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EX-32.2 - RICHARD C LARSON SOX CERTIFICATION - WATERSTONE FINANCIAL INCexhibit322.htm
EX-31.1 - DOUGLAS S GORDON CERTIFICATION - WATERSTONE FINANCIAL INCexhibit311.htm
EX-31.2 - RICHARD C LARSON CERTIFICATION - WATERSTONE FINANCIAL INCexhibit312.htm
EX-32.1 - DOUGLAS S GORDON SOX CERTIFICATION - WATERSTONE FINANCIAL INCexhibit321.htm


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549

Form 10-Q

R
Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
   
   
 
For the quarterly period ended March 31, 2011
   
 
OR
   
   
*
Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934


Commission File Number 000-51507

WATERSTONE FINANCIAL, INC.

(Exact name of registrant as specified in its charter)


Federal
20-3598485
(State or other jurisdiction of
incorporation or organization)
(IRS Employer Identification No.)


11200 W. Plank Ct.
Wauwatosa, WI  53226
(414) 761-1000
(Address, including Zip Code, and telephone number,
including area code, of registrant’s principal executive offices)

Indicate by check mark 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 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.

Yes
R
 
No
*

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).      Yes   o    No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer.  See definition of “accelerated filer and large accelerated filer” in Rule 12b-2 of the Exchange Act.

Large accelerated filer
*
 
Accelerated filer
R
 
Non-accelerated filer
*
 
Smaller Reporting Company
*

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).

Yes
*
 
No
R


The number of shares outstanding of the issuer’s common stock, $0.01 par value per share, was 31,250,097 at April 30, 2011.
 
 
 
 
 
 


10-Q INDEX








 
Page No.
   
 
     
     
3
   
4
   
5
   
6
   
7-29
   
30-43
   
44
   
45
   
46
   
46
   
46
   
46
   
47
   
 
   
   
   
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 


 
 
- 2 -
 


CONSOLIDATED STATEMENTS OF FINANCIAL CONDITION


   
(Unaudited)
       
   
March 31,
   
December 31,
 
   
2011
   
2010
 
Assets
 
(In Thousands, except share data)
 
Cash
  $ 116,104       65,900  
Federal funds sold
    8,738       9,426  
Short term investments
    -       5  
Cash and cash equivalents
    124,842       75,331  
Securities available for sale (at fair value)
    206,269       203,166  
Securities held to maturity (at amortized cost),
               
fair value of $2,575 in 2011 and $2,501 in 2010
    2,648       2,648  
Loans held for sale (at fair value)
    29,092       96,133  
Loans receivable
    1,274,393       1,306,437  
Less: Allowance for loan losses
    32,094       29,175  
Loans receivable, net
    1,242,299       1,277,262  
Office properties and equipment, net
    28,005       28,196  
Federal Home Loan Bank stock (at cost)
    21,653       21,653  
Cash surrender value of life insurance
    35,537       35,385  
Real estate owned
    61,184       57,752  
Prepaid expenses and other assets
    9,497       11,440  
Total assets
  $ 1,761,026       1,808,966  
                 
Liabilities and Shareholders’ Equity
               
Liabilities:
               
Demand deposits
  $ 65,770       67,735  
Money market and savings deposits
    105,776       103,403  
Time deposits
    957,862       974,391  
Total deposits
    1,129,408       1,145,529  
                 
Short term borrowings
    979       22,959  
Long term borrowings
    434,000       434,000  
Advance payments by borrowers for taxes
    8,767       2,379  
Other liabilities
    17,035       31,879  
Total liabilities
    1,590,189       1,636,746  
                 
Shareholders’ equity:
               
Preferred stock (par value $.01 per share)
               
Authorized 20,000,000 shares, no shares issued
           
Common stock (par value $.01 per share)
               
Authorized - 200,000,000 shares in 2011 and 2010
               
Issued - 33,974,450 shares in 2011 and in 2010
               
Outstanding - 31,250,097 shares in 2011 and in 2010
    340       340  
Additional paid-in capital
    110,224       109,953  
Accumulated other comprehensive income, net of taxes
    1,234       1,558  
Retained earnings
    107,502       109,046  
Unearned ESOP shares
    (3,202 )     (3,416 )
Treasury shares (2,724,353 shares), at cost
    (45,261 )     (45,261 )
Total shareholders’ equity
    170,837       172,220  
Total liabilities and shareholders’ equity
  $ 1,761,026       1,808,966  


See Accompanying Notes to Unaudited Consolidated Financial Statements.

 
 
- 3 -
 

CONSOLIDATED STATEMENTS OF OPERATIONS
(Unaudited)


   
Three months ended
March 31,
 
   
2011
   
2010
 
     (In Thousands, except share data)  
Interest income:
           
Loans
   $ 18,465       20,753  
Mortgage-related securities
    1,037       1,490  
Debt securities, cash and cash equivalents
    835       806  
Total interest income
    20,337       23,049  
Interest expense:
               
Deposits
    4,099       5,845  
Borrowings
    4,311       4,771  
Total interest expense
    8,410       10,616  
Net interest income
    11,927       12,433  
Provision for loan losses
    4,875       5,457  
Net interest income after provision for loan losses
    7,052       6,976  
Noninterest income:
               
Service charges on loans and deposits
    249       286  
Increase in cash surrender value of life insurance
    152       182  
Mortgage banking income
    6,163       3,591  
Other
    233       242  
Total noninterest income
    6,797       4,301  
Noninterest expenses:
               
Compensation, payroll taxes, and other employee benefits
    7,917       5,113  
Occupancy, office furniture and equipment
    1,619       1,307  
Advertising
    321       204  
Data processing
    350       364  
Communications
    258       233  
Professional fees
    394       309  
Real estate owned
    1,795       1,430  
FDIC insurance premiums
    1,061       1,122  
Other
    1,639       1,019  
Total noninterest expenses
    15,354       11,101  
Income (loss) before income taxes
    (1,505 )     176  
Income taxes
    39       -  
Net income (loss)
   $ (1,544 )     176  
Income (loss) per share:
               
Basic
   $ (0.05 )     0.01  
Diluted
   $ (0.05 )     0.01  
Weighted average shares outstanding:
               
Basic
    30,898,687       30,773,335  
Diluted
    30,898,687       30,773,335  


See Accompanying Notes to Unaudited Consolidated Financial Statements.


 
 
- 4 -
 

CONSOLIDATED STATEMENTS OF CHANGES IN SHAREHOLDERS’ EQUITY
(Unaudited)

                     
Accumulated
                         
               
Additional
   
Other
         
Unearned
         
Total
 
   
Common Stock
   
Paid-In
   
Comprehensive
   
Retained
   
ESOP
   
Treasury
   
Shareholders'
 
   
Shares
   
Amount
   
Capital
   
Loss
   
Earnings
   
Shares
   
Shares
   
Equity
 
   
(In Thousands)
 
Balances at December 31, 2009
    31,250     $ 340       108,883       (2,001 )     110,900       (4,269 )     (45,261 )     168,592  
                                                                 
                                                                 
Comprehensive income:
                                                               
Net income
                            176                   176  
Other comprehensive income:
                                                               
Net unrealized holding gain on
                                                               
available for sale securities arising during
the period, net of taxes of $588
                      1,043                         1,043  
Reclassification of adjustment for net losses on
                                                               
available for sale securities realized during
the period, net of taxes of $4
                      7                         7  
Total comprehensive income
                                                            1,226  
                                                                 
ESOP shares committed to be released to Plan participants
                (165 )                 213             48  
Stock based compensation
                413                               413  
                                                                 
Balances at March 31, 2010
    31,250     $ 340       109,131       (951 )     111,076       (4,056 )     (45,261 )     170,279  
                                                                 
                                                                 
Balances at December 31, 2010
    31,250     $ 340       109,953       1,558       109,046       (3,416 )     (45,261 )     172,220  
                                                                 
Comprehensive income (loss):
                                                               
Net loss
                            (1,544 )                 (1,544 )
Other comprehensive income (loss):
                                                               
Net unrealized holding loss on
                                                               
available for sale securities arising during
the period, net of taxes of $51
                      (324 )                       (324 )
Total comprehensive income (loss)
                                                            (1,868 )
                                                                 
ESOP shares committed to be released to Plan participants
                (160 )                 214             54  
Stock based compensation
                431                               431  
                                                                 
Balances at March 31, 2011
    31,250     $ 340       110,224       1,234       107,502       (3,202 )     (45,261 )     170,837  
 
 
See Accompanying Notes to Unaudited Consolidated Financial Statements.

 
 
- 5 -
 

CONSOLIDATED STATEMENTS OF CASH FLOWS
(Unaudited)


   
Three months ended March 31,
 
   
2011
   
2010
 
   
(In Thousands)
 
Operating activities:
           
Net income (loss)
  $ (1,544 )     176  
Adjustments to reconcile net income (loss) to net
               
cash provided by operating activities:
               
Provision for loan losses
    4,875       5,457  
Depreciation
    466       465  
Deferred income taxes
    39       (168 )
Stock based compensation
    431       413  
Net amortization of premium on debt and mortgage-related securities
    135       (6 )
Amortization of unearned ESOP shares
    54       48  
Loss on sale of real estate owned and other assets
    215       201  
Gain on sale of loans held for sale
    (6,163 )     (3,455 )
Loans originated for sale
    (182,970 )     (151,582 )
Proceeds on sales of loans originated for sale
    256,174       160,817  
Increase in accrued interest receivable
    (80 )     (345 )
Increase in cash surrender value of bank owned life insurance
    (152 )     (182 )
Decrease in accrued interest on deposits and borrowings
    (166 )     (643 )
Decrease in other liabilities
    (10,679 )     (3,417 )
(Increase) decrease in accrued tax receivable
    (67 )     3,111  
Other
    2,028       858  
Net cash provided by operating activities
    62,596       11,748  
                 
Investing activities:
               
Net decrease in loans receivable
    20,777       3,407  
Purchases of:
               
Debt securities
    (25,382 )     (30,000 )
Premises and equipment, net
    (287 )     (128 )
Proceeds from:
               
Principal repayments on mortgage-related securities
    9,727       9,567  
Sales of mortgage-related securities
          2,056  
Sales of debt securities
          8,349  
Maturities of debt securities
    8,184       15,303  
Sales of real estate owned and other assets
    5,609       4,650  
Net cash provided by investing activities
    18,628       13,204  
 
Financing activities:
           
  Net increase (decrease) in deposits
    (16,121 )     13,629  
  Net change in short-term borrowings
    (21,980 )     (37,000 )
  Net change in advance payments by borrowers for taxes
    6,388       7,415  
    Net cash used in financing activities
    (31,713 )     (15,956 )
    Increase in cash and cash equivalents
    49,511       8,996  
Cash and cash equivalents at beginning of period
    75,331       71,120  
Cash and cash equivalents at end of period
  $ 124,842       80,116  
                 
Supplemental information:
               
  Cash paid, credited or (received) during the period for:
               
    Income tax payments (refunds)
    67       (3,111 )
    Interest payments
    8,575       11,259  
  Noncash investing activities:
               
    Loans receivable transferred to real estate owned
    9,311       7,248  


 

See Accompanying Notes to Unaudited Consolidated Financial Statements.

 
 
- 6 -
 

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(Unaudited)

Note 1 — Basis of Presentation

The consolidated financial statements include the accounts of Waterstone Financial, Inc. (the “Company”) and the Company’s subsidiaries.

The accompanying unaudited consolidated financial statements have been prepared in accordance with generally accepted accounting principles (GAAP) for interim financial information, Rule 10-01 of Regulation S-X and the instructions to Form 10-Q. The financial statements do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, the accompanying unaudited consolidated financial statements contain all adjustments (consisting of normal recurring accruals) necessary to present fairly the financial position, results of operations, changes in shareholders’ equity, and cash flows of the Company for the periods presented.

The accompanying unaudited consolidated financial statements and related notes should be read in conjunction with the Company’s December 31, 2010 Annual Report on Form 10-K. Operating results for the three months ended March 31, 2011, are not necessarily indicative of the results that may be expected for the year ending December 31, 2011.

The preparation of the unaudited consolidated financial statements requires management of the Company to make a number of estimates and assumptions relating to the reported amount of assets and liabilities and the disclosure of contingent assets and liabilities at the date of the consolidated financial statements and the reported amounts of revenues and expenses during the period.  Significant items subject to such estimates and assumptions include the allowance for loan losses, deferred income taxes, certain investment securities and real estate owned.  Actual results could differ from those estimates.
 
 
 
 
 
 
 
 
 
 
 
 
 
 


 
 
- 7 -
 

Note 2 — Securities

Securities Available for Sale

The amortized cost and fair values of the Company’s investment in securities available for sale follow:


 
   
March 31, 2011
 
         
Gross
   
Gross
       
   
Amortized
   
unrealized
   
unrealized
       
   
cost
   
gains
   
losses
   
Fair value
 
   
(In Thousands)
 
Mortgage-backed securities
  $ 38,878       1,778       (71 )     40,585  
Collateralized mortgage obligations:
                               
Government sponsored enterprise issued
    33,577       864       (116 )     34,325  
Private-label issued
    24,793       254       (1,079 )     23,968  
Mortgage-related securities
    97,248       2,896       (1,266 )     98,878  
                                 
Government sponsored enterprise bonds
    63,736       235       (52 )     63,919  
Municipal securities
    38,591       815       (1,188 )     38,218  
Other debt securities
    5,000       254             5,254  
Debt securities
    107,327       1,304       (1,240 )     107,391  
    $ 204,575       4,200       (2,506 )     206,269  

 

   
December 31, 2010
 
         
Gross
   
Gross
       
   
Amortized
   
unrealized
   
unrealized
       
   
cost
   
gains
   
losses
   
Fair value
 
   
(In Thousands)
 
Mortgage-backed securities
  $ 42,607       1,839       (116 )     44,330  
Collateralized mortgage obligations:
                               
Government sponsored enterprise issued
    38,262       1,141       (126 )     39,277  
Private-label issued
    26,199       280       (1,032 )     25,447  
Mortgage-related securities
    107,068       3,260       (1,274 )     109,054  
                                 
Government sponsored enterprise bonds
    57,327       391       (20 )     57,698  
Municipal securities
    31,804       721       (1,405 )     31,120  
Other debt securities
    5,000       294             5,294  
Debt securities
    94,131       1,406       (1,425 )     94,112  
    $ 201,199       4,666       (2,699 )     203,166  

 
 
 
 
 
 
 
 

 
 
- 8 -
 
 
The majority of the Company’s mortgage-backed securities and collateralized mortgage obligations issued by government sponsored enterprises are guaranteed by either Fannie Mae or Freddie Mac.  At March 31, 2011, $41.4 million of the Company’s government sponsored entity bonds and $57.3 million of the Company’s mortgage-related securities were pledged as collateral to secure repurchase agreement obligations of the Company.
 
The amortized cost and fair values of investment securities by contractual maturity at March 31, 2011, are shown below. Actual maturities may differ from contractual maturities because issuers have the right to call or prepay obligations with or without call or prepayment penalties.
 

   
Amortized
   
Fair
 
   
Cost
   
Value
 
   
(In Thousands)
 
Debt securities
           
   Due within one year
  $ 6,779       6,783  
   Due after one year through five years
    76,290       76,884  
   Due after five years through ten years
    8,645       9,021  
   Due after ten years
    15,613       14,703  
Mortgage-related securities
    97,248       98,878  
    $ 204,575       206,269  


Gross unrealized losses on securities available for sale and the fair value of the related securities, aggregated by investment category and length of time that individual securities have been in a continuous unrealized loss position were as follows:


   
March 31, 2011
 
   
Less than 12 months
   
12 months or longer
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
value
   
loss
   
value
   
loss
   
value
   
loss
 
   
(In Thousands)
 
Mortgage-backed securities
  $ 12,995       (71 )                 12,995       (71 )
Collateralized mortgage obligations:
                                               
     Government sponsored entities
    12,181       (116 )                 12,181       (116 )
     Private-label issue
    200       (1 )     15,978       (1,078 )     16,178       (1,079 )
Government sponsored enterprise bonds
    17,934       (52 )                 17,934       (52 )
Municipal securities
    5,419       (434 )     3,731       (754 )     9,150       (1,188 )
    $ 48,729       (674 )     19,709       (1,832 )     68,438       (2,506 )
                                                 
                                                 
   
December 31, 2010
 
   
Less than 12 months
   
12 months or longer
   
Total
 
   
Fair
   
Unrealized
   
Fair
   
Unrealized
   
Fair
   
Unrealized
 
   
value
   
loss
   
value
   
loss
   
value
   
loss
 
     (In Thousands)  
Mortgage-backed securities
  $ 14,215       (116 )                 14,215       (116 )
Collateralized mortgage obligations:
                                               
     Government sponsored entities
    13,145       (126 )                 13,145       (126 )
     Private-label issue
                16,908       (1,032 )     16,908       (1,032 )
Government sponsored enterprise bonds
    7,553       (20 )                 7,553       (20 )
Municipal securities
    7,206       (545 )     3,619       (860 )     10,825       (1,405 )
    $ 42,119       (807 )     20,527       (1,892 )     62,646       (2,699 )

The Company reviews the investment securities portfolio on a quarterly basis to monitor its exposure to other-than-temporary impairment.  In evaluating whether a security’s decline in market value is other-than-temporary, management considers the length of time and extent to which the fair value has been less than cost, financial condition of the issuer and the underlying obligors, quality of credit enhancements, volatility of the fair value of the security, the expected recovery period of the security and ratings agency evaluations.  In addition, with regard to its debt securities, the Company may also evaluate payment structure, whether there are defaulted payments or expected defaults, prepayment speeds and the value of any underlying collateral.  For certain debt securities in unrealized loss positions, the Company prepares cash flow analyses to compare the present value of cash flows expected to be collected from the security with the amortized cost basis of the security.
 
