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EX-32 - Franklin Financial Corpv222116_ex32.htm
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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, DC 20549

FORM 10-Q
(Mark one)

x
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
For the transition period from ______________ to _____________
 
Commission file number:   1-35085
 
FRANKLIN FINANCIAL CORPORATION

(Exact name of registrant as specified in its charter)

Virginia
   
27-4132729
(State or other jurisdiction of incorporation or
 
(I.R.S. Employer Identification No.)
organization)
   

4501 Cox Road, Glen Allen, Virginia
   
23060
(Address of principal executive offices)
 
(Zip Code)

(804) 967-7000

(Registrant’s telephone number, including area code)

Not applicable

(Former name, former address and former fiscal year, if changed since last report)

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  x     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 shorter period that the registrant was reported to submit and post such files).  Yes ¨  No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act. (Check one):

 
Large accelerated filer ¨
Accelerated filer  ¨  
 
Non-accelerated filer  x
Smaller Reporting Company  ¨
  
(Do not check if a 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  x

14,302,838 shares of the registrant’s common stock, par value $0.01 per share, were outstanding at May 1, 2011.
 
 
 

 
 
FRANKLIN FINANCIAL CORPORATION

FORM 10-Q

Table of Contents

 
Page No.
Part I.  Financial Information
 
   
Item 1.  Financial Statements
 
   
Consolidated Statements of Financial Condition at March 31, 2011 and September 30, 2010 (unaudited)
3
   
Consolidated Statements of Earnings for the Three and Six Months Ended March 31, 2011 and 2010 (unaudited)
4
   
Consolidated Statements of Comprehensive Income and Changes in Net Worth for the Six Months Ended March 31, 2011 and 2010 (unaudited)
5
   
Consolidated Statements of Cash Flows for the Six Months Ended March 31, 2011 and 2010 (unaudited)
6
   
Notes to the Unaudited Consolidated Financial Statements
7
   
Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations
26
   
Item 3.   Quantitative and Qualitative Disclosures About Market Risk
39
   
Item 4.   Controls and Procedures
40
   
Part II.  Other Information
 
   
Item 1.    Legal Proceedings
41
   
Item 1A. Risk Factors
41
   
Item 2     Unregistered Sales of Equity Securities and Use of Proceeds
41
   
Item 3.    Defaults Upon Senior Securities
41
   
Item 4.    [Removed and Reserved]
41
   
Item 5.    Other Information
41
   
Item 6.    Exhibits
41
   
Signatures
43
 
 
2

 

PART I. FINANCIAL INFORMATION
Item 1. Financial Statements

FRANKLIN FINANCIAL CORPORATION MHC AND SUBSIDIARIES
Consolidated Statements of Financial Condition
(Dollars in thousands)
 
March 31,
2011
   
September 30,
2010
 
 
 
(unaudited)
       
Assets
           
Cash and cash equivalents:
           
Cash and due from banks
  $ 121,052     $ 7,401  
Interest-bearing deposits in other banks
    190,527       90,028  
Money market investments
    859       480  
Total cash and cash equivalents
    312,438       97,909  
                 
Securities available for sale
    342,400       276,643  
Securities held to maturity
    31,128       35,518  
                 
Loans, net of deferred loan fees
    490,715       490,454  
Less allowance for loan losses
    11,922       13,419  
Net loans
    478,793       477,035  
                 
Loans held for sale
    249       2,781  
Federal Home Loan Bank stock
    12,071       12,542  
Office properties and equipment, net
    6,021       6,099  
Real estate owned
    11,636       11,581  
Accrued interest receivable:
               
Loans
    2,480       2,442  
Mortgage-backed securities and collateralized mortgage obligations
    747       667  
Other investment securities
    1,786       1,613  
Total accrued interest receivable
    5,013       4,722  
                 
Cash surrender value of bank-owned life insurance
    31,066       30,430  
Prepaid expenses and other assets
    19,137       15,795  
Total assets
  $ 1,249,952     $ 971,055  
                 
Liabilities
               
Deposits:
               
Savings deposits
  $ 277,507     $ 266,694  
Time deposits
    401,603       380,433  
Total deposits
    679,110       647,127  
                 
Stock order funds
    242,377       -  
Federal Home Loan Bank borrowings
    190,000       190,000  
Advance payments by borrowers for property taxes and insurance
    2,448       2,340  
Accrued expenses and other liabilities
    5,675       4,819  
Total liabilities
    1,119,610       844,286  
                 
