The following table shows, at September 30, 2002, the dollar amount of adjustable-rate loans and fixed-rate loans in the Company's portfolio based on their contractual terms to maturity. The amounts in the table do not include adjustments for deferred loan fees and discounts or allowances for loan losses. Demand loans, loans having no stated schedule of repayments and no stated maturity, and overdrafts are reported as due in one year or less. Contractual principal repayments of loans do not necessarily reflect the actual term of the Company's loan portfolios. The average life of mortgage loans is substantially less than their contractual terms because of loan prepayments and because of enforcement of due-on-sale clauses, which gives the Company the right to declare a loan immediately due and payable if, among other things, the borrower sells the real property subject to the mortgage. The average life of mortgage loans tends to increase when current market rates on mortgage loans substantially exceed rates on existing mortgage loans. Correspondingly, when market rates on mortgages decline below rates on existing mortgage loans, the average life of these loans tends to be reduced.

 

Consolidated		Within One Year	Over One to Two Years	Over Two to Three Years	Over Three to Five Years	Over Five to Ten Years	Over Ten to Fifteen Years	Over Fifteen Years	Total
		(in thousands)
Real estate mortgages:
	Adjustable-rate	$   12,170	$     3,984	$      1,015	$      5,833	$     25,366	$     88,664	$     688,987	$    826,019
	Fixed-rate	47,177	27,053	18,845	42,130	74,310	132,331	284,500	626,346
Consumer loans:
	Adjustable-rate	157,041	131	240	574	1,436	667	-	160,089
	Fixed-rate	24,412	8,220	14,188	21,934	36,825	19,490	88,549	213,618
Commercial business loans:
	Adjustable-rate	49,473	4,330	4,084	6,464	663	-	-	65,014
	Fixed-rate	24,138	7,591	7,516	10,153	272	-	-	49,670
Total		$  314,411	$    51,309	$    45,888	$    87,088	$  138,872	$   241,152	$ 1,062,036	$ 1,940,756

 

 

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Residential Mortgage Lending

 

At September 30, 2002, the Company's real estate loans totaled approximately $1.5 billion, or 76.6% of net loans receivable. One- to four-family residential mortgage loans totaled $1.2 billion, or 82.7% of the Company's real estate loans and 63.4% of total net loans receivable. The Company offers adjustable-rate mortgage loans ("ARMs") and fixed-rate mortgage loans with terms generally ranging from 10 years to 30 years.

 

The ARMs currently offered by the Company have up to 30-year terms and interest rates which adjust annually or adjust annually after being fixed for a period of three, five or seven years in accordance with a designated index. ARMs may be originated with a 1% or 2% cap on any increase or decrease in the interest rate per year, with a 4%, 5% or 6% limit on the amount by which the interest rate can increase or decrease over the life of the loan.

 

The Company emphasizes the origination of ARMs rather than long-term, fixed-rate mortgage loans for inclusion in its loan portfolios. In order to encourage the origination of ARMs with interest rates which adjust annually, the Company, like many of its competitors, may offer a rate of interest on such loans below the fully-indexed rate for the initial period of the loan. These loans are underwritten on the basis of the fully-indexed rate. The Company presently offers single-family ARMs indexed to the one-year constant maturity treasury index. While these loans are expected to adjust more quickly to changes in market interest rates, they may not adjust as rapidly as changes occur in the Company's cost of funds.

 

The Company originates residential mortgage loans with loan-to-value ratios up to 95%. Generally, on mortgage loans exceeding an 80% loan-to-value ratio, the Company requires private mortgage insurance which protects the Company against losses of at least 20% of the mortgage loan amount. All property securing real estate loans made by the Company is appraised either by appraisers employed by the Company or by independent appraisers selected by the Company. Loans are usually made pursuant to certain guidelines which will permit the sale of these loans in the secondary market.

 

The Company offers various other residential lending programs, including bi-weekly mortgage loans and two-step mortgage loans originated principally for first-time homebuyers. The Company also offers, as part of its Community Reinvestment Act program, more flexible underwriting criteria to broaden the availability of mortgage loans in the communities it serves.

 

The majority of the Company's residential construction loans are made to finance the construction of individual owner-occupied houses with up to 90% loan-to-value ratios. Residential construction loans totaled $64.2 million at September 30, 2002. These construction loans are generally structured to be converted to permanent loans at the end of the construction phase. Loan proceeds are disbursed in increments as construction progresses and as inspections warrant. As part of its residential lending program, the Company also offers construction loans with 75% loan-to-value ratios to qualified builders. These construction loans are generally at a competitive fixed rate of interest for one- or two-year periods. The Company also offers lot loans intended for residential use, which may be on a fixed-rate or adjustable-rate basis.

 

Commercial Real Estate, Multi-family and Land Lending

 

At September 30, 2002, the Company's commercial real estate portfolio totaled $140.0 million, or 7.3% of total net loans. Its multi-family portfolio totaled $39.3 million, or 2.0% of total net loans. Loans made with land as security totaled $76.5 million, or 4.0% of total net loans. In recent years the Company has limited growth in loans made on commercial real estate, multi-family properties and on land acquisition and development projects and placed greater emphasis on single-family real estate lending.

 

Interest rates charged on permanent commercial real estate loans are determined by market conditions existing at the time of the loan commitment. Generally, the loans are adjustable in interest and the rate is fixed for three to five years determined by market conditions, collateral and the relationship with the borrower. The amortization of the loans may vary but will not exceed 20 years. In the past, the Company originated a substantial portion of its commercial real estate loans at rates generally two to three percentage points above its prevailing cost of funds. As these loans reach call or loan review dates or refinance, it is the Company's current policy to negotiate most of these 

 

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loans to new terms based either on the prime lending rate as the interest rate index or to fix the rate of interest for a three year to five year period.

 

Commercial and multi-family mortgage lending generally involves greater risk than single-family lending. Such lending typically involves larger loan balances to single borrowers or groups of related borrowers than single-family lending. Furthermore, the repayment of loans secured by income-producing properties is typically dependent upon the successful operation of the related real estate project. If the cash flow from the property is reduced (for example, if leases are not obtained or renewed), the borrower's ability to repay the Company's loans may be impaired. These risks can be affected significantly by supply and demand in the market for the type of property securing the loan and by general economic conditions. Thus, commercial and multi-family loans may be subject, to a greater extent than single-family property loans, to adverse conditions in the economy.

 

Consumer Lending

 

Federal regulations permit the Company to make secured and unsecured consumer loans up to 35% of assets. In addition, the Association had lending authority above the 35% category for certain consumer loans, such as home equity loans, property improvement loans, mobile home loans and loans secured by savings accounts. The Company's consumer loans totaled $373.7 million at September 30, 2002, or 19.4% of net loans receivable. The largest component of consumer lending is comprised of single-family home equity lines of credit and other equity loans, currently totaling $157.5 million, or 42.1% of all consumer loans. Mobile home loans comprise $111.8 million, or 29.9% of consumer loans. Other consumer loans primarily consist of loans secured by boats, automobiles and credit cards.

 

Commercial Business Lending

 

The Company is permitted under federal law to make secured or unsecured loans for commercial, corporate business and agricultural purposes including issuing letters of credit. The aggregate amount of such loans outstanding generally may not exceed 20% of an institution's assets, provided that amounts in excess of 10% of total assets may be used only for small business loans.

 

The Company's commercial business loans are generally made on a secured basis with terms that usually do not exceed five years. Most of the Company's commercial business loans to date have interest rates that change at periods ranging from 30 days to one year based on the Company's prime lending rate. Some loans have fixed interest rates determined at the time of commitment. At September 30, 2002, the Company's commercial business loans outstanding were $114.7 million, which represented 6.0% of total net loans receivable.

 

Loan Sales and Servicing

 

While the Company originates adjustable-rate loans for its own portfolio, fixed-rate loans are generally made on terms that will permit their sale in the secondary market. The Company participates in secondary market activities by selling whole loans and participations in loans to the Federal Home Loan Bank ("FHLB") of Atlanta, the Federal National Mortgage Association ("FNMA"), the Federal Home Loan Mortgage Corporation ("FHLMC"), as well as other institutional investors. This practice enables the Company to satisfy the demand for such loans in its local communities, to meet asset and liability objectives of management and to develop a source of fee income through loan servicing. At September 30, 2002, the Company was servicing loans for others in the amount of $877.5 million.

 

Based on the current level of market interest rates and other factors, the Company presently intends to sell selected current originations of conforming 30-year and 15-year conventional fixed-rate mortgage loans. The Company's policy with respect to the sale of fixed-rate loans is dependent to a large extent on the general level of market interest rates. Sales of fixed-rate residential loans totaled $353.7 million in fiscal 2002, $237.1 million in fiscal 2001 and $48.4 million in fiscal 2000.

 

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Risk Factors

 

Certain risks are inherent with loan portfolios containing commercial real estate, multi-family, commercial business and consumer loans. While these types of loans provide benefits to the Company's asset/liability management programs and reduce exposure to interest rate changes, such loans may entail significant additional credit risks compared to residential mortgage lending. Commercial real estate and multi-family loans may involve large loan balances to single borrowers or groups of related borrowers. In addition, the payment experience on loans secured by income-producing properties is typically dependent on the successful operation of the properties and thus may be subject to a greater extent to adverse conditions in the local or regional real estate market or in the general economy.

 

Commercial business lending generally involves greater risk than residential mortgage lending and involves risks that are different from those associated with residential, commercial and multi-family real estate lending. Real estate lending is generally considered to be collateral based lending with loan amounts based on predetermined loan to collateral values and liquidation of the underlying real estate collateral is viewed as the primary source of repayment in the event of borrower default. Although commercial business loans are often collateralized by equipment, inventory, accounts receivable or other business assets, the liquidation of collateral in the event of a borrower default is often not a sufficient source of repayment because accounts receivable may be uncollectible, and inventories and equipment may be obsolete or of limited use, among other things. Accordingly, the repayment of a commercial business loan depends primarily on the cred itworthiness of the borrower (and any guarantors), while liquidation of collateral is a secondary and often insufficient source of repayment.

 

Construction loans also involve additional risks because loan funds are advanced upon the security of the project under construction.

 

Consumer loans entail greater risk than do residential mortgage loans, particularly in the case of loans that are unsecured or secured by rapidly depreciating assets such as automobiles and other vehicles. In such cases, any repossessed collateral for a defaulted consumer loan may not provide an adequate source of repayment of the outstanding loan balance as a result of the greater likelihood of damage, loss or depreciation. The remaining deficiency often does not warrant further substantial collection efforts against the borrower beyond obtaining a deficiency judgment. In addition, consumer loan collections are dependent on the borrower's continuing financial stability, and thus are more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. Furthermore, the application of various federal and state laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on such lo ans.

 

Mobile home lending involves additional risks due to higher loan to value ratios usually associated with such loans. Mobile home lending may also involve higher loan amounts than other types of consumer loans. Mobile home loan customers have historically been more adversely impacted by weak economic conditions, loss of employment and increases in other household costs. In addition, the values of mobile homes decline over time and higher levels of inventories of repossessed and used mobile homes may affect the values of collateral and result in higher charge-offs and provisions for loan losses.

 

All of the above risk factors are present in the Company's loan portfolio and could have an impact on future delinquency and charge-off rates and levels.

 

Limits on Loan Concentrations

 

The Association's permissible lending limits for loans to one borrower is the greater of $500,000, or 15% of unimpaired capital and surplus (except for loans fully secured by certain readily marketable collateral, in which case this limit is increased to 25% of unimpaired capital and surplus). At September 30, 2002, First Federal's lending limits under this restriction was $27.3 million. A broader limitation (the lesser of $30 million, or 30% of unimpaired capital and surplus) is provided under certain circumstances and subject to OTS approval for loans to develop domestic residential housing units. In addition, the Association may provide purchase money financing for the sale of any asset without regard to the loans to one borrower limitation so long as no new funds are advanced and the Association is not placed in a more detrimental position than if it had held the asset. At September 30, 2002, the largest aggregate amount of loans by First Fed eral to any one borrower, including related entities, was

 

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approximately $15.5 million. All of these loans were performing according to their respective terms at September 30, 2002.

 

Delinquencies and Nonperforming Assets

 

Delinquent and problem loans are a normal part of any lending activity. When a borrower fails to make a required payment on a loan, the Company attempts to cure the default by contacting the borrower. The Company contacts the borrower after a payment is past due less than 20 days, and a late charge is assessed on the loan. In most cases, defaults are cured promptly. If the delinquency on a mortgage loan continues 60 to 90 days and is not cured through normal collection procedures or an acceptable arrangement is not worked out with the borrower, the Company will institute measures to remedy the default, including commencing a foreclosure action. The Company may accept voluntary deeds of the secured property in lieu of foreclosure.