 
 
- 9 -
 
 
As of March 31, 2011, the Company had six securities which had been in an unrealized loss position for twelve months or longer, including one private-label collateralized mortgage obligation security and five municipal securities.  Based upon the aforementioned factors, the Company identified two collateralized mortgage obligation securities at March 31, 2011 with a combined amortized cost of $20.7 million for which a cash flow analysis was performed to determine whether an other-than-temporary impairment was warranted.  This evaluation indicated that the two collateralized mortgage obligations were other-than-temporarily impaired.  Estimates of discounted cash flows based on expected yield at time of original purchase, prepayment assumptions based on actual and anticipated prepayment speed, actual and anticipated default rates and estimated level of severity given the loan to value ratios, credit scores, geographic locations, vintage and levels of subordination related to the security and its underlying collateral resulted in a projected credit loss on the collateralized mortgage obligations.  One of these securities had been deemed other-than-temporarily impaired in 2008 and a cumulative-effect adjustment of $1.1 million was made to retained earnings as of January 1, 2009 to reflect the difference between the present value of cash flows expected to be collected and the amortized cost basis as of the beginning of the period in which the aforementioned accounting principals were adopted.  Additional estimated credit losses on the two collateralized mortgage obligations of $1.1 million were charged to earnings during the year ended December 31, 2009.  The fair value of these two securities was $19.8 million as of March 31, 2011.  As of March 31, 2011, unrealized losses on these collateralized mortgage obligations include other-than-temporary impairment recognized in other comprehensive income (before taxes) of $935,000.
 
The following table presents the change in other-than-temporary credit related impairment charges on collateralized mortgage obligations for which a portion of the other-than-temporary impairments related to other factors was recognized in other comprehensive loss.
 

 
   
(in thousands)
 
Credit related impairments on securities as of December 31, 2009
    1,762  
Credit related impairments related to securites for which an other-than-temporary
       
     impairment was not previously recognized
    -  
Increase in credit related impairments related to securities for which an other-than-
       
     temporary impairment was previously recognized
    -  
Reduction for increases in cash flows expected over the remaining life
       
     of the securities
    (122 )
Credit related impairments on securities as of December 31, 2010
  $ 1,640  
Credit related impairments related to securites for which an other-than-temporary
       
     impairment was not previously recognized
    -  
Increase in credit related impairments related to securities for which an other-than-
       
     temporary impairment was previously recognized
    -  
Reduction for increases in cash flows expected over the remaining life
       
     of the securities
    -  
Credit related impairments on securities as of March 31, 2011
  $ 1,640  

 
Exclusive of the two aforementioned collateralized mortgage obligations, the Company has determined that the decline in fair value of the remaining securities is not attributable to credit deterioration, and based on the foregoing evaluation criteria and as the Company does not intend to sell nor is it more likely than not that it will be required to sell these securities before recovery of the amortized cost basis, these securities are not considered other-than-temporarily impaired.
 
Continued deterioration of general economic market conditions could result in the recognition of future other-than-temporary impairment losses within the investment portfolio and such amounts could be material to our consolidated financial statements.
 
Securities Held to Maturity
 
As of March 31, 2011, the Company held one security that has been designated as held to maturity.  The security has an amortized cost of $2.65 million and an estimated fair value of $2.58 million.  The final maturity of this security is 2022, however, it is callable quarterly.  The Company has performed an assessment to determine whether this security is other-than-temporarily impaired.  Based upon a number of factors, including significant and repeated investments on the part of the United States government, the Company has determined that the security is not other-than-temporarily impaired at March 31, 2011.
 



 
- 10 -
 

 
Note 3 — Loans Receivable

Loans receivable are summarized as follows:
 
 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
(In Thousands)
 
Mortgage loans:
           
Residential real estate:
           
One- to four-family
  $ 563,641       584,014  
Over four-family residential
    539,253       542,602  
Home equity
    68,889       71,952  
Commercial real estate
    50,234       51,733  
Construction and land
    55,209       56,794  
Consumer loans
    135       154  
Commercial business loans
    37,799       40,442  
Gross loans receivable
    1,315,160       1,347,691  
Less:
               
Undisbursed loan proceeds
    38,826       39,265  
Unearned loan fees
    1,941       1,989  
Total loans receivable
  $ 1,274,393       1,306,437  

 
The Company provides several types of loans to its customers, including residential, construction, commercial and consumer loans.  Significant loan concentrations are considered to exist for a financial institution when there are amounts loaned to one borrower or to multiple borrowers engaged in similar activities that would cause them to be similarly impacted by economic or other conditions.  While credit risks tend to be geographically concentrated in the Company’s Milwaukee metropolitan area and while 87.7% of the Company’s loan portfolio involves loans that are secured by residential real estate, there are no concentrations with individual or groups of related borrowers.  While the real estate collateralizing these loans is primarily residential in nature, it ranges from owner-occupied single family homes to large apartment complexes.  In addition, real estate collateralizing $118.1 million or 9.0% of total mortgage loans is located outside of the state of Wisconsin.   The Company does not have a concentration of loans in any specific industry.
 
The unpaid principal balance of loans serviced for others was $6.3 million at both March 31, 2011 and December 31, 2010. These loans are not reflected in the consolidated financial statements.
 
During the three months ended March 31, 2011, $183.0 million in residential loans were originated for sale.  During the same period sales of loans held for sale totaled $250.0 million in loans held for sale at a gain of $6.2 million.
 

 

 
 
- 11 -
 

An analysis of past due financing receivables as of March 31, 2011 and December 31, 2010:
 

 
   
As of March 31, 2011
 
                                     
   
1-59 Days Past Due (1)
   
60-89 Days Past Due (2)
   
Greater Than 90 Days
   
Total Past Due
   
Current (3)
   
Total Loans
 
Mortgage loans:
 
(In Thousands)
 
Residential real estate:
                                   
One- to four-family
  $ 27,966       3,470       36,422       67,858       493,842       561,700  
Over four-family
    2,953       1,037       10,948       14,938       524,315       539,253  
Home equity
    583       111       227       921       43,268       44,189  
Construction and land
    457       62       1,882       2,401       48,265       50,666  
Commercial real estate
    761       -       997       1,758       48,476       50,234  
Consumer
    -       -       -       -       135       135  
Commercial loans
    -       -       868       868       27,348       28,216  
Total
  $ 32,720       4,680       51,344       88,744       1,185,649       1,274,393  
                                                 
   
As of December 31, 2010
 
Mortgage loans:
                                               
Residential real estate:
                                               
One- to four-family
  $ 13,220       7,887       44,055       65,162       516,864       582,026  
Over four-family
    1,639       2,366       12,307       16,312       526,290       542,602  
Home equity
    497       96       207       800       45,349       46,149  
Construction and land
    586       1,326       2,754       4,666       49,295       53,961  
Commercial real estate
    574       222       1,101       1,897       49,836       51,733  
Consumer
    -       -       -       -       154       154  
Commercial loans
    394       -       1,432       1,826       27,986       29,812  
Total
  $ 16,910       11,897       61,856       90,663       1,215,774       1,306,437  
 
 
 
(1)  
Includes $11.6 million and $3.5 million for March 31, 2011 and December 31, 2010, respectively, which are on non-accrual status.
(2)  
Includes $4.7 million and $3.0 million for March 31, 2011 and December 31, 2010, respectively, which are on non-accrual status.
(3)  
Includes $16.4 million and $15.8 million for March 31, 2011 and December 31, 2010, respectively, which are on non-accrual status.

 
As of March 31, 2011 and December 31, 2010, there are no loans that are 90 or more days past due and still accruing.
 
 
 
 

 
 

 
- 12 -
 
 

 
A summary of the activity for the three months ended March 31, 2011 and 2010 in the allowance for loan losses follows:
 

 
                                                 
   
One- to Four- Family
   
Over Four Family
   
Home Equity
   
Construction and Land
   
Commercial Real Estate
   
Consumer
   
Commercial
   
Total
 
   
(In Thousands)
 
                                                 
Three months ended March 31, 2011
                                           
Balance at beginning of period
  $ 16,150       6,877       1,196       3,252       671       28       1,001       29,175  
Provision for loan losses
    2,948       1,323       (5 )     (26 )     284       5       346       4,875  
Charge-offs
    (1,033 )     (524 )     (73 )     (4 )     (176 )     (8 )     (185 )     (2,003 )
Recoveries
    33       11       2       -       -       1       -       47  
Balance at end of period
  $ 18,098       7,687       1,120       3,222       779       26       1,162       32,094  
                                                                 
                                                                 
Three months ended March 31, 2010
                                                         
Balance at beginning of period
  $ 17,875       5,208       1,642       2,635       720       43       371       28,494  
Provision for loan losses
    3,089       1,774       (293 )     355       105       3       424       5,457  
Charge-offs
    (1,668 )     (585 )     -       -       (117 )     (2 )     (1 )     (2,373 )
Recoveries
    49       -       1       2       -       -       -       52  
Balance at end of period
  $ 19,345       6,397       1,350       2,992       708       44       794       31,630  

 
 
A summary of the allowance for loan loss by collateral class as of the period ended March 31, 2011 follows:
 

 
                                                 
   
One- to Four- Family
   
Over Four Family
   
Home Equity
   
Construction and Land
   
Commercial Real Estate
   
Consumer
   
Commercial
   
Total
 
   
(In Thousands)
 
Allowance related to loans
                                               
individually evaluated for impairment
  $ 6,811       2,803       213       2,212       142       -       493       12,674  
Allowance related to loans
                                                               
collectively evaluated for impairment
    11,287       4,884       907       1,010       637       26       669       19,420  
                                                                 
Balance at end of period
  $ 18,098       7,687       1,120       3,222       779       26       1,162       32,094  
                                                                 
                                                                 
                                                                 
Loans individually evaluated for impairment
  $ 78,023       31,448       846       11,896       2,349       -       1,323       125,885  
                                                                 
Loans collectively evaluated for impairment
    483,677       507,805       43,343       38,770       47,885       135       26,893       1,148,508  
                                                                 
Total gross loans
  $ 561,700       539,253       44,189       50,666       50,234       135       28,216       1,274,393  

 
 
 
 
 
 
 
- 13 -
 

 
A summary of the allowance for loan loss by collateral class as of the year ended December 31, 2010 follows:

 
 
                                                 
   
One- to Four- Family
   
Over Four Family
   
Home Equity
   
Construction and Land
   
Commercial Real Estate
   
Consumer
   
Commercial
   
Total
 
   
(In Thousands)
 
Allowance related to loans
                                               
individually evaluated for impairment
  $ 5,775       2,548       311       2,112       162       -       185       11,093  
Allowance related to loans
                                                               
collectively evaluated for impairment
    10,375       4,329       885       1,140       509       28       816       18,082  
                                                                 
Balance at end of period
  $ 16,150       6,877       1,196       3,252       671       28       1,001       29,175  
                                                                 
                                                                 
                                                                 
Loans individually evaluated for impairment
  $ 78,434       30,288       804       12,337       1,838       -       2,030       125,731  
                                                                 
Loans collectively evaluated for impairment
    503,592       512,314       45,345       41,624       49,895       154       27,782       1,180,706  
                                                                 
Total gross loans
  $ 582,026       542,602       46,149       53,961       51,733       154       29,812       1,306,437  

 
 
 
The following table presents information relating to the Company’s internal risk ratings of its loans receivable as of March 31, 2011 and December 31, 2010:
 

 
                                                 
   
One- to Four- Family
   
Over Four Family
   
Home Equity
   
Construction and Land
   
Commercial Real Estate
   
Consumer
   
Commercial
   
Total
 
At March 31, 2011
 
(In Thousands)
 
                                                 
Substandard
  $ 76,596       28,826       2,074       10,424       2,513       -       1,513       121,946  
                                                                 
Watch
    23,969       27,782       1,537       8,725       2,042       -       416       64,471  
                                                                 
Pass
    461,135       482,645       40,578       31,517       45,679       135       26,287       1,087,976  
    $ 561,700       539,253       44,189       50,666       50,234       135       28,216       1,274,393  
                                                                 
                                                                 
                                                                 
At December 31, 2010
                                                               
                                                                 
Substandard
  $ 72,846       25,071       1,874       9,569       1,936       -       2,557       113,853  
                                                                 
Watch
    24,343       30,877       1,401       14,394       892       -       706       72,613  
                                                                 
Pass
    484,837       486,654       42,874       29,998       48,905       154       26,549       1,119,971  
    $ 582,026       542,602       46,149       53,961       51,733       154       29,812       1,306,437  
 
 

 
 
 
- 14 -
 

Factors that are important to managing overall credit quality include sound loan underwriting and administration, systematic monitoring of existing loans and commitments, effective loan review on an ongoing basis, early identification of potential problems, an allowance for loan losses, and sound non-accrual and charge-off policies.  Our underwriting policies require an officers’ loan committee review and approve all loans in excess of $500,000.  In addition, an independent loan review function exists for all residential loans.  Our ability to manage credit risk depends in large part on our ability to properly identify and manage problem loans.  To do so, we maintain a loan review system under which our credit management personnel review non-owner occupied one-to four-family, over four-family, construction and land, commercial real estate and commercial loans that individually, or as part of an overall borrower relationship exceed $1.0 million in potential exposure.  Loans meeting these criteria are reviewed on an annual basis, or more frequently, if the loan renewal is less than one year.  With respect to this review process, management has determined that pass loans include credits that exhibit acceptable financial statements, cash flow and leverage.  Watch credits have potential weaknesses that deserve management’s attention, and if left uncorrected, these potential weaknesses may result in deterioration of the repayment prospects for the credit.  Substandard loans are considered inadequately protected by the current net worth and paying capacity of the obligor or the collateral pledged.  These loans generally have a well-defined weakness that may jeopardize liquidation of the debt and are characterized by the distinct possibility that the Bank will sustain some loss if the deficiencies are not corrected.  Finally, a loan is considered to be impaired when it is probable that the Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement.  Management has determined that all non-accrual loans and loans modified under troubled debt restructurings have been determined by the Bank to meet the definition of an impaired loan.
 

The following tables present data on impaired loans at March 31, 2011 and December 31, 2010.
 
 
   
As of or for the Period Ended March 31, 2011
 
   
Recorded Investment
   
Unpaid Pricipal
   
Reserve
   
Charge-Offs
 
Average
Recorded
Investment
 
Int Paid YTD
 
   
(In Thousands)
 
Total Impaired with Reserve
                               
One- to four-family
  $ 47,684       49,311       6,811       1,627     42,079     163  
Over four-family
    22,406       22,541       2,803       135     20,575     117  
Construction and land
    9,560       9,560       2,212       -     9,373     59  
Commercial real estate
    1,399       3,153       142       1,754     1,082     -  
Home equity
    599       599       213       -     605     3  
Commercial
    569       569       493       -     349     2  
    $ 82,217       85,733       12,674       3,516     74,063     344  
                                           
Total Impaired with no Reserve
                                         
                                           
One- to four-family
  $ 30,339       34,393       -       4,054     35,053     211  
Over four-family
    9,042       12,215       -       3,173     9,885     41  
Construction and land
    2,336       2,336       -       -     3,148     7  
Commercial real estate
    950       1,118       -       168     882     15  
Home equity
    247       247       -       -     247     2  
Commercial
    754       1,229       -       475     1,129     4  
    $ 43,668       51,538       -       7,870     50,344     280  
                                           
Total Impaired
                                         
                                           
One- to four-family
  $ 78,023       83,704       6,811       5,681     77,132     374  
Over four-family
    31,448       34,756       2,803       3,308     30,460     158  
Construction and land
    11,896       11,896       2,212       -     12,521     66  
Commercial real estate
    2,349       4,271       142       1,922     1,964     15  
Home equity
    846       846       213       -     852     5  
Commercial
    1,323       1,798       493       475     1,478     6  
    $ 125,885       137,271       12,674       11,386     124,407     624  

 
The difference between a loan’s recorded investment and the unpaid principal balance represents a partial charge-off resulting from a confirmed loss due to the value of the collateral securing the loan being below the loan balance and management’s assessment that the full collection of the loan balance is not likely.  The average recorded investment in impaired loans is based upon a monthly average.
 
