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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
Quarterly Report Pursuant to Section 13 or 15(d) of
the Securities Exchange Act of 1934
For the Quarter Ended June 30, 2004
FIDELITY FEDERAL BANCORP
------------------------------------------------------
(Exact name of registrant as specified in its charter)
Indiana 0-22880 35-1894432
- ---------------------------- ---------- -------------
(State of other jurisdiction Commission (IRS Employer
of Incorporation of File No. Identification No.)
Organization)
18 NW Fourth Street
Evansville, Indiana 47708
---------------------------------------------------
(Address of principal executive offices) (Zip Code)
(812) 424-0921
--------------------------------------------------
Registrant's telephone number, including area code
Indicate by checkmark whether the registrant (1) has filed all reports required
to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during
the preceding twelve months and (2) has been subject to such filing requirements
for the past 90 days.
YES X NO
----- -----
Indicate by checkmark whether the registrant is an accelerated filer (as defined
in Rule 12b-2 of the Exchange Act).
YES NO X
----- -----
As of July 22, 2004, there were 10,999,871 shares of the Registrant's common
stock, $1 stated value, issued and outstanding.
FIDELITY FEDERAL BANCORP AND SUBSIDIARIES
Index
Page
PART I - FINANCIAL INFORMATION
ITEM 1- Financial Statements:
Condensed Consolidated Balance Sheets................................ 3
Condensed Consolidated Statements of Income.......................... 4
Condensed Consolidated Statements of Changes in Stockholders' Equity. 5
Condensed Consolidated Statements of Cash Flows...................... 6
Notes to Condensed Consolidated Financial Statements................. 7
ITEM 2 - Management's Discussion and Analysis of Results of Operations
and Financial Condition.............................................. 11-22
ITEM 3 - Quantitative and Qualitative Disclosures about Market Risk... 22
ITEM 4 - Controls and Procedures...................................... 22
PART II - OTHER INFORMATION............................................. 24
SIGNATURES.............................................................. 26
Index to Exhibits....................................................... 27
CERTIFICATIONS.......................................................... 28-31
2
Item 1 - Financial Statements
Part I - Financial Information
Fidelity Federal Bancorp And Subsidiaries
Condensed Consolidated Balance Sheets
(In thousands except share data)
June 30, December 31,
2004 2003
--------- ---------
(Unaudited)
Assets
Cash and due from banks $ 1,656 $ 1,705
Interest-bearing demand deposits 1,163 1,263
--------- ---------
Cash and cash equivalents 2,819 2,968
Investment securities available for sale 62,376 52,208
Loans, net of allowance for loan losses of $699 and $737 (Also includes
loans to related parties, net of allowance for loan losses of $371 and $394) 107,104 100,437
Premises and equipment 4,529 4,620
Federal Home Loan Bank of Indianapolis stock 3,542 3,466
Deferred income tax 6,441 6,093
Foreclosed assets held for sale 110 30
Interest receivable and other assets 5,836 5,568
--------- ---------
Total assets $ 192,757 $ 175,390
========= =========
Liabilities
Deposits:
Non-interest bearing (includes related party deposits of $728 and $854) $ 6,119 $ 6,903
Interest bearing 114,282 113,777
--------- ---------
Total deposits 120,401 120,680
Federal funds purchased 8,000 0
Federal Home Loan Bank advances 39,900 31,550
Borrowings (includes borrowings from a related party of $0 and $1,000) 7,367 8,077
Other liabilities 1,511 1,716
--------- ---------
Total liabilities 177,179 162,023
--------- ---------
Commitments and Contingencies -- --
Stockholders' Equity
Preferred stock, no par or stated value
Authorized and unissued--5,000,000 shares
Common stock, $1 stated value - Authorized--15,000,000 shares
Issued and outstanding--10,999,871 and 9,618,658 shares 11,000 9,619
Additional paid-in capital 17,728 16,634
Stock warrants 261 261
Retained earnings (12,763) (12,938)
Accumulated other comprehensive income (648) (209)
--------- ---------
Total stockholders' equity 15,578 13,367
--------- ---------
Total liabilities and stockholders' equity $ 192,757 $ 175,390
========= =========
See notes to condensed consolidated financial statements.
3
FIDELITY FEDERAL BANCORP AND SUBSIDIARIES
Condensed Consolidated Statements of Income
(In Thousands, Except Share Data)
(Unaudited)
Three Months Ended Six Months Ended
June 30, June 30,
2004 2003 2004 2003
------------ ------------ ------------ ------------
Interest Income
Loans receivable $ 1,519 $ 1,181 $ 3,008 $ 2,360
Investment securities--taxable 492 364 997 689
Loans held for sale -- -- -- 39
Deposits with financial institutions 4 16 7 38
Other dividend income 35 35 79 73
------------ ------------ ------------ ------------
Total interest income 2,050 1,596 4,091 3,199
------------ ------------ ------------ ------------
Interest Expense
Deposits 643 744 1,289 1,633
Federal funds purchased 17 -- 26 --
Federal Home Loan Bank advances 187 59 372 81
Borrowings 130 177 271 425
------------ ------------ ------------ ------------
Total interest expense 977 980 1,958 2,139
------------ ------------ ------------ ------------
Net Interest Income 1,073 616 2,133 1,060
Provision for loan losses 39 (18) 209 (122)
------------ ------------ ------------ ------------
Net Interest Income After Provision for Loan Losses 1,034 634 1,924 1,182
------------ ------------ ------------ ------------
Other Income
Service charges on deposit accounts 120 113 230 219
Net gains on loan sales 108 225 199 483
Net gains on sales of securities available for sale -- -- 47 320
Letter of credit fees 123 121 246 242
Servicing fees on loans sold 90 74 167 137
Income from interest only strip 17 54 36 114
Dealer interest recovery 52 79 103 162
Gain on sale of real estate owned -- 305 -- 317
Other income 149 135 333 331
------------ ------------ ------------ ------------
Total non-interest income 659 1,106 1,361 2,325
------------ ------------ ------------ ------------
Other Expenses
Salaries and employee benefits 792 844 1,599 1,724
Occupancy 86 83 178 175
Equipment 95 99 190 199
Data processing 135 115 256 215
Deposit insurance 14 12 27 26
Legal and professional 66 64 124 115
Advertising 53 44 111 89
Promotions 35 47 64 102
Printing, postage, and office supplies expense 35 49 62 105
Insurance 46 73 104 135
Letter of credit valuation provision -- (170) -- (170)
Correspondent bank charges 36 37 73 71
Other 209 361 401 634
------------ ------------ ------------ ------------
Total non-interest expense 1,602 1,658 3,189 3,420
------------ ------------ ------------ ------------
Income Before Income Tax 91 82 96 87
Income tax benefit (19) (21) (79) (71)
------------ ------------ ------------ ------------
Net Income $ 110 $ 103 $ 175 $ 158
============ ============ ============ ============
Basic Earnings per Share $ 0.01 $ 0.01 $ 0.02 $ 0.02
Diluted Earnings per Share $ 0.01 $ 0.01 $ 0.02 $ 0.02
Average Common and Common Equivalent shares outstanding 10,335,466 9,618,659 9,979,430 8,234,129
See notes to condensed consolidated financial statements
4
FIDELITY FEDERAL BANCORP AND SUBSIDIARIES
Condensed Consolidated Statements of Changes in Stockholders' Equity
(In Thousands, Except Share Data)
Six Months Ended
June 30,
---------------------------------------------------
2004 2003
--------- ---------
Beginning Balance $13,367 $9,588
Comprehensive income (loss)
Net income 175 158
Other comprehensive loss - net of tax (439) (152)
--------- ---------
Comprehensive income (loss) (264) 6
Issuance of stock 4,153
2,475
--------- ---------
Balances, June 30 (unaudited) $15,578 $13,747
========= =========
See notes to condensed consolidated financial statements.