 

The Company's mortgage loans are generally secured by the use of a mortgage instrument. Notice of default under these loans is required to be recorded and mailed. If the default is not cured within three months, a notice of sale is posted, mailed and advertised, and a sale is then conducted.

 

Real estate acquired by the Company as a result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until it is sold. When property is acquired, it is recorded at the lower of cost or estimated fair value less cost to sell at the date of acquisition, and any resulting write-down is charged to the allowance for losses. Generally, interest accrual on a loan ceases when the loan becomes 90 days delinquent.

 

OTS Asset Classification System

 

OTS regulations include a classification system for problem assets. Under this classification system, problem assets for insured institutions are classified as "substandard," "doubtful" or "loss," depending on the presence of certain characteristics discussed below.

 

An asset is considered "substandard" if inadequately protected by the current net worth and paying capacity of the obligor or of the collateral pledged, if any. "Substandard" assets include those assets characterized by the "distinct possibility" that the institution will sustain "some loss" if the deficiencies are not corrected. Assets classified as "doubtful" have all of the weaknesses inherent in those classified "substandard" with the added characteristic that the weaknesses present make "collection or liquidation in full," on the basis of currently existing facts, conditions, and values, "highly questionable and improbable." Assets classified "loss" are those considered "uncollectible" and of such little value that continuance as assets without the establishment of a specific loss reserve is not warranted.

 

When an institution classifies problem assets as either substandard or doubtful, it is required to establish general allowances for loan losses in an amount deemed prudent by management. General allowances represent loss allowances which have been established to recognize the inherent risks associated with lending activities, but which, unlike specific allowances, have not been allocated to particular problem assets. When an institution classifies problem assets as "loss," it is required either to establish a specific allowance for losses equal to 100% of the amount of the asset so classified or to charge off such amount. An institution's determination as to the classification of its assets and the amount of its valuation allowances is subject to review by the OTS, which can order the establishment of additional general or specific loss allowances. The Company has classified $16.2 million in assets as substandard as of September 30, 2002 .

 

The OTS classification of assets regulation also provides for a "special mention" designation, in addition to the "substandard," "doubtful" and "loss" classifications. "Special mention" assets are defined as those that do not currently expose an institution to a sufficient degree of risk to warrant classification as either "substandard," "doubtful" or "loss" but do possess credit deficiencies or potential weaknesses deserving management's close attention which, if not corrected, could weaken the asset and increase such risk in the future. The Company had $8.6 million of assets designated "special mention," $430 thousand of assets designated as "doubtful" and $323 thousand of assets designated as "loss" as of September 30, 2002.

 

 

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Management periodically reviews its loan portfolio, and has, in the opinion of management, appropriately classified and established allowances against all assets requiring classification under the regulation.

 

For further discussion of the Company's problem assets, see Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations - -- Financial Position - - Asset Quality," and Note 6 of Notes to Consolidated Financial Statements contained in Item 8 herein.

 

INVESTMENT ACTIVITIES

 

The Association is required under federal regulations to maintain adequate liquidity to ensure safe-and-sound operations. Investment decisions are made by authorized officers of the Company and the Association within policies established by the Company's and the Association's Boards of Directors.

 

At September 30, 2002, the Company's investment and mortgage-backed securities portfolio totaled approximately $170.6 million, which included stock in the FHLB of Atlanta of $29.8 million. Investment securities include U.S. Government and agency obligations, corporate bonds and mutual funds approximating $7.3 million. Mortgage-backed securities totaled $133.6 million as of September 30, 2002. See Note 1 of Notes to Consolidated Financial Statements, contained in Item 8 herein for a discussion of the Company's accounting policy for investment and mortgage-backed securities. See Notes 3 and 4 of Notes to Consolidated Financial Statements for additional information regarding investment and mortgage-backed securities and FHLB of Atlanta stock.

 

Objectives of the investment policies of the Company are achieved through investing in U.S. Government, federal agency, corporate debt securities, mortgage-backed securities, short-term money market instruments, mutual funds, loans and other investments as authorized by OTS regulations and specifically approved by the Boards of Directors of the Company and the Association. Investment portfolio guidelines specifically identify those securities eligible for purchase and describe the operations and reporting requirements of the Investment Committee which executes investment policy. The primary objective of the Company in its management of the investment portfolio is to maintain a portfolio of high quality, highly liquid investments with returns competitive with short-term treasury or agency securities and highly rated corporate securities.

 

As a member of the FHLB System, the Association is required to maintain an investment in the common stock of the FHLB of Atlanta. See "Regulation -- Federal Regulation of Savings Associations -- Federal Home Loan Bank System." The stock of the FHLB of Atlanta is redeemable at par value.

 

Securities may differ in terms of default risk, interest risk, liquidity risk and expected rate of return. Default risk is the risk that an issuer will be unable to make interest payments, or to repay the principal amount on schedule. The Company primarily invests in U.S. Government and federal agency obligations. U.S. Government obligations are regarded as free of default risk. The issues of most government agencies are backed by the strength of the agency itself plus a strong implication that in the event of financial difficulty the agency would be assisted by the federal government. The credit quality of corporate debt varies widely. The Company only invests in corporate debt securities rated in one of the three highest categories by two nationally recognized investment rating services.

 

The Company's investment in mortgage-backed securities serves several primary functions. First, the Company has securitized whole loans for mortgage-backed securities issued by federal agencies to use as collateral for certain of its borrowings and to secure public agency deposits. Second, the Company previously securitized loans with federal agencies to reduce its credit risk exposure and to reduce regulatory risk-based capital requirements. Third, the Company acquires mortgage-backed securities from time to time to meet earning asset growth objectives and provide additional interest income when necessary to augment lower loan originations and replace loan portfolio runoff.

 

The following tables set forth the carrying value of the Company's investment and mortgage-backed securities portfolio (excluding stock in the FHLB of Atlanta), maturities and average yields at September 30, 2002. The fair value of the Company's investment and mortgage-backed securities portfolio (excluding stock in the FHLB of Atlanta) was $140.9 million on September 30, 2002.

 

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Investment and Mortgage-backed Securities Portfolio
				As of September 30,
				2002			2001		2000
				Amortized Cost	Fair		Amortized Cost	Fair	Amortized Cost	Fair
					Value			Value		Value
Securities Held to Maturity:				(in thousands)
State and local government obligations				$         -	$         -		$         -	$         -	$      249	$       255
Mortgage-backed securities				-	-		-	-	19	21
Total securities held to maturity				$         -	$         -		$         -	$         -	$       268	$       276
				As of September 30,
				2002			2001		2000
				Amortized Cost	Fair		Amortized Cost	Fair	Amortized Cost	Fair
					Value			Value		Value
Securities Available for Sale:				(in thousands)
U.S. Treasury and U.S. Government
	agencies and corporations			$    2,246	$    2,281		$ 2,251	$ 2,264	$ 3,241	$ 3,247
Corporate debt and other securities				4,278	4,174		2,499	2,440	2,331	2,301
Mutual funds				830	830		1,555	1,555	370	370
Mortgage-backed securities				129,855	133,568		203,397	208,153	249,450	247,076
	Total securities available for sale			$ 137,209	$ 140,853		$ 209,702	$ 214,412	$ 255,392	$ 252,994
Maturity and Yield Schedule as of September 30, 2002
				Amortized Cost	Weighted Average Yield
			(dollar amounts in thousands)
U.S. Treasury and U.S. Government agencies and corporations:
	After 1 but within 5 years			$     2,246	2.87%
				2,246	2.87
Corporate debt and other securities:
	Within 1 year			775	-
	After 1 but within 5 years			987	2.66
	After 5 but within 10 years			249	6.98
	After 10 years			2,267	2.83
				4,278	2.52
Mutual funds
	Within 1 year			830	1.85
				830	1.85
Mortgage-backed securities
	Within 1 year			288	7.02
	After 1 but within 5 years			2,334	5.98
	After 5 but within 10 years			12,685	5.92
	After 10 years			114,548	5.40
				129,855	5.46
				$ 137,209	5.31%

 

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INSURANCE ACTIVITIES

 

FSIns. and its subsidiaries, Kinghorn Insurance Services, Johnson Insurance and Benefit Administrators, operate as an independent insurance agency and brokerage headquartered in Charleston, South Carolina. FSIns. operates through nine offices, six located throughout the coastal region of South Carolina, two offices in Florence County, South Carolina, and one office in Columbia, South Carolina. Total revenues for fiscal 2002 were $9.6 million and consist principally of commissions paid by insurance companies. Commission income also includes contingency commissions, which is income received from insurance companies based on the growth, volume or profitability of insurance policies written with companies in prior periods. Substantially all contingency income, which totaled $1.3 million in fiscal 2002, is received in the first calendar quarter of each year.

 

Commission revenues are subject to fluctuations based on the premium rates established by insurance companies. Contingency commissions can also be significantly affected by the loss experience of FSIns.' customers. In the recent past, reacting to higher loss ratios, the increased cost of litigation and insurance awards, and the cost of reinsurance, many insurance companies have increased premium rates. Additionally, the willingness of insurance companies to write business and homeowners property insurance in coastal market places, the renewal of business with existing customers, and economic and competitive market conditions also may impact the revenues of FSIns.

 

Through its relationship, First Federal markets FSIns.'s insurance products and services to First Federal customers. Additionally, First Federal employees refer retail and business customers to FSIns. for their insurance needs.

 

SOURCES OF FUNDS

 

Deposits have historically been the primary source of funds for lending and investing activities. The amortization and scheduled payment of loans and mortgage-backed securities and maturities of investment securities provide a stable source of funds, while deposit fluctuations and loan prepayments are significantly influenced by the overall interest rate environment and other market conditions. FHLB advances and short-term borrowings provide supplemental liquidity sources based on specific needs or if management determines that these are the best sources of funds to meet current requirements.

 

Deposits

 

The Company offers a number of deposit accounts including noninterest-bearing checking accounts, interest-bearing checking accounts, savings accounts, money market accounts, Individual Retirement Accounts ("IRA") and certificate accounts which generally range in maturity from three months to five years. Deposit account terms vary, with the principal differences being the minimum balance required, the time period the funds must remain on deposit and the interest rate. For a schedule of the dollar amounts in each major category of the Company's deposit accounts, see Note 10 of Notes to Consolidated Financial Statements contained in Item 8 herein.

 

The Association is subject to fluctuations in deposit flows because of the influence of general interest rates, money market conditions and competitive factors. The Asset and Liability Committee of the Association meets frequently and makes changes relative to the mix, maturity and pricing of assets and liabilities in order to minimize the impact on earnings from such external conditions. Deposits are attractive sources of liquidity because of their stability, generally lower cost than other funding and the ability to provide fee income through service charges and cross-sales of other services.

 

The Association's deposits are obtained primarily from residents of South Carolina. Management estimates that less than 3% of deposits at September 30, 2002, are obtained from customers residing outside of its market area in South Carolina and North Carolina. The principal methods used by the Company to attract deposit accounts include the offering of a wide variety of services and accounts, competitive interest rates, and convenient office locations and service hours. The Company utilizes traditional marketing methods to attract new customers and savings deposits, including mass media advertising and direct mail. The Company also provides customers with access to the convenience of automated teller machines ("ATMs") through a proprietary ATM network and access to regional and national ATM networks. The Company also provides access through telephone voice response systems and through Internet banking. Management believes the Company enjoys an excelle nt reputation for providing products and services to meet the needs of market segments, such as seniors. For example, 50-Plus Club members benefit 

 

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from a number of advantageous programs, such as exclusive travel packages, special events and classic movies. The Company also emphasizes the promotion of savings programs for children and teens.

 

Jumbo Certificates of Deposit

 

The Company does not rely significantly on large denomination time deposits. The following table indicates the amount of the Company's jumbo certificates of deposit by time remaining until maturity as of September 30, 2002. Jumbo certificates of deposit require minimum deposits of $100,000 and have negotiable interest rates.

 

Maturity Period		At September 30, 2002
		(in thousands)
Three months or less			$  22,818
Over three through six months			13,105
Over six through twelve months			11,085
Over twelve months			2,571
Total			$  49,579

Borrowings

 

The Company relies upon advances from the FHLB of Atlanta to supplement its supply of lendable funds and to meet deposit withdrawal requirements. The FHLB of Atlanta serves as the Company's primary borrowing source. Advances from the FHLB of Atlanta are typically secured by the Company's stock in the FHLB of Atlanta and a portion of the Company's first mortgage loans. Interest rates on advances vary from time to time in response to general economic conditions. Advances must be fully collateralized and limits are established for the Association. Currently the Association has been granted an advance limit of 35% of assets by the FHLB of Atlanta.

 

At September 30, 2002, the Company had advances totaling $577 million from the FHLB of Atlanta at an average rate of 4.99%. At September 30, 2002, the maturity of the Association's FHLB advances ranged from one to eight years.

 

For more information on borrowings, see Note 11 of Notes to Consolidated Financial Statements contained in Item 8 herein.