 
- 15 -
 
 
 
   
As of or for the Year Ended December 31, 2010
 
   
Recorded Investment
   
Unpaid Pricipal
   
Reserve
   
Charge Offs
 
Average
Recorded
Investment
 
Int Paid YTD
 
   
(In Thousands)
 
Total Impaired with Reserve
                               
One- to four-family
  $ 42,186       44,505       5,775       2,319     50,785     1,277  
Over four-family
    20,200       20,460       2,548       260    24,305     191  
Construction and land
    9,550       9,770       2,112       220   12,569     243  
Commercial real estate
    976       2,730       162       1,754    938     3  
Home equity
    565       565       311       -     628     19  
Commercial
    584       584       185       -     313     30  
    $ 74,061       78,614       11,093       4,553     89,538     1,763  
                                           
Total Impaired with no Reserve
                                         
                                           
One- to four-family
  $ 36,248       43,567       -       7,319     40,598     1,167  
Over four-family
    10,088       13,527       -       3,439     13,947     481  
Construction and land
    2,787       5,859       -       3,072     1,491     10  
Commercial real estate
    862       1,030       -       168     2,084     27  
Home equity
    239       239       -       -     733     13  
Commercial
    1,446       1,446       -       -     2,409     16  
    $ 51,670       65,668       -       13,998     61,262     1,714  
                                           
Total Impaired
                                         
                                           
One- to four-family
  $ 78,434       88,072       5,775       9,638     91,383     2,444  
Over four-family
    30,288       33,987       2,548       3,699     38,252     672  
Construction and land
    12,337       15,629       2,112       3,292   14,060     253  
Commercial real estate
    1,838       3,760       162       1,922     3,022     30  
Home equity
    804       804       311       -     1,361     32  
Commercial
    2,030       2,030       185       -     2,722     46  
    $ 125,731       144,282       11,093       18,551     150,800     3,477  

 
The determination as to whether an allowance is required with respect to impaired loans is based upon an analysis of the value of the underlying collateral and/or the borrower’s intent and ability to make all principal and interest payments in accordance with contractual terms.  The evaluation process is subject to the use of significant estimates and actual results could differ from estimates.  This analysis is primarily based upon third party appraisals and/or a discounted cash flow analysis.  In those cases in which no allowance has been provided for an impaired loan, the Company has determined that the estimated value of the underlying collateral exceeds the remaining outstanding balance of the loan.  Of the total $43.7 million of impaired loans for which no allowance has been provided, $7.9 million in charge-offs have been recorded to reduce the outstanding loans balance to an amount that is commensurate with the estimated fair value of the underlying collateral.  To the extent that further deterioration in property values continues, the Company may have to reevaluate the sufficiency of the collateral servicing these impaired loans resulting in additional provisions to the allowance for loans losses or charge-offs.
 
At March 31, 2010, total impaired loans includes $39.5 million of troubled debt restructurings, of which, $34.7 million are classified as performing.  The vast majority of debt restructurings include a modification of terms to allow for an interest only payment and/or reduction in interest rate.  The restructured terms are typically in place for six to twelve months.  At December 31, 2010, total impaired loans included $36.5 million of troubled debt restructurings, of which, $33.6 million are classified as performing.
 

 
- 16 -
 
 
The following table presents data on non-accrual loans and troubled debt restructurings at March 31, 2011 and December 31, 2010:
 

   
As of March 31,
   
As of December 31,
 
   
2011
   
2010
 
   
(Dollars in Thousands)
 
Non-accrual loans:
           
Residential
           
One- to four-family
  $ 56,671       56,759  
Over four-family
    20,810       20,587  
Home equity
    1,455       712  
Construction and land
    2,203       3,013  
Commercial real estate
    1,476       1,577  
Commercial
    1,323       1,530  
Consumer
    -       -  
Total non-accrual loans
  $ 83,938       84,178  
                 
                 
Total performing troubled debt restructurings
  $ 33,875       33,592  
                 
Total non-accrual loans to total loans, net
    6.59 %     6.44 %
Total non-accrual loans and performing troubled
               
      debt restructurings to total loans receivable
    9.24 %     9.01 %
Total non-accrual loans to total assets
    4.77 %     4.65 %







Note 4 — Real Estate Owned


 
Real estate owned is summarized as follows:
 

 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
(In Thousands)
 
             
One- to four-family
  $ 28,559       28,142  
Over four-family
    17,805       14,903  
Construction and land
    10,143       9,926  
Commercial real estate
    4,677       4,781  
    $ 61,184       57,752  

 
During the three months ended March 31, 2011, the Company transferred $9.3 million to real estate owned from the loan portfolio.  During the same period the Company sold approximately $5.6 million of real estate owned.  The overall $3.4 million increase in real estate owned was primarily due to a $2.9 million increase in over four-family properties.


 
 
 
- 17 -
 

Note 5 — Deposits

A summary of the contractual maturities of time deposits at March 31, 2011 is as follows:
 
 
 
   
(In Thousands)
 
       
Within one year
  $ 446,384  
More than one to two years
    491,087  
More than two to three years
    7,584  
More than three to four years
    4,250  
More than four through five years
    8,557  
    $ 957,862  

 
 
Note 6 — Borrowings
 
Borrowings consist of the following:
 

 
     
March 31, 2011
   
December 31, 2010
 
           
Weighted
         
Weighted
 
           
Average
         
Average
 
     
Balance
   
Rate
   
Balance
   
Rate
 
     
(Dollars in Thousands)
 
Short term:
                         
Bank line of credit
    $ 979       4.75 %     22,959       4.75 %
                                   
Long term:
                                 
Federal Home Loan Bank, Chicago (FHLBC) advances maturing:
                                 
 
2016
    220,000       4.34 %     220,000       4.34 %
 
2017
    65,000       3.19 %     65,000       3.19 %
 
2018
    65,000       2.97 %     65,000       2.97 %
                                   
Repurchase agreements maturing
2017
    84,000       3.96 %     84,000       3.96 %
      $ 434,979       3.89 %     456,959       3.94 %

 
The bank line of credit is the outstanding portion of $70.0 million in revolving lines with unrelated banks.  The lines of credit are utilized by Waterstone Mortgage Corporation to finance loans originated for sale.  Related interest rates are based upon the note rate associated with the loans being financed.
 
The $220.0 million in advances due in 2016 consist of eight advances with rates ranging from 4.01% to 4.82% callable quarterly until maturity.
 
The $65.0 million in advances due in 2017 consist of three advances with rates ranging from 3.09% to 3.46% callable quarterly until maturity.
 
The $65.0 million in advances due in 2018 consist of three callable advances with rates ranging from 2.73% to 3.03% callable quarterly until maturity.
 
The $84.0 million in repurchase agreements due in 2017 have rates ranging from 2.89% to 4.31% callable quarterly until maturity.
 
The Company selects loans that meet underwriting criteria established by the FHLBC as collateral for outstanding advances.  The Company’s FHLBC borrowings are limited to 60% of the carrying value of qualifying, unencumbered one- to four-family mortgage loans, 50% of the carrying value of home equity loans and 60% of the carrying value of over four-family loans.  In addition, these advances are collateralized by FHLBC stock totaling $21.7 million at March 31, 2011 and December 31, 2010.  The repurchase agreements are collateralized by securities available for sale with an estimated fair value of $98.7 million at March 31, 2011.  In the event of prepayment, the Company is obligated to pay all remaining contractual interest on long-term borrowings.
 

 
 
- 18 -
 

Note 7 – Regulatory Capital
 

The Bank is subject to various regulatory capital requirements administered by the federal banking agencies. Failure to meet minimum capital requirements, or overall financial performance deemed by the regulators to be inadequate, can initiate certain mandatory and possibly additional discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company’s financial statements. Under capital adequacy guidelines and the regulatory framework for prompt corrective action, the Bank must meet specific capital guidelines that involve quantitative measures of the Bank’s assets, liabilities, and certain off-balance-sheet items, as calculated under regulatory accounting practices. The Bank’s capital amounts and classifications are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors.
 
Quantitative measures established by regulation to ensure capital adequacy require the Bank to maintain minimum amounts and ratios (set forth in the table below) of total and Tier I capital (as defined in the regulations) to risk-weighted assets (as defined) and of Tier I capital (as defined) to average assets (as defined).  As of March 31, 2011, that the Bank meets all capital adequacy requirements to which it is subject.  On December 18, 2009, WaterStone Bank entered into a consent order with its federal and state bank regulators whereby it has agreed to maintain a minimum Tier 1 capital ratio of 8.50% and a minimum total risk based capital ratio of 12.00%.  At March 31, 2011, we were in compliance with these higher capital requirements.  The consent order prohibits the Bank from paying dividends or repurchasing common stock without the written consent of the WDFI and FDIC.
 
As of March 31, 2011 the most recent notification from the Federal Deposit Insurance Corporation categorized the Bank as quantitatively “well capitalized” under the regulatory framework for prompt corrective action. To be categorized as “well capitalized,” the Bank must maintain minimum total risk-based, Tier I risk-based and Tier I leverage ratios, as set forth in the table below. There are no conditions or events since that notification that management believes have changed the Bank’s category, however, the outstanding consent order limits transactions otherwise available to “well capitalized” banks.
 
As a state-chartered savings bank, the Bank is required to meet minimum capital levels established by the state of Wisconsin in addition to federal requirements. For the state of Wisconsin, regulatory capital consists of retained income, paid-in-capital, capital stock equity and other forms of capital considered to be qualifying capital by the Federal Deposit Insurance Corporation.
 
The actual and required capital amounts and ratios for WaterStone Bank as of March 31, 2011 and December 31, 2010 are presented in the table below:
 

 
   
March 31, 2011
 
                           
To Be Well-Capitalized
 
               
For Capital
   
Under Prompt Corrective
 
   
Actual
   
Adequacy Purposes
   
Action Provisions
 
   
Amount
   
Ratio
   
Amount
   
Ratio
   
Amount
   
Ratio
 
               
(Dollars in Thousands)
             
WaterStone Bank
                                   
Total capital (to risk-weighted assets)
  $ 178,983       14.52 %   $ 98,629       8.00 %   $ 123,287       10.00 %
Tier I capital (to risk-weighted assets)
    163,367       13.25 %     49,315       4.00 %     73,972       6.00 %
Tier I capital (to average assets)
    163,367       9.22 %     70,856       4.00 %     88,570       5.00 %
State of Wisconsin capital required (to total assets)
    163,367       9.30 %     105,407       6.00 %     N/A       N/A  
                                                 
   
December 31, 2010
 
WaterStone Bank
                                               
Total capital (to risk-weighted assets)
  $ 180,718       14.13 %   $ 102,324       8.00 %   $ 127,905       10.00 %
Tier I capital (to risk-weighted assets)
    164,568       12.87 %     51,162       4.00 %     76,743       6.00 %
Tier I capital (to average assets)
    164,568       8.83 %     74,567       4.00 %     93,208       5.00 %
State of Wisconsin capital required (to total assets)
    164,568       9.12 %     108,228       6.00 %     N/A       N/A  

 
 
- 19 -
 
 
Note 8 – Income Taxes
 
Despite a pre-tax loss, we recorded income tax expense of $39,000 in the first quarter of 2011. Because of the valuation allowance on our deferred tax assets we were not able to record an income tax benefit related to the pre-tax loss incurred.  A current income tax benefit that would normally result from a pre-tax loss was offset by additional deferred tax expense due to an increase in the required valuation allowance.  The income tax expense recorded in the first quarter of 2011 relates to various states in which our mortgage banking subsidiary does business and will file a separate company state income tax return.  There was no comparable amount in the first quarter of 2010.

Under generally accepted accounting principles, a deferred tax asset valuation allowance is required to be recognized if it is “more likely than not” that the deferred tax asset will not be realized.  The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management’s evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. We consider both positive and negative evidence regarding the ultimate realizability of our deferred tax assets.  Examples of positive evidence may include the existence, if any, of taxes paid in available carry-back years and the likelihood that taxable income will be generated in future periods.  Examples of negative evidence may include a cumulative loss in the current year and prior two years and negative general business and economic trends.  We currently maintain a valuation allowance against substantially all of our net deferred tax assets because it is “more likely than not” that all of these net deferred tax assets will not be realized.  This determination was based, largely, on the negative evidence of a cumulative loss in the most recent three-year period caused primarily by the loan loss provisions made during those periods.  In addition, general uncertainty surrounding future economic and business conditions has increased the likelihood of volatility in our future earnings.
 
 
Note 9 – Financial Instruments with Off-Balance Sheet Risk
 

Off-balance sheet financial instruments or obligations whose contract amounts represent credit and/or interest rate risk are as follows:
 

 
   
March 31,
   
December 31,
 
   
2011
   
2010
 
   
(In Thousands)
 
Financial instruments whose contract amounts represent
           
potential credit risk:
           
Commitments to extend credit under amortizing loans (1)
  $ 17,540       14,681  
Unused portion of home equity lines of credit
    24,700       25,803  
Unused portion of construction loans
    4,543       2,832  
Unused portion of business lines of credit
    9,584       10,630  
Standby letters of credit
    991       991  
 
(1) Excludes commitments to originate loans held for sale and are addressed in Note 11.
 
 
Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract. Commitments generally have fixed expiration dates or other termination clauses and may require payment of a fee. Since many of the commitments are expected to expire without being drawn upon, the total commitment amounts do not necessarily represent future cash requirements of the Company. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The amount of collateral obtained, if deemed necessary by the Company upon extension of credit, is based on management’s credit evaluation of the counter-party. Collateral obtained generally consists of mortgages on the underlying real estate.
 
Standby letters of credit are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk involved in issuing letters of credit is essentially the same as that involved in extending loan facilities to customers. The Company holds mortgages on the underlying real estate as collateral supporting those commitments for which collateral is deemed necessary.
 
The Company has determined that there are no probable losses related to commitments to extend credit or the standby letters of credit as of March 31, 2011 and December 31, 2010.
 
 
- 20 -
 
 
Note 10 – Derivative Financial Instruments

In connection with its mortgage banking activities, the Company enters into derivative financial instruments as part of its strategy to manage its exposure to changes in interest rates.  Mortgage banking derivatives include interest rate lock commitments provided to customers to fund mortgage loans to be sold in the secondary market and forward commitments for the future delivery of such loans.  It is the Company’s practice to enter into forward commitments for the future delivery of residential mortgage loans when interest rate lock commitments are entered into in order to economically hedge the effect of future changes in interest rates on its commitments to fund the loans as well as on its portfolio of mortgage loans held-for-sale.  The Company’s mortgage banking derivatives have not been designated as being in hedge relationships.  These instruments are used to manage the Company’s exposure to interest rate movements and other identified risks but do not meet the strict hedge accounting requirements of ASC 815.  Changes in the fair value of derivatives not designated in hedging relationships are recorded directly in earnings.  The Company does not use derivatives for speculative purposes.

Forward commitments to sell mortgage loans represent commitments obtained by the Company from a secondary market agency to purchase mortgages from the Company at specified interest rates and within specified periods of time.  Commitments to sell loans are made to mitigate interest rate risk on interest rate lock commitments to originate loans and loans held for sale.  At March 31, 2011, The Company had forward commitments to sell mortgage loans with an aggregate notional amount of approximately $101.8 million and interest rate lock commitments with an aggregate notional amount of approximately $98.3 million.  The fair value of the mortgage derivatives at March 31, 2011 included a net gain of $642,000 on forward commitments to sell residential mortgage loans to various investors and the net loss of $71,000 on interest rate lock commitments to originate residential mortgage loans held for sale to individuals.

In determining the fair value of its derivative loan commitments, the Company considers the value that would be generated when the loan arising from exercise of the loan commitment is sold in the secondary mortgage market. That value includes the price that the loan is expected to be sold for in the secondary mortgage market.  The fair value of these commitments is recorded on the consolidated statements of financial condition with the changes in fair value recorded as a component of mortgage banking income.


Note 11 – Earnings (loss) per share

Earnings per share are computed using the two-class method.  Basic earnings per share is computed by dividing net income allocated to common shares by the weighted average number of common shares outstanding during the applicable period, excluding outstanding participating securities.  Participating securities include unvested restricted shares.  Unvested restricted shares are considered participating securities because holders of these securities have the right to receive dividends at the same rate as holders of the Company’s common stock.  Diluted earnings (loss) per share is computed by dividing net income (loss) by the weighted average number of common shares outstanding adjusted for the dilutive effect of all potential common shares.  Unvested restricted stock and stock options are considered outstanding for diluted earnings (loss) per share only.  Unvested restricted stock and stock options totaling 54,200 and 211,500 shares for the three months ended March 31, 2011 and 103,400 and 314,000 shares for the three months ended March 31, 2010 are antidilutive and are excluded from the earnings (loss) per share calculation.
 
Presented below are the calculations for basic and diluted earnings (loss) per share:
 

   
Three Months Ended
 
   
March 31,
 
   
2011
   
2010
 
       
             
Net income (loss)
  $ (1,544 )     176  
Net income (loss) available to unvested restricted shares
    -       1  
Net income (loss) available to common stockholders
  $ (1,544 )     175  
                 
Weighted average shares outstanding
    30,899       30,773  
Effect of dilutive potential common shares
    -       -  
Diluted weighted average shares outstanding
    30,899       30,773  
                 
Basic earnings (loss) per share
  $ (0.05 )     0.01  
Diluted earnings (loss) per share
  $ (0.05 )     0.01  
 

 
 
- 21 -
 

Note 12 – Fair Value Measurements

The FASB issued an accounting standard (subsequently codified into ASC Topic 820, “Fair Value Measurements and Disclosures”) which defines fair value, establishes a framework for measuring fair value, and expands disclosures about fair value measurements. This accounting standard applies to reported balances that are required or permitted to be measured at fair value under existing accounting pronouncements. The standard also emphasizes that fair value (i.e., the price that would be received in an orderly transaction that is not a forced liquidation or distressed sale at the measurement date), among other things, is based on exit price versus entry price, should include assumptions about risk such as nonperformance risk in liability fair values, and is a market-based measurement, not an entity-specific measurement. When considering the assumptions that market participants would use in pricing the asset or liability, this accounting standard establishes a fair value hierarchy that distinguishes between market participant assumptions based on market data obtained from sources independent of the reporting entity (observable inputs that are classified within Levels 1 and 2 of the hierarchy) and the reporting entity’s own assumptions about market participant assumptions (unobservable inputs classified within Level 3 of the hierarchy).