5
Fidelity Federal Bancorp and Subsidiaries
Condensed Consolidated Statements of Cash Flows
(In thousands)
(Unaudited)
Six Months Ended
June 30,
--------------------
2004 2003
-------- --------
Operating Activities
Net income $ 175 $ 158
Adjustments to reconcile net income to net
cash provided (used) by operating activities
Provision for loan losses 209 (122)
Letter of credit valuation provision (170)
Net gain on sales of securities available for sale (47) (320)
Net gain on sale of loans (199) (483)
Gain on sale of foreclosed assets (312)
Depreciation and amortization 216 219
Mortgage loans originated for sale (5,582) (16,525)
Proceeds from sale of mortgage loans 5,695 16,853
Consumer loan origination transferred to held for sale (14,230) (17,932)
Proceeds from consumer loan sales 14,316 18,087
Changes in
Interest payable and other liabilities (205) 382
Interest receivable and other assets (136) (615)
Other (360) 47
-------- --------
Net cash used by operating activities (148) (733)
-------- --------
Investing Activities
Purchases of securities available for sale (23,222) (33,028)
Proceeds from maturities of securities available for sale 10,199 8,966
Proceeds from sales of securities available for sale 2,555 12,098
Proceeds from the sale of foreclosed assets 2,666
Purchase of FHLB stock (76) (36)
Net change in loans (7,168) (3,810)
Purchase of premises and equipment (125) (40)
-------- --------
Net cash used by investing activities (17,837) (13,184)
-------- --------
Financing Activities
Net change in
Noninterest-bearing, interest-bearing demand
and savings deposits (1,392) 454
Certificates of deposit 1,113 3,097
Net change in federal funds purchased 8,000
Proceeds from borrowings 2,465
Repayment of borrowings (2,175) (6,284)
Repayment of borrowings to a related party (1,000)
Proceeds from FHLB advances 64,500 14,000
Repayment of FHLB advances (56,150)
Sale of stock 2,475 4,153
-------- --------
Net cash provided by financing activities 17,836 15,420
-------- --------
Net Change in Cash and Cash Equivalents (149) 1,503
Cash and Cash Equivalents, Beginning of Period 2,968 3,823
-------- --------
Cash and Cash Equivalents, End of Period $ 2,819 $ 5,326
======== ========
Additional Cash Flows Information
Interest paid $ 1,896 $ 2,127
Real estate acquired in settlement of loans 291 657
See notes to condensed consolidated financial statements
6
Fidelity Federal Bancorp
and Subsidiaries
Notes to Condensed Consolidated Financial Statements
(Unaudited)
o Accounting Policies
The significant accounting policies followed by Fidelity Federal Bancorp
("Fidelity") and its wholly owned subsidiaries for interim financial reporting
are consistent with the accounting policies followed for annual financial
reporting. All adjustments which are necessary for a fair presentation of the
results for the periods reported, consist only of normal recurring adjustments,
and have been included in the accompanying unaudited condensed consolidated
financial statements. The results of operations for the six months ended June
30, 2004 are not necessarily indicative of those expected for the remainder of
the year. The condensed consolidated balance sheet at December 31, 2003 has been
derived from the audited financial statements.
Certain information and note disclosures normally included in the company's
annual financial statements prepared in accordance with accounting principles
generally accepted in the United States of America have been condensed or
omitted. These condensed consolidated financial statements should be read in
conjunction with the consolidated financial statements and notes thereto
included in the company's Form 10-K annual report for 2003 filed with the
Securities and Exchange Commission.
o Company Subsidiaries
Fidelity's savings bank subsidiary, United Fidelity Bank, fsb ("United"), was
organized in 1914, is a federally-chartered stock savings bank located in
Evansville, Indiana, and is regulated by the Office of Thrift Supervision
("OTS"). Fidelity, through its savings bank subsidiary, is engaged in the
business of obtaining funds in the form of savings deposits and other borrowings
and investing such funds in consumer, commercial, and mortgage loans, and in
investment and money market securities.
o Stockholders' Equity
In March 2004, Fidelity filed a registration statement for a stockholder rights
offering with the Securities and Exchange Commission. A total of 1.4 million
shares were registered in this filing. For every 6.9 shares of Fidelity held on
the record date, shareholders could subscribe to purchase one share of Fidelity
at $1.81. The rights offering was completed on May 14, 2004. Fidelity raised
$2.5 million net of cost associated with the offering. The shares purchased by
shareholders with these funds were issued in May 2004.
In April 2003, Fidelity issued 2.8 million shares of common stock for $4.0
million in cash through the exercise of an option held by Pedcor Financial, LLC
("Pedcor Financial") and affiliates. The exercise price per share was $1.44, and
was determined under a formula included in the shareholder-approved stock
purchase agreement effective May 19, 2000. The proceeds of the option exercise
were utilized to reduce Fidelity's long-term debt outstanding. The remaining
options expired on May 19, 2003. Pedcor Financial is a member of a group of
companies which is controlled by Bruce A. Cordingley, Gerald K. Pedigo and
Phillip J. Stoffregen directors of Fidelity. Following the option exercise in
April 2003, Pedcor Financial and group beneficially owned approximately 67.75%
of Fidelity's issued and outstanding stock.
o Cash Dividend
Fidelity's dividend policy is to pay cash or distribute stock dividends when its
Board of Directors deems it to be appropriate, taking into account Fidelity's
financial condition and results of operations, economic and market conditions,
industry standards, and other factors, including regulatory capital requirements
of its savings bank subsidiary. Fidelity is not subject to any regulatory
restrictions on payments to its stockholders. United has entered into a
Supervisory Agreement ("Agreement") with the Office of Thrift Supervision
("OTS"). One of the
7
provisions of the Agreement requires prior approval from OTS for payments of
dividends from United to Fidelity. Fidelity is uncertain when it will pay
dividends in the future and the amount of such dividends, if any.
o Other Restrictions
United entered into a supervisory agreement with the OTS on February 3, 1999.
The supervisory agreement, as amended on November 18, 2003, currently requires
United to:
o Refrain from paying dividends without OTS approval.
o Continue to comply with its strategic plan, including its capital targets,
as noted in the "Regulatory Capital" note, consistent with United's
business plan as approved by the OTS.
o Refrain from engaging in any transaction with or distribution of funds to
Fidelity or its subsidiaries or selling any assets to an affiliate without
OTS approval.
o Not engage in new activities not included in its strategic plan without OTS
approval.
United believes that it currently is in compliance with all provisions of the
supervisory agreement.
o Earnings per share
Earnings per share (EPS) were computed as follows:
Three Months Ended June 30, 2004
----------------------------------------------
Income Weighted-Average Per Share
Shares Amount
----------------------------------------------
Net income $ 110
=====
Basic earnings per share
Income available to common stockholders $ 110 10,332,032 $ 0.01
======
Effect of dilutive securities
Stock options - 3,434
----- ----------
Diluted earnings per share
Income available to common stockholders and
assumed conversions $ 110 10,335,466 $ 0.01
====== ========== ======
Three Months Ended June 30, 2003
----------------------------------------------
Income Weighted-Average Per Share
Shares Amount
----------------------------------------------
Net income $ 103
=====
Basic earnings per share
Income available to common stockholders $ 103 9,618,659 $0.01
=====
Effect of dilutive securities
Stock options - -
----- ---------
Diluted earnings per share
Income available to common stockholders and
assumed conversions $ 103 9,618,659 $0.01
===== ========= =====
8
Earnings per share (EPS) were computed as follows:
Six Months Ended June 30, 2004
----------------------------------------------
Income Weighted-Average Per Share
Shares Amount
----------------------------------------------
Net income $ 175
=====
Basic earnings per share
Income available to common stockholders $ 175 9,975,345 $ 0.02
======
Effect of dilutive securities
Stock options - 4,085
----- ---------
Diluted earnings per share
Income available to common stockholders and
assumed conversions $ 175 9,979,430 $ 0.02
===== ========= ======
Six Months Ended June 30, 2003
----------------------------------------------
Income Weighted-Average Per Share
Shares Amount
----------------------------------------------
Net income $ 158
=====
Basic earnings per share
Income available to common stockholders $ 158 8,234,129 $0.02
=====
Effect of dilutive securities
Stock options - -
----- ---------
Diluted earnings per share
Income available to common stockholders and
assumed conversions $ 158 8,234,129 $0.02
===== ========= =====
Options to purchase 307,696 shares of common stock at prices ranging from $2.88
to $11.81 per share as well as stock warrants representing the right to purchase
509,471 share of common stock at prices ranging from $3.00 to $8.93 per share
were outstanding at June 30, 2004, but were not included in the computation of
diluted EPS because the options' exercise price was greater than the average
market price of the common shares.
o Automobile Loan Securitization
United completed an automobile loan securitization transaction in 2002.