 

During 1998, the Company entered into a loan agreement with another bank for a $25.0 million funding line. The rate on the funding line is based on LIBOR. During fiscal 2000, the line was increased to $35.0 million. At September 30, 2002, $26.8 million was outstanding under this agreement with a weighted average rate of 3.82%. The loan is subject to a 10% principal reduction annually beginning in September 2003, with a final maturity of September 2012. Other borrowings at September 30, 2002 also include loans totaling $157,000 with another bank secured by vehicles.

 

The following table sets forth certain information regarding short-term borrowings by the Company at the end of and during the periods indicated:

 

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			At or For the Year Ended September 30,
			2002		2001		2000
			(dollar amounts in thousands)
Weighted Average Rate Paid On (at end of period):
		FHLB advances	4.99%		4.90%		6.38%
		Securities sold under agreements to repurchase	-		3.66		6.73
		Bank line of credit	3.82		5.58		8.63
Maximum Amount of Borrowings Outstanding (during period):
		FHLB advances	$ 701,000		$ 803,500		$ 795,500
		Securities sold under agreements to repurchase	66,316		99,210		73,943
		Bank line of credit	26,750		23,750		12,250
Approximate Average Amount of Short-term Borrowings
	With Respect To:
		FHLB advances	633,553		728,100		706,551
		Securities sold under agreements to repurchase	5,434		66,385		57,138
		Bank line of credit	23,758		17,928		9,645
Approximate Weighted Average Rate Paid On (during period):
		FHLB advances	4.70%		5.75%		6.10%
		Securities sold under agreements to repurchase	2.92		5.31		6.26
		Bank line of credit	4.12		7.04		8.35

 

 

ASSET AND LIABILITY MANAGEMENT

 

Market Risk

 

Market risk is the risk of economic loss resulting from adverse changes in market prices and rates. This risk of loss can be reflected in either diminished current market values or reduced potential net interest income in future periods. The Company's market risk arises principally from interest rate risk inherent in its lending, deposit and borrowing activities. Management actively monitors and manages its interest rate risk exposure. Although the Company manages other risks, as in credit quality and liquidity risk, in the normal course of business, management considers interest rate risk to be its most significant market risk and could potentially have the largest material effect on the Company's financial condition and results of operations. Other types of market risks, such as foreign currency exchange rate risk and commodity price risk, do not arise in the normal course of the Company's business activities.

 

The Company's profitability is affected by fluctuations in interest rates. Management's goal is to maintain a reasonable balance between exposure to interest rate fluctuations and earnings. A sudden and substantial increase in interest rates may adversely impact the Company's earnings to the extent that the interest rates on interest-earning assets and interest-bearing liabilities do not change at the same speed, to the same extent or on the same basis. The Company monitors the impact of changes in interest rates on its net interest income using several tools. One measure of the Company's exposure to differential changes in interest rates between assets and liabilities is shown in the Company's Interest Rate Sensitivity Analysis Table. See Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Asset and Liability Management and Liquidity." Another measure, required to be performed by OTS-regulated institutio ns, is the test specified by OTS Thrift Bulletin No. 13A, "Interest Rate Risk Management." This test measures the impact on net interest income and net portfolio value of an immediate change in interest rates in 100 basis point increments. Net portfolio value is defined as the net present value of assets, liabilities and off-balance sheet contracts. At September 30, 2002, the Company's internal calculations, based on the information and assumptions produced for the analysis, suggested that a 200 basis point increase in rates would decrease net interest income over a twelve-month period by 6.19% and increase net portfolio value by 6.13%. According to OTS instructions, due to the current historically low level of market interest rates, modeling a 200 basis point decline in rates was deemed unrealistic and not performed. However, based on internal calculations, a 100 basis point decline in rates would decrease net interest income over a twelve-month period by 1.18% and decrease net portfolio value by 5.05% in the same period.

 

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Computation of prospective effects of hypothetical interest rate changes are based on numerous assumptions, including relative levels of market interest rates, loan prepayments and deposit decay rates, and should not be relied upon as indicative of actual results. Further, the computations do not contemplate any actions the Company could undertake in response to changes in interest rates.

 

The following table shows the Company's financial instruments that are sensitive to changes in interest rates, categorized by expected maturity, and the instruments' fair values at September 30, 2002. Market risk sensitive instruments are generally defined as on- and off-balance sheet derivatives and other financial instruments.

 

Expected Maturity/Principal Repayments at September 30,
			Average Rate		2003	2004	2005	2006	2007	Thereafter	Cost	Fair Value
Interest-sensitive assets:			(dollar amounts in thousands)
	Loans receivable		7.13%		$ 481,207	$ 360,905	$ 270,679	$ 203,009	$ 152,257	$ 456,771	$ 1,924,828	$ 1,974,962
	Mortgage-backed securities		5.46		32,464	24,348	18,261	13,696	10,272	30,814	129,855	133,568
	Investments and other
		interest-earning assets	2.22		10,799		987			2,516	14,302	14,233
	FHLB Stock		5.25							29,750	29,750	29,750
Interest-sensitive liabilities:
	Checking accounts		0.74		76,771	41,829	28,444	19,342	13,152	27,949	207,487	207,487
	Savings accounts		1.51		23,188	17,609	17,609	11,485	11,471	55,037	136,399	136,399
	Money Market accounts		1.85		251,101	17,482	17,482	8,328	8,328	15,130	317,849	317,849
	Certificate accounts		3.77		431,726	78,231	86,839	10,183	46,690	4,851	658,520	672,153
	Borrowings		4.93		117,000	100,000	210,000			176,907	603,907	646,345

 

 

Expected maturities are contractual maturities adjusted for prepayments of principal. The Company uses certain assumptions to estimate fair values and expected maturities. For assets, expected maturities are based upon contractual maturity, projected repayments and prepayment of principal. The prepayment experience reflected herein is based on the Company's historical experience. For deposit liabilities, in accordance with standard industry practice, the Company has used decay rates utilized by the OTS. The actual maturities and run-off of loans could vary substantially if future prepayments differ from the Company's historical experience.

 

Rate/Volume Analysis

 

For the Company's rate/volume analysis and information regarding the Company's yields and costs and changes in net interest income, refer to Item 7, "Management's Discussion and Analysis of Financial Condition and Results of Operations -- Net Interest Income."

 

SUBSIDIARY ACTIVITIES OF THE ASSOCIATION

 

The Carolopolis Corporation

 

The Carolopolis Corporation ("Carolopolis") was incorporated in 1976 for the principal purpose of land acquisition and development and construction of various projects for resale. Development activities began in 1981 and ended in 1989. Carolopolis had been inactive for a number of years until 1996 when a lower tier corporation of Carolopolis was formed to operate and market for resale a commercial real estate property acquired through foreclosure by First Federal. Carolopolis is currently inactive.

 

Broad Street Holdings

 

Broad Street Holdings was incorporated in 1998 as the holding company for Broad Street Investments, Inc., which was also formed in 1998. Broad Street Investments has been organized as a real estate investment trust to hold mortgage-related assets.

 

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First Reinsurance

 

First Reinsurance was incorporated in 1998 as the holding company for First Southeast Reinsurance, Inc., a company also organized in 1998 and domiciled in Vermont. First Southeast Reinsurance reinsures mortgage insurance originated through mortgage insurance companies in connection with real estate loans originated by the Association.

 

First Southeast Fiduciary and Trust

 

First Southeast Fiduciary and Trust Services, Inc. was incorporated in 1998 for the purpose of extending trust and other asset management services to customers of the Association. Assets under management totaled $61.4 million at September 30, 2002.

 

SUBSIDIARY ACTIVITIES OF THE COMPANY

 

First Southeast Insurance Services

 

First Southeast Insurance Services, formerly known as the Magrath Insurance Agency, was purchased by Peoples Federal in 1986. In 1988, the agency purchased two smaller insurance agencies. During 1995 the Epps-McLendon Agency in Lake City, South Carolina was purchased. In 1995 the Adams Insurance Agency in Charleston, South Carolina, which had been purchased by First Federal in 1990, was purchased from a subsidiary of First Federal. During 2000, the operations of Associated Insurors of Myrtle Beach, South Carolina were acquired. Subsequent purchases have included the Hilton Head, Bluffton and Ridgeland operations of Kinghorn Insurance in 2001 and Johnson Insurance Associates and Benefit Administrators of Columbia, South Carolina, in 2002.

 

First Southeast Investor Services

 

First Southeast Investor Services, incorporated in South Carolina, has been a NASD-registered broker dealer since 1998.  First Southeast Investor Services offers a variety of investment products and services in strategically located offices throughout First Financial's market area.

 

COMPETITION

 

First Federal was the largest savings association headquartered in South Carolina at September 30, 2002, based on asset size as reported by the OTS. The Company faces strong competition in the attraction of savings deposits and in the origination of real estate and other loans. The Company's most direct competition for savings deposits has historically come from commercial banks and from other savings institutions located throughout South Carolina. The Company also faces competition for savings from credit unions and competition for investors' funds from short-term money market securities and other corporate and government securities. In the more recent past, money market, stock, and fixed-income mutual funds have attracted an increasing share of household savings and are significant competitors of the Company.

 

The Company's competition for real estate and other loans comes principally from commercial banks, other thrift institutions, mortgage-banking companies, insurance companies, developers, tract builders and other institutional lenders. The Company competes for loans principally through the interest rates and loan fees charged and the efficiency and quality of the services provided borrowers, developers, real estate brokers, and home builders.

 

PERSONNEL

 

As of September 30, 2002, the Company had 763 full-time equivalent employees. The Company provides its full-time employees and certain part-time employees with a comprehensive program of benefits, including medical and dental benefits, life insurance, long-term disability coverage, a profit-sharing plan and a 401(k) plan. The employees are not represented by a collective bargaining agreement. The Company believes its employee relations are excellent.

 

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REGULATION

 

As a federally chartered and federally insured thrift institution, the Association is subject to extensive regulation, examination and supervision by the OTS as its chartering agency, and the FDIC, as the insurer of its deposits. Lending activities and other investments must comply with various statutory and regulatory capital requirements. The Association is regularly examined by federal regulators and files periodic reports concerning its activities and financial condition. In addition, the Association's relationship with its depositors and borrowers also is regulated to a great extent by both federal and state laws, especially in such matters as the ownership of deposit accounts and the form and content of the Association's mortgage documents.

 

Federal Regulation of Savings Associations

 

Office of Thrift Supervision

 

The OTS is an office in the Department of the Treasury subject to the general oversight of the Secretary of the Treasury. Among other functions, the OTS issues and enforces regulations affecting federally insured savings associations and regularly examines these institutions.

 

All savings associations are required to pay assessments to the OTS to fund the agency's operations. The general assessments, paid on a semi-annual basis, are determined based on the savings association's total assets, including consolidated subsidiaries. The Association's OTS assessment for the fiscal year ended September 30, 2002 was $421,000.

 

Federal Home Loan Bank System

 

The FHLB System, consisting of 12 FHLBs, is under the jurisdiction of the Federal Housing Finance Board ("FHFB"). The Association, as a member of the FHLB of Atlanta, is required to acquire and hold shares of capital stock in the FHLB of Atlanta in an amount equal to the greater of (i) 1.0% of the aggregate outstanding principal amount of residential mortgage loans, home purchase contracts and similar obligations at the beginning of each year, or (ii) 5% of its advances (borrowings) from the FHLB of Atlanta. First Federal is in compliance with this requirement with an investment in FHLB of Atlanta stock of $29.8 million at September 30, 2002.

 

Among other benefits, the FHLB of Atlanta provides a central credit facility primarily for member institutions. It is funded primarily from proceeds derived from the sale of consolidated obligations of the FHLB System. It makes advances to members in accordance with policies and procedures established by the FHFB and the Board of Directors of the FHLB of Atlanta.

 

Federal Deposit Insurance Corporation

 

The FDIC is an independent federal agency established originally to insure the deposits, up to prescribed statutory limits, of federally insured banks and to preserve the safety and soundness of the banking industry. The FDIC maintains two separate insurance funds: the Bank Insurance Fund ("BIF") and the SAIF. The Association's deposit accounts are insured by the FDIC under the SAIF to the maximum extent permitted by law. As insurer of the Association's deposits, the FDIC has examination, supervisory and enforcement authority over the Association.

 

As insurer, the FDIC imposes deposit insurance premiums and is authorized to conduct examinations of and to require reporting by FDIC-insured institutions. It also may prohibit any FDIC-insured institution from engaging in any activity the FDIC determines by regulation or order to pose a serious risk to the SAIF or the BIF. The FDIC also has the authority to initiate enforcement actions against savings institutions, after giving the OTS an opportunity to take such action, and may terminate the deposit insurance if it determines that the institution has engaged in unsafe or unsound practices or is in an unsafe or unsound condition.