The fair value hierarchy prioritizes inputs used to measure fair value into three broad levels.

Level 1 inputs - In general, fair values determined by Level 1 inputs use quoted prices in active markets for identical assets or liabilities that we have the ability to access.

Level 2 inputs - Fair values determined by Level 2 inputs use inputs other than quoted prices included in Level 1 inputs that are observable for the asset or liability, either directly or indirectly.  Level 2 inputs include quoted prices for similar assets and liabilities in active markets, quoted prices for identical or similar assets or liabilities in markets where there are few transactions and inputs other than quoted prices that are observable for the asset or liability, such as interest rates and yield curves that are observable at commonly quoted intervals.

Level 3 inputs - Level 3 inputs are unobservable inputs for the asset or liability and include situations where there is little, if any, market activity for the asset or liability.

In instances where the determination of the fair value measurement is based on inputs from different levels of the fair value hierarchy, the level in the fair value hierarchy within which the entire fair value measurement falls is based on the lowest level input that is significant to the fair value measurement in its entirety.  The Company’s assessment of the significance of a particular input to the fair value measurement in its entirety requires judgment, and considers factors specific to the asset or liability.


 
 
 
 
 

 









 
- 22 -
 

 
The following table presents information about our assets recorded in our consolidated statement of financial position at their fair value on a recurring basis as of March 31, 2011 and December 31, 2010, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.



         
Fair Value Measurements Using
 
   
March 31, 2011
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
                         
Available for sale securities
                       
Mortgage-backed securities
  $ 40,585       -       40,585       -  
Collateralized mortgage obligations
                               
Government sponsored enterprise bonds
    34,325       -       34,325       -  
Private-label issued
    23,968       -       4,175       19,793  
Government sponsored enterprise bonds
    63,919       -       63,919       -  
Municipal securities
    38,218       -       38,218       -  
Other debt securities
    5,254       5,254       -       -  
                                 
Loans held for sale
    29,092       -       29,092       -  
Mortgage banking derivative assets
    642       -       -       642  
Mortgage banking derivative liabilities
    71       -       -       71  
    $ 236,074       5,254       210,314       20,506  
 
                               
           
Fair Value Measurements Using
 
   
December 31, 2010
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
                                 
Available for sale securities
                               
Mortgage-backed securities
  $ 44,330       -       44,330       -  
Collateralized mortgage obligations
                               
Government sponsored enterprise bonds
    39,277       -       39,277       -  
Private-label issued
    25,447       -       5,146       20,301  
Government sponsored enterprise bonds
    57,698       -       57,698       -  
Municipal securities
    31,120       -       31,120       -  
Other debt securities
    5,294       5,294       -       -  
                                 
Loans held for sale
    96,133       -       96,133       -  
Mortgage banking derivative assets
    470       -       -       470  
Mortgage banking derivative liabilities
    63       -       -       63  
    $ 299,832       5,294       273,704       20,834  


The following summarizes the valuation techniques for assets recorded in our consolidated statements of financial condition at their fair value on a recurring basis:

Available for sale securities – The Company’s investment securities classified as available for sale include: mortgage-backed securities, collateralized mortgage obligations, government sponsored enterprise bonds, municipal securities and other debt securities. The fair value of mortgage-backed securities, collateralized mortgage obligations and government sponsored enterprise bonds are determined by a third party valuation source using observable market data utilizing a matrix or multi-dimensional relational pricing model.  Standard inputs to these models include observable market data such as benchmark yields, reported trades, broker quotes, issuer spreads, benchmark securities, prepayment models and bid/offer market data.  For securities with an early redemption feature, an option adjusted spread model is utilized to adjust the issuer spread.  These model and matrix measurements are classified as Level 2 and Level 3 in the fair value hierarchy.  The fair value of municipal securities is determined by a third party valuation source using observable market data utilizing a multi-dimensional relational pricing model.  Standard inputs to this model include observable market data such as benchmark yields, reported trades, broker quotes, rating updates and issuer spreads.  These model measurements are classified as Level 2 in the fair value hierarchy.  The fair value of other debt securities, which includes a trust preferred security issued by a financial institution, is determined through quoted prices in active markets and is classified as Level 1 in the fair value hierarchy.
 
 
 
- 23 -
 

Loans held for sale – The Company carries loans held for sale at fair value under the fair value option model.  Fair value is generally determined by estimating a gross premium or discount, which is derived from pricing currently observable in the secondary market, principally from observable prices for forward sale commitments.  At March 31, 2011 and December 31, 2010, loans held-for-sale totaled $29.1 million and $96.1 million, respectively.  Loans held-for-sale are considered to be Level 2 in the fair value hierarchy of valuation techniques.

Mortgage banking derivatives - Mortgage banking derivatives include interest rate lock commitments to originate residential loans held for sale to individual customers and forward commitments to sell residential mortgage loans to various investors.  The Company relies on a valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes applying a pull through rate based upon historical experience and the current interest rate environment and then multiplying by quoted investor prices.  The Company also relies on a valuation model to estimate the fair value of its forward commitments to sell residential loans, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available.  While there are Level 2 and 3 inputs used in the valuation models, the Company has determined that one or more of the inputs significant in the valuation of both of the mortgage banking derivatives fall within Level 3 of the fair value hierarchy.

The table below presents reconciliation for all assets measured at fair value on a recurring basis using significant unobservable inputs (Level 3) during 2011 and 2010.


   
Available for sale securities
   
Mortgage banking derivatives
 
   
(In Thousands)
 
             
Balance at December 31, 2009
  $ 15,799       41  
                 
Transfer into level 3
    -       -  
Unrealized holding losses arising during the period:
               
   Included in other comprehensive income
    5,261       -  
   Other than temporary impairment included in net loss
    -       -  
Principal repayments
    (881 )     -  
Net accretion of discount/amortization of premium
    122       -  
Mortgage derivative gain, net
    -       366  
Balance at December 31, 2010
    20,301       407  
                 
Transfer into level 3
    -       -  
Unrealized holding losses arising during the period:
               
   Included in other comprehensive income
    (53 )     -  
   Other than temporary impairment included in net loss
    -       -  
Principal repayments
    (455 )     -  
Net accretion of discount/amortization of premium
    -       -  
Mortgage derivative gain, net
    -       164  
Balance at March 31, 2011
  $ 19,793       571  


Level 3 available-for-sale securities include two corporate collateralized mortgage obligations.  The market for these securities was not active as of March 31, 2011.  As such, the Company valued this security based on the present value of estimated future cash flows   Additional impairment may be incurred in future periods if estimated future cash flows are less than the cost basis of the securities. There were no transfers in or out of Level 1 or Level 2 measurements during the periods.
 
 
 
- 24 -
 

Assets Recorded at Fair Value on a Non-recurring Basis

The following table presents information about our assets recorded in our consolidated statement of financial position at their fair value on a non-recurring basis as of March 31, 2011 and December 31, 2010, and indicates the fair value hierarchy of the valuation techniques utilized to determine such fair value.


         
Fair Value Measurements Using
 
   
March 31, 2011
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
                         
Loans (1)
  $ 69,543       -       -       69,543  
Real estate owned
    61,184       -       -       61,184  
                                 
           
Fair Value Measurements Using
 
   
December 31, 2010
   
Level 1
   
Level 2
   
Level 3
 
   
(In Thousands)
 
                                 
Loans (1)
  $ 62,968       -       -       62,968  
Real estate owned
    57,752       -       -       57,752  

(1)  Represents collateral-dependent impaired loans, net, which are included in loans.
 

Loans – We do not record loans at fair value on a recurring basis.  On a non-recurring basis, loans determined to be impaired are analyzed to determine whether a collateral shortfall exists, and if such a shortfall exists, are recorded on our consolidated statements of financial condition at net realizable value of the underlying collateral.  Fair value is determined based on third party appraisals.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  Given the significance of the adjustments made to appraised values necessary to estimate the fair value of impaired loans, loans that have been deemed to be impaired are considered to be Level 3 in the fair value hierarchy of valuation techniques.  At March 31, 2011, loans determined to be impaired with an outstanding balance of $82.2 million were carried net of specific reserves of $12.7 million for a fair value of $69.5 million.  At December 31, 2010, loans determined to be impaired with an outstanding balance of $74.1 million were carried net of specific reserves of $11.1 million for a fair value of $63.0 million.  Impaired loans collateralized by assets which are valued in excess of the net investment in the loan do not require any specific reserves.

Real estate owned – On a non-recurring basis, real estate owned, is recorded in our consolidated statements of financial condition at the lower of cost or fair value.  Fair value is determined based on third party appraisals and, if less than the carrying value of the loan, the carrying value of the loan is adjusted to the fair value.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  Given the significance of the adjustments made to appraised values necessary to estimate the fair value of the properties, real estate owned is considered to be Level 3 in the fair value hierarchy of valuation techniques.  Changes in the value of real estate owned totaled $923,000 and $223,000 during the three months ended March 31, 2011 and 2010, respectively and are recorded in real estate owned expense. At March 31, 2011 and December 31, 2010, real estate owned totaled $61.1 million and $57.8 million, respectively.

Fair value information about financial instruments follows, whether or not recognized in the consolidated statements of financial condition, for which it is practicable to estimate that value. In cases where quoted market prices are not available, fair values are based on estimates using present value or other valuation techniques. Those techniques are significantly affected by the assumptions used, including the discount rate and estimates of future cash flows. In that regard, the derived fair value estimates cannot be substantiated by comparison to independent markets and, in many cases, could not be realized in immediate settlement of the instrument. Certain financial instruments and all nonfinancial instruments are excluded from its disclosure requirements. Accordingly, the aggregate fair value amounts presented do not represent the underlying value of the Company.
 
 
 
 
- 25 -
 

The carrying amounts and fair values of the Company’s financial instruments consist of the following at March 31, 2011 and December 31, 2010:
 

 
   
March 31, 2011
   
December 31, 2010
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
   
amount
   
value
   
amount
   
value
 
   
(In Thousands)
 
Financial Assets
                       
Cash and cash equivalents
  $ 124,842       124,842       74,945       74,945  
Securities available-for-sale
    206,269       206,269       203,166       203,166  
Securities held-to-maturity
    2,648       2,575       2,648       2,501  
Loans held for sale
    29,092       29,092       96,133       96,133  
Loans receivable
    1,274,393       1,279,818       1,306,437       1,313,854  
FHLB stock
    21,653       21,653       21,653       21,653  
Cash surrender value of life insurance
    35,537       35,537       35,385       35,385  
Accrued interest receivable
    4,181       4,181       4,101       4,101  
Mortgage banking derivative assets
    642       642       470       470  
                                 
Financial Liabilities
                               
Deposits
    1,129,408       1,135,188       1,145,529       1,153,065  
Advance payments by
                               
borrowers for taxes
    8,767       8,767       2,379       2,379  
Borrowings
    434,979       464,467       456,959       482,933  
Accrued interest payable
    2,161       2,161       2,326       2,326  
Mortgage banking derivative liabilities
    71       71       63       63  
                                 
Other Financial Instruments
                               
Stand-by letters of credit
    5       5       5       5  

 
The following methods and assumptions were used by the Company in determining its fair value disclosures for financial instruments.
 
Cash and Cash Equivalents
 
The carrying amount reported in the consolidated statements of financial condition for cash and cash equivalents is a reasonable estimate of fair value.
 
 Securities
 
The fair value of securities is determined by a third party valuation source using observable market data utilizing a matrix or multi-dimensional relational pricing model.  Standard inputs to these models include observable market data such as benchmark yields, reported trades, broker quotes, issuer spreads, benchmark securities and bid/offer market data.  For securities with an early redemption feature, an option adjusted spread model is utilized to adjust the issuer spread.  Prepayment models are used for mortgage related securities with prepayment features.
 
Loans Held for Sale
 
Fair value is estimated using the prices of the Company’s existing commitments to sell such loans and/or the quoted market price for commitments to sell similar loans.
 
Loans Receivable
 
Loans determined to be impaired are analyzed to determine whether a collateral shortfall exists, and if such a shortfall exists, are recorded on our consolidated statements of financial condition at fair value.  Fair value is determined based on third party appraisals.  Appraised values are adjusted to consider disposition costs and also to take into consideration the age of the most recent appraisal.  With respect to loans that are not considered to be impaired, fair value is estimated by discounting the future contractual cash flows using discount rates that reflect a current rate offered to borrowers of similar credit standing for the remaining term to maturity.  This method of estimating fair value does not incorporate the exit-price concept of fair value prescribed by ASC 820-10 and generally produces a higher fair value.
 
 
 
- 26 -
 
 
FHLBC Stock
 
For FHLBC stock, the carrying amount is the amount at which shares can be redeemed with the FHLBC and is a reasonable estimate of fair value.
 
Cash Surrender Value of Life Insurance
 
The carrying amounts reported in the consolidated statements of financial condition for the cash surrender value of life insurance approximate those assets’ fair values.
 
Deposits and Advance Payments by Borrowers for Taxes
 
The fair values for interest-bearing and noninterest-bearing negotiable order of withdrawal accounts, savings accounts, and money market accounts are, by definition, equal to the amount payable on demand at the reporting date (i.e., their carrying amounts). The fair values for fixed-rate certificates of deposit are estimated using a discounted cash flow calculation that applies interest rates currently being offered on certificates of similar remaining maturities to a schedule of aggregated expected monthly maturities of the outstanding certificates of deposit. The advance payments by borrowers for taxes are equal to their carrying amounts at the reporting date.
 
Borrowings
 
Fair values for borrowings are estimated using a discounted cash flow calculation that applies current interest rates to estimated future cash flows of the borrowings.
 
Accrued Interest Payable and Accrued Interest Receivable
 
For accrued interest payable and accrued interest receivable, the carrying amount is a reasonable estimate of fair value.
 
Commitments to Extend Credit and Standby Letters of Credit
 
Commitments to extend credit and standby letters of credit are generally not marketable. Furthermore, interest rates on any amounts drawn under such commitments would be generally established at market rates at the time of the draw. Fair values for the Company’s commitments to extend credit and standby letters of credit are based on fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements, the counterparty’s credit standing, and discounted cash flow analyses. The fair value of the Company’s commitments to extend credit is not material at March 31, 2011 and December 31, 2010.
 
Mortgage Banking Derivative Assets and Liabilities
 
Mortgage banking derivatives include interest rate lock commitments to originate residential loans held for sale to individual customers and forward commitments to sell residential mortgage loans to various investors.  The Company relies on a valuation model to estimate the fair value of its interest rate lock commitments to originate residential mortgage loans held for sale, which includes applying a pull through rate based upon historical experience and the current interest rate environment, and then multiplying by quoted investor prices.  The Company also relies on a valuation model to estimate the fair value of its forward commitments to sell residential loans, which includes matching specific terms and maturities of the forward commitments against applicable investor pricing available.  On the Company’s Consolidated Statements of Condition, instruments that have a positive fair value are included in prepaid expenses and other assets, and those instruments that have a negative fair value are included in other liabilities.
 
 
 
 
 
 
- 27 -
 

Note 13 – Segment Reporting

During the three months ended March 31, 2011, the Company determined that it has two reportable segments: community banking and mortgage banking.  During this period, the Company realigned its operations to allow for all mortgage banking activities to be managed exclusively within its mortgage banking subsidiary.  Based upon this realignment, the Company determined that the mortgage banking subsidiary represents a segment that is distinct from the operations of the core community banking function.  The Company’s operating segments are presented based on its management structure and management accounting practices.  The structure and practices are specific to the Company and therefore, the financial results of the Company’s business segments are not necessarily comparable with similar information for other financial institutions.

Community Banking

The Community Banking segment provides consumer and business banking products and services to customers primarily within Southeastern Wisconsin.  Consumer products include loan and deposit products:  mortgage, home equity loans and lines, personal term loans, demand deposit accounts, interest bearing transaction accounts and time deposits.  Business banking products include secured and unsecured lines and term loans for working capital, inventory and general corporate use, commercial real estate construction loans, demand deposit accounts, interest bearing transaction accounts and time deposits.

Mortgage Banking

The Mortgage Banking segment provides residential mortgage loans for the purpose of sale on the secondary market.  Mortgage banking products and services are provided in nine states including: Wisconsin, Arizona, Colorado, Florida, Idaho, Illinois, Maryland, Minnesota and Tennessee.