A summary of the components of managed loans, which represents both owned and
securitized loans, follows. The automobile loans presented represent the managed
portfolio of indirect prime automobile loans.
Loans Past
Principal Due Over
As of June 30, 2004 Balance 30 Days
- -----------------------------------------------------------------------------
Total managed automobile loans $ 96,486 $714
Less: Automobile loans securitized (16,705) (278)
Automobile loans serviced for others (38,911) (146)
----------------------------
Total automobile loans held in portfolio $40,870 $290
============================
United estimates the fair value of the retained interest at the date of the
transfer and during the period of the transaction based on a discounted cash
flow analysis. United receives annual servicing fees based on the loan
9
balances outstanding, the rights to future cash flows arising after investors in
the securitization trust have received their contractual return and after
certain administrative costs of operating the trust. These cash flows are
estimated over the life of the loans using prepayment, default and interest rate
assumptions that market participants would use for financial instruments subject
to similar levels of prepayment, credit and interest rate risk.
A summary of the fair values of the interest-only strip and servicing asset
retained, key economic assumptions used to arrive at the fair values, and the
sensitivity of the June 30, 2004 fair values to immediate 10% and 20% adverse
changes in those assumptions follows. Actual credit losses experienced through
year-end 2003 and thus far in 2004 on the pool of automobile loans securitized
have been consistent with initial projections. As such, the expected static pool
loss assumption would perform consistently with that disclosed in the
sensitivity analysis. The sensitivities are hypothetical. Changes in fair value
may not be linear. Also, the effect of a variation in a particular assumption on
the fair value of the retained interests is calculated without changing any
other assumption; in reality, changes in one factor may result in changes in
another (for example, increases in market interest rates may result in lower
prepayments and increased credit losses), which might either magnify or
counteract the sensitivities.
Weighted- Monthly Expected
Average Prepayment Cumulative Annual Weighted-
Fair Life Speed Credit Discount Average
Value (in months) (% ABS) Losses Rate Coupon
---------------------------------------------------------------------------------
Interest-only strip
As of the date of securitization $ 2,707 39 1.50% 1.50% 15.0% 9.09%
As of June 30, 2004 1,258 12 1.19 1.50 15.0 8.49
Decline in fair value of 10%
adverse change $ 9 $ 8 $ 15
Decline in fair value of 20%
adverse change 27 15 30
Servicing asset
As of the date of securitization 362 39 1.50% 1.50% 15.0%
As of June 30, 2004 * 24 15 1.19 1.50 15.0
Decline in fair value of 10%
adverse change $ 7 $ 0 $ 0
Decline in fair value of 20%
adverse change 15 0 1
*Carrying value of the servicing asset approximated fair value at June 30, 2004.
o Stock Option
Stock options and Fidelity's stock-based incentive compensation plans are
discussed more fully in the notes to Fidelity's December 31, 2003 audited
financial statements contained in Fidelity's annual report. Fidelity accounts
for these plans under the recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to Employees, and related Interpretations.
No stock-based employee compensation cost is reflected in net income, as all
options granted under those plans had an exercise price that was equal to or
greater than the market value of the underlying common stock on the grant date.
The following table illustrates the effect on net income and earnings per share
if Fidelity had applied the fair value provisions of FASB statement No. 123,
Accounting for Stock-Based Compensation, to stock-based employee compensation.
10
Three Months Ended Six Months Ended
June 30 June 30
----------------------------------------------------------
2004 2003 2004 2003
----------------------------------------------------------
Net income as reported $ 110 $ 103 $ 175 $ 158
Less: Total stock-based compensation cost determined
under the fair value based method, net of income (4) (8) (7) (16)
taxes
----------------------------------------------------------
Pro forma net income $ 106 $ 95 $ 168 $ 142
==========================================================
Basic earnings per share - as reported $0.01 $0.01 $0.02 $0.02
Basic earnings per share - pro forma $0.01 $0.01 $0.02 $0.02
Diluted earnings per share - as reported $0.01 $0.01 $0.02 $0.02
Diluted earnings per share - pro forma $0.01 $0.01 $0.02 $0.02
o Reclassifications
Reclassifications of certain amounts from the condensed consolidated income
statements for the three and six month periods ended June 30, 2003 have been
made to conform to the presentation of the three and six month periods ended
June 30, 2004. These reclassifications had no effect on net income.
Item 2 - Management's Discussion and Analysis of Financial Condition and
Results of Operations
Management's discussion and analysis of financial condition and results of
operations is intended to assist in understanding the financial condition and
results of operations of Fidelity. The information contained in this section
should be read in conjunction with the consolidated financial statements and
accompanying notes contained in this report.
Portions of this Management's Discussion and Analysis, as well as the notes to
the consolidated financial statements contain certain forward-looking statements
(as defined in the Private Securities Litigation Reform Act of 1995), which
reflect management's current beliefs and expectations and are intended to
benefit the reader. These forward-looking statements are inherently subject to
various risks and uncertainties which may cause actual results to differ
materially from expected results. Such risks and uncertainties include, but are
not limited to, economic conditions, generally and in the market areas of the
Company, increased competition in the financial services industry, actions by
the Federal Reserve Board, changes in interest rates and governmental regulation
and legislation.
Comparison of Financial Condition at June 30, 2004 and December 31, 2003
Total assets at June 30, 2004 were $192.8 million, an increase of $17.4 million
from $175.4 million at December 31, 2003. The increase in total assets was
attributable to an $10.2 million increase in investment securities and $6.7
million increase in net loans.
At June 30, 2004, the investment portfolio represented 32.4% of Fidelity's
assets, compared to 29.8% at December 31, 2003 and is managed in a manner
designed to meet the Board's investment policy objectives. Fidelity expects
moderate investment activity in 2004, which includes new purchases to reinvest
investments in maturities and paydowns in the mortgage-back portfolio. At June
30, 2004, the entire investment portfolio was classified as available for sale.
The net unrealized loss at June 30, 2004, which is included as a component of
stockholders' equity, was $648,000 and was comprised of gross unrealized gains
of $31,000 and gross unrealized losses of $1.1 million and tax benefit of
$396,000. The increase in unrealized loss from December 31, 2003 was caused
primarily by market interest rate changes during the period.
Net loans increased $6.7 million to $107.1 million at June 30, 2004. The
increase is primarily attributable to a increase in commercial, commercial real
estate and consumer loans. Total commercial real estate loans outstanding
11
have increased by $4.9 million, consumer loans have increased $3.5 million and
total commercial and industrial loans have increased by approximately $1.5
million in 2004.
Consumer loans increased by $3.5 million to $42.5 million at June 30, 2004. The
portfolio is primarily composed of prime automobile loans generated through a
network of automobile dealers in Indiana, Kentucky, Illinois and Missouri. In
connection with United's strategic plan, United may increase its consumer loan
portfolio up to 28% of total assets. At June 30, 2004, United's consumer loans
to total assets was 22.4%.
These increases were offset partially by a $3.6 million decrease in first
mortgage loans. Fidelity continues to sell originated fixed-rated conventional
mortgage loans, record the gain or loss at the time of sale and use the proceeds
to fund future originations. Payments received during 2004 exceeded originations
placed in the portfolio during 2004 resulting in a net decrease in first
mortgage loans.
Fidelity has no loans to foreign governments, foreign enterprises, foreign
operations of domestic companies or highly leveraged transactions, nor any
concentration to borrowers engaged in the same or similar industries that exceed
ten percent of total loans.
The allowance for loan losses decreased $38,000 to $699,000 at June 30, 2004
from $737,000 at December 31, 2003. During the first half of 2004 Fidelity
provided an additional $323,000 in provision for loan losses which were offset
by $323,000 in charge-offs for the first half of 2004. Recoveries of $76,000
were received during the first six months in addition to a $114,000 credit to
the provision for consumer loans in connection with consumer loans transferred
to held for sale which totaled $14.2 million during the first half of 2004.
Fidelity completed consumer loan sales during the month the loans were
identified for sale, therefore no consumer loans were identified as held for
sale at June 30, 2004. Net charge offs for the quarter totaled $81,000 and were
associated with consumer loans. An additional $63,000 charge-off was recorded in
the first quarter of 2004 on a problem commercial loan with a remaining
outstanding balance of $170,000 at June 30, 2004. The allowance for loan losses
represented 0.65% of total loans at June 30, 2004, compared to 0.73% at December
31, 2003. Relative to non-performing loans, the allowance for loan losses was
77.2% compared to 43.3% at December 31, 2003.