 

The FDIC's deposit insurance premiums are assessed through a risk-based system under which all insured depository institutions are placed into one of nine categories and assessed insurance premiums based upon their level of capital and supervisory evaluation. Under the system, institutions classified as well capitalized (i.e., a core 

 

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capital ratio of at least 5%, a ratio of Tier 1, or core capital, to risk-weighted assets ("Tier 1 risk-based capital") of at least 6% and a risk-based capital ratio of at least 10%) and considered healthy pay the lowest premium while institutions that are less than adequately capitalized (i.e., core or Tier 1 risk-based capital ratios of less than 4% or a risk-based capital ratio of less than 8%) and considered of substantial supervisory concern pay the highest premium. Risk classification of all insured institutions is made by the FDIC for each semi-annual assessment period.

 

The FDIC is authorized to increase assessment rates, on a semi-annual basis, if it determines that the reserve ratio of the SAIF will be less than the designated reserve ratio of 1.25% of SAIF insured deposits. In setting these increased assessments, the FDIC must seek to restore the reserve ratio to that designated reserve level, or such higher reserve ratio as established by the FDIC. The FDIC may also impose special assessments on SAIF members to repay amounts borrowed from the United States Treasury or for any other reason deemed necessary by the FDIC.

 

The premium schedule for BIF and SAIF insured institutions ranged from 0 to 27 basis points. However, SAIF insured institutions and BIF insured institutions are required to pay a Financing Corporation assessment in order to fund the interest on bonds issued to resolve thrift failures in the 1980s. This amount is currently equal to about 1.70 points for each $100 in domestic deposits for SAIF and BIF insured institutions. These assessments, which may be revised based upon the level of BIF and SAIF deposits, will continue until the bonds mature in 2017 through 2019.

 

Under the Federal Deposit Insurance Act, insurance of deposits may be terminated by the FDIC upon a finding that the institution has engaged in unsafe or unsound practices, is in an unsafe or unsound condition to continue operations or has violated any applicable law, regulation, rule, order or condition imposed by the FDIC or the OTS. Management of the Association does not know of any practice, condition or violation that might lead to termination of deposit insurance.

 

Prompt Corrective Action

 

The federal banking agencies have implemented, by regulation, a system of prompt corrective action for all insured depository institutions. Under the regulations, an institution shall be deemed to be "well capitalized" if it has a total risk-based capital ratio of 10.0% or more, has a Tier I risk-based capital ratio of 6.0% or more, has a leverage ratio of 5.0% or more and is not subject to specified requirements to meet and maintain a specific capital level for any capital measure. At September 30, 2002, First Federal was categorized as "well capitalized" under the prompt corrective action regulations of the OTS. See Note 16 of Notes to Consolidated Financial Statements contained in Item 8 herein.

 

Standards for Safety and Soundness

 

The federal banking regulatory agencies have prescribed, by regulation, standards for all insured depository institutions relating to: (i) internal controls, information systems and internal audit systems; (ii) loan documentation; (iii) credit underwriting; (iv) interest rate risk exposure; (v) asset growth; (vi) asset quality; (vii) earnings; and (viii) compensation, fees and benefits ("Guidelines"). The Guidelines set forth the safety and soundness standards that the federal banking agencies use to identify and address problems at insured depository institutions before capital becomes impaired. If the OTS determines that the Association fails to meet any standard prescribed by the Guidelines, the OTS may require the Association to submit to it an acceptable plan to achieve compliance with the standard. Management is aware of no conditions relating to these safety and soundness standards which would require submission of a plan of compliance.

 

Qualified Thrift Lender Test

 

The Qualified Thrift Lender ("QTL") test requires that a savings association maintain at least 65% of its total tangible assets in "qualified thrift investments" on a monthly average basis in nine out of every 12 months. At September 30, 2002, the Association was in compliance with the QTL test.

 

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Capital Requirements

 

Federally insured savings associations, such as the Association, are required to maintain a minimum level of regulatory capital. The OTS has established capital standards, including a tangible capital requirement, a leverage ratio (or core capital) requirement and a risk-based capital requirement applicable to such savings associations. The capital regulations require tangible capital of at least 1.5% of adjusted total assets (as defined by regulation). The capital standards also require core capital equal to at least 3% to 4% of adjusted total assets, depending on an institution's supervisory rating. Core capital generally consists of tangible capital.

 

The OTS risk-based requirement requires savings associations to have total capital of at least 8% of risk-weighted assets. Total capital consists of core capital, as defined above, and supplementary capital. Supplementary capital consists of certain permanent and maturing capital instruments that do not qualify as core capital and general valuation loan and lease loss allowances up to a maximum of 1.25% of risk-weighted assets. Supplementary capital may be used to satisfy the risk-based requirement only to the extent of core capital.

 

In determining the amount of risk-weighted assets, all assets, including certain off-balance sheet items, will be multiplied by a risk weight, ranging from 0% to 100%, based on the risk inherent in the type of asset. For example, the OTS has assigned a risk weight of 50% for prudently underwritten permanent one- to- four family first lien mortgage loans not more than 90 days delinquent and having a loan-to-value ratio of not more than 90% at unless insured to such ratio by an insurer approved by Fannie Mae or Freddie Mac.

 

The OTS is authorized to impose capital requirements in excess of these standards on individual associations on a case-by-case basis. The OTS and FDIC are authorized and, under certain circumstances required, to take certain actions against savings associations that fail to meet their capital requirements. The OTS is generally required to take action to restrict the activities of an "undercapitalized association" (generally defined to be one with less than either a 4% core capital ratio, a 4% Tier 1 risk-based capital ratio or an 8% risk-based capital ratio). Any such association must submit a capital restoration plan and until such plan is approved by the OTS may not increase its assets, acquire another institution, establish a branch or engage in any new activities, and generally may not make capital distributions. The OTS is authorized to impose the additional restrictions that are applicable to significantly undercapitalized associations.

 

See Note 16 of Notes to Consolidated Financial Statements contained in Item 8 herein for a summary of all applicable capital requirements of First Federal.

 

Limitations on Capital Distributions

 

OTS regulations require the Association to give the OTS 30 days' advance notice of any proposed declaration of dividends, and the OTS has the authority under its supervisory powers to prohibit the payment of dividends.

 

OTS regulations impose uniform limitations on the ability of all savings associations to engage in various distributions of capital such as dividends, stock repurchases and cash-out mergers. In addition, the regulation utilizes a three-tiered approach permitting various levels of distributions based primarily upon a savings association's capital level.

 

The Association currently meets the criteria to be designated Tier 1 association and, consequently, could at its option (after prior notice to, and no objection made by, the OTS) distribute up to 100% of its net income during the calendar year plus 50% of its surplus capital at the beginning of the calendar year less any distributions previously paid during the year.

 

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Regulation of the Company

 

The Company is a unitary savings and loan company subject to regulatory oversight of the OTS. Accordingly, the Company is required to register and file reports with the OTS and is subject to regulation and examination by the OTS. In addition, the OTS has enforcement authority over the Company and its non-savings association subsidiaries which also permits the OTS to restrict or prohibit activities that are determined to a serious risk to the subsidiary savings association.

 

The Company is subject to certain restrictions under the Home Owners Loan Act ("HOLA") and the OTS regulations issued thereunder. Such restrictions generally concern, among others, acquisitions of other savings associations and savings and loan holding companies.

 

Gramm-Leach-Bliley Financial Services Modernization Act of 1999

 

On November 12, 1999, the Gramm-Leach-Bliley Financial Services Modernization Act of 1999 ("GLBA") was signed into law. The purpose of this legislation is to modernize the financial services industry by establishing a comprehensive framework to permit affiliations among commercial banks, insurance companies, securities firms and other financial service providers. Generally, the GLBA:

 

a)     repealed the historical restrictions and eliminates many federal and state law barriers to affiliations among banks, securities firms, insurance companies and other financial service providers;

b)     provided a uniform framework for the functional regulation of the activities of banks, savings institutions and their holding companies;

c)     broadened the activities that may be conducted by national banks, banking subsidiaries of bank holding companies and their financial subsidiaries;

d)     provided an enhanced framework for protecting the privacy of consumer information;

e)     adopted a number of provisions related to the capitalization, membership, corporate governance and other measures designed to modernize the FHLB system;

f)      modified the laws governing the implementation of the CRA; and

g)     addressed a variety of other legal and regulatory issues affecting day-to-day operations and long-term activities of financial institutions.

 

The GLBA also imposes certain obligations on financial institutions to develop privacy policies, restrict the sharing of nonpublic customer data with nonaffiliated parties at the customer's request, and establish procedures and practices to protect and secure customer data. These privacy provisions were implemented by regulations that were effective on November 12, 2000. Compliance with the privacy provisions was required by July 1, 2001.

 

The USA Patriot Act

 

In response to the terrorist events of September 11^th, 2001, President George W. Bush signed into law the Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act of 2001, or the USA PATRIOT Act, on October 26, 2001. The USA PATRIOT Act gives the federal government new powers to address terrorist threats through enhanced domestic security measures, expanded surveillance powers, increased information sharing, and broadened anti-money laundering requirements. By way of amendments to the Bank Secrecy Act, Title III of the USA PATRIOT Act takes measures intended to encourage information sharing among bank regulatory agencies and law enforcement bodies. Further, certain provisions of Title III impose affirmative obligations on a broad range of financial institutions, including banks, thrifts, brokers, dealers, credit unions, money transfer agents and parties registered under the Commodity Excha nge Act.

 

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

 

l  Pursuant to Section 352, all financial institutions must establish anti-money laundering programs that include, at minimum: (i) internal policies, procedures, and controls, (ii) specific designation of an anti-money 

 

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laundering compliance officer, (iii) ongoing employee training programs, and (iv) an independent audit function to test the anti-money laundering program.

 

l  Section 326 of the Act authorizes the Secretary of the Department of Treasury, in conjunction with other bank regulators, to issue regulations by October 26, 2002 that provide for minimum standards with respect to customer identification at the time new accounts are opened.

 

l  Section 312 of the Act requires financial institutions that establish, maintain, administer, or manage private banking accounts or correspondent accounts in the United States for non-United States persons or their representatives (including foreign individuals visiting the United States) to establish appropriate, specific, and, where necessary, enhanced due diligence policies, procedures, and controls designed to detect and report money laundering.

 

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

 

l  Bank regulators are directed to consider a holding company's effectiveness in combating money laundering when ruling on Federal Reserve Act and Bank Merger Act applications.

 

To date, it has not been possible to predict the impact the USA PATRIOT Act and its implementing regulations may have on the Company and the Bank.

 

Sarbanes-Oxley Act of 2002

 

The Sarbanes-Oxley Act of 2002 ("Sarbanes-Oxley Act") was signed into law by President Bush on July 30, 2002 in response to public concerns regarding corporate accountability in connection with the recent accounting scandals at Enron and WorldCom. The stated goals of the Sarbanes-Oxley Act are to increase corporate responsibility, to provide for enhanced penalties for accounting and auditing improprieties at publicly traded companies and to protect investors by improving the accuracy and reliability of corporate disclosures pursuant to the securities laws.

 

The Sarbanes-Oxley Act is the most far-reaching U.S. securities legislation enacted in some time. The Sarbanes-Oxley Act generally applies to all companies, both U.S. and non-U.S., that file or are required to file periodic reports with the Securities and Exchange Commission ("SEC"), under the Securities Exchange Act of 1934 ("Exchange Act").

 

The Sarbanes-Oxley Act includes very specific additional disclosure requirements and new corporate governance rules, requires the SEC and securities exchanges to adopt extensive additional disclosure, corporate governance and other related rules and mandates further studies of certain issues by the SEC and the Comptroller General. The Sarbanes-Oxley Act represents significant federal involvement in matters traditionally left to state regulatory systems, such as the regulation of the accounting profession, and to state corporate law, such as the relationship between a board of directors and management and between a board of directors and its committees.

 

The Sarbanes-Oxley Act addresses, among other matters:

 

l audit committees;

l certification of financial statements by the chief executive officer and the chief financial officer;

l the forfeiture of bonuses or other incentive-based compensation and profits from the sale of an issuer's securities by directors and senior officers in the twelve month period following initial publication of any financial statements that later require restatement;

l a prohibition on insider trading during pension plan black out periods;

l disclosure of off-balance sheet transactions;

l a prohibition on personal loans to directors and officers;

l expedited filing requirements for Form 4s;

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

l "real time" filing of periodic reports;

 

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l the formation of a public accounting oversight board;

l auditor independence; and

l various increased criminal penalties for violations of securities laws.

 

The Sarbanes-Oxley Act contains provisions which became effective upon enactment on July 30, 2002 and provisions which will become effective from within 30 days to one year from enactment. The SEC has been delegated the task of enacting rules to implement various of the provisions with respect to, among other matters, disclosure in periodic filings pursuant to the Exchange Act.