   
Three months ended March 31, 2011
 
   
Community Banking
   
Mortgage Banking
   
Holding Company and Other
   
Consolidated
 
   
(in thousands)
 
                         
Net interest income
  $ 11,739       67       121       11,927  
Provision for loan losses
    4,860       15       -       4,875  
Net interest income after provision for loan losses
    6,879       52       121       7,052  
                                 
Noninterest income:
    580       6,217               6,797  
                                 
Noninterest expenses:
                               
Compensation, payroll taxes, and other employee benefits
    3,746       4,373       (202 )     7,917  
Occupancy, office furniture and equipment
    898       721       -       1,619  
FDIC insurance premiums
    1,061       -       -       1,061  
Real estate owned
    1,795       -       -       1,795  
Other
    1,144       1,583       235       2,962  
Total noninterest expenses
    8,644       6,677       33       15,354  
Income (loss) before income taxes
    (1,185 )     (408 )     88       (1,505 )
Income taxes
    135       (96 )     -       39  
Net income (loss)
  $ (1,320 )     (312 )     88       (1,544 )
                                 
                                 
Total Assets
  $ 1,747,227       40,584       (26,785 )     1,761,026  



   
Three months ended March 31, 2010
 
   
Community Banking
   
Mortgage Banking
   
Holding Company and Other
   
Consolidated
 
   
(in thousands)
 
                         
Net interest income
  $ 12,155       154       124       12,433  
Provision for loan losses
    5,402       55       -       5,457  
Net interest income after provision for loan losses
    6,753       99       124       6,976  
                                 
Noninterest income:
    699       3,602       -       4,301  
                                 
Noninterest expenses:
                               
Compensation, payroll taxes, and other employee benefits
    3,411       1,909       (207 )     5,113  
Occupancy, office furniture and equipment
    856       451       -       1,307  
FDIC insurance premiums
    1,122       -       -       1,122  
Real estate owned
    1,430       -       -       1,430  
Other
    1,173       848       108       2,129  
Total noninterest expenses
    7,992       3,208       (99 )     11,101  
Income (loss) before income taxes
    (540 )     493       223       176  
Income taxes
    (176 )     176       -       -  
Net income (loss)
  $ (364 )     317       223       176  
                                 
Total Assets
  $ 1,836,836       45,909       (37,807 )     1,844,938  


 
- 28 -
 

Note 14 – Recent Accounting Developments

In January 2011, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in Update No. 2010-20 (Topic 310), deferring the new disclosure requirements (paragraphs 310-10-50-31 through 50-34 of the FASB Accounting Standards Codification) about troubled debt restructurings to be concurrent with the effective date of the guidance for determining what constitutes a troubled debt restructuring, as presented in proposed Accounting Standards Update, Receivables (Topic 310): Clarifications to Accounting for Troubled Debt Restructurings by Creditors. As a result of the issuance of Update 2011-02, the provisions of Update 2011-01 are effective for the first interim or annual period beginning on or after June 15, 2011 or July 1, 2011 for the Company, and should be applied retrospectively to the beginning of the annual period of adoption.  Management does not expect the adoption of the Update to have a material effect on the Company’s financial statements at the date of adoption.

In April 2011, the FASB issued ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring, providing additional guidance for creditors in determining whether a creditor has granted a concession and whether a debtor is experiencing financial difficulties for purposes of determining whether a restructuring constitutes a troubled debt restructuring. The provisions of this standard are effective for the first interim or annual period beginning on or after June 15, 2011 or September 2011 for the Company, and should be applied retrospectively to the beginning of the annual period of adoption.  Management does not expect the adoption of the Update to have a material effect on the Company’s financial statements at the date of adoption.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

 
 
- 29 -
 


Cautionary Statements Regarding Forward-Looking Information

This report contains or incorporates by reference various forward-looking statements concerning the Company’s prospects that are based on the current expectations and beliefs of management.  Forward-looking statements may also be made by the Company from time to time in other reports and documents as well as in oral presentations.  When used in written documents or oral statements, the words “anticipate,” “believe,” “estimate,” “expect,” “objective” and similar expressions and verbs in the future tense, are intended to identify forward-looking statements.  The statements contained herein and such future statements involve or may involve certain assumptions, risks and uncertainties, many of which are beyond the Company’s control, that could cause the Company’s actual results and performance to differ materially from what is expected.  In addition to the assumptions and other factors referenced specifically in connection with such statements, the following factors could impact the business and financial prospects of the Company:
 
 
Ÿ
regulatory action requiring maintenance of minimum regulatory capital ratios higher than required minimum ratios; noncompliance could result in additional regulatory enforcement action; compliance could result in lower future return on equity and dilution for current stockholders;
Ÿ
adverse changes in the real estate markets;
Ÿ
adverse changes in the securities markets;
Ÿ
general economic conditions, either nationally or in our market areas, that are worse than expected;
Ÿ
inflation and changes in the interest rate environment that reduce our margins or reduce the fair value of financial instruments;
Ÿ
changes in interest rates that reduce loan origination volumes and, ultimately, income from our mortgage banking operations;
Ÿ
our ability to maintain adequate levels of liquidity given regulatory limits on sources of funding and rates that can be paid for funding;
Ÿ
legislative or regulatory changes that adversely affect our business;
Ÿ
our ability to enter new markets successfully and take advantage of growth opportunities;
Ÿ
significantly increased competition among depository and other financial institutions;
Ÿ
changes in accounting policies and practices, as may be adopted by the bank regulatory agencies and the Financial Accounting Standards Board; and
Ÿ
changes in consumer spending, borrowing and savings habits.

See also the factors referred to in reports filed by the Company with the Securities and Exchange Commission (particularly those under the caption “Risk Factors” in Item 1A of the Company’s 2010 Annual Report on Form 10-K).
 
Overview

The following discussion and analysis is presented to assist the reader in the understanding and evaluation of the Company’s financial condition and results of operations. It is intended to complement the unaudited consolidated financial statements, footnotes, and supplemental financial data appearing elsewhere in this Form 10-Q and should be read in conjunction therewith. The detailed discussion focuses on the results of operations for the three months ended March 31, 2011 and 2010 and the financial condition as of March 31, 2011 compared to the financial condition as of December 31, 2010.
 
Our profitability is highly dependent on our net interest income, mortgage banking income and the provision for loan losses.  Net interest income is the difference between the interest income we earn on loans receivable, investment securities and cash and cash equivalents and the interest we pay on deposits and other borrowings.  The Company’s banking subsidiary, WaterStone Bank SSB (“WaterStone Bank” or “Bank”) is primarily a mortgage lender with loans secured by real estate comprising 97.1% of total loans receivable on March 31, 2011.  Further, 89.1% of loans receivable are residential mortgage loans with over four-family loans comprising 41.0% of all loans on March 31, 2011.  WaterStone Bank funds loan production primarily with retail deposits and Federal Home Loan Bank advances.  The Bank’s mortgage banking subsidiary, Waterstone Mortgage Corporation, utilizes a line of credit provided by the Bank as its primary source of funding loans held for sale.  In addition, Waterstone Mortgage Corporation utilizes lines of credit with external banks when loan origination volumes exceed the limit of the line of credit provided by the Bank.  On March 31, 2011, deposits comprised 71.0% of total liabilities.  Time deposits, also known as certificates of deposit, accounted for 84.8% of total deposits at March 31, 2011.  Federal Home Loan Bank advances outstanding on March 31, 2011 totaled $350.0 million, or 22.0% of total liabilities.  During the current period of low interest rates and economic weakness, we have determined that an investment philosophy emphasizing short-term liquid investments is prudent and will position the Company to take advantage of the investment, lending and interest rate risk management opportunities that will exist as the local and national economies recover from the recession.  Our high level of time deposits, relative to total deposits, may result in an increase in our costs of funds in the event that market interest rates begin to increase.
 
During the three-month period ended March 31, 2011, our results of operations continued to be adversely affected by elevated levels of nonperforming loans and real estate owned.  Weaknesses in our loan portfolio have required that we establish higher provisions for loan losses and incur significant loan charge-offs.  The continued downturn in the local real estate market requires the Company to continually reevaluate the assumptions used to determine the fair value of collateral and net present value of discounted future estimated cash flows related to loans receivable to ensure that the allowance for loan losses continues to be an accurate reflection of management’s best estimate of the amount needed to provide for the probable and estimable loss on impaired loans and other incurred losses in the loan portfolio.  As a result, the Company determined that a provision for loan losses of $4.9 million was necessary during the three months ended March 31, 2011 in order to maintain the allowance for loan losses at an appropriate level in relation to the risks management believe are inherent and estimable in our portfolio.  Additional information regarding loan quality and its impact on our financial condition and results of operations can be found in the “Asset Quality” discussion.  Our results of operations are also affected by noninterest income and noninterest expense.  Noninterest income consists primarily of mortgage banking income.  A significant increase in the sale of mortgage loans in the secondary market, resulting from a decline in mortgage interest rates during the period and additional mortgage banking offices added over the past twelve months, yielded a $2.6 million increase in mortgage
 
 
- 30 -
 
 
banking income during the three months ended March 31, 2011 compared to the three months ended March 31, 2010.  Noninterest expense consists primarily of compensation and employee benefits, FDIC insurance premiums, occupancy expenses and real estate owned expense.  The primary reason for the increase in noninterest expense compared to the prior year relates to the expansion of our mortgage banking operations.  Of the $4.3 million increase in noninterest expense for the three months ended March 31, 2011, compared to the three months ended March 31, 2010, $3.5 million relates to our mortgage banking operations. During 2011 our noninterest expense has been and will continue to be adversely affected by higher deposit insurance premium assessments from the FDIC.  FDIC insurance premium expense totaled $1.1 million during the three months ended March 31, 2011 and 2010, which are significantly higher than historical levels.  Our results of operations are also significantly affected by general and local economic and competitive conditions, governmental policies and actions of regulatory authorities.
 
Critical Accounting Policies

Critical accounting policies are those that involve significant judgments and assumptions by management and that have, or could have, a material impact on our income or the carrying value of our assets.
 
Allowance for Loan Losses. WaterStone Bank establishes valuation allowances on loans deemed to be impaired. A loan is considered impaired when, based on current information and events, it is probable that WaterStone Bank will not be able to collect all amounts due according to the contractual terms of the loan agreement. A valuation allowance is established for an amount equal to the impairment when the carrying amount of the loan exceeds the present value of the expected future cash flows, discounted at the loan’s original effective interest rate or the fair value of the underlying collateral.
 
WaterStone Bank also establishes valuation allowances based on an evaluation of the various risk components that are inherent in the credit portfolio. The risk components that are evaluated include past loan loss experience; the level of non-performing and classified assets; current economic conditions; volume, growth, and composition of the loan portfolio; adverse situations that may affect the borrower’s ability to repay; the estimated value of any underlying collateral; regulatory guidance; and other relevant factors. The allowance is increased by provisions charged to earnings and recoveries of previously charged-off loans and reduced by charge-offs. The adequacy of the allowance for loan losses is reviewed and approved quarterly by the WaterStone Bank board of directors. The allowance reflects management’s best estimate of the amount needed to provide for the probable loss on impaired loans and other inherent losses in the loan portfolio, and is based on a risk model developed and implemented by management and approved by the WaterStone Bank board of directors.
 
Actual results could differ from this estimate, and future additions to the allowance may be necessary based on unforeseen changes in loan quality and economic conditions.  More specifically, if our future charge-off experience increases substantially from our past experience; or if the value of underlying loan collateral, in our case real estate, declines in value by a substantial amount; or if unemployment in our primary market area increases significantly; our allowance for loan losses may be inadequate and we will incur higher provisions for loan losses and lower net income in the future.
 
 In addition, state and federal regulators periodically review the WaterStone Bank allowance for loan losses. Such regulators have the authority to require WaterStone Bank to recognize additions to the allowance at the time of their examination.
 
Income Taxes.  The Company and its subsidiaries file consolidated federal and combined state income tax returns. The provision for income taxes is based upon income in the consolidated financial statements, rather than amounts reported on the income tax return.  Deferred tax assets and liabilities are recognized for the future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases as well as for net operating loss carry forwards.  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 as income or expense in the period that includes the enactment date.  

Under generally accepted accounting principles, a valuation allowance is required to be recognized if it is “more likely than not” that a deferred tax asset will not be realized.  The determination of the realizability of the deferred tax assets is highly subjective and dependent upon judgment concerning management's evaluation of both positive and negative evidence, the forecasts of future income, applicable tax planning strategies, and assessments of current and future economic and business conditions. Examples of positive evidence may include the existence of taxes paid in available carry-back years as well as the probability that taxable income will be generated in future periods.  Examples of negative evidence may include cumulative losses in a current year and prior two years and general business and economic trends.  At both March 31, 2011 and December 31, 2010, the Company determined a valuation allowance continued to be necessary, largely based on the negative evidence represented by a cumulative loss in the most recent three-year period caused by the significant loan loss provisions recorded during those three years.  In addition, general uncertainty regarding the economy and the housing market has increased the potential volatility and uncertainty of projected earnings.  Management is required to re-evaluate the deferred tax asset and the related valuation allowance quarterly.
 
Positions taken in the Company’s tax returns are subject to challenge by the taxing authorities upon examination.  The benefit of uncertain tax positions are initially recognized in the financial statements only when it is more likely than not the position will be sustained upon examination by the tax authorities.  Such tax positions are both initially and subsequently measured as the largest amount of tax benefit that has a greater than 50% likelihood of being realized upon settlement with the tax authority, assuming full knowledge of the position and all relevant facts.   Interest and penalties on income tax uncertainties are classified within income tax expense in the income statement.
 
Management believes the Company’s tax policies and practices are critical because the determination of the tax provision and current and deferred tax assets and liabilities have a material impact on our net income and the carrying value of our assets.  We have no plans to change the tax recognition methodology in the future without hard evidence of sustainable earnings trends which are reliant on net interest income, mortgage banking income and significantly reduced credit losses.  If the estimated valuation allowance against our deferred asset is adjusted it will affect our future net income.
 
 
- 31 -
 
 
Fair Value Measurements.  The Company determines the fair value of its assets and liabilities in accordance with ASC 820. ASC 820 establishes a standard framework for measuring and disclosing fair value under GAAP. A number of valuation techniques are used to determine the fair value of assets and liabilities in the Company’s financial statements. The valuation techniques include quoted market prices for investment securities, appraisals of real estate from independent licensed appraisers and other valuation techniques. Fair value measurements for assets and liabilities where limited or no observable market data exists are based primarily upon estimates, and are often calculated based on the economic and competitive environment, the characteristics of the asset or liability and other factors. Therefore, the valuation results cannot be determined with precision and may not be realized in an actual sale or immediate settlement of the asset or liability. Additionally, there are inherent weaknesses in any calculation technique, and changes in the underlying assumptions used, including discount rates and estimates of future cash flows, could significantly affect the results of current or future values. Significant changes in the aggregate fair value of assets and liabilities required to be measured at fair value or for impairment are recognized in the income statement under the framework established by GAAP.
 
Comparison of Operating Results for the Three Months Ended March 31, 2011 and 2010

General - Net loss for the three months ended March 31, 2011 totaled $1.5 million, or $0.05 for both basic and diluted loss per share, compared to net income of $176,000, or $0.01 for both basic and diluted loss per share, for the three months ended March 31, 2010.  The three months ended March 31, 2010 generated an annualized loss on average assets of 0.35% and an annualized loss on average equity of 3.67%, compared to an annualized return on average assets of 0.04% and an annualized return on average equity of 0.42% for the comparable period in 2010.  The decrease in the results of operations for the three months ended March 31, 2011 compared to the three months ended March 31, 2010 reflects a $506,000 decrease in net interest income, a $365,000 increase in real estate owned expense and a $901,000 decrease in the pre-tax results of operations from our mortgage banking operations.  The provision for loan losses totaled $4.9 million during the three months ended March 31, 2011, compared to $5.5 million for the three months ended March 31, 2010.  Loan charge-off activity and specific loan loss reserves are discussed in additional detail in the Asset Quality section.  The net interest margin decreased slightly to 2.90% for the three months ended March 31, 2011 compared to 2.92% for the three months ended March 31, 2010.
 
Segment ReviewAs described in Note 13, “Segment Reporting,” of the notes to consolidated financial statements, the Company’s primary reportable segment is community banking.  Community banking consists of lending and deposit gathering (as well as other banking-related products and services) to consumers and businesses and the support to deliver, fund, and manage such banking services. The Company’s mortgage banking segment provides residential mortgage products for the purpose of sale on the secondary market.
 
The Company’s results of operations are dominated by net interest income, the level of the provision for loan losses and noninterest expense of its community banking segment. The consolidated discussion, therefore, predominantly describes the community banking segment results.
 
Mortgage banking segment assets (which consist predominantly of loans held for sale) decreased $68.3 million, or 62.8%, to $40.6 million as of March 31, 2011 compared to $108.9 million as of December 31, 2010.  Additional details are provided in the “Loans Held for Sale” section.  The $2.6 million increase in mortgage banking revenues from the three months ended March 31, 2010 to the three months ended March 31, 2011 was attributable to increased margins on the sale of loans held for sale as well as an increase in the volume of loans sold.  The major components of mortgage banking revenues include fees and premiums associated with the sale of residential loans held for sale, which are discussed in section “Mortgage Banking Income.” The major expenses for the mortgage banking segment are compensation, payroll taxes and other employee benefits, as well as occupancy, office furniture and equipment and other expenses, which are covered generally in the consolidated discussion in section “Noninterest Expense.”

Average Balance Sheets, Interest and Yields/Costs
 
The following tables set forth average balance sheets, average yields and costs, and certain other information for the periods indicated.  No tax-equivalent yield adjustments were made, as the effect thereof was not material.  Non-accrual loans were included in the computation of average balances.  The yields set forth below include the effect of deferred fees, discounts and premiums that are amortized or accreted to interest income or expense.
 