Multifamily letters of credit, an off-balance sheet item, carry the same risk
characteristics as conventional loans and totaled $27.0 million at June 30, 2004
compared to $27.8 million at December 31, 2003. The valuation allowance for
letters of credit to total letters of credit totaled 1.1% at June 30, 2004
compared to 1.0% at December 31, 2003. The valuation allowance for letters of
credit is included in other liabilities and totaled $300,000 at June 30, 2004.
The allowance for loan losses and letters of credit to total loans and letters
of credit at June 30, 2004 and December 31, 2003 was 0.74% and 0.80%,
respectively.
Management considers the allowance for loan losses and valuation allowance for
letters of credit adequate to meet losses inherent in the loan and letter of
credit portfolios at June 30, 2004.
The following table sets forth an analysis of the allowance for loan losses for
the six months ended June 30, 2004 and the year ended December 31, 2003:
Six months
ended Year ended
June 30, December 31,
2004 2003
----------- ------------
(dollars in thousands)
Allowance for loan losses at beginning of period $ 737 $ 837
Provision for losses 323 492
Provision transferred to held for sale (114) (479)
Loans charged off (323) (236)
Recoveries on loans 76 123
----------- ------------
Allowance for loan losses at end of period $ 699 $ 737
=========== ============
12
Average deposits increased $15.3 million to $127.2 million at June 30, 2004
compared to $111.9 million at December 31, 2003. United utilizes retail, public,
and brokered deposits to assist in asset growth. Average non-interest bearing
accounts at June 30, 2004 increased $1.7 million over December 31, 2003.
Fidelity also utilized its various federal fund lines of credit to assist in
asset growth. At June 30, 2004, Fidelity's federal funds purchased totaled $8.0
million compared to none at December 31, 2003.
At June 30, 2004, Fidelity's borrowings consisted of FHLB advances, senior notes
and junior notes. Of the $47.3 million outstanding at June 30, 2004, $39.9
million were FHLB advances. FHLB advances increased by $8.4 million over
December 31, 2003 to assist in funding investment and loan growth. During the
first half of 2004, Fidelity utilized funds received from its debt and equity
offerings that were completed during the quarter to reduce the amount
outstanding on its line of credit by $275,000 in addition to paying off a $1.0
million unsecured note to a related party. The remaining $1.8 million in 10%
senior subordinated notes due June 2005 were retired in the second quarter of
2004.
Total stockholders' equity increased $2.2 million to $15.6 million at June 30,
2004. The increase was attributable to net income of $175,000, and the issuance
of $2.5 million in stock in connection with the equity offering that was
completed on May 18, 2004. These increases were reduced $439,000 due to the
change in unrealized losses on investment securities available for sale.
Non-Performing Assets
Non-performing assets decreased $716,000 from December 31, 2003 to $1.0 million
or 0.53% of total assets at June 30, 2004 compared to $1.7 million or 0.99% of
total assets at December 31, 2003. The decrease is primarily due to one large
residential loan that paid off during the first quarter of 2004 and a reduction
in non-accrual consumer loans.
The following table provides information on Fidelity's non-performing assets as
of June 30, 2004 and December 31, 2003:
June 30, December 31,
2004 2003
- ----------------------------------------------------------------------------
(Dollars in Thousands)
Non-accrual loans
Real estate mortgage $ 134 $ 788
Home equity 200 127
Consumer 100 233
Commercial 204 267
------ ------
Total non-accrual loans 638 1,415
90 days or more past due and accruing
Consumer 37 54
Commercial 231 233
------ ------
Total 90 days or more past due and accruing 268 287
Other real estate owned and repossessed assets 110 30
------ ------
Total non-performing assets $1,016 $1,732
====== ======
Ratio of non-performing assets to total assets 0.53% 0.99%
====== ======
Classified Assets
Classified assets totaled $1.1 million at June 30, 2004 compared to $1.8 million
at December 31, 2003. Total classified assets were 6.9% and 12.2% of Fidelity's
capital and reserves at June 30, 2004 and December 31, 2003, respectively. In
addition to the classified assets and letters of credit, there are other assets
and letters of credit
13
totaling $3.5 million at June 30, 2004, compared to $6.2 million at December 31,
2003, for which management was closely monitoring the borrower's abilities to
comply with payment terms.
Capital Resources
United is subject to various regulatory capital requirements administered by the
federal banking agencies and is assigned to a capital category. The assigned
category is largely determined by three ratios that are calculated according to
the regulations: total risk adjusted capital, Tier I capital, and Tier I
leverage ratios. The ratios are intended to measure capital relative to assets
and credit risk associated with those assets and off balance sheet exposures of
the entity. The capital category assigned to an entity can also be affected by
qualitative judgments made by regulatory agencies about the risk inherent in the
entity's activities that are not part of the calculated ratios.
There are five capital categories defined in the regulations, ranging from well
capitalized to critically undercapitalized. Classification of a bank in any of
the undercapitalized categories can result in actions by regulators that could
have a material effect on a bank's operations. At June 30, 2004 and December 31,
2003, United is categorized as well capitalized and met all subject capital
adequacy requirements.
Tangible Core Tier 1 Risk-based
Dollars in thousands Capital Capital Capital Capital
- ------------------------------------------ ------------ ---------- ----------- --------------
Regulatory capital $13,192 $13,287 $12,100 $17,066
Minimum capital requirement 2,813 7,505 4,929 9,858
------------ --------- ----------- --------------
Excess capital $10,379 $5,782 $ 7,171 $7,208
============ ========= =========== ==============
Regulatory capital 7.03% 7.08% 9.82% 13.85%
Required capital requirements 1.50% 4.00% 4.00% 8.00%
------------ --------- ----------- --------------
Excess over minimum 5.53% 3.08% 5.82% 5.85%
============ ========= =========== ==============
Regulatory capital 7.03% 7.08% 9.82% 13.85%
Strategic plan capital requirement N/A 6.25% 8.25% 11.00%
------------ --------- ----------- --------------
Excess over minimum 7.03% 0.83% 1.57% 2.85%
============ ========= =========== ==============
United continues to evaluate and pursue opportunities to improve its capital
ratios. There are no specific targets for capital levels included in the
Supervisory Agreement between United and the OTS, only a requirement that United
include capital minimums within its strategic plan. The strategic plan
established minimum capital ratios of 6.25% for core capital 8.25% for Tier I
and 11.0% for risk-based capital. United exceeded these minimums at June 30,
2004.
Liquidity
The primary sources of funds from operations are principal and interest payments
on loans, deposits from customers, and sales and maturities of investment
securities. Fidelity's entire investment portfolio is classified as "available
for sale" and totaled $62.4 million at June 30, 2004 and could be utilized to
assist in liquidity management. In addition, United is authorized to borrow
money from the Federal Home Loan Bank (FHLB) or draw on $15.0 million in secured
lines of credit with other financial institutions. At June 30, 2004, United's
gross borrowing capacity at the FHLB is $75.0 million with approximately $3.7
million available to draw upon based on current assets pledged. United had
approximately $5.1 million available to draw on its lines of credit at June 30,
2004. During the first half of 2004, Fidelity completed a debt and equity rights
offering that raised approximately $4.9 million. Approximately $1.0 million of
these proceeds was used to redeem a portion of the 10% senior subordinated notes
on April 20, 2004 with an additional $800,000 redeemed on May 7, 2004.
Approximately $275,000 was used to paydown a line of credit and $1.0 million was
used to pay off an unsecured note to a related party. An additional $1.0 million
was infused into United for additional capital to support asset growth. Fidelity
believes that the above actions will assist it in meeting its future liquidity
needs.
14
Fidelity is not subject to any regulatory restrictions on the payment of
dividends to its stockholders. However, United is restricted from paying any
dividends to Fidelity without prior approval of the OTS under the terms of the
Supervisory Agreement.
Fidelity has a $500,000 line of credit and can draw on this line until the
expiration in September 2004. At June 30, 2004, $0 was outstanding on the line
of credit. Fidelity's liquidity position may be further improved by the
potential issuance of additional stock, additional debt or equity financing, or
dividends from United to Fidelity.