 

ITEM 2. PROPERTIES

 

The Company's principal executive offices are located at 2440 Mall Drive, North Charleston, South Carolina, in an office building partially leased by First Federal. The building also serves as First Federal's Operations Center. First Federal owns 32 of its branch offices, including its home office at 34 Broad Street in downtown Charleston. A substantial portion of its home office is now leased and approximately 50% of its offices in Beaufort County are also leased to others. The remaining 12 branch offices are leased properties on which First Federal has constructed banking offices. All of the leases include various renewal or purchase options. A regional operations center is also located in Conway, South Carolina. Approximately 65% of the building is leased to others.

 

First Southeast Insurance Services, Inc. and its affiliates lease space for certain insurance agency operations in Charleston, Lake City, Myrtle Beach, Hilton Head, Bluffton, Ridgeland and Columbia, South Carolina. In addition, First Federal leases properties in several locations for off-site ATM facilities. The Association also owns land purchased for potential future branch locations.

 

The Company evaluates on a continuing basis the suitability and adequacy of all of its facilities, including branch offices and service facilities, and has active programs of relocating, remodeling or closing any as necessary to maintain efficient and attractive facilities. The Company believes its present facilities are adequate for its operating purposes.

 

At September 30, 2002, the total book value of the premises and equipment owned by the Company was $33.5 million. Reference is made to Note 15 of Notes to Consolidated Financial Statements contained in Item 8 herein for information relating to minimum rental commitments under the Company's leases for office facilities and to Note 7 for further details on the Company's properties.

 

ITEM 3. LEGAL PROCEEDINGS

 

The Company is subject to various legal proceedings and claims which arise in the ordinary course of its business. Any litigation is vigorously defended by the Company, and, in the opinion of management based on consultation with external legal counsel, any outcome of such litigation would not materially affect the Company's consolidated financial position or results of operations.

 

On September 3, 1998, Peoples Federal filed a declaratory judgment action in Georgetown County, which named certain of the original plaintiffs in the previous litigation and others, seeking a judicial determination of claims made against its rights as purchasers of the property foreclosed. The civil action has been tried and the judge's final amended order was issued October 29, 2001. The ruling resulted in a net money judgment in Peoples Federal's favor. There were other rulings pertaining to such issues as declaration of developers' rights, future assessments, restrictive covenants and density designation which were varied. The recent ruling was appealed by Peoples Federal on November 23, 2001, to increase the net award to Peoples Federal by challenging the offsetting awards to the opposing parties. The appeal is fully briefed by both parties and is awaiting action by the Court of Appeals, which may or may not schedule oral argument for sometime in 2003. First Federal, as successor to Peoples Federal, intends to continue to pursue this appeal vigorously.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year ended September 30, 2002.

 

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PART II

 

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER MATTERS

 

Stock Prices and Dividends:

						Cash Dividend
		High		Low		Declared
2002:
	First Quarter		$ 25.64		$ 20.93		$ 0.170
	Second Quarter		27.86		23.10		$ 0.170
	Third Quarter		32.75		26.74		$ 0.170
	Fourth Quarter		32.49		25.73		$ 0.170
2001:
	First Quarter		$ 19.69		$ 15.00		$ 0.155
	Second Quarter		21.75		17.75		$ 0.155
	Third Quarter		23.73		19.05		$ 0.155
	Fourth Quarter		26.45		20.70		$ 0.155

 

The Company's common stock is traded in the Nasdaq National Market under the symbol "FFCH." Trading information in newspapers is provided on the Nasdaq Stock Market quotation page under the listing, "FSTFNHLD." As of September 30, 2002, there were approximately 2,441 stockholders of record.

 

The Company has paid a quarterly cash dividend since February 1986. The amount of the dividend to be paid is determined by the Board of Directors and is dependent upon the Company's earnings, financial condition, capital position and such other factors as the Board may deem relevant. The dividend rate has been increased 15 times with the most recent dividend paid in November 2002, at $.19 per share. Cash dividends per share totaled $.68, $.62 and $.56 for fiscal 2002, 2001 and 2000, respectively. These dividends per share amounted to 32.38%, 36.69% and 37.58% of basic net income per common share, respectively.

 

Please refer to Item 1. "Business--Regulation--Federal Regulation of Savings Associations--Limitations on Capital Distributions" for information with respect to current restrictions on the Association's ability to pay dividends to the Company.

 

 

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ITEM 6. SELECTED CONSOLIDATED FINANCIAL DATA

 

			At or For the Year Ended September 30,
			2002	2001	2000	1999	1998
			(dollar amounts in thousands, except per share amounts)
Summary of Operations
	Interest income		$ 154,026	$ 173,277	$ 161,642	$ 140,832	$ 136,345
	Interest expense		71,342	102,908	98,888	80,394	81,689
	Net interest income		82,684	70,369	62,754	60,438	54,656
	Provision for loan losses		(5,888)	(4,975)	(2,745)	(2,765)	(2,405)
	Net interest income after provision for loan losses		76,796	65,394	60,009	57,673	52,251
	Other income		30,959	24,918	18,310	15,314	13,357
	Non-interest expense		(63,944)	(55,143)	(47,884)	(43,280)	(40,158)
	Income tax expense		(15,659)	(12,610)	(10,507)	(10,400)	(8,571)
	Net income before extraordinary loss		28,152	22,559	19,928	19,307	16,879
	Extraordinary loss on retirement of debt (1)						(340)
	Net income		$   28,152	$ 22,559	$ 19,928	$   19,307	$   16,539
Per Common Share
	Net income before extraordinary loss		$ 2.10	$ 1.69	$ 1.49	$ 1.44	$ 1.24
	Net income before extraordinary loss, diluted		2.04	1.64	1.47	1.40	1.20
	Extraordinary loss						(0.02)
	Extraordinary loss, diluted						(0.03)
	Net income		2.10	1.69	1.49	1.44	1.22
	Net income, diluted		2.04	1.64	1.47	1.40	1.17
	Book value		12.55	11.71	10.35	9.43	9.16
	Dividends		0.68	0.62	0.56	0.48	0.42
	Dividend payout ratio		32.38%	36.69%	37.58%	33.33%	34.43%
Core Earnings (2)
	Net income before extraordinary loss		$   28,152	$  22,559	$  19,928	$  19,307	$   16,879
	Investors merger related expenses						210
	Core income		$   28,152	$  22,559	$  19,928	$  19,307	$   17,089
Core Earnings Per Share (2)
	Basic:
		Net income before extraordinary loss	$       2.10	$      1.69	$      1.49	$      1.44	$      1.24
		Investors merger related expenses					0.02
		Core income	$       2.10	$      1.69	$      1.49	$      1.44	$      1.26
	Diluted:
		Net income before extraordinary loss	$       2.04	$      1.64	$      1.47	$     1.40	$      1.20
		Investors merger related expenses	-	-	-	-	0.01
		Core income	$       2.04	$ 1.64	$      1.47	$     1.40	$      1.21

 

 

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SELECTED CONSOLIDATED FINANCIAL DATA, CONTINUED

			At or For the Year Ended September 30,
			2002	2001	2000	1999	1998
			(dollar amounts in thousands, except per share amounts)
At September 30,
	Assets		$ 2,264,674	$ 2,325,664	$ 2,256,511	$ 2,070,752	$ 1,839,708
	Loans receivable, net		1,924,828	1,905,333	1,838,497	1,742,150	1,565,040
	Mortgage-backed securities		133,568	208,153	247,095	181,245	148,630
	Investment securities and FHLB stock		37,035	39,409	45,492	37,743	40,412
	Deposits		1,440,271	1,395,785	1,241,295	1,219,848	1,164,440
	Borrowings		603,907	715,066	828,022	677,241	504,942
	Stockholders' equity		165,648	156,893	137,851	125,881	125,163
	Number of offices		44	44	40	38	36
	Full-time equivalent employees		763	719	638	611	576
Selected Ratios:
	Return on average equity		17.29%	15.27%	15.21%	15.38%	13.97%
	Return on average assets		1.23	0.98	0.91	0.99	0.90
	Core return on average equity		17.29	15.27	15.21	15.38	14.43
	Core return on average assets		1.23	0.98	0.91	0.99	0.93
	Gross interest margin		3.69	3.00	2.77	2.99	2.84
	Net interest margin		3.82	3.20	2.99	3.22	3.10
	Efficiency ratio		56.29	58.76	59.45	57.23	59.00
	Average equity as a percentage of average assets		7.10	6.40	5.99	6.42	6.48
Asset Quality Ratios:
	Allowance for loan losses to net loans		0.82%	0.84%	0.84%	0.84%	0.82%
	Allowance for loan losses to nonperforming loans		129.77	141.44	178.65	202.08	177.76
	Nonperforming assets to loans and real estate
		and other assets acquired in settlement of loans	0.78	0.77	0.79	0.74	0.83
	Nonperforming assets to total assets		0.67	0.63	0.64	0.62	0.71
	Net charge-offs to average loans		0.31	0.24	0.11	0.06	0.11

(1)	Loss on retirement of First Financial's 9.375% senior notes, net of income tax benefit of $173.
(2)	Core earnings represents net income before extraordinary loss exclusive of after-tax expenses related to the Investors Savings Bank pooling.

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

General

 

The information presented in the following discussion of financial results of First Financial is largely indicative of the activities of its operating subsidiary, First Federal, which comprises the substantial majority of the consolidated net income, revenues and assets of the Company. During the year ended September 30, 2002, the Company consolidated its previously owned subsidiary, Peoples Federal into First Federal. The following discussion should be read in conjunction with the Selected Consolidated Financial Data contained in Item 6 of this report and the Consolidated Financial Statements and accompanying notes contained in Item 8 of this report.

 

First Financial achieved earnings of $28.2 million in fiscal 2002, increasing 24.8% from $22.6 million in fiscal 2001. Basic and diluted earnings per share in 2002 improved to $2.10 and $2.04, respectively, compared with $1.69 and $1.64, respectively, in 2001. Net income was $19.9 million in 2000. Basic and diluted earnings per share totaled $1.49 and $1.47 in 2000, respectively. Net earnings resulted in a return on average equity of 17.29%, 

 

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15.27% and 15.21% for the three years ended September 30, 2002, respectively. The return on average assets for the three years ended September 30, 2002 was 1.23%, .98% and .91%, respectively.

 

First Financial's earnings increased in fiscal 2002 due to several factors. First, the Company's net interest margin improved to 3.82% in fiscal 2002 from 3.20% in fiscal 2001, leading to a $12.3 million increase in net interest income. Secondly, non-interest revenues increased $6.0 million, or 24.2%, over fiscal 2001 due principally to growth in revenues from insurance services, banking fees and increased loan sales. Offsetting these increases was an $8.8 million increase in non-interest expense, due principally to additional insurance operations acquired and normal growth due to the level of business activity.

 

First Financial's net income increased $2.6 million in fiscal 2001, or approximately 13.2%, over fiscal 2000. Growth in net income was principally attributable to expansion of net interest income, as average net interest margins increased substantially. Another important factor in fiscal 2001 was the $6.6 million, or 36.1%, increase in non-interest revenues over fiscal 2000.

 

On September 17, 2001, First Financial announced that its Board of Directors had authorized the repurchase of up to 600,000 shares of First Financial's common stock. Approximately 441,000 shares were repurchased under the program in fiscal 2002 with a total of approximately 477,500 shares purchased under the plan since its inception. The plan expired on September 30, 2002. The Board of Directors authorized a new stock repurchase program on October 24, 2002 to acquire up to 650,000 shares, or 4.9%, of the Company's common stock.

 

Critical Accounting Policy

 

First Financial's accounting policies are discussed in Item 8, Note 1 to the Consolidated Financial Statements. Of these significant accounting policies, First Financial considers its policy regarding the allowance for loan losses (the "Allowance") to be its most critical accounting policy since it requires a significant degree of management judgment. First Financial has developed policies and procedures for assessing the adequacy of the Allowance, recognizing that this process requires a number of assumptions and estimates with respect to its loan portfolio. The Company's assessments may be impacted in future periods by changes in economic conditions, the impact of regulatory examinations, and the discovery of information with respect to borrowers, which is not known to management at the time of the issuance of the consolidated financial statements. For additional discussion concerning the Company's Allowance and related matters, see "-- Financial Position -- Allowance for Loan Losses."

 

Acquisitions

 

During fiscal 2002, First Financial acquired Johnson Insurance Associates, Inc. ("Johnson Insurance"), a full-service independent insurance agency located in Columbia, South Carolina, specializing primarily in commercial insurance lines. The Company also acquired Benefit Administrators, Inc. ("Benefit Administrators"), an affiliated company providing third party administrative services for self-insured health insurance plans. This acquisition occurred on August 12, 2002. This transaction was accounted for as a purchase of stock with 1.5 months of Johnson Insurance's operations included in fiscal 2002 results.

 

On May 31, 2001, the Company acquired the Hilton Head, Bluffton and Ridgeland operations of the Kinghorn Insurance Agency, a full-service independent insurance agency specializing primarily in retail insurance lines. These operations are included under Kinghorn Insurance Services, Inc. ("Kinghorn"), a subsidiary of First Southeast Insurance Services. The transaction was accounted for as a purchase of assets with four months of Kinghorn's operations included in fiscal 2001 results.

 

During fiscal 2000, First Financial acquired the operations of Associated Insurors, Inc. of Myrtle Beach, South Carolina ("Associated Insurors"), a full-service insurance agency, specializing in commercial insurance lines. The transaction was accounted for as a purchase of assets with four months of operations included in fiscal 2000 results.

 

One of the stated long-term objectives of the Company is diversification of its revenue sources. Increasingly, the Company has sought to achieve this objective through either the purchase of insurance agencies or assets of insurance agencies. The Company also believes these acquisitions present significant cross-sales opportunities and provide the Company with the ability to offer an expanded menu of products to customers.

 

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National and Economic Events

 

As fiscal 2002 began, the nation was in a recession. The Federal Reserve Open Market Committee ("FOMC") cut interest rates during the first quarter, reducing the Federal Funds rate to 1.75% by December 31, 2001. This cut was the last of 11 rate cuts by the FMOC after the longest peacetime economic expansion in United States history came to an end in fiscal 2001. The uncertainty surrounding the terrorist attacks of September 11, 2001 likely resulted in prolonging the nation's recession for several more months. The extent and duration of the economic impact from the attacks are not quantifiable but likely have affected consumer confidence and the financial activities of retail and business customers during fiscal 2002. As a response to protecting the country from terrorist activities, the nation also experienced increased deployment of the military as a deterrent to future terrorist activities. During fiscal 2002, the national economy continued to experience very slow levels of growth in a number of key economic indicators amid these national events. Recently, in November 2002 the FOMC reduced the Fed Funds rate another 50 basis points to 1.25%. Rates are now at historically low levels.

 

During the year the economy was also affected by another 12 months of lower returns and expectations of the equity markets. The Company believes lower short-term interest rates in fiscal 2002 had a positive effect on reductions in the average cost of funds. The shape of the yield curve, recovering significantly from the flat to inverted curve during a substantial portion of fiscal 2001, also benefited the Company's net interest margins.

 

Management continues to believe that First Financial's markets generally have performed better than national markets, including times of recession.

 

Financial Position

 

At September 30, 2002, First Financial's assets totaled $2.3 billion, declining slightly, by 2.6%, or $61.0 million, from September 30, 2001. The decline in assets was principally attributable to declines of $74.6 million in mortgage-backed securities, $9.7 million in cash and cash equivalents and $8.6 million in net loans receivable offset partially by growth of $28.1 million in loans held for sale. Average assets decreased .56% during the year and average interest-earning assets decreased by 1.8%. Lower market interest rates in fiscal 2002 led to increased fixed-rate residential loan originations. Agency-qualifying fixed-rate mortgage loan originations are normally sold by the Company, increasing loans sales substantially in fiscal 2002. As deposit inflows also improved, the Company reduced its reliance on wholesale funding sources, leading to a net reduction in borrowings of $111.2 million, or 15.5%, during fiscal 2002.

 

At September 30, 2001, First Financial's assets also totaled $2.3 billion, increasing 3.1%, or $69.2 million, from September 30, 2000. Net asset growth was principally attributable to growth in net loans receivable, which increased $66.8 million during 2001, and growth in cash and cash equivalents of $33.6 million. Average interest-earning assets increased by 5.0% in 2001. Borrowings also were reduced in fiscal 2001 by $113.0 million due to better deposit cash flows.

 

Investment Securities and Mortgage-backed Securities

 

At September 30, 2002, available for sale securities totaled $140.9 million compared to $214.4 million at September 30, 2001. As market interest rates declined in fiscal 2002, prepayment of the mortgage-backed securities portfolio increased dramatically.

 

The primary objective of the Company in its management of the investment and mortgage-backed securities portfolio is to maintain a portfolio of high quality, highly liquid investments with returns competitive with short-term U.S. Treasury or agency securities and highly rated corporate securities. The Association is required to maintain an adequate amount of liquidity to ensure safe and sound operations. The Association has maintained balances in short-term investments and mortgage-backed securities based on a continuing assessment of cash flows, the level of loan production, current interest rate risk strategies and the assessment of the potential direction of market interest rate changes.

 

Loans Receivable

 

Loans comprise the major portion of interest-earning assets of the Company, accounting for 89.1% and 85.9% of average interest-earning assets in fiscal 2002 and fiscal 2001, respectively. Compared with balances on September 30, 2001, net loans receivable declined slightly during fiscal 2002. Loans held for sale increased $28.1 million to $40.5 million at September 30, 2002. Real estate loan originations were higher in fiscal 2002 than in 

 

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fiscal 2001 due principally to the effect of lower market interest rates. Loan growth, however, slowed due to more sales of agency-qualifying residential loans. During fiscal 2001, the Company's loan portfolio grew by 3.6%. Consumer loans grew to $373.7 million at September 30, 2002, increasing $23.3 million, or 6.6% from September 30, 2001. The Company's manufactured housing portfolio increased $21.6 million, or 23.9%, during fiscal 2002. The Company's home equity loan balances also increased $12.3 million, or 8.5%, in fiscal 2002. Commercial loans increased $21.6 million, or 23.2% during the fiscal year ended September 30, 2002. The Company continues to emphasize growth in consumer lending and commercial business lending.

 

The Company's loan portfolio consists of real estate mortgage and construction loans, home equity, mobile home and other consumer loans, credit card receivables and commercial business loans. The Company believes the change in percentages of consumer and commercial loans and a lower percentage of single- family mortgage loans has had a positive effect of the overall yield of the loan portfolio. However, these loans generally have higher credit risks than single-family residential loans, another factor in the growth in consumer loan net charge-offs during recent years.

 

Asset Quality

 

The Company believes it maintains a conservative philosophy regarding its lending mix as well as its underwriting guidelines. The Company also maintains loan quality monitoring policies and systems that require detailed monthly and quarterly analyses of delinquencies, nonperforming loans, real estate owned and other repossessed assets. Reports of such loans and assets by various categories are reviewed by management and the Board of Directors of the Association. The majority of the Company's loan originations are in coastal South Carolina and North Carolina and inland in Florence, South Carolina.

 

The largest component of loan growth during fiscal 2002 has been in consumer loans. The largest percentage increase in loan growth was attributable to commercial business loans. Both of these categories of loans are expected to have higher charge-off rates than generally experienced with residential loans.

 

As a result of management's ongoing review of the loan portfolio, loans are classified as non-accruing when uncertainty exists about the ultimate collection of principal and interest under the original terms. The Company closely monitors trends in problem assets which include non-accrual loans, loans 90 days or more delinquent, renegotiated loans, and real estate and other assets acquired in settlement of loans. Renegotiated loans are those loans on which the Company has agreed to modifications of the terms of the loan such as changes in the interest rate charged and/or other concessions. The following table illustrates trends in problem assets and other asset quality indicators over the past five years.

 

Problem Assets

 

	At September 30,
	2002		2001		2000		1999		1998
	(dollar amounts in thousands)
Non-accrual loans	$ 11,860		$ 8,547		$ 5,881		$ 4,466		$ 2,647
Accruing loans 90 days or more delinquent	29		25		29		20		50
Renegotiated loans	305		2,700		2,712		2,724		4,493
Real estate and other assets acquired in settlement of loans	2,913		3,337		5,895		5,685		5,871
	$ 15,107		$ 14,609		$ 14,517		$ 12,895		$ 13,061
As a percent of loans receivable and real estate and other assets acquired in settlement of loans	0.78%		0.77%		0.79%		0.74%		0.83%
As a percent of total assets	0.67		0.63		0.64		0.62		0.71
Allowance for loan losses as a percent of problem loans	129.77		141.44		178.65		202.08		177.76
Net charge-offs to average loans outstanding	0.31		0.24		0.11		0.06		0.11

 

 

Problem assets were $15.1 million at September 30, 2002, or .67% of assets and .78% of loans receivable and real estate and other assets acquired in settlement of loans. At September 30, 2001, problem assets were $14.6 million, or .63% of assets and .77% of loans receivable and real estate and other assets acquired in settlement of 

 

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loans. Loans on non-accrual increased to $11.9 million at September 30, 2002 from $8.5 million in fiscal 2001. The increase was primarily related to an increase in more severely delinquent residential mortgage and consumer loans. Renegotiated loans declined by $2.4 million in fiscal 2002 to $305 thousand. The Company negotiated with the borrowers to accept a discounted payoff of two long-term problem credits. Real estate and other assets in settlement of loans declined to $2.9 million from $3.3 million at September 30, 2001.

 

Management's long-term goals continue to include lower ratios of problem assets to total assets, although management expects there will always remain a core level of delinquent loans and real estate acquired in settlement of loans from normal lending operations.

 

Allowance for Loan Losses

 

The Allowance is maintained at a level sufficient to provide for estimated probable losses in the loan portfolio at each reporting date. Management reviews the adequacy of the Allowance no less frequently than each quarter, utilizing its internal portfolio analysis system. The factors that are considered in a determination of the level of the allowance are management's assessment of current economic conditions, the composition of the loan portfolio, previous loss experience on certain types of credit, a review of specific high-risk sectors of the loan portfolio, selected individual loans and concentrations of credit. The value of the underlying collateral is also considered during such reviews.

 

The methodology for assessing the adequacy of the Allowance establishes both an allocated and an unallocated component. The allocated component of the Allowance for loans is based principally on current loan grades and historical loss rates. For consumer loans, it is based on loan payment status and historical loss rates.

 

The unallocated component of the Allowance represents the results of analyses that estimate probable losses inherent in the portfolio that are not fully captured in the allocated allowance. These analyses include industry concentrations, model imprecision and the estimated impact of current economic conditions on historical loss rates. We continually monitor trends in loan portfolio qualitative and quantitative factors, including trends in the levels of past due, criticized and nonperforming loans. The trends in these factors are used to evaluate the reasonableness of the unallocated component.

 

To determine the adequacy of the Allowance and the need for potential changes to the Allowance, a formal analysis is completed quarterly to assess the risk with in the loan portfolio. This assessment includes analyses of historical performance, past due trends, the level of nonperforning loans, reviews of certain impaired loans, loan activity since the last quarter, consideration of current economic conditions, and other pertinent information. Loans are assigned ratings, either individually for larger credits or in homogeneous pools, based on an internally developed grading system. The resulting conclusions are reviewed and approved by senior management.

 

The allocation of the Allowance to the respective loan classifications is not necessarily indicative of future losses or future allocations. The entire Allowance is available to absorb losses in the loan portfolio.

 

Assessing the adequacy of the Allowance is a process that requires considerable judgment. Management's judgments are based on numerous assumptions about current events, which we believe to be reasonable, but which may or may not be valid. Thus, there can be no assurance that loan losses in future periods will not exceed the current Allowance amount or that future increases in the Allowance will not be required. No assurance can be given that management's ongoing evaluation of the loan portfolio in light of changing economic conditions and other relevant circumstances will not require significant future additions to the Allowance, thus adversely affecting the operating results of the Company.

 

The Allowance is also subject to examination and adequacy testing by regulatory agencies, which may consider such factors as the methodology used to determine adequacy and the size of the Allowance relative to that of peer institutions, and other adequacy tests. In addition, such regulatory agencies could require us to adjust our Allowance based on information available to them at the time of their examination.

 

The Allowance totaled $15.8 million and $15.9 million, or .84% of loans held for investment, at September 30, 2002 and 2001, respectively. During fiscal 2002, First Financial reduced the Allowance by $119,000 as a consequence of reductions in classified assets, changes in the composition of loans, higher balances of loans held for sale or sold during the year and the level of charge-offs. The Allowance to nonperforming loans ratio was 1.30 times and 1.41 times at September 30, 2002 and September 30, 2001, respectively. Nonperforming loans increased to $12.2 million as of September 30, 2002 from $11.3 million at September 30, 2001. See "-- Asset Quality" above. Our analysis of 

 

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Allowance adequacy includes an impairment analysis for each nonperforming commercial loan. Based on the current economic environment and other factors, management believes that the Allowance at September 30, 2002 was maintained at a level adequate to provide for estimated probable losses in the Company's loan portfolio.