   
Three Months Ended March 31,
 
   
2011
   
2010
 
   
Average Balance
   
Interest
   
Yield/Cost
   
Average Balance
   
Interest
   
Yield/Cost
 
   
(Dollars in Thousands)
 
Assets
                                   
Interest-earning assets:
                                   
Loans receivable, net(1)
  $ 1,341,460       18,465       5.58 %   $ 1,442,353       20,753       5.84 %
Mortgage related securities(2)
    103,249       1,037       4.07       113,067       1,490       5.35  
Debt securities,(2) federal funds sold and short-term investments
    224,900       835       1.51       170,736       806       1.91  
Total interest-earning assets
    1,669,609       20,337       4.94       1,726,156       23,049       5.42  
                                                 
Noninterest-earning assets
    107,791                       98,277                  
Total assets
  $ 1,777,400                     $ 1,824,433                  
                                                 
Liabilities and equity
                                               
Interest-bearing liabilities:
                                               
Demand accounts
  $ 36,376       7       0.08     $ 35,920       8       0.09  
Money market and savings accounts
    111,235       95       0.35       95,461       112       0.48  
Time deposits
    964,549       3,997       1.68       1,010,528       5,725       2.30  
Total interest-bearing deposits
    1,112,160       4,099       1.50       1,141,909       5,845       2.08  
Borrowings
    446,666       4,311       3.91       480,347       4,771       4.03  
Total interest-bearing liabilities
    1,558,826       8,410       2.19       1,622,256       10,616       2.65  
                                                 
Noninterest-bearing liabilities
                                               
Non interest-bearing deposits
    29,216                       23,358                  
Other noninterest-bearing liabilities
    18,730                       10,454                  
Total noninterest-bearing liabilities
    47,946                       33,812                  
Total liabilities
    1,606,772                       1,656,068                  
Equity
    170,628                       168,365                  
Total liabilities and equity
  $ 1,777,400                     $ 1,824,433                  
                                                 
Net interest income
          $ 11,927                     $ 12,433          
Net interest rate spread (3)
                    2.75 %                     2.77 %
Net interest-earning assets (4)
  $ 110,783                     $ 103,900                  
Net interest margin (5)
                    2.90 %                     2.92 %
Average interest-earning assets to average interest-bearing liabilities
                    107.11 %                     104.89 %
_________  
(1)   Interest income includes net deferred loan fee amortization income of $220,000 and $166,000 for the three months ended March 31, 2011 and 2010, respectively.
(2)  Average balance of mortgage related and debt securities are based on amortized historical cost.
(3)  Net interest rate spread represents the difference between the yield on average interest-earning assets and the cost of average interest-bearing liabilities.
(4)  Net interest-earning assets represent total interest-earning assets less total interest-bearing liabilities.
(5)  Net interest margin represents net interest income divided by average total interest-earning assets.
 
 
- 32 -
 

Rate/Volume Analysis
The following table sets forth the effects of changing rates and volumes on our net interest income for the periods indicated.  The rate column shows the effects attributable to changes in rate (changes in rate multiplied by prior volume).  The volume column shows the effects attributable to changes in volume (changes in volume multiplied by prior rate).  The net column represents the sum of the prior columns.  For purposes of this table, changes attributable to changes in both rate and volume that cannot be segregated have been allocated proportionately based on the changes due to rate and the changes due to volume.
 

   
Three Months Ended March 31,
 
   
2011 versus 2010
 
   
Increase (Decrease) due to
 
   
Volume
   
Rate
   
Net
 
   
(In Thousands)
 
Interest income:
                 
Loans receivable(1) (2)
  $ (1,413 )     (875 )     (2,288 )
Mortgage related securities(3)
    (121 )     (332 )     (453 )
Other earning assets(3)
    226       (197 )     29  
 Total interest-earning assets
    (1,308 )     (1,404 )     (2,712 )
                         
Interest expense:
                       
Demand accounts
    -       (1 )     (1 )
Money merket and savings accounts
    17       (34 )     (17 )
Time deposits
    (249 )     (1,479 )     (1,728 )
Total interest-bearing deposits
    (232 )     (1,514 )     (1,746 )
Borrowings
    (327 )     (133 )     (460 )
Total interest-bearing liabilities
    (559 )     (1,647 )     (2,206 )
Net change in net interest income
  $ (749 )     243       (506 )

 
______________
(1)
Includes net deferred loan fee amortization income of $220,000 and $166,000 for the three months ended March 31, 2011 and 2010, respectively.
(2)
Non-accrual loans have been included in average loans receivable balance.
(3)    Includes available for sale securities.  Average balance of available for sale securities is based on amortized historical cost.

Total Interest Income - Total interest income decreased $2.7 million, or 11.8%, to $20.3 million during the three months ended March 31, 2011 from $23.0 million during the three months ended March 31, 2010.

Interest income on loans decreased $2.3 million, or 11.0%, to $18.5 million during the three months ended March 31, 2011 from $20.8 million during the three months ended March 31, 2010.  The decrease in interest income was primarily due to a $100.9 million, or 7.0%, decrease in the average balance of loans outstanding to $1.34 billion during the three months ended March 31, 2011 from $1.44 billion during the comparable period in 2010.  The decrease in interest income also reflects a 26 basis point decrease in the average yield on loans to 5.58% for the three-month period ended March 31, 2011 from 5.84% for the comparable period in 2010.  Unrecognized interest income on non-accrual loans totaled $880,000 during the three months ended March 31, 2011.  This had the effect of reducing the average yield on loans during the same period by 27 basis points.  Unrecognized interest income on non-accrual loans totaled $1.1 million during the three months ended March 31, 2010, effectively reducing the average yield on loans for that period by 32 basis points.

Interest income from mortgage-related securities decreased $454,000, or 30.4%, to $1.0 million during the three months ended March 31, 2011 from $1.5 million during the three months ended March 31, 2010.  The decrease in interest income was primarily due to a 127 decrease in the average yield on mortgage-related securities to 4.07% for the three months ended March 31, 2011 from 5.35% for the comparable period in 2010.  The decrease in interest income from mortgage-related securities also reflects a $9.8 million, or 8.7%, decrease in the average balance of mortgage-related securities to $103.2 million for the three months ended March 31, 2011 from $113.1 million during the comparable period in 2010. The decline in the average balance of mortgage-related securities during the three months ended March 31, 2011 reflects management’s decision to deemphasize investments in mortgage-related securities and emphasize more liquid, less volatile, government agency and municipal securities.

Finally, interest income from other interest earning assets (comprised of debt securities, federal funds sold and short-term investments) increased slightly to $835,000 for the three months ended March 31, 2011 compared to $806,000 for the three months ended March 31, 2010.  Interest income increased due to an increase of $54.2 million, or 31.7%, in the average balance of other earning assets to $224.9 million during the three months ended March 31, 2011 from $170.7 million during the comparable period in 2010.  The increase in average balance reflects a strategic shift towards investments which provide higher levels of liquidity.  The Company intends to maintain higher than usual liquidity given the current economic environment and relatively low rates of return available on loans and mortgage related securities.  The increase in interest income due to an increase in average balance was partially offset by a 40 basis point decline in the average yield on other earning assets to 1.51% for the three months ended March 31, 2011 from 1.91% for the comparable period in 2010.  The decline in average yield provided by these assets reflects the lower overall interest rate environment as opposed to a shift in investment strategy and product mix.
 
 
 
- 33 -
 
 
Total Interest Expense - Total interest expense decreased by $2.2 million, or 20.8%, to $8.4 million during the three months ended March 31, 2011 from $10.6 million during the three months ended March 31, 2010.  This decrease was the result of a decrease of 46 basis points in the average cost of funds to 2.19% for the three months ended March 31, 2011 from 2.65% for the comparable period ended March 31, 2010.  The decrease in interest expense resulted from a decrease in the average cost of funds as well as a decrease of $63.4 million, or 3.9%, in average interest bearing deposits and borrowings outstanding to $1.56 billion for the three months ended March 31, 2011 compared to an average balance of $1.62 billion for the three months ended March 31, 2010.

Interest expense on deposits decreased $1.7 million, or 29.9%, to $4.1 million during the three months ended March 31, 2011 from $5.8 million during the comparable period in 2010.  This was due to a decrease in the cost of average deposits of 58 basis points to 1.50% for the three months ended March 31, 2011 compared to 2.08% for the comparable period during 2010.  The decrease in interest expense attributable to the decrease in the cost of deposits was compounded by a decrease of $29.7 million, or 2.6%, in the average balance of interest bearing deposits to $1.11 billion during the three months ended March 31, 2011 from $1.14 billion during the comparable period in 2010.  The decrease in the cost of deposits reflects the low interest rate environment due to the Federal Reserve’s low short term interest rate policy.  These rates are typically used by financial institutions in pricing deposit products.  The decrease in the average balance of interest bearing deposits was primarily due to a $46.3 million decline in average non-local or brokered deposits.  The average balance of brokered deposits totaled $4.3 million for the three months ended March 31, 2011 compared to $50.6 million for the three months ended March 31, 2010.  Because of the consent order issued by state and federal regulators effective December 18, 2009, the Bank is prohibited from accepting or renewing brokered deposits.

Interest expense on borrowings decreased $461,000, or 9.7%, to $4.3 million during the three months ended March 31, 2011 from $4.8 million during the comparable period in 2010.  The decrease resulted from a $33.7 million, or 7.0%, decrease in average borrowings outstanding to $446.7 million during the three months ended March 31, 2011 from $480.3 million during the comparable period in 2010.  The decrease in interest expense due to average balance was compounded by a 12 basis point decrease in the average cost of borrowings to 3.91% during the three months ended March 31, 2011 from 4.03% during the comparable period in 2009.  The decreased use of borrowings as a source of funding during the three months ended March 31, 2010 reflects our decision to utilize core deposits as our primary funding source.

Net Interest Income - Net interest income decreased by $506,000 or 4.1%, to $11.9 million during the three months ended March 31, 2011 as compared to $12.4 million during the comparable period in 2010.  The decrease in net interest income resulted primarily from a decrease in our interest rate spread to 2.75% for the three month period ended March 31, 2011 from 2.77% for the comparable period in 2010.  The 2 basis point decrease in the interest rate spread resulted from a 48 decrease in the yield on interest earning assets, which was partially offset by a 46 basis point decrease in the cost of interest bearing liabilities.  The decrease in net interest income due to a decrease in our interest rate spread was partially offset by an increase in our net average earning assets of $6.9 million, or 6.6%, to $110.8 million for the three months ended March 31, 2011 from $103.9 million during the comparable period in 2010.

Provision for Loan Losses – Our provision for loan losses decreased $582,000, or 10.7%, to $4.9 million during the three months ended March 31, 2011, from $5.5 million during the three months ended March 31, 2010.  While the provision for loan losses has decreased from the prior year, it remains at high levels.  These levels remain high due to continued general economic stress resulting in reduced levels of income earned by many of our borrowers combined with loan collateral values, primarily real estate, that remain at levels below those estimated at the time the loans were originally made.  These factors result in higher levels of actual loss experience which when applied to the portfolio in general require higher loan loss provisions.  They also result in more loans exhibiting risk characteristics that require estimated loan loss provisions in excess of our historical average experience rates.  These risk characteristics include reduced borrower cash flow, reduced borrower FICO scores and known declines in collateral value even though the loan may still be performing.  The provision for the three months ended March 31, 2011 was the result of $2.0 million of net loan charge-offs combined with continued weakness in local real estate markets which required an overall increase to the allowance for loan losses.  See the Asset Quality section for an analysis of charge-offs, nonperforming assets, specific reserves and additional provisions.

Noninterest Income - Total noninterest income increased $2.5 million to $6.8 million during the three months ended March 31, 2011 from $4.3 million during the comparable period in 2010.  The increase resulted primarily from an increase in mortgage banking income.

Mortgage Banking Income - Mortgage banking income increased $2.6 million to $6.2 million for the three months ended March 31, 2011, compared to $3.6 million during the comparable period in 2010.  The increase was the combined result of increased volume, increased sales margins and an expansion of the branch network.  During the three months ended March 31, 2011, the mortgage banking branch network consisted of 31 branches, compared to 28 branches during the three months ended March 31, 2010.  The expansion of the branch network occurred in Wisconsin, Illinois and Tennessee.
 
Of the $2.6 million increase in mortgage banking income that occurred during the three months ended March 31, 2011 compared to the three months ended March 31, 2010, $1.6 million related to an increase in margin.  The increase in margin was driven by a shift in loan production mix towards loan products and geographic markets that yielded a higher return.  In addition to the increase due to improved margins, mortgage banking income increased $1.0 million due to an increase in loan origination volume.  During the three months ended March 31, 2011, the Company sold $256.2 million of mortgage loans into the secondary market, as compared to $160.8 million during the comparable period in 2010.  The increase in volume was driven by an expansion of our mortgage banking branch network as well as a decrease in average mortgage rates during the three months ended March 31, 2011 as compared to the three months ended March 31, 2010.
 
 
- 34 -
 

Noninterest Expense - Total noninterest expense increased $4.3 million, or 38.3%, to $15.4 million during the three months ended March 31, 2011 from $11.1 million during the comparable period in 2010.  The increase was primarily attributable to increased compensation, real estate owned expense and other noninterest expense.

Compensation, payroll taxes and other employee benefit expense increased $2.8 million, or 54.8%, to $7.9 million during the three months ended March 31, 2011 compared to $5.1 million during the comparable period in 2010.  Due primarily to an expansion of our mortgage banking operations, total compensation, payroll taxes and other benefits at our mortgage banking subsidiary increased $2.5 million  to $4.4 million for the three months ended March 31, 2011 compared to $1.9 million during the comparable period in 2010.  The increase in compensation at our mortgage banking subsidiary correlates to the increase in mortgage banking income due to the commission based compensation structure in place for our mortgage banking loan officers.

Real estate owned expense increased $365,000 or 25.6%, to $1.8 million during the three months ended March 31, 2011 from $1.4 million during the comparable period in 2010.  Real estate owned expense includes the net operating and carrying costs related to the properties.  In addition, it includes net gain or loss recognized upon the sale of a foreclosed property, as well as writedowns recognized to maintain the properties at their estimated fair value.  During the three months ended March 31, 2011, net operating expense, which includes but is not limited to property taxes, maintenance and management fees, net of rental income increased $148,000 to $1.6 million from $1.4 million during the comparable period in 2010.  The increase in net operating expense compared to the prior period resulted from an increase in the number of properties owned.  The average balance of real estate owned totaled $60.8 million for the three months ended March 31, 2011 compared to $53.1 million for the three months ended March 31, 2010.  Net losses recognized on the sale or writedown of real estate owned totaled $225,000 during the three months ended March 31, 2011, compared to $7,000 during the comparable period in 2010.

Other noninterest expense increased $620,000 or 60.9%, to $1.6 million during the three months ended March 31, 2011 from $1.0 million during the comparable period in 2010.  The increase resulted from an increase in operational costs related to the expansion of our mortgage banking operations of $513,000 to $1.1 million for the three months ended March 31, 2011, compared to $635,000 during the comparable period in 2010.

Income Taxes – We recorded income tax expense of $39,000 during the three months ended March 31, 2011 related to certain states in which our mortgage banking subsidiary conducts business and will file a separate company state income tax return.  There was no income tax expense during the three months ended March 31, 2010 as expense was fully offset by reductions in deferred tax asset valuation allowances.

Net Income (Loss) - As a result of the foregoing factors, net loss for the three months ended March 31, 2011 was $1.5 million as compared to net income of $176,000 during the comparable period in 2010.

Comparison of Financial Condition at March 31, 2011 and December 31, 2010

Total Assets - Total assets decreased by $47.9 million, or 2.7%, to $1.76 billion at March 31, 2011 from $1.81 billion at December 31, 2010. The decrease in total assets is comprised of decreases in loans receivable, net of $35.0 million and loans held for sale of $67.0 million.  Funds received upon the repayment of loans held in portfolio and sales of loans held for sale were utilized to pay down $22.0 million of short term borrowed funds and $13.5 million in nonlocal deposits.  The remainder of the funds realized upon the paydown of loans held in portfolio and loans held for sale were utilized to purchase securities available for sale and increase cash and cash equivalents.  Securities available for sale and cash and cash equivalents increased $3.1 million and $49.5 million, respectively at March 31, 2011, compared to December 31, 2010.

Cash and Cash EquivalentsCash and cash equivalents increased by $49.5 million, or 65.7%, to $124.8 million at March 31, 2011 from $75.3 million at December 31, 2010.  The increase in cash and cash equivalents reflects the Company’s decision to maintain higher than usual liquidity given the current economic environment and relatively low rates of return available on securities and other investments.

Securities Available for Sale – Securities available for sale increased by $3.1 million, or 1.5%, to $206.3 million at March 31, 2011 from $203.2 million at December 31, 2010.  This increase reflects a $7.1 million increase in municipal securities and a $6.2 million increase in government sponsored enterprise bonds, partially offset by $10.2 million decrease in mortgage-backed securities and collateralized mortgage obligations.  The shift in the composition of the securities portfolio towards less volatile, shorter-term debt securities reflects a decision to increase portfolio liquidity.  As of March 31, 2011, the Company holds two available for sale securities with a total fair value of $19.8 million and an amortized cost of $20.7 million that were determined to be other than temporarily impaired.  The $935,000 unrealized loss (before taxes) is included in other comprehensive income.