Comparison of Operating Results for the Three Months Ended June 30, 2004 and
2003
Net income for the three months ended June 30, 2004 was $110,000 compared to net
income of $103,000 for the three months ended June 30, 2003. This change was
primarily attributable to an increase in net interest income and a reduction in
non-interest expense partially offset by an increase in the provision for loan
losses and reduction in non-interest income.
Net Interest Income
The following table summarizes Fidelity's average interest-earning assets and
average interest-bearing liabilities with the accompanying average rates for the
first three months of 2004 and 2003:
Three months ended Average yield for
June 30, Three months ended
(dollars in thousands) June 30,
-------------------------------- -----------------------------
2004 2003 2004 2003
--------------- ------------ ------------ ------------
Interest-earning assets $178,380 $124,287 4.62% 5.15%
Interest-bearing liabilities 170,525 122,457 2.30 3.21
-------- -------- ---- ----
Net interest bearing assets (liabilities) $ 7,855 $ 1,830
======== ========
Net interest spread 2.32% 1.94%
===== =====
Net interest margin 2.42% 1.99%
===== =====
Net interest income for the quarter ended June 30, 2004 was $1.1 million
compared to $616,000 earned during the same period in 2003. Total interest
income increased $454,000 to $2.1 million for the quarter ended June 30, 2004
from $1.6 million for the same period in 2003. The increase in interest income
was primarily attributable to an increase in average consumer loans of $23.5
million. The remaining increase in interest income from loans was a result of
increased outstandings in commercial and commercial real estate loans of $8.4
million and a $5.3 million increase in real estate mortgage loans.
Average investment securities increased by $22.9 million which attributed to
additional interest income but was partially offset by a decrease in yield on
the investment portfolio resulting in a net increase in interest income of
$128,000 for the quarter ended June 30, 2004 when compared to the same period in
2003.
Total interest expense decreased by $3,000 for the three months ended June 30,
2004 compared to the same period in 2003. Interest expense on deposits decreased
by $101,000 due to a combination of an increase in outstandings in certificates
of deposits offset by a decrease in their average rate. This decrease in expense
was partially offset by an increase in outstandings for FHLB advances and
borrowings that resulted in additional expense of $97,000 for the quarter ended
June 30, 2004.
Provision for Loan Losses and Letters of Credit Valuation Provision
The provision for loan losses for the three months ended June 30, 2004 was
$39,000 compared to a $18,000 credit for the three months ended June 30, 2003.
Additional loan loss provisions were made during the second quarter of 2004
based on loan growth, delinquency and charge-off trends.
15
A provision for loan losses of $118,000 for the second quarter of 2004 was
recognized but was partially offset by a $79,000 reduction due to a consumer
loan sale, resulting in a net provision of $39,000. During the second quarter of
2003 the net $86,000 provision for loan losses was offset by a $104,000
reduction due to a consumer loan sale for a net credit to the provision for loan
losses for the quarter of $18,000.
Fidelity makes provisions for loan losses in amounts estimated to be sufficient
to maintain the allowance for loan losses at a level considered necessary by
management to absorb losses in the loan portfolios. Specific reserves are
assigned to certain credits. The reserves are determined by management's
evaluation of those credits, which include evaluations of borrower's ability to
repay outstanding debt, as well as the value of supporting collateral. The
results of internal loan reviews, previous regulatory reviews, and past events
assist Fidelity in making that evaluation. The independent support for the
allowance for loan losses and letter of credit valuation reserve includes
documentation that supports the amount of recorded reserves for these credits.
General reserves for loans and letters of credit not specifically reserved are
also determined. Fidelity computes general reserves for the commercial,
commercial mortgage, residential mortgage and consumer loan portfolios by
utilizing historical information and information currently available about the
loans within those portfolios that provides information as to the likelihood of
loss. The potential effect of current economic conditions is also considered
with respect to establishing general reserve amounts.
United expects to increase the allowance for loan losses if loan growth and
losses meets 2004 targets. As a result, the provision for loan losses may also
increase on a quarter to quarter comparison in 2004.
Non-interest income
Non-interest income for the three months ended June 30, 2004 was $659,000
compared to $1.1 million for the same period in 2003, a decrease of $447,000.
Net gains on loan sales decreased $117,000 from the prior year due to a decrease
in volume of automobile and mortgage loans sold. Income of $17,000 was
recognized on the retained interests in securitized assets compared to $54,000
in 2003. The sale of two foreclosed properties in the second quarter of 2003
generated gains totaling $305,000. There were no sales of foreclosed properties
in the second quarter of 2004.
Non-interest expense
Non-interest expense decreased $56,000 to $1.6 million for the three months
ended June 30, 2004 compared to $1.7 million for the same period in 2003.
Excluding a $170,000 credit to the letter of credit valuation provision,
non-interest expense would have decreased by $226,000.
Salaries and employee benefits decreased $52,000 from the quarter ended June 30,
2003 due to a reduction in full-time equivalent employees. Data processing
expense increased $20,000 over the prior year due to increased volume of
mortgage and consumer loans serviced, and the introduction of internet banking
late in 2003. Bond issuance expense decreased $45,000 from 2003 due to the
retirement of subordinated notes in the prior year and the deferred cost
associated with the retired debt. Insurance decreased $27,000 for the quarter
ended June 30, 2004 when compared to the same period in 2003.
Income tax benefit
The income tax benefit was $19,000 for the three months ending June 30, 2004
compared to $21,000 for the same period last year. Included in the 2004 benefit
are tax credits of $55,000. These credits are received from Fidelity's remaining
investments in limited partnership interests in affordable housing properties
and are a component of the overall return on these investments.
16
Comparison of Operating Results for the Six Months Ended June 30, 2004 and 2003
Net income for the six months ended June 30, 2004 was $175,000 compared to net
income of $158,000 for the six months ended June 30, 2003. This change was
primarily attributable to an increase in net interest income and a reduction in
non-interest expense partially offset by an increase in the provision for loan
losses and reduction in non-interest income.
Net Interest Income
The following table summarizes Fidelity's average interest-earning assets and
average interest-bearing liabilities with the accompanying average rates for the
first six months of 2004 and 2003:
Six months ended Average yield for
June 30, Six months ended
(dollars in thousands) June 30,
-------------------------------- -----------------------------
2004 2003 2004 2003
--------------- ------------ ------------ ------------
Interest-earning assets $173,193 $120,212 4.75% 5.37%
Interest-bearing liabilities 166,909 120,756 2.36 3.57
-------- -------- ---- ----
Net interest bearing assets (liabilities) $ 6,284 $ (544)
======== ========
Net interest spread 2.39% 1.80%
===== =====
Net interest margin 2.48% 1.78%
===== =====
Net interest income for the first six months ended June 30, 2004 was $2.1
million compared to $1.1 million earned during the first six months ended June
30, 2003. Total interest income increased $892,000 to $4.1 million for the six
months ended June 30, 2004 from $3.2 million for the same period in 2003. The
increase in interest income was primarily attributable to an increase in average
consumer loans of $23.5 million. The yield on consumer loans decreased from
7.49% at June 30, 2003 to 5.81% at June 30, 2004. This decrease in rate which
impacted the margin negatively by $369,000 was offset by the increase in average
balances which resulted in an increase in consumer loan income of $880,000 for a
net effect of $511,000. The remaining increase in interest income from loans was
a result of increased outstandings in commercial and commercial real estate
loans.
Average investment securities increased by $22.9 million which attributed to
additional interest income of $426,000. However this interest income was
partially offset by a decrease in yield on the investment portfolio resulting in
$117,000 decrease in interest income for a net effect of additional interest
income of $309,000.
Total interest expense decreased by $181,000 for the six months ended June 30,
2004 compared to the same period in 2003. This decrease was due to a combination
of a decrease in certificates of deposits and borrowings and their average rate
of $681,000 and $207,000, respectively. This decrease in expense was partially
offset by an increase in outstandings for certificates of deposit and borrowings
(including FHLB advances) resulting in additional expense of $337,000 and
$370,000, respectively.
17
The following table sets forth the details of the rate and volume change for the
first six months of 2004 compared to the same period in 2003.
Six Months Ended June 30,
2004 vs 2003
Increase (Decrease)
Due to change in
-----------------------------------------------
Volume Rate Total
------------- ----------- ---------------
Interest Income:
Loans and mortgage-backed securities $ 1,574 $ (618) $ 956
Other interest-earning assets (47) (17) (64)
------- ------ -------
Total interest-earning assets 1,527 (635) 892
Interest Expense:
Deposits 337 (681) (344)
FHLB advances and other borrowings 370 (207) 163
------- ------ -------
Total interest-bearing liabilities 707 (888) (181)
------- ------ -------
Change in net interest income $ 820 $ 253 $ 1,073
======= ====== =======
Provision for Loan Losses and Letters of Credit Valuation Provision
The provision for loan losses for the six months ended June 30, 2004 was
$209,000 compared to a $122,000 credit for the six months ended June 30, 2003.
Additional loan loss provisions were made during the first six months of 2004
based on loan growth, delinquency and charge-off trends.
A provision of $323,000 for the first half of 2004 was recognized but partially
offset by a $114,000 reduction due to a consumer loan sale in 2004, resulting in
a net provision of $209,000. During the first half of 2003 the $161,000
provision was offset by a $283,000 reduction due to a consumer loan sale for a
net credit of $122,000 for 2003.
Fidelity makes provisions for loan losses in amounts estimated to be sufficient
to maintain the allowance for loan losses at a level considered necessary by
management to absorb losses in the loan portfolios. Specific reserves are
assigned to certain credits. The reserves are determined by management's
evaluation of those credits, which include evaluations of borrower's ability to
repay outstanding debt, as well as the value of supporting collateral. The
results of internal loan reviews, previous regulatory reviews, and past events
assist Fidelity in making that evaluation. The independent support for the
allowance for loan losses and letter of credit valuation reserve includes
documentation that supports the amount of recorded reserves for these credits.
General reserves for loans and letters of credit not specifically reserved are
also determined. Fidelity computes general reserves for the commercial,
commercial mortgage, residential mortgage and consumer loan portfolios by
utilizing historical information and information currently available about the
loans within those portfolios that provides information as to the likelihood of
loss. The potential effect of current economic conditions is also considered
with respect to establishing general reserve amounts.
United expects to increase the allowance for loan losses if loan growth and
losses meets 2004 targets. As a result, the provision for loan losses may also
increase on a quarter to quarter comparison in 2004.
Non-interest income
Non-interest income for the six months ended June 30, 2004 was $1.4 million
compared to $2.3 million for the same period in 2003, a decrease of $964,000.
Net gains on loan sales decreased $284,000 from the prior year due to a decrease
in volume of automobile and mortgage loans sold. A $320,000 gain on the sale of
available for sale investments was recognized during the first half of 2003
compared to $47,000 in 2004 for the same time period. Increased prepayment
speeds, remaining premiums, and pricing made it advantageous to sell the
securities for a gain in 2003. Income of $36,000 was recognized on the retained
interests in securitized assets compared to $114,000 in 2003. An increase in
early payoffs on automobile loans due to the historically low interest rate
environment in 2003 resulted in the
18
repayment of $162,000 in interest previously written off compared to $103,000
for the same period in 2004. The sale of two foreclosed properties generated
gains totaling $317,000 during the first half of 2003 compared to none in 2004.
Included in other income in 2003 were non-recurring items which Fidelity
received during 2003 totaling approximately $125,000 from Fidelity's active
participation in affordable housing activities, which ended late in 2002. This
decrease in the current year was partially offset in 2004 by slower amortization
of loan servicing rights which contributed to additional non-interest income of
$106,000.
Non-interest expense
Non-interest expense decreased $231,000 to $3.2 million for the six months ended
June 30, 2004 compared to $3.4 million for the same period in 2003. Excluding a
$170,000 credit to the letter of credit provision, non-interest expense would
have decreased by $401,000.
Salaries and employee benefits decreased $125,000 from the first six months
ended June 30, 2003 due to a reduction in full-time equivalent employees. Data
processing expense increased $41,000 over the prior year due to increased volume
of mortgage and consumer loans serviced, and the introduction of internet
banking later in 2003. Promotion expense decreased $38,000 from 2003 due
primarily to a decrease in automobile originations in the current year.
Advertising increased $22,000 over 2003. Printing, postage and office supplies
decreased $43,000 from 2003 due to cost cutting procedures implemented in 2004.
Professional liability insurance decreased $31,000 from the prior year due to
market rate decreases. Bond issuance expense decreased $54,000 from 2003 due to
the retirement of subordinated notes in 2003 and the deferred cost associate
with the retired debt. Credit bureau expense decreased $13,000 from the prior
year due to lower automobile volume.
Income tax benefit
The income tax benefit was $79,000 for the six months ending June 30, 2004
compared to $71,000 for the same period last year. Included in the 2004 benefit
are tax credits of $111,000. These credits are received from Fidelity's
remaining investments in limited partnership interests in affordable housing
properties and are a component of the overall return on these investments.
Consideration of the need for a valuation allowance for the deferred tax asset
was made at June 30, 2004 after projecting the reversal of the deferred items.
These analyses were based on projected operating income in future years, action
plans developed and partially implemented included in Fidelity's business plan
and cost reductions. These analyses showed that not all carryforwards would be
utilized within the carryforward periods (federal and state) and a valuation
allowance would be necessary. The analyses assume that Fidelity will execute
approximately 50% of the initiatives included within its current business plan
and then achieve 10% growth in annual earnings thereafter. The conservative
level of earnings contemplated by these analyses, if achieved, will constitute
for the majority of the carryforward periods, earnings levels that are below
other thrift holding companies included within Fidelity's peer group. Due to the
level of projected profitability for 2002 being less than originally
anticipated, Fidelity established a valuation allowance of $600,000 at December
31, 2002. Fidelity considers the current valuation allowance adequate at June
30, 2004 based upon the results of the above analysis and assumptions, but
cannot assure that future income will be enough to support the current level of
deferred taxes.
The assumptions used to help consider the need for a valuation allowance for the
deferred tax asset are subject to certain risks and uncertainties that could
impact the final determination regarding the amount of the valuation allowance.
These risks include the failure to implement the business plan targets for
increased revenues, cost reductions, the potential loss of key employees,
ability to maintain projected interest rate margins, and the potential
disruption of activities in key income-producing areas.
Sarbanes-Oxley Act
On July 30, 2002, President George W. Bush signed into law the Sarbanes-Oxley
Act of 2002 (the "Sarbanes-Oxley Act"). The Sarbanes-Oxley Act implements a
broad range of corporate governance and accounting measures for public companies
designed to promote honesty and transparency in corporate America and better
protect investors from the type of corporate and accounting scandals that have
occurred during the past years. We anticipate that
19
we will incur additional expense in complying with the provisions of the
Sarbanes-Oxley Act and the resulting regulations. The financial impact on our
results of operations or financial condition is not yet determinable. Fidelity's
Board of Directors has discussed the desirability of taking steps to delist its
shares of common stock from NASDAQ and to terminate its reporting obligations
under the Securities Exchange Act of 1934. At this time, the Board has come to
no conclusions regarding this matter and is not able to predict when it may do
so. The Board is currently reviewing the additional costs expected to be
incurred in connection with new requirements imposed by the Sarbanes-Oxley Act.
Application of Critical Accounting Policies
Fidelity's financial statements are prepared in accordance with accounting
principles generally accepted in the United States of America and reporting
practices followed within the banking industry. The application of these
principles requires management to make estimates, assumptions, and judgments
that affect the amounts reported in the financial statements and accompanying
notes. These estimates, assumptions, and judgments are based on information
available as of the date of the financial statements; as this information
changes, the financial statements could reflect different estimates,
assumptions, and judgments.
Allowance for Loan Losses: Fidelity maintains a reserve to absorb probable loan
losses inherent in the portfolio. The reserve for credit losses is maintained at
a level Fidelity considers to be adequate to absorb probable loan losses
inherent in the portfolio and is based on ongoing quarterly assessments and
evaluations of the collectibility and historical loss experience of loans.
Credit losses are charged and recoveries are credited to the reserve. Provisions
for credit losses are based on Fidelity's review of the historical credit loss
experience and such factors that, in management's judgment, deserve
consideration under existing economic conditions in estimating probable credit
losses. In determining the appropriate level of reserves, Fidelity estimates
losses using a range derived from "base" and "conservative" estimates.