Commitments and contingencies (see note 8)
               
                 
Net worth:
               
Retained earnings
    128,109       124,339  
Accumulated other comprehensive income
    2,233       2,430  
Total net worth
    130,342       126,769  
Total liabilities and net worth
  $ 1,249,952     $ 971,055  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
  
 
3

 

FRANKLIN FINANCIAL CORPORATION MHC AND SUBSIDIARIES
Consolidated Statements of Earnings
Three and Six Months Ended March 31, 2011 and 2010 (Unaudited)
 
   
Three months ended
March 31,
   
Six months ended
March 31,
 
(Dollars in thousands)
 
2011
   
2010
   
2011
   
2010
 
Interest and dividend income:
                       
Interest and fees on loans
  $ 7,800     $ 8,382     $ 15,983     $ 16,426  
Interest on deposits in other banks
    33       44       77       75  
Interest and dividends on securities:
                               
Taxable
    3,250       4,071       6,472       8,025  
Nontaxable
    79       79       159       167  
Total interest and dividend income
    11,162       12,576       22,691       24,693  
Interest expense:
                               
Interest on deposits
    2,672       3,590       5,437       7,504  
Interest on borrowings
    2,266       2,721       4,582       5,509  
Total interest expense
    4,938       6,311       10,019       13,013  
Net interest income
    6,224       6,265       12,672       11,680  
Provision for loan losses
    290       156       712       2,101  
Net interest income after provision for loan losses
    5,934       6,109       11,960       9,579  
Noninterest income (expense) :
                               
Service charges on deposit accounts
    12       13       20       29  
Other service charges and fees
    91       332       153       437  
Gains on sales of loans
    65       59       216       142  
Gains (losses) on sales of securities, net
    364       (2 )     264       1,975  
Impairment of securities, net:
                               
Impairment of securities
    (490 )     (1,440 )     (786 )     (2,960 )
Less: Impairment recognized in other comprehensive income
    (108 )     (127 )     (105 )     (456 )
Net impairment reflected in earnings
    (382 )     (1,313 )     (681 )     (2,504 )
Net increase (decrease) in value of call options on equity securities
    26       (6 )     26       (9 )
Increase in cash surrender value of bank-owned life insurance
    316       304       636       638  
Other operating income
    81       135       306       267  
Total noninterest income (expense)
    573       (478 )     940       975  
Other noninterest expenses:
                               
Personnel expense
    2,045       1,903       3,999       3,857  
Occupancy expense
    207       231       408       456  
Equipment expense
    221       219       446       437  
Advertising expense
    32       79       72       120  
Federal deposit insurance premiums
    272       285       518       551  
Fee on early retirement of FHLB borrowings
    -       -       -       318  
Other operating expenses
    1,398       757       2,183       1,388  
Total other noninterest expenses
    4,175       3,474       7,626       7,127  
Income before provision for income taxes
    2,332       2,157       5,274       3,427  
Federal and state income tax expense
    597       599       1,504       840  
Net income
  $ 1,735     $ 1,558     $ 3,770     $ 2,587  
 
The accompanying notes are an integral part of these consolidated financial statements.
 
 
 
4

 

FRANKLIN FINANCIAL CORPORATION MHC AND SUBSIDIARIES
Consolidated Statements of Comprehensive Income and Changes in Net Worth
Six Months Ended March 31, 2011 and 2010 (Unaudited)
 
(Dollars in thousands)
 
Retained
earnings
   
Accumulated 
other
comprehensive
income (loss)
   
Net worth
 
Balance at September 30, 2009
  $ 125,420     $ (1,782 )   $ 123,638  
Net income
    2,587       -       2,587  
Other comprehensive income (loss):
                       
Net unrealized holding gains on available-for-sale securities arising during the period, net of income tax expense of $1,684
            2,915       2,915  
                         
Reclassification adjustment for gains on available-for-sale securities included in net earnings, net of income tax expense of $743
            (1,213 )     (1,213 )
                         
Other-than-temporary impairment of held-to-maturity securities related to factors other than credit, net of amortization, net of income tax benefit of $126
            (205 )     (205 )
                         
Amortization of previously recognized other-than-temporary impairment of available-for-sale securities related to factors other than credit, net of income tax expense of $261
            426       426  
                         