Loans Held for SaleLoans held for sale decreased by $67.0 million, or 69.7%, to $29.1 million at March 31, 2011, from $96.1 million at December 31, 2010.  During the later half of fiscal 2010, Waterstone Mortgage Corporation capitalized on its branch expansion and low interest rate environment to significantly increase its loan origination activity.  This origination activity resulted in a historically high level of loans held for sale as of December 31, 2010.  The subsequent sale of these loans along with an increase in interest rates on long-term fixed-rate real estate loan products during the three months ended March 31, 2011, which resulted in a decrease in loan originations compared to the fourth quarter of 2010, has resulted in a decrease in loans held for sale.
 
 
 
- 35 -
 

Loans Receivable - Loans receivable held for investment decreased $32.0 million, or 2.5%, to $1.27 billion at March 31, 2011 from $1.31 billion at December 31, 2010.  The 2011 decrease in total loans receivable was primarily attributable to a $20.4 million decrease in one- to four-family loans.  The decrease reflects a decline in loan demand for variable-rate real estate mortgage loans as recent borrowers have preferred long-term fixed-rate products that the Company does not generally retain in its portfolio.  Decreases in loan balances in this and other categories also reflect an overall decrease in demand due to current economic conditions combined with the Company’s more stringent loan underwriting requirements.  As a result of the low interest rate environment with respect to long-term fixed-rate real estate mortgage products, the Company has experienced a shift in the composition of loan originations during 2011 and 2010 from one- to four-family residential variable-rate loans to residential real estate loans collateralized by over four-family properties, as this category of borrower displayed relatively stable levels of demand for our existing products.  During the three months ended March 31, 2011, $9.3 million in loans were transferred to real estate owned and $2.0 million were charged-off.

The following table shows loan origination, principal repayment activity, transfers to real estate owned, charge offs and sales during the periods indicated.
 

   
As of or for the
   
As of or for the
 
   
Three Months Ended March 31,
   
Year Ended
 
   
2011
   
2010
   
December 31, 2010
 
   
(In Thousands)
 
Total gross loans receivable and held for sale at
                 
beginning of period
  $ 1,443,824       1,516,800       1,516,800  
Real estate loans originated for investment:
                       
Residential
                       
One- to four-family
    2,969       700       11,390  
Over four-family
    10,119       17,806       69,602  
Home equity
    1,189       1,392       5,528  
Construction and land
    1,589       100       8,355  
Commercial real estate
    4,512       375       5,813  
Total real estate loans originated for investment
    20,378       20,373       100,688  
Consumer loans originated for investment
    -       73       76  
Commerical business loans originated for investment
    5,559       3,393       11,204  
Total loans originated for investment
    25,937       23,839       111,968  
                         
Principal repayments
    (47,201 )     (32,688 )     (169,093 )
Transfers to real estate owned
    (9,311 )     (7,248 )     (41,781 )
Loan principal charged-off, net of recoveries
    (1,956 )     (2,320 )     (25,151 )
Net activity in loans held for investment
    (32,531 )     (18,417 )     (124,057 )
                         
Loans originated for sale
    182,970       151,582       1,084,362  
Loans sold
    (250,011 )     (157,362 )     (1,033,281 )
Net activity in loans held for sale
    (67,041 )     (5,780 )     51,081  
Total gross loans receivable and held for sale at end of period
  $ 1,344,252       1,492,603       1,443,824  


Allowance for Loan Losses - The allowance for loan losses increased $2.9 million, or 10.0%, to $32.1 million at March 31, 2011 from $29.2 million at December 31, 2010.  The $2.9 million increase in the allowance for loan losses during the three months ended March 31, 2011 is attributable to a $1.6 million increase in specific loan loss reserves related to impaired loans, and a $1.3 million increase in the general valuation allowance.  The $1.6 million increase in specific loan loss reserves was primarily the result of an increase in number and amount of impaired loans with significant collateral shortfalls.  The increase in the general valuation allowance resulted from an increase in non-performing loans and loans that, while still performing, have been identified as having higher risk characteristics.  The increase in the amount and number of loans identified as exhibiting elevated levels of risk with respect to loss outweighed the decline in overall delinquent loans.  Loans with elevated risk profiles include loans internally classified as special mention and watch.  These loans resulted in a $1.3 million increase to the general valuation allowance during the three months ended March 31, 2011.  As of March 31, 2011, the allowance for loan losses to total loans receivable was 2.52% and was equal to 38.24% of non-performing loans, compared to 2.23% and 34.66%, respectively, at December 31, 2010.  Of the overall $2.9 million increase in the allowance for loan losses during the quarter ended March 31, 2011, $1.9 million related to the one- to four family category.  Weakness in the residential real estate market has continued for the past three years and the risk of loss on loans secured by residential real estate remains at an elevated level.  That portion of the allowance for loan losses attributable to mortgage loans secured by residential real estate is substantially unchanged at 83.8% of the total allowance for loan losses at March 31, 2011 compared to 83.0% at December 31, 2010.

Real Estate Owned – Total real estate owned increased $3.4 million, or 6.0%, to $61.2 million at March 31, 2011 from $57.8 million at December 31, 2010.  The $3.4 million increase was primarily due to a $2.9 million increase in over four-family residential real estate.  During the three months ended March 31, 2011, real estate owned increase by $9.3 million due to transfers from loans receivable, net of charge offs.  During that same period, real estate owned was reduced by $5.6 million in real estate sales net of gains and losses.
 

 
 
- 36 -
 
 
Prepaid Expenses and Other AssetsPrepaid expenses and other assets declined by $1.9 million or 17.0%, to $9.5 million at March 31, 2011 from $11.4 million at December 31, 2010.  The decline is primarily due to a decrease in receivables due from third parties related to the origination of loans held for sale.

Deposits – Total deposits decreased $16.1 million, or 1.4%, to $1.13 billion at March 31, 2011 from $1.15 billion at December 31, 2010.  Total time deposits decreased $16.5 million, or 1.7%, to $957.9 million at March 31, 2011 from $974.4 million at December 31, 2010.  Time deposits originated through local retail outlets decreased $3.0 million, or 0.3%, to $956.9 million at March 31, 2011 from $960.0 million at December 31, 2010.  Time deposits originated through the wholesale market decreased $13.5 million, or 93.7%, to $914,000 at March 31, 2011 from $14.4 million at December 31, 2010.  Due to the consent order issued by state and federal regulators effective December 18, 2009, the Bank is prohibited from accepting or renewing brokered deposits and all other deposit rates are capped by the FDIC.  Total money market and savings deposits increased $2.4 million, or 2.3%, to $105.8 million at March 31, 2011 from $103.4 million at December 31, 2010.  Total demand deposits decreased $2.0 million, or 2.9%, to $65.8 million at March 31, 2011 from $67.7 million at December 31, 2010.

Borrowings – Total borrowings decreased $22.0 million, or 4.8%, to $435.0 million at March 31, 2011 from $457.0 million at December 31, 2010.  The decrease in borrowings relates entirely to a reduction in the use of bank lines of credit to finance loans held for sale.  The balance of these lines of credit decreased by $22.0 million, to $979,000 at March 31, 2011, from $23.0 million at December 31, 2010.  Interest rates on the lines of credit are based on the note rate of the loans financed and equaled 4.75% at March 31, 2011 and December 31, 2010.

Advance Payments by Borrowers for Taxes - Advance payments by borrowers for taxes increased $6.4 million to $8.8 million at March 31, 2011 from $2.4 million at December 31, 2010.  The increase was the result of payments received from borrowers for their real estate taxes and is seasonally normal, as balances increase during the course of the calendar year until real estate tax obligations are paid out in the fourth quarter.

Other Liabilities - Other liabilities decreased $14.9 million, or 46.6%, to $17.0 million at March 31, 2011 from $31.9 million at December 31, 2010.  The decrease resulted primarily from a $14.1 million seasonal decrease in outstanding escrow checks.  The Company receives payments from borrowers for their real estate taxes during the course of the calendar year until real estate tax obligations are paid out in the fourth quarter.  These amounts remain classified as other liabilities until settled.

Shareholders’ Equity – Shareholders’ equity decreased $1.4 million, or 0.8%, to $170.8 million at March 31, 2011 from $172.2 million at December 31, 2010.  The decrease was primarily due to a $1.5 million decrease in retained earnings reflecting the net loss for the three months ended March 31, 2011.  In addition to the decrease in retained earnings, accumulated other comprehensive income decreased by $323,000 resulting from a decrease in the fair value of available for sale securities.  These decreases to shareholders’ equity were partially offset by a $271,000 increase in additional paid in capital related to stock compensation benefits and a $214,000 decrease in unearned ESOP shares.
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
- 37 -
 
 
 
ASSET QUALITY

 
The following table summarizes nonperforming loans and assets:
 
NONPERFORMING ASSETS
 

   
At March 31,
   
At December 31,
 
   
2011
   
2010
 
   
(Dollars in Thousands)
 
Non-accrual loans:
           
Residential
           
One- to four-family
  $ 56,671       56,759  
Over four-family
    20,810       20,587  
Home equity
    1,455       712  
Construction and land
    2,203       3,013  
Commercial real estate
    1,476       1,577  
Commercial
    1,323       1,530  
Total non-accrual loans
    83,938       84,178  
Real estate owned
               
One- to four-family
    28,559       28,142  
Over four-family
    17,805       14,903  
Construction and land
    10,143       9,926  
Commercial real estate
    4,677       4,781  
Total real estate owned
    61,184       57,752  
Total nonperforming assets
  $ 145,122       141,930  
                 
Total non-accrual loans to total loans receivable
    6.59 %     6.44 %
Total non-accrual loans to total assets
    4.77 %     4.65 %
Total nonperforming assets to total assets
    8.24 %     7.85 %


 
The following table summarizes troubled debt restructurings:

 
TROUBLED DEBT RESTRUCTURINGS


   
At March 31,
   
At December 31,
 
   
2011
   
2010
 
   
(Dollars in Thousands)
 
             
Troubled debt restructurings - accrual
  $ 33,875       33,592  
Troubled debt restructurings - non-accrual
    5,660       2,879  
Total troubled debt restructurings
  $ 39,535       36,471  
                 
Total non-accrual loans and accruing troubled debt
               
restructurings to total loans receivable
    9.24 %     9.01 %

 

 
 
- 38 -
 
 
The following table summarizes loan delinquency in total dollars and as a percentage of the total loan portfolio:
 
 
LOAN DELINQUENCY


   
At March 31,
   
At December 31,
 
   
2011
   
2010
 
   
(Dollars in Thousands)
 
             
Loans past due less than 90 days
    37,400       28,807  
Loans past due in excess of 90 days
    51,344       61,856  
Total loans past due
    88,744       90,663  
                 
Total loans past due to total loans receivable
    6.96 %     6.94 %


Total non-accrual loans decreased by $240,000, or 0.3%, to $83.9 million as of March 31, 2011 compared to $84.2 million as of December 31, 2010.  The ratio of non-accrual loans to total loans receivable was 6.59% at March 31, 2011 compared to 6.44% at December 31, 2009.  The $240,000 decrease in non-accrual loans during the three months ended March 31, 2011 resulted from $17.4 million in loans that were placed on non-accrual status during the period.  The increase due to loans placed on non-accrual during the three months ended March 31, 2010 was partially offset by $9.3 million in transfers to real estate owned (net of $467,000 in charge-offs), $1.6 million in partial charge-offs, $4.1 million in loans that returned to accrual status and $1.8 million in loans that were paid in full.

Of the $83.9 million in total non-accrual loans as of March 31, 2011, $64.2 million in loans have been specifically reviewed to assess whether a specific valuation allowance is necessary.  A specific valuation allowance is established for an amount equal to the impairment when the carrying value of the loan exceeds the present value of expected future cash flows, discounted at the loan’s original effective interest rate or the fair value of the underlying collateral with an adjustment made for costs to dispose of the asset.  Based upon these specific reviews, a total of $10.6 million in partial charge-offs have been recorded with respect to these loans as of March 31, 2011.  In addition, specific reserves totaling $9.0 million have been recorded as of March 31, 2011.  The remaining $19.7 million of non-accrual loans were reviewed on an aggregate basis and $4.8 million in general valuation allowance was deemed necessary as of March 31, 2011.   The $4.8 million in general valuation allowance is based upon a migration analysis performed with respect to similar non-accrual loans in prior periods.

Total real estate owned increased by $3.4 million, or 5.9%, to $61.2 million at March 31, 2011, compared to $57.8 million at December 31, 2010.  During the three months ended March 31, 2011, $9.3 million was transferred from loans to real estate owned upon completion of foreclosure.  Declines in property values evidenced by updated appraisals, responses to list prices on properties held for sale and/or deterioration in the condition of properties resulted in write downs totaling $923,000 during the three months ended March 31, 2011.  During the same period, proceeds from the sale of real estate owned totaled $5.6 million which resulted in a net gain of $698,000.  The net gain on sale of real estate owned properties represented 12.5% of the recorded value of the properties as of the date of sale.  We owned 310 properties as of March 31, 2011, compared to 284 properties at December 31, 2010.  Of the $61.2 million in real estate owned properties as of March 31, 2011, $51.0 million consist of one– to four-family, over four-family and commercial real estate properties.  Of all real estate owned, these property types present the greatest opportunity to offset operating expenses through the generation of rental income.  Of the $51.0 million in one- to four-family, over four-family and commercial real estate properties, $25.4 million, or 49.8%, represent properties that are generating rental revenue.  Foreclosed properties are recorded at the lower of carrying value or fair value with charge-offs, if any, charged to the allowance for loan losses upon transfer to real estate owned.  The fair value is primarily based upon updated appraisals in addition to an analysis of current real estate market conditions.

During 2011 and 2010, as a result of continuing efforts to mitigate the risk of loan losses, the Company has increased its activity with respect to loans modified in a troubled debt restructuring.  Troubled debt restructurings involve granting concessions to a borrower who is experiencing financial difficulty by temporarily modifying the terms of the loan, such as changes in payment schedule or interest rate, in an effort to avoid foreclosure.   As of March 31, 2011, $39.5 million in loans had been modified in troubled debt restructurings, and $5.7 million of these loans are included in the non-accrual loan total.  The remaining $33.9 million, while meeting the internal requirements for modification in a troubled debt restructuring, were current with respect to payments under their original loan terms at the time of the restructuring and thus, continue to be included with accruing loans.  Provided these loans perform in accordance with the modified terms, they will continue to be accounted for on an accrual basis.  Typical restructured terms include six to twelve months of principal forbearance and a reduction in interest rate.  Of the $39.5 million in restructured loans as of March 31, 2011, $24.8 million were one- to four-family loans.  An additional $11.1 million were over four-family loans.  All loans that have been modified in a troubled debt restructuring are considered to be impaired.  As such, a specific analysis has been performed with respect to all of these loans to determine the need for a valuation reserve.  When a borrower is expected to perform in accordance with the restructured terms and ultimately return to and perform under original terms, a valuation allowance is established for an amount equal to the impairment when the carrying amount of the loan exceeds the present value of the expected future cash flows discounted using the loan’s original effective rate.  When there is doubt as to the borrower’s ability to perform under the restructured terms or ultimately return to and perform under market terms, a valuation allowance is established equal to the impairment when the carrying amount exceeds fair value of the underlying collateral.  As a result of the impairment analysis, a $1.9 million valuation allowance has been established as of March 31, 2011 with respect to the $39.5 million in troubled debt restructurings.
 
 
There were no accruing loans past due 90 days or more during the three months ended March 31, 2011 and 2010.
 
 
 
 
- 39 -
 

A summary of the allowance for loan losses is shown below:

ALLOWANCE FOR LOAN LOSSES


   
At or for the Three Months
 
   
Ended March 31,
 
   
2011
   
2010
 
   
(Dollars in Thousands)
 
             
Balance at beginning of period
  $ 29,175       28,494  
Provision for loan losses
    4,875       5,457  
Charge-offs:
               
Mortgage
               
One- to four-family
    1,033       1,668  
Over four-family
    524       585  
Home Equity
    73       -  
Commercial real estate
    176       117  
Construction and land
    4       -  
Consumer
    8       2  
Commercial
    185       1  
Total charge-offs
    2,003       2,373  
Recoveries:
               
Mortgage
               
One- to four-family
    33       49  
Over four-family
    11       -  
Home Equity
    2       1  
Construction and land
    -       2  
Consumer
    1       -  
Total recoveries
    47       52  
Net charge-offs
    1,956       2,321  
Allowance at end of period
  $ 32,094       31,630  
                 
Ratios:
               
Allowance for loan losses to non-accrual loans at end of period
    38.24 %     41.57 %
Allowance for loan losses to loans receivable at end of period
    2.52 %     2.25 %
Net charge-offs to average loans outstanding (annualized)
    0.59 %     0.65 %
Current year provision for loan losses to net charge-offs
    249.19 %     235.09 %
Net charge-offs (annualized) to beginning of the year allowance
    27.19 %     33.04 %
                                                                   _______________

At March 31, 2011, the allowance for loan losses was $32.1 million, compared to $29.2 million at December 31, 2010.  As of March 31, 2011, the allowance for loan losses represented 2.52% of total loans receivable and was equal to 38.24% of non-performing loans, compared to 2.23% and 34.66%, respectively, at December 31, 2010.  The $2.9 million increase in the allowance for loan loss during the three months ended March 31, 2011 is attributable to a $1.6 million increase in specific loan loss reserves related to impaired loans and a $1.3 million increase in the general valuation allowance.  The increase in specific loan loss reserves was the result of an increase in impaired loans and a decline in the value of collateral as evidenced by updated appraisals reflecting further decline in the value of those properties during the period.  The increase in the general valuation allowance resulted from an increase in loans that, while still performing, have been identified as having higher risk characteristics.  The increase in the amount and number of loans identified as exhibiting elevated levels of risk with respect to loss compounded the increase in overall delinquent loans.  Loans with elevated risk profiles include loans internally classified as special mention and watch.  An evaluation of the loan portfolio resulted in a $1.3 million increase to the general valuation allowance during the three months ended March 31, 2011.  Weakness in the residential real estate market has continued for the past three years and the risk of loss on loans secured by residential real estate remains at an elevated level.

Net charge-offs totaled $2.0 million, or an annualized 0.59% of average loans for the three months ended March 31, 2011, compared to $2.3 million, or an annualized 0.65% of average loans for the three months ended March 31, 2010.  Of the $2.0 million in net charge-offs during the three months ended March 31, 2011, $1.0 million related to loans secured by one- to four-family residential loans.

The $4.9 million loan loss provision for the three months ended March 31, 2011 reflects the Company’s conclusion as to the need for the ending allowance to be $32.1 million following the net charge-offs recorded during the period and a review of the Bank’s loan portfolio and general economic conditions.

 
 
- 40 -
 
 
Our revised underwriting policies and procedures emphasize the fact that credit decisions must rely on both the credit quality of the borrower and the estimated value of the underlying collateral.  Credit quality is assured only when the estimated value of the collateral is objectively determined and is not subject to significant fluctuation.  The quantified deterioration of the credit quality of our loan portfolio as described above is the direct result of borrowers who were not financially strong enough to make regular interest and principal payments or maintain their properties when the economic environment no longer allowed them the option of converting estimated real estate value increases into short-term cash flow.

The allowance for loan losses has been determined in accordance with GAAP. We are responsible for the timely and periodic determination of the amount of the allowance required. Future provisions for loan losses will continue to be based upon our assessment of the overall loan portfolio and the underlying collateral, trends in nonperforming loans, current economic conditions and other relevant factors. To the best of management’s knowledge, all probable losses have been provided for in the allowance for loan losses.

The establishment of the amount of the loan loss allowance inherently involves judgments by management as to the adequacy of the allowance, which ultimately may or may not be correct. Higher than anticipated rates of loan default would likely result in a need to increase provisions in future years. See “Critical Accounting Policies” above for a discussion on the use of judgment in determining the amount of the allowance for loan losses.

Impact of Inflation and Changing Prices

The financial statements and accompanying notes of the Company have been prepared in accordance with GAAP. GAAP generally requires the measurement of financial position and operating results in terms of historical dollars without consideration for changes in the relative purchasing power of money over time due to inflation. The impact of inflation is reflected in the increased cost of our operations. Unlike industrial companies, our assets and liabilities are primarily monetary in nature. As a result, changes in market interest rates have a greater impact on performance than do the effects of inflation.

Liquidity and Capital Resources

We maintain liquid assets at levels we consider adequate to meet our liquidity needs.  Our liquidity ratio averaged 6.0% and 3.5% for the three months ended March 31, 2011 and 2010, respectively.  The liquidity ratio is equal to average daily cash and cash equivalents for the period divided by average total assets.  We adjust our liquidity levels to fund loan commitments, repay our borrowings, fund deposit outflows and pay real estate taxes on mortgage loans.  We also adjust liquidity as appropriate to meet asset and liability management objectives.  The operational adequacy of our liquidity position at any point in time is dependent upon the judgment of the senior management as supported by the Asset/Liability Committee.  Liquidity is monitored on a daily, weekly and monthly basis using a variety of measurement tools and indicators.
 
Our primary sources of liquidity are deposits, amortization and repayment of loans, sales of loans held for sale, maturities of investment securities and other short-term investments, and earnings and funds provided from operations.  While scheduled principal repayments on loans are a relatively predictable source of funds, deposit flows and loan repayments are greatly influenced by market interest rates, economic conditions, and rates offered by our competitors.  We set the interest rates on our deposits to maintain a desired level of total deposits.  In addition, we invest excess funds in short-term, interest-earning assets, which provide liquidity to meet lending requirements.  Additional sources of liquidity used for the purpose of managing long- and short-term cash flows include advances from the FHLBC.
 
A portion of our liquidity consists of cash and cash equivalents, which are a product of our operating, investing and financing activities.  At March 31, 2011 and 2010, respectively, $124.8 million and $80.1 million of our assets were invested in cash and cash equivalents.  Cash and cash equivalents are comprised of the following: $116.1 million in cash held at the Federal Reserve Bank and other depository institutions and $8.7 million in federal funds sold.  Our primary sources of cash are principal repayments on loans, proceeds from the calls and maturities of debt and mortgage-related securities, increases in deposit accounts, federal funds purchased and advances from the FHLBC.
 
 
 
- 41 -
 
During the three months ended March 31, 2011, the collection of principal payment on loans, net of loan originations provided cash flow of $20.8 million, compared to $3.4 million for the three months ended March 31, 2010.  The decrease in loans receivable is reflective of the general decline in loan demand for variable-rate residential real estate mortgage loans combined with the Company’s tightened underwriting standards given the current economic environment.  The decrease in the loan portfolio during the three months ended March 31, 2011 was primarily attributable to a $20.4 million decrease in one- to four-family loans.
 
Deposit flows are generally affected by the level of interest rates, the interest rates and products offered by local competitors, and other factors.  Deposits decreased by $16.1 million for the three months ended March 31, 2011.  Brokered deposits accounted for $13.5 million of the $16.1 million decrease in deposits.  As a result of the consent order issued by state and federal regulators effective December 18, 2009, the Bank is prohibited from accepting or renewing brokered deposits and all other deposit rates are capped by the FDIC.
 
Liquidity management is both a daily and longer-term function of business management.  If we require funds beyond our ability to generate them internally, borrowing agreements exist with the FHLBC which provide an additional source of funds.  At March 31, 2011, we had $350.0 million in advances from the FHLBC with final maturity dates in 2016, 2017 or 2018.  All advances are callable quarterly until maturity.  As an additional source of funds, we also enter into repurchase agreements.  At March 31, 2011, we had $84.0 million in repurchase agreements.  The agreements mature at various times in 2017, however, all are callable quarterly until maturity.
 
On October 10, 2007, the FHLBC entered into a consensual cease and desist order with its regulator, the Federal Housing Finance Board. Under the terms of the order, capital stock repurchases and redemptions, including redemptions upon membership withdrawal or other termination, are prohibited unless the FHLBC has received approval of the Director of the Office of Supervision of the Federal Housing Finance Board ("OS Director"). The order also provides that dividend declarations are subject to the prior written approval of the OS Director.  At the request of the FHLBC, on July 24, 2008, the Finance Board amended the cease and desist order to allow the FHLBC to redeem incremental purchases of capital stock tied to increased levels of borrowing through advances after repayment of those new advances.  We currently hold, at cost, $21.7 million of FHLBC stock, all of which we believe we will ultimately be able to recover.  Based upon correspondence we received from the FHLBC, there is currently no expectation that this cease and desist order will impact the short- and long-term funding options provided by the FHLBC.
 
At March 31, 2011, we had outstanding commitments to originate loans of $17.5 million.  In addition, at March 31, 2011 we had unfunded commitments under construction loans of $4.5 million, unfunded commitments under business lines of credit of $9.6 million and unfunded commitments under home equity lines of credit and standby letters of credit of $25.7 million.  At March 31, 2011, certificates of deposit scheduled to mature in one year or less totaled $446.4 million.  Based on prior experience, management believes that a significant portion of such deposits will remain with us, although there can be no assurance that this will be the case.  In the event a significant portion of our deposits is not retained by us, we will have to utilize other funding sources, such as FHLBC advances, in order to maintain our level of assets.  However, we cannot assure that such borrowings would be available on attractive terms, or at all, if and when needed.  Alternatively, we would reduce our level of liquid assets, such as our cash and cash equivalents and securities available-for-sale in order to meet funding needs.  In addition, the cost of such deposits may be significantly higher if market interest rates are higher or there is an increased amount of competition for deposits in our market area at the time of renewal.
 

 
 
- 42 -
 

 Contractual Obligations, Commitments, Contingent Liabilities, and Off-balance Sheet Arrangements
 
The following tables present information indicating various contractual obligations and commitments of the Company as of March 31, 2011 and the respective maturity dates.
 

 
Contractual Obligations
 
               
More than
   
More than
       
               
One Year
   
Three Years
   
Over
 
         
One Year
   
Through
   
Through
   
Five
 
   
Total
   
or Less
   
Three Years
   
Five Years
   
Years
 
   
(In Thousands)
 
Deposits without a stated maturity (4)
  $ 171,546       171,546       -       -       -  
Certificates of deposit (4)
    957,862       446,384       498,671       12,807       -  
Bank lines of credit (4)
    979       979                          
Federal Home Loan Bank advances (1)
    350,000       -       -       50,000       300,000  
Repurchase agreements (2)(4)
    84,000       -       -       -       84,000  
Operating leases (3)
    239       239       -       -       -  
Salary continuation agreements
    1,063       170       340       340       213  
    $ 1,565,689       619,318       499,011       63,147       384,213  
_____________
 
(1)  Secured under a blanket security agreement on qualifying assets, principally, mortgage loans.  Excludes interest which will accrue on
      the advances.  All Federal Home Loan Bank advances with maturities exceeding one year are callable on a quarterly basis.
(2)  The repurchase agreements are callable on a quarterly basis until maturity.
(3)  Represents non-cancelable operating leases for offices and equipment.
(4)  Excludes interest.


The following table details the amounts and expected maturities of significant off-balance sheet commitments as of March 31, 2011.


Other Commitments
 
               
More than
   
More than
       
               
One Year
   
Three Years
   
Over
 
         
One Year
   
Through
   
Through
   
Five
 
   
Total
   
or Less
   
Three Years
   
Five Years
   
Years
 
   
(In Thousands)
 
Real estate loan commitments (1)
  $ 17,540       17,540       -       -       -  
Unused portion of home equity lines of credit (2)
    24,700       24,700       -       -       -  
Unused portion of business lines of credit
    9,584       9,584       -       -       -  
Unused portion of construction loans (3)
    4,543       4,543       -       -       -  
Standby letters of credit
    991       945       46       -       -  
  Total Other Commitments
  $ 57,358       57,312       46       -       -  
______________
General:  Commitments to extend credit are agreements to lend to a customer as long as there is no violation of any condition established in the contract and generally have fixed expiration dates or other termination clauses.
(1)  Commitments for loans are extended to customers for up to 90 days after which they expire.
(2)  Unused portions of home equity loans are available to the borrower for up to 10 years.
(3)  Unused portions of construction loans are available to the borrower for up to 1 year.
 
 
 
 
- 43 -
 



Management of Market Risk

General. The majority of our assets and liabilities are monetary in nature.  Consequently, our most significant form of market risk is interest rate risk.  Our assets, consisting primarily of mortgage loans, have longer maturities than our liabilities, consisting primarily of deposits.  As a result, a principal part of our business strategy is to manage interest rate risk and reduce the exposure of our net interest income to changes in market interest rates.  Accordingly, WaterStone Bank’s board of directors has established an Asset/Liability Committee which is responsible for evaluating the interest rate risk inherent in our assets and liabilities, for determining the level of risk that is appropriate given our business strategy, operating environment, capital, liquidity and performance objectives, and for managing this risk consistent with the guidelines approved by the Board of directors.  Management monitors the level of interest rate risk on a regular basis and the Asset/Liability Committee meets at least weekly to review our asset/liability policies and interest rate risk position, which are evaluated quarterly.

We have sought to manage our interest rate risk in order to minimize the exposure of our earnings and capital to changes in interest rates.  We have implemented the following strategies to manage our interest rate risk: (i) emphasizing variable rate loans including variable rate one- to four-family, and commercial real estate loans as well as three to five year commercial real estate balloon loans; (ii) reducing and shortening the expected average life of the investment portfolio; and (iii) whenever possible, lengthening the term structure of our deposit base and our borrowings from the FHLBC.  These measures should reduce the volatility of our net interest income in different interest rate environments.
 
Income Simulation.  Simulation analysis is an estimate of our interest rate risk exposure at a particular point in time.  At least quarterly we review the potential effect changes in interest rates may have on the repayment or repricing of rate sensitive assets and funding requirements of rate sensitive liabilities.  Our most recent simulation uses projected repricing of assets and liabilities at March 31, 2011 on the basis of contractual maturities, anticipated repayments and scheduled rate adjustments.  Prepayment rate assumptions may have a significant impact on interest income simulation results.  Because of the large percentage of loans and mortgage-backed securities we hold, rising or falling interest rates may have a significant impact on the actual prepayment speeds of our fixed-rate mortgage related assets that may in turn affect our interest rate sensitivity position.  When interest rates rise, prepayment speeds slow and the average expected lives of our fixed-rate assets would tend to lengthen more than the expected average lives of our liabilities and therefore would most likely have a negative impact on net interest income and earnings.  This effect is offset by the impact that variable-rate assets have on net interest income as interest rates rise and fall.
 
 
       
 
Percentage Increase (Decerease) in
Estimated Annual Net Interest
Income Over 12 Months
300 basis point gradual rise in rates
 
(0.34%)
 
200 basis point gradual rise in rates
 
(1.60%)
 
100 bassis point gradual rise in rates
 
(2.96%)
 
100 bassis point gradual decline in rates
 
(4.93%)
 
200 bassis point gradual decline in rates
 
(7.54%)
 
300 bassis point gradual decline in rates
 
(9.36%)
 

 
WaterStone Bank’s Asset/Liability policy limits projected changes in net average annual interest income to a maximum decline of 20% for various levels of interest rate changes measured over a 12-month period when compared to the flat rate scenario.  In addition, projected changes in the economic value of equity are limited to a maximum decline of 10% to 80% for interest rate movements of 100 to 300 basis points when compared to the flat rate scenario.  These limits are re-evaluated on a periodic basis and may be modified, as appropriate.  Because our balance sheet is asset sensitive, net interest income is projected to decline as interest rates fall.  At March 31, 2011, a 100 basis point gradual increase in interest rates had the effect of decreasing forecast net interest income by 2.96% while a 100 basis point decrease in rates had the effect of decreasing net interest income by 4.93%.  At March 31, 2011, a 100 basis point gradual increase in interest rates had the effect of decreasing the economic value of equity by 0.19% while a 100 basis point decrease in rates had the effect of decreasing the economic value of equity by 1.37%.  While we believe the assumptions used are reasonable, there can be no assurance that assumed prepayment rates will approximate actual future mortgage-backed security and loan repayment activity.
 
 
 
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Disclosure Controls and Procedures : Company management, with the participation of the Company’s Chief Executive Officer and Chief Financial Officer, has evaluated the effectiveness of the Company’s disclosure controls and procedures (as such term is defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934, as amended (the “Exchange Act”)) as of the end of the period covered by this report. Based on such evaluation, the Company’s Chief Executive Officer and Chief Financial Officer have concluded that, as of the end of such period, the Company’s disclosure controls and procedures are effective in recording, processing, summarizing and reporting, on a timely basis, information required to be disclosed by the Company in the reports that it files or submits under the Exchange Act.

Internal Control Over Financial Reporting : There have been no changes in the Company’s internal control over financial reporting (as such term is defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act) during the fiscal quarter to which this report relates that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

 
 
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We are not involved in any pending legal proceedings as a defendant other than routine legal proceedings occurring in the ordinary course of business.  At March 31, 2011, we believe that any liability arising from the resolution of any pending legal proceedings will not be material to our financial condition or results of operations.
 
 
In addition to the “Risk Factors” in Item 1A of the Company’s annual report on Form 10-K for the year ended December 31, 2010, we set forth the following additional risk factors.
 
A Significant Portion of our Liabilities are Time Deposits
 
If interest rates rise, our cost of funds could significantly increase, adversely affecting our ability to generate a profit.  At March 31, 2011, time deposits totaled $957.9 million, comprising 84.8% of our total deposits.  If market rates begin to rise our costs of funds may significantly increase or we may experience significant deposit outflows.  Either of which will adversely affect our ability to operate profitably.
 
 

    (a) Exhibits: See Exhibit Index, which follows the signature page hereof.

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.




 
WATERSTONE FINANCIAL, INC.
(Registrant)
Date: May 6, 2011
 
   /s/ Douglas S. Gordon
 
Douglas S. Gordon
 
Chief Executive Officer
Date: May 6, 2011
 
   /s/ Richard C. Larson
 
Richard C. Larson
 
Chief Financial Officer
 

 
 
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EXHIBIT INDEX

WATERSTONE FINANCIAL, INC.

Form 10-Q for Quarter Ended March 31, 2011



Exhibit No.
Description
Filed Herewith
31.1
 
Sarbanes-Oxley Act Section 302 Certification signed by the Chief Executive Officer of Waterstone Financial, Inc.
X
31.2
Sarbanes-Oxley Act Section 302 Certification signed by the Chief Financial Officer of Waterstone Financial, Inc.
 
X
32.1
Certification pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Executive Officer of Waterstone Financial, Inc.
X
32.2
Certification pursuant to 18 U.S. C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 signed by the Chief Financial Officer of Waterstone Financial, Inc.
X