Fidelity's methodology for assessing the appropriate reserve level consists of
several key elements, as discussed below. Fidelity's strategy for credit risk
management includes a combination of conservative exposure limits significantly
below legal lending limits, and conservative underwriting, documentation and
collection standards. The strategy also emphasizes diversification on a
geographic, industry and customer level, regular credit examinations and
quarterly management reviews of large credit exposures and loans experiencing
deterioration of credit quality.
Larger commercial loans that exhibit probable or observed credit weaknesses are
subject to individual review. Where appropriate, reserves are allocated to
individual loans based on management's estimate of the borrower's ability to
repay the loan given the availability of collateral, other sources of cash flow
and legal options available to Fidelity. Included in the review of individual
loans are those that are impaired as provided in SFAS No. 114, "Accounting by
Creditors for Impairment of a Loan." Any reserves for impaired loans are
measured based on the present value of expected future cash flows discounted at
the loan's effective interest rate or fair value of the underlying collateral.
Fidelity evaluates the collectibility of both principal and interest when
assessing the need for a loss accrual. Historical loss rates are applied to
other commercial loans not subject to specific reserve allocations.
Homogenous loans, such as consumer installment and residential mortgage loans,
are not individually risk graded. Rather, standard credit scoring systems and
delinquency monitoring are used to assess credit risks. Reserves are established
for each pool of loans based on the expected net charge-offs for one year.
Factors considered in establishing loss rates include expected future losses,
historical loss rate, and adjustments in loan underwriting by category.
Historical loss rates for commercial and consumer loans may be adjusted for
significant factors that, in management's judgment, reflect the impact of any
current conditions on loss recognition. Factors that management consider in the
analysis include the effects of the national and local economies, trends in the
nature and volume of loans (delinquencies, charge-offs and nonaccrual loans),
changes in mix, credit score migration comparisons, asset quality trends, risk
management and loan administration, changes in the internal lending policies and
credit standards, collection practices and examination results from bank
regulatory agencies and Fidelity's external credit examiners.
An unallocated reserve is maintained to recognize the imprecision in estimating
and measuring loss when evaluating reserves for individual loans or pools of
loans. Reserves on individual loans and historical loss rates are reviewed
20
quarterly and adjusted as necessary based on changing borrower and/or collateral
conditions and actual collection and charge-off experience.
Fidelity, has not substantively changed any aspect of its overall approach in
the determination of the reserve for loan and lease losses. There have been no
material changes in assumptions or estimation techniques as compared to prior
periods that impacted the determination of the current year reserve for loan
losses.
Based on the procedures discussed above, management is of the opinion that the
reserve of $699,000 was adequate, but not excessive, to absorb estimated credit
losses associated with the loan portfolio at June 30, 2004.
Valuation of Servicing Rights: When Fidelity sells loans through either
securitizations or Freddie Mac, it may retain one or more subordinated tranches,
servicing rights, interest-only strips, credit recourse, other residual
interests, all of which are considered retained interests in the securitized or
sold loans. Gain or loss on sale or securitization of the loans depends in part
on the previous carrying amount of the financial assets sold or securitized,
allocated between the assets sold and the retained interests based on their
relative fair value at the date of sale or securitization. To obtain fair
values, quoted market prices are used if available. If quotes are not available
for retained interests, Fidelity calculates fair value based on the present
value of future expected cash flows using both management's best estimates and
third-party data sources for the key assumptions - credit losses, prepayment
speeds, forward yield curves and discount rates commensurate with the risks
involved. Gain or loss on sale or securitization of loans is reported as a
component of other non-interest income in the Consolidated Statements of Income.
Retained interests from securitized or sold loans, excluding servicing rights,
are carried at fair value. Adjustments to fair value for retained interests are
included in other non-interest expense in the Consolidated Statements of Income
if the fair value has declined below the carrying amount and such decline has
been determined to be other-than-temporary. See "Automobile Loan Securitization"
in the footnotes to the consolidated financial statements for projected adverse
changes in assumptions and the impact on the fair value.
Servicing rights resulting from loan sales are amortized in proportion to and
over the period of estimated net servicing revenues. Servicing rights are
assessed for impairment quarterly, based on fair value, with temporary
impairment recognized through a valuation allowance and permanent impairment
recognized through a write-off of the servicing asset and related valuation
reserve. Key economic assumptions used in measuring any potential impairment of
the servicing rights include the prepayment speed of the underlying loans, the
weighted-average life of the loan, the discount rate and the weighted-average
default rate, as applicable. The primary risk of material changes to the value
of the servicing rights resides in the potential volatility in the economic
assumptions used, particularly the prepayment speed. Fidelity monitors this risk
and adjusts its valuation allowance as necessary to adequately reserve for any
probable impairment in the portfolio. For purposes of measuring impairment, the
mortgage servicing rights are stratified based on financial asset type and
interest rates. Fees received for servicing loans owned by investors are based
on a percentage of the outstanding monthly principal balance of such loans and
are included in non-interest income as loan payments are received. Costs of
servicing loans are charged to expense as incurred. See "Loan Servicing" in the
footnotes to the consolidated financial statements in Fidelity's 2003 Annual
Report.
Income Taxes: Fidelity accounts for income taxes using the asset and liability
method. Under this method, deferred tax assets and liabilities are recognized
for the future tax consequences attributable to differences between the
financial statement carrying amount of existing assets and liabilities and their
respective tax bases. Such differences can relate to differences in accounting
for credit losses, deprecation timing differences, unrealized gains and losses
on investment securities, deferred compensation and leases, which are treated as
operating leases for tax purposes and loans for financial statement purposes.
Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years in which those temporary
differences are expected to be recovered or settled. The effect on deferred tax
assets and liabilities of a change in tax rates is recognized in income in the
period that includes the enactment date.
The determination of current and deferred income taxes is based on complex
analyses of many factors including interpretation of Federal and state income
tax laws, the difference between tax and financial reporting basis of assets and
liabilities (temporary differences), estimates of amounts due or owed, the
timing of reversals of temporary differences and current financial accounting
interpretations used in determining the current and deferred income tax
liabilities.
21
Fidelity has a net deferred tax asset of $6.4 million at June 30, 2004. The
realization of the recorded deferred tax assets ultimately rests upon Fidelity's
ability to generate taxable income to utilize the net operating loss
carryforwards and low income housing tax credits that make up the majority of
the recorded deferred tax asset. To determine that it is more likely than not
that these carryforwards and tax credits will be utilized prior to their
expiration, management utilizes a model that projects the utilization of the
carryforwards and credits based upon the estimated future taxable income of
Fidelity. The most significant assumption used in the model is pre-tax income
estimated by management.
The amount used for pre-tax income for 2004, 2005 and 2006 is estimated based on
a percentage of the budgeted income in United's most recent strategic plan as
approved by the OTS. Amounts used for pre-tax income for 2007 and into the
future assumes 10% growth in earnings. Fidelity established a $600,000 valuation
allowance at December 31, 2002. Additional details on Fidelity's deferred tax
asset and model assumptions may be found under the heading "Income Tax" in the
notes to the consolidated financial statements and under the heading "Income Tax
Expense (Benefit)" in the Management Discussion and Analysis in Fidelity's 2003
Annual report.
Additional accounting policies followed by Fidelity and United are presented in
Note 1 to the financial statements in Fidelity's Annual Report. These policies,
along with the disclosures presented in the other financial statement notes and
in this financial review, provide information on how significant assets and
liabilities are valued in the financial statements and how those values are
determined.
Item 3 - Asset/Liability Management--Quantitative and Qualitative Disclosures
about Market Risk
Fidelity is subject to interest rate risk to the degree that its interest
bearing liabilities, primarily deposits with short and medium term maturities,
mature or reprice at different rates than its interest-earning assets. Although
having liabilities that mature or reprice less frequently will be beneficial in
times of rising interest rates, such an asset/liability structure will result in
lower net income during periods of declining interest rates, unless off-set by
other factors.
The OTS utilizes a model, the "Office of Thrift Supervision Net Portfolio Value"
("NPV") model, which uses a net market value methodology to measure the interest
rate risk exposure of savings associations. Under this model, an institution's
"normal" level of interest rate risk in the event of an assumed change in
interest rates is a decrease in the institution's NPV in an amount not exceeding
2% of the present value of its assets. Savings associations with over $300
million in assets or less than 12% risk-based capital ratio are required to file
the OTS Schedule CMR. Data from Schedule CMR is used by the OTS to calculate
changes in NPV (and the related "normal" level of interest rate risk) based upon
certain interest rate changes (discussed below). Associations which do not meet
either of the filing requirements are not required to file OTS Schedule CMR, but
may do so voluntarily. United voluntarily submits a CMR quarterly to the OTS.
The data for June 30, 2004 is not required to be filed with the OTS until 45
days after quarter end, which coincides with the 10-Q filing. Management
monitors its interest rate sensitivity during the quarter and will request the
OTS to run scenarios on the NPV model to determine the change in interest rate
sensitivity for management in an effort to assist management with its decision
making regarding the maturities and pricing of its products.
Although United has not yet submitted its CMR to the OTS for June 30, 2004,
management anticipates there has been no material change from the information
disclosed in Fidelity's annual report to shareholders at December 31, 2003.
Item 4 - Controls and Procedures
a. Evaluation of Disclosure Controls and Procedures. Fidelity's principal
executive officer and principal financial officer have concluded that
Fidelity's disclosure controls and procedures (as defined in Rule 13a-14(c)
under the Securities Exchange Act of 1934, as amended), based on their
evaluation of these controls and procedures by the end of the period
covered by this Form 10-Q, are effective.
22
b. Changes in Internal Controls. There have been no significant changes in
Fidelity's internal controls or in other factors that could significantly
affect these controls subsequent to the date of the evaluation thereof,
including any corrective actions with regard to significant deficiencies
and material weaknesses.
c. Limitations on the Effectiveness of Controls. Fidelity's management,
including its principal executive officer and principal financial officer,
does not expect that Fidelity's disclosure controls and procedures and
other internal controls will prevent all error and all fraud. A control
system, no matter how well conceived and operated, can provide only
reasonable, not absolute, assurance that the objectives of the control
system are met. Further, the design of a control system must reflect the
fact that there are resource constraints, and the benefits of controls must
be considered relative to their costs. Because of the inherent limitations
in all control systems, no evaluation of controls can provide absolute
assurance that all control issues and instances of fraud, if any, within
the company have been detected. These inherent limitations include the
realities that judgments in decision-making can be faulty, and that
breakdowns can occur because of simple error or mistake. Additionally,
controls can be circumvented by the individual acts of some persons, by
collusion of two or more people, or by management override of the control.
The design of any system of controls also is based in part upon certain
assumptions about the likelihood of future events, and there can only be
reasonable assurance that any design will succeed in achieving its stated
goals under all potential future conditions; over time, control may become
inadequate because of changes in conditions, or the degree of compliance
with the policies or procedures may deteriorate. Because of the inherent
limitations in a cost-effective control system, misstatements due to error
or fraud may occur and not be detected.
d. CEO and CFO Certifications. Exhibits 31.1 and 31.2 contain the
Certifications of Fidelity's principal executive officer and principal
financial officer. The Certifications are required in accord with Section
302 of the Sarbanes-Oxley Act of 2002 (the "Section 302 Certifications").
This Item of this report which you are currently reading is the information
concerning the Evaluation referred to in the Section 302 Certifications and
this information should be read in conjunction with the Section 302
Certifications for a more complete understanding of the topics presented.
23
PART II -- OTHER INFORMATION
ITEM 1 Legal Proceedings:
------------------
There are no material pending legal proceedings, other than ordinary
routine litigation incidental to the Registrant's business, to which
the Registrant or its subsidiaries are a party of or which any of
their property is the subject.
ITEM 2 None
ITEM 3 Defaults Upon Senior Securities:
--------------------------------
Not applicable.
ITEM 4 Submission of Matters to a Vote of Security Holders:
----------------------------------------------------
At the annual meeting of shareholders held on April 28, 2004, in
addition to the election of directors, the shareholders voted upon the
one board proposal contained in Fidelity Federal Bancorp's Proxy
Statement dated March 26, 2004.
The Board nominees were elected as directors with the following
vote:
Nominee For Withheld
------- --- --------
Paul E. Becker 8,357,176 951,003
Bruce A. Cordingley 8,357,756 950,423
Jack Cunningham 8,366,823 941,356
Michael Elliott 8,357,176 951,003
Donald R. Neel 8,359,303 948,876
Gerald K. Pedigo 8,358,153 950,026
Barry A. Schnakenburg 8,364,087 944,092
Phillip J. Stoffregen 8,356,853 951,226
The Board proposal was approved with the following vote:
Abstentions
(Other Than
Broker Broker
Proposal For Against Non-Votes) Non-Votes
-------- --- ------- ---------- ---------
Board proposal to ratify the appointment of BKD LLP as the
Company's independent auditors 9,037,729 262,745 7,705 310,479
ITEM 5 Other Information:
------------------
24
None
ITEM 6 Exhibits and Reports on Form 8-K:
---------------------------------
Exhibit Number Description
a. 3(i) (a) Articles of Incorporation of Fidelity, filed as exhibit 3(a) to
Fidelity's 1995 Annual Report on Form 10-K, are incorporated
herein by reference
3(i) (b) Articles of Amendment of the Articles of Incorporation, filed as
exhibit 4.1 with Fidelity's Registration Statement on Form S-3
(file no. 333-53668), are incorporated by reference
3(ii) By-Laws of Fidelity, filed as exhibit 4.2 with Fidelity's
Registration Statement on Form S-3 (file no. 333-53668), are
incorporated by reference
10 (a) The 1993 Director's Stock Option Plan, filed as exhibit 10(d) to
Fidelity's 1995 Annual Report on Form 10-K, is incorporated
herein by reference.
(b) The 1995 Key Employee's Stock Option Plan, filed as exhibit 10(c)
to Fidelity's 1996 Annual Report on Form 10-K, is incorporated
herein by reference.
(c) Employment agreement between Fidelity and Donald R. Neel, filed
as exhibit 10(d) to Fidelity's 2000 Annual Report on Form 10-K,
is incorporated herein by reference
31.1 Certification of CEO required pursuant to 15d-14(a) of the
Securities Exchange Act of 1934
31.2 Certification of CFO required pursuant to 15d-14(a) of the
Securities Exchange Act of 1934
32.1 Certification of Chief Executive Officer required pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
32.2 Certification of Chief Financial Officer required pursuant to
Section 906 of the Sarbanes-Oxley Act of 2002
b. A form 8-K was filed on April 30, 2004 announcing that on April
26, 2004, Fidelity issued a press release in connection with
Fidelity's first quarter 2004 earnings release.
25
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
Registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
FIDELITY FEDERAL
BANCORP
Date: August 12, 2004 By: /s/ DONALD R. NEEL
- -------------------------- ------------------------------------
Donald R. Neel
President and CEO
By: /s/ MARK A. ISAAC
------------------------------------
Mark A. Isaac
Vice President and CFO
(Principal Financial Officer)
26
Index to Exhibits
Page Exhibit Number Exhibit
- --------------------------------------------------------------------------------
a. 3(i) (a) Articles of Incorporation of Fidelity, filed as exhibit 3(a)
to Fidelity's 1995 Annual Report on Form 10-K, are
incorporated herein by reference
3(i) (b) Articles of Amendment of the Articles of Incorporation,
filed as exhibit 4.1 with Fidelity's Registration Statement
on Form S-3 (file no. 333-53668), are incorporated by
reference
3(ii) By-Laws of Fidelity, filed as exhibit 4.2 with Fidelity's
Registration Statement on Form S-3 (file no. 333-53668), are
incorporated by reference
10 (a) The 1993 Director's Stock Option Plan, filed as exhibit
10(d) to Fidelity's 1995 Annual Report on Form 10-K, is
incorporated herein by reference.
(b) The 1995 Key Employee's Stock Option Plan, filed as exhibit
10(c) to Fidelity's 1996 Annual Report on Form 10-K, is
incorporated herein by reference.
(c) Employment agreement between Fidelity and Donald R. Neel,
filed as exhibit 10(d) to Fidelity's 2000 Annual Report on
Form 10-K, is incorporated herein by reference
31.1 Certification of CEO required pursuant to 15d-14(a) of the
Securities Exchange Act of 1934
31.2 Certification of CFO required pursuant to 15d-14(a) of the
Securities Exchange Act of 1934
32.1 Certification of Chief Executive Officer required pursuant
to Section 906 of the Sarbanes - Oxley Act of 2002
32.2 Certification of Chief Financial Officer required pursuant
to Section 906 of the Sarbanes - Oxley Act of 2002
27