 

The following two tables set forth the changes in the Allowance and an allocation of the Allowance by loan category at the dates indicated. Total net loan charge-offs increased to $6.0 million in 2002 from $4.4 million in 2001. Net real estate loan charge-offs totaled $1.1 million in 2002 compared with net charge-offs of $320,000 in 2001. Consumer loan net charge-offs were $4.5 million in 2002 compared with $3.9 million in 2001. Consumer loan charge-offs increased due to growth in consumer loans and a continuation of higher net charge-off rates on auto loans and mobile homes. Underwriting standards were tightened in late fiscal 2001 on certain auto lending programs. The Company expects the charge-off rate to be lower in the future on this sector of its portfolio. Commercial business loan net charge-offs were $362,000 in 2002 compared with $249,000 in net charge-offs in 2001. Charge-off levels are expected to remain above historical levels. Management believes that the Allowance can be allocated by category only on an approximate basis. The allocation of the Allowance to each category is not necessarily indicative of future losses and does not restrict the use of the Allowance to absorb losses in any category.

 

Allowance for Loan Losses

 

 

				At or For the Year Ended September 30,
				2002		2001		2000		1999		1998
				(dollar amounts in thousands)
Balance, beginning of period				$ 15,943		$ 15,403		$ 14,570		$ 12,781		$ 12,103
Loans charged-off:
	Real estate loans			1,121		377		338		122		981
	Commercial business loans			432		273		62		46		122
	Consumer loans			5,071		4,282		1,992		1,428		1,427
		Total charge-offs		6,624		4,932		2,392		1,596		2,530
Recoveries:
	Real estate loans			16		57		21		245		159
	Commercial business loans			70		24		47		82		407
	Consumer loans			531		416		412		293		237
		Total recoveries		617		497		480		620		803
		Net charge-offs		6,007		4,435		1,912		976		1,727
	Provision for loan losses			5,888		4,975		2,745		2,765		2,405
Balance, end of period				$ 15,824		$ 15,943		$ 15,403		$ 14,570		$ 12,781
Balance as a percent of net loans:				0.82	%	0.84	%	0.84	%	0.84	%	0.82	%
Net charge-offs as a percent of average net loans:
		Real estate loans		0.08	%	0.02	%	0.02	%	(0.01)	%	0.06	%
		Commercial business loans		0.35		0.33		0.03		(0.09)		(0.85)
		Consumer loans (1)		1.25		1.17		0.60		0.58		0.75
		Total net loans		0.31		0.24		0.11		0.06		0.11
(1) Consumer loans include home equity lines of credit

 

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			At September 30,
			2002		2001		2000		1999		1998
			(dollar amounts in thousands)
Allowance for loan losses applicable to:
	Real estate loans		$  8,276		$  5,477		$  6,374		$  8,456		$  8,753
	Commercial business loans		1,684		2,475		1,883		2,079		1,087
	Consumer loans		5,470		7,991		7,146		4,035		2,941
	Unallocated		394
		Total	$ 15,824		$ 15,943		$ 15,403		$ 14,570		$ 12,781
Percent of loans to total net loans:
	Real estate loans		75.0%		77.3%		80.4%		85.5%		87.1%
	Commercial business loans		5.9		4.7		3.0		2.3		2.1
	Consumer loans		19.1		18.0		16.6		12.2		10.8
		Total	100.0%		100.0%		100.0	%	100.0	%	100.0	%

 

Deposits

Retail deposits have traditionally been the primary source of funds for the Company and also provide a customer base for the sale of additional financial products and services. Business deposits have in the past been a lesser source of funding. The Company has set strategic targets for net growth in retail and business transaction accounts annually and in numbers of households served. The Company believes that its future focus must be on increasing the number of available opportunities to provide a broad array of products and services to retail consumers and to commercial customers. New commercial business products have been developed and the Company proactively seeks development of business relationships. During fiscal 2002, the Company emphasized a focus on growing core deposits, particularly money market, checking and other such products with the goal of reducing its cost of funds.

 

The Company's total deposits increased $44.5 million during the year ended September 30, 2002. First Financial's deposit composition at September 30, 2002 and 2001 is as follows:

 

	At September 30,
	2002			2001
	Balance	Percent of Total		Balance	Percent of Total
	(dollar amounts in thousands)
Checking accounts	$ 327,503	22.74	%	$   308,784	22.12	%
Statement and other accounts	136,399	9.47		120,676	8.65
Money market accounts	317,849	22.07		220,802	15.82
Certificate accounts	658,520	45.72		745,523	53.41
Total deposits	$ 1,440,271	100.00	%	$ 1,395,785	100.00	%

Long term national and local market trends over the past several years suggest that consumers have moved an increasing percentage of discretionary savings funds into investments such as annuities and stock and fixed income mutual funds. While deposits remain a primary, highly stable source of funds for the Company, deposits had started to decline in prior fiscal years as a percentage of liabilities. Management believes that conditions in fiscal 2002 and fiscal 2001 were more favorable for deposit growth. Factors such as the low returns on investments and mutual funds may have increased traditional deposit inflows recently. Core deposits grew by $131.5 million in fiscal 2002, or 20.2%, while higher costing consumer certificate of deposit balances declined by $87.0 million, or 11.7%. As of September 30, 2002, deposits as a percentage of liabilities were 68.6% compared with 64.4% at September 30, 2001. The Company expects to maintain a significant portion of its deposits in core account relationships; however, future growth in deposit balances may be achieved primarily through specifically targeted programs offering higher yielding investment alternatives to consumers. Such targeted programs may increase the Company's overall cost of funds and thus affect the Company's future net margins. The Company's average cost of deposits at September 30, 2002 was 2.38% compared with 3.79% at September 30, 2001.

 

 

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Borrowings

 

Borrowings declined $111.2 million during the current year to $603.9 million as of September 30, 2002. Borrowings as a percentage of total liabilities were approximately 28.8% at the end of 2002 compared with 33.0% at the end of fiscal 2001. Borrowings from the FHLB of Atlanta declined $48.0 million, reverse repurchase agreements declined $66.3 million and other short-term borrowings increased $3.2 million.

 

The Company's average cost of FHLB advances, reverse repurchase agreements and other borrowings increased from 4.81% at September 30, 2001 to 4.94% at September 30, 2002. During the year the Company also extended the average maturity of FHLB advances to reduce interest rate risk. Approximately $117 million in FHLB advances mature within one year. Other advances are subject to call during the next 12 months but, based on the current market interest rates, such calls will likely not be exercised by the FHLB.

 

Capital Resources

 

Average shareholders' equity was $162.9 million during fiscal 2002, or 7.1% of average assets, increasing from 6.4% during 2001. The Consolidated Statement of Stockholders' Equity and Comprehensive Income contained in Item 8 herein details the changes in stockholders' equity during the year. The principal reason for the increase in average equity to average assets during the current period is due to the retention of net income. Total equity capital increased from $156.9 million at September 30, 2001 to $165.6 million at September 30, 2002. The Company's capital ratio of total capital to total assets, was 7.31% at September 30, 2002 compared to 6.75% at September 30, 2001. The Company's tangible capital ratio at September 30, 2002 was 6.69% compared with 6.32% at September 30, 2001.

 

Recent stock repurchases included the purchase of 506,000 shares of common stock in fiscal 2002, approximately 57,000 shares of common stock in fiscal 2001 and 94,000 shares of common stock in fiscal 2000. The dollar amount of such purchases totaled $14.3 million in fiscal 2002, $1.2 million in fiscal 2001 and $1.3 million in fiscal 2000.

 

During fiscal 2002, the Company's cash dividend payout was 32.4% of per share earnings compared with a payout ratio of 36.7% in 2001. The Company recently increased its cash dividend by 11.8% to $.76 per share on an annual basis, effective with the payment during November 2002 to shareholders.

 

The Association is required to meet the regulatory capital requirements of the OTS, which currently include several measures of capital. Under current regulations, First Federal meets all requirements including those to be categorized as well-capitalized under risk-based capital guidelines. Current capital distribution regulations of the OTS allow the greatest flexibility to well-capitalized institutions.

 

Asset and Liability Management

 

Asset/liability management is the process by which the Company constantly changes the mix, maturity and pricing of assets and liabilities in an attempt to reduce a materially adverse impact on earnings resulting from the direction, frequency and magnitude of change in market interest rates. Although the net interest income of any financial institution is perceived as being vulnerable to fluctuations in interest rates, the Company's management has attempted to minimize that vulnerability. The future regulatory capital requirements of all financial institutions will become subject to the inclusion of additional components measured by exposure to interest rate sensitivity.

 

The Company, working principally through the Asset and Liability Committee of the Association, has established policies and monitors results to control interest rate risk. The Company utilizes measures such as static gap, which is the measurement of the difference between interest-sensitive assets and interest-sensitive liabilities repricing for a particular time period. More important may be the process of evaluating how particular assets and liabilities are affected by changes in interest rates or selected indices as they reprice. Asset/liability modeling is performed by the Company to assess varying interest rate and balance sheet mix assumptions.

 

Management may adjust the Company's interest rate sensitivity position primarily through decisions on the pricing, maturity and marketing of particular deposit and loan products and by decisions regarding the maturities of FHLB advances and other borrowings. The Company has continued to emphasize adjustable-rate mortgage real estate lending and short-term consumer and commercial business lending to accomplish its objectives.

 

The following table sets forth in summary form the repricing attributes of the Company's interest-earning assets and interest-bearing liabilities. The time periods in the table represent the time period before an asset or liability matures or can be repriced.

 

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Interest Rate Sensitivity Analysis at September 30, 2002

			Interest Rate Sensitivity Period
			3 Months	4-6 Months	7-12 Months	13 Months- 2 years	Over 2 Years	Cost
Interest-earning assets:			(dollar amounts in thousands)
	Loans (1)		$ 332,160	$ 116,993	$   229,091	$   188,610	$ 1,073,902	$ 1,940,756
	Mortgage-backed securities		73,072	8,399	5,206	1,375	41,803	129,855
	Interest-earning deposits, investments and FHLB stock		39,510	1,000	-	2,246	1,296	44,052
Total interest-earning assets			444,742	126,392	234,297	192,231	1,117,001	2,114,663
Interest-bearing liabilities:
	Deposits:
		Checking accounts (2)	19,193	19,193	38,385	41,829	88,887	207,487
		Savings accounts (2)	5,797	5,797	11,594	19,246	93,965	136,399
		Money market accounts	317,849	-	-	-	-	317,849
		Certificate accounts	82,557	59,388	214,776	140,646	161,153	658,520
	Total deposits		425,396	84,378	264,755	201,721	344,005	1,320,255
	Borrowings (3)		88,750	25,000	30,000	100,157	360,000	603,907
Total interest-bearing liabilities			514,146	109,378	294,755	301,878	704,005	1,924,162
Current period gap			$ (69,404)	$   17,014	$ (60,458)	$ (109,647)	$    412,996	$   190,501
Cumulative gap			$ (69,404)	$ (52,390)	$ (112,848)	$ (222,495)	$    190,501
Percent of total assets			(3.06%)	(2.31%)	(4.98%)	(9.82%)	8.41%

Assumptions:

(1) Fixed-rate loans are shown in the time frame corresponding to contractual principal amortization schedules. Adjustable-rate loans are shown in the time frame corresponding to the next contractual interest rate adjustment date.

(2) Decay rates for savings accounts approximate 17% in the first year and 14% in the second year. Decay rates for checking accounts approximate 37% in the first year and 20% in the second year.

(3) Borrowings include fixed-rate FHLB advances at the earlier of maturity date or potential call dates. If FHLB advances are not called, maturities may extend.

 

Based on the Company's September 30, 2002 static gap position, in a one-year time period $805 million in interest-sensitive assets will reprice and approximately $918 million in interest-sensitive liabilities will reprice or are subject to call. This current static gap position results in a negative mismatch of $113 million, or 5.0% of assets. The Company's static gap position one year ago was a negative 24.2% of assets. The respective ratios and dollars repricing as shown in the above table do not take into effect prepayments to mortgage, consumer and other loans and mortgage-backed securities, which are expected to be significant in the upcoming fiscal year, based on the current level and direction of market interest rates. The above table also does not consider the repricing considerations inherent in adjustable-rate loans, such as minimum and maximum annual and lifetime interest rate adjustments and also the index utilized. After applying the Company's estimates of prepayments of fixed-rate loans and mortgage-backed securities in a one-year period and the Company's expectations at call dates of certain FHLB advances, the Company estimates it has a positive one-year gap position of 7.32% of assets at September 30, 2002.

 

During the past five years the Company extended maturities of interest-sensitive assets through retention of certain types of loans, particularly those originated under newer "hybrid" lending programs with both fixed-rate and variable-rate features. These loans have become very popular with consumers and carry a fixed rate of interest for three, five, or seven years and then adjust annually to an established index. Under current lower levels of market interest rates, the pace of prepayments has increased on these types of loans as consumers lock into longer-term fixed-rate loans. During the fiscal year ended September 30, 2002, the Company purchased $32.8 million of hybrid loans originated in the Northeast to allow for additional portfolio growth as expectations of prepayments increased.

 

Under normal economic conditions, a negative gap would normally suggest that net interest income would increase if market rates declined. A rise in market rates would normally have a detrimental effect on net interest income based on a negative gap. The opposite would normally occur when an institution is positively gapped. As market interest rates declined during fiscal 2002 the Company's negative gap position was a factor in increasing the net interest margin. It may be difficult to quantify expectations when interest rates are at very low levels, as we are 

 

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currently experiencing. With market interest rates at the lowest levels in many years, further declines may not result in the magnitude of change in asset and liability pricing experienced under more historical market conditions and would actually be expected to adversely affect the Company's net interest margin because core deposit accounts may have already priced to potential floor levels. It is unlikely that the Company will have the ability to adjust core deposit rates to the extent suggested by the most recent 50 basis point decline in market interest rates, although loans may gradually decline in reaction to certain market indices.

 

During fiscal 2001 as compared with fiscal 2000, lower interest rates and a steeper yield curve resulted in expansion in the Company's net interest margin and improvement in interest sensitivity.

 

Derivatives and Hedging Activities

 

Derivative transactions may be used by the Company to better manage its interest rate sensitivity to reduce risks associated with its lending, deposit taking, and borrowing activities. Effective October 1, 2000, with the adoption of Statement of Financial Accounting Standards ("SFAS") No. 133, "Accounting for Derivative Instruments and Hedging Activities," the Company began recognizing all derivatives as either assets or liabilities on the consolidated balance sheet and reporting these instruments at fair value with realized and unrealized gains and losses included in either earnings or in other comprehensive income, depending on the purpose for which the derivative is used and whether the derivative qualifies for hedge accounting.

 

By using derivative instruments, the Company is exposed to credit and market risk. Credit risk, which is the risk that the counterparty to a derivative instrument will fail to perform, is equal to the extent of the fair value gain in a derivative. Credit risk is created when the fair value of a derivative contract is positive, since this generally indicates that the counterparty owes us. When the fair value of the derivative contract is negative, no credit risk exists since the Company would owe the counterparty. The Company minimizes the credit risk in derivative instruments by entering into transactions with high-quality counterparties as evaluated by management. Market risk is the adverse effect on the value of a financial instrument from a change in interest rates or implied volatility of rates. We manage the market risk associated with interest rate contracts by establishing and monitoring limits as to the types and degree of risk that may be undertaken. The market risk associated with derivatives used for interest rate risk management activity is fully incorporated into our market risk sensitivity analysis.

 

At September 30, 2002, the fair value of derivative assets totaled $1.8 million and was related to commitments to originate fixed rate loans held for sale and forward sales commitments. The Company's derivative and hedging activities are discussed in further detail in Item 8, Note 15 of the Consolidated Financial Statements.

 

Off-Balance Sheet Arrangements

 

In the normal course of operations, the Company engages in a variety of financial transactions that, in accordance with generally accepted accounting principles, are not recorded in the financial statements, or are recorded in amounts that differ from the notional amounts. These transactions involve, to varying degrees, elements of credit, interest rate, and liquidity risk. Such transactions are used by the Company for general corporate purposes or for customer needs. Corporate purpose transactions are used to help manage credit, interest rate, and liquidity risk or to optimize capital. Customer transactions are used to manage customers' requests for funding.

 

The Company's off-balance sheet arrangements, which principally include lending commitments and derivatives, are described blow. At September 30, 2002 and 2001, the Company had no interests in non-consolidated special purpose entities.

 

Lending Commitments

 

Lending commitments include loan commitments, standby letters of credit and unused business credit card lines. These instruments are not recorded in the consolidated balance sheet until funds are advanced under the commitments. The Company provides these lending commitments to customers in the normal course of business.

 

For commercial customers, loan commitments generally take the form of revolving credit arrangements to finance customers' working capital requirements. For retail customers, loan commitments are generally lines of credit secured by residential property. At September 30, 2002, commercial and retail loan commitments totaled $61.9 million. Standby letters of credit totaled $1.9 million. Standby letters of credit are conditional commitments to guarantee performance, typically contract or financial integrity, of a customer to a third party. Unused business, personal and credit card lines, which totaled $268.9 million at September 30, 2002, are generally for short-term borrowings.

 

 

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First Financial applies essentially the same credit policies and standards as it does in the lending process when making these commitments. See Item 8, Note 15 to the Consolidated Financial Statements for additional information regarding lending commitments.

 

Derivatives

 

In accordance with SFAS No. 133, the Company records derivatives at fair value, as either assets or liabilities, on the consolidated balance sheets. Derivative transactions are measured in terms of the notional amount, but this amount is not recorded on the balance sheet and is not, when viewed in isolation, a meaningful measure of the risk profile of the instrument. The notional amount is not exchanged, but is used only as the basis upon which interest and other payments are calculated. See Item 8, Note 15 to Consolidated Financial Statements for additional information regarding derivatives.

 

Liquidity

 

The desired level of liquidity for the Company is determined by management in conjunction with the Asset/Liability Committee of the Association. The level of liquidity is based on management's strategic direction for the Company, commitments to make loans and the Committee's assessment of the Association's ability to generate funds. Historically, sources of liquidity have included net deposits to savings accounts, amortizations and prepayments of loans, FHLB advances, reverse repurchase agreements and sales of securities and loans held for sale.

 

Proper liquidity management is crucial to ensure that the Company is able to take advantage of new business opportunities as well as meet the demands of its customers. In this process, we focus on assets and liabilities and on the manner in which they combine to provide adequate liquidity to meet our needs. The table below summarizes future contractual obligations as of September 30, 2002.

 

Contractual Obligations

	At September 30, 2002
	Payments Due by Period
	(dollar amounts in thousands)
	Within One Year	Over One to Two Years	Over Two to Three Years	Over Three to Five Years	After Five Years	Total
	(in thousands)
Certificate accounts	$  431,726	$   78,231	$   86,839	$ 56,873	$     4,851	$    658,520
Borrowings	117,000	100,000	210,000	-	176,907	603,907
Operating leases	1,569	1,388	584	670	385	4,596
Total contractual obligations	$  550,295	$ 179,619	$ 297,423	$ 57,543	$ 182,143	$ 1,267,023

 

The Company's most stable and traditional source of funding has been the attraction and retention of deposit accounts, the success of which the Company believes is based primarily on the strength and reputation of the Association, effective marketing and rates paid on deposit accounts. First Federal has a major market share of deposits in Charleston, Berkeley and Dorchester Counties and a significant share of deposits in the Georgetown, Horry and Florence Counties. As a new entrant into Beaufort County, South Carolina and to Brunswick County, North Carolina, the Company holds a small but growing market share. By continuing to promote innovative new products, pricing competitively and encouraging the highest level of quality in customer service, the Company continues to successfully meet challenges from competitors, many of which are non-banking entities offering investment products.

 

Other primary sources of funds include borrowings from the FHLB, principal repayments on loans and mortgage-backed securities, reverse repurchase agreements and sales of loans. To minimize vulnerability, the Association has back-up sources of funds available, including FHLB borrowing capacity and securities available for sale. During fiscal 1999, the FHLB of Atlanta instituted a general policy of limiting borrowing capacity to a percent of assets, regardless of the level of advances that could be supported by available collateral for such advances. This new policy serves to define an upper cap for FHLB advances for the Association of approximately $793 million at September 30, 2002, based on its current approved cap. Should it be desired, the Association may request an increase in the cap level up to 40% of assets, subject to standard lending policies in effect at the FHLB.

 

 

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During 2002, the Company experienced a net cash inflow from investing activities of $76.2 million, consisting principally of $30.5 million in proceeds of sales of mortgage-backed securities and $56.6 million in repayments to mortgage-backed securities offset partially by purchases of $13.1 million. Significant operating activities of the Company included $377.1 million of residential loans originated for sale with sales of $353.7 million. Based on a net increase in deposits of $44.5 million, higher payments and prepayments of mortgage-backed securities and slower growth in loans due to sales, the Company reduced other borrowing sources by $111.2 million during the year ended September 30, 2002.

 

Proceeds from the sale of loans of $353.7 million in 2002 increased significantly from $237.1 million in 2001. Based on recent asset/liability management objectives, management expects to continue its strategy of selling selected longer-term, fixed-rate loans in fiscal 2002 and it anticipates volume may be strong due to declining market interest rates and their likely effect on fixed-rate loan originations. Current interest rate levels have pushed loan origination rates down to a level not experienced in several decades. Management is concerned with its ability to maintain its long-term growth objectives when a high percentage of current fixed-rate single family originations are being sold into the secondary market. The Company may increase its holdings of investments and mortgage-backed securities during future periods should loan portfolio growth slow dramatically.

 

Parent Company Liquidity

 

As a holding company, First Financial conducts its business through its subsidiaries. Unlike the Association, First Financial is not subject to any regulatory liquidity requirements. Potential sources for First Financial's payment of principal and interest on its borrowings and for its periodic repurchase programs include (i) dividends from First Federal and other subsidiaries; (ii) payments from existing cash reserves and sales of marketable securities; and (iii) interest on its investment securities. As of September 30, 2002, First Financial had cash reserves and existing marketable securities of $2.1 million compared with $2.3 million at September 30, 2001.

 

The Association's ability to pay dividends and make other capital contributions to First Financial is restricted by regulation and may require regulatory approval. Such distributions may also depend on the Association's ability to meet minimum regulatory capital requirements in effect during the period. Current OTS regulations permit institutions meeting certain capital requirements and subject to "normal supervision" to pay out 100% of net income to date over the calendar year and 50% of surplus capital existing at the beginning of the calendar year without supervisory approval. The Association is currently subject to "normal supervision" as to the payment of dividends.

 

Results of Operations

 

Net Interest Income

 

The largest component of operating earnings for the Company is net interest income. One of the Company's strategic initiatives has been to reduce the Company's reliance on net interest income through expansion of other sources of revenues. Net interest income totaled $82.7 million in fiscal 2002 compared with $70.4 million in fiscal 2001 and $62.8 million in fiscal 2000. Net interest income represented approximately 73% of the gross income of First Financial in fiscal 2002 compared with 74% in fiscal 2001 and 77% in fiscal 2000. The level of net interest income is determined by balances of earning assets and successfully managing the net interest margin. Changes in interest rates paid on assets and liabilities, the rate of growth of the asset and liability base, the ratio of interest-earning assets to interest-bearing liabilities and management of the balance sheet's interest rate sensitivity all factor into changes in net interest income. The absolute level of market interest rates also significantly affects the Company's ability to quickly react to balance sheet changes.

 

Net interest income increased by 17.5% to $82.7 million in fiscal 2002. This followed an increase of 12.1% in fiscal 2001 and 3.8% in fiscal 2000. The increase in fiscal 2002 was principally as a result of a slower decline in average yields on interest-earning assets relative to the reduction in the average cost of interest-bearing liabilities. As short-term market interest rates declined, the Company's interest-sensitive liabilities repriced to an average cost of 3.43% from an average cost of 4.87% in fiscal 2001. Average yields declined to 7.12% in fiscal 2002 from 7.87% in fiscal 2001. The Company's success in growing core deposit balances by $44.5 million also contributed to the dramatic decline in the Company's cost of funds in fiscal 2002. The Company's net interest margin increased in fiscal 2002 to 3.82% from 3.20% in fiscal 2001.

 

Economic conditions, market interest rates and competitive pressures in fiscal 2001 were less challenging than in fiscal 2000 when the Federal Reserve was moving interest rates to higher levels to combat the threat of higher growth in 

 

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inflation. The Company's average cost of interest-bearing liabilities declined to 4.87% in fiscal 2001 from 4.94% in fiscal 2000. Average yields on interest-earning assets increased from 7.71% in fiscal 2000 to 7.87% in fiscal 2001.

 

As the table below illustrates, for the year ended September 30, 2002 the net interest margin increased to 3.82% compared to 3.20% in fiscal 2001. The net interest margin also increased to 3.20% in 2001 from 2.99% in fiscal 2000.

 

The Company's net interest margin may be affected by many factors. Competition for deposit funds within the Company's markets ranges from many well-established national and regional banks and large credit unions to many smaller local banks. The general level and direction of interest rates and national monetary policy also can affect consumer deposit patterns and thus affect the Company's ability to utilize retail sources of funds. Management believes that conditions in fiscal 2002 and fiscal 2001 were much more favorable for deposit growth than in fiscal 2000. Expansion into new markets such as Hilton Head and declining stock market returns may have factored into the substantial growth in deposits in fiscal 2001, which continued at favorable levels in fiscal 2002. Fiscal 2000 was a very challenging year for retail deposit pricing. Late in calendar year 1999, many banks perceived the need to gather additional liquidity related to public concerns over the transition to the Year 2000. Many competitors developed special certificate of deposit products with higher interest rates to attract funds. Higher retail certificate of deposit pricing did not abate as expected after the first of the year and continued to affect the repricing of deposits, leading to higher average deposit costs for 2000. The demand for funds to originate loans required the Company to utilize other sources of funds, particularly FHLB borrowings.

 

Average Yields and Rates