Comprehensive income
                    4,510  
Balance at March 31, 2010
  $ 128,007     $ 141     $ 128,148  
                         
Balance at September 30, 2010
  $ 124,339     $ 2,430     $ 126,769  
Net income
    3,770       -       3,770  
Other comprehensive income (loss):
                       
Net unrealized holding losses on available-for-sale securities arising during the period, net of income tax benefit of $1,199
            (516 )     (516 )
                         
Reclassification adjustment for gains on available-for-sale securities included in net earnings, net of income tax expense of $81
            (132 )     (132 )
                         
Other-than-temporary impairment of held-to-maturity securities related to factors other than credit, net of amortization, net of income tax expense of $15
            25       25  
                         
Amortization of previously recognized other-than-temporary impairment of available-for-sale securities related to factors other than credit, net of income tax expense of $261
            426       426  
                         
Comprehensive income
                    3,573  
Balance at March 31, 2011
  $ 128,109     $ 2,233     $ 130,342  
 
The accompanying notes are an integral part of these consolidated financial statements.
 

 
5

 

FRANKLIN FINANCIAL CORPORATION MHC AND SUBSIDIARIES
Consolidated Statements of Cash Flows
Six Months Ended March 31, 2011 and 2010 (Unaudited)
 
   
2011
   
2010
 
 (Dollars in thousands)
           
Cash Flows From Operating Activities
           
Net income
  $ 3,770     $ 2,587  
Adjustments to reconcile net income to net cash and cash
               
equivalents provided by operating activities:
               
Depreciation and amortization
    350       334  
Provision for loan losses
    712       2,101  
Impairment charge on other real estate owned
    781       -  
Gain on sales of securities available for sale, net
    (264 )     (1,975 )
Net (increase) decrease in the value of call options on equity securities
    (26 )     9  
Impairment charge on securities
    681       2,504  
Loss (gain) on sales or disposal of office properties and equipment, net
    1       (10 )
Gain on sale of other real estate owned
    (54 )     -  
Net amortization (accretion) on securities
    767       (415 )
Originations of loans held for sale
    (8,559 )     (8,131 )
Sales and principal payments on loans held for sale
    11,091       7,998  
Changes in assets and liabilities:
               
Accrued interest receivable
    (291 )     (35 )
Cash surrender value of bank-owned life insurance
    (636 )     (638 )
Prepaid expenses and other assets
    (2,339 )     (4,060 )
Advance payments by borrowers for property taxes and insurance
    108       561  
Accrued expenses and other liabilities
    856       (739 )
Net cash and cash equivalents provided by operating activities
    6,948       91  
Cash Flows From Investing Activities
               
Net redemptions of Federal Home Loan Bank stock
    471       -  
Net deposits of term interest bearing deposits in other banks
    -       (56 )
Proceeds from maturities, calls and paydowns of securities available for sale
    54,269       29,871  
Proceeds from sales and redemptions of securities available for sale
    12,173       26,486  
Purchases of securities available for sale
    (134,455 )     (52,404 )
Proceeds from maturities and paydowns of securities held to maturity
    4,260       4,782  
Proceeds from sales of call options on equity securities
    26       -  
Net (increase) decrease in loans
    (4,235 )     4,676  
Purchases of office properties and equipment
    (277 )     (284 )
Proceeds from sales of office properties and equipment
    5       12  
Capitalized improvements of real estate owned
    (46 )     -  
Proceeds from sales of real estate owned
    1,030       244  
Net cash and cash equivalents provided (used) by investing activities
    (66,779 )     13,327  
Cash Flows From Financing Activities
               
Net increase in savings deposits
    10,813       35,249  
Net increase(decrease) in time deposits
    21,170       (21,177 )
Net increase in stock order funds
    242,377       -  
Net repayments of long-term Federal Home Loan Bank borrowings
    -       (10,000 )
Net cash and cash equivalents provided by financing activities
    274,360       4,072  
Net increase in cash and cash equivalents
    214,529       17,490  
Cash and cash equivalents at beginning of period
    97,909       62,783  
Cash and cash equivalents at end of period
  $ 312,438     $ 80,273  
                 
Supplemental disclosures of cash flow information
               
Cash payments for:
               
Interest
  $ 9,981     $ 13,080  
Income taxes
  $ 1,400     $ 700  
Supplemental schedule of noncash investing and financing activities
               
Unrealized (losses) gains on securