registrant                                                                                                                       |
|                |       |                                                                                                                                              |
| 23.1                |       | Consent of  Independent Registered Public Accounting Firm                                                                                         |
|                |       |                                                                                                                                              |
| 23.2                |       | Consent of  Independent Registered Public Accounting Firm                                                                                         |
|                |       |                                                                                                                                              |
| 31.1                |       | Certification of  Chairman, President and Chief Executive Officer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002                 |
|                |       |                                                                                                                                              |
| 31.2                |       | Certification of  Executive Vice President, Chief Financial Officer and Treasurer Pursuant to Section 302  of the Sarbanes-Oxley Act of 2002 |
|                |       |                                                                                                                                              |
| 32.1                |       | Certification of  Chairman, President and Chief Executive Officer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002                 |
|                |       |                                                                                                                                              |
| 32.2                |       | Certification of  Executive Vice President, Chief Financial Officer and Treasurer Pursuant to Section 906  of the Sarbanes-Oxley Act of 2002 |

 

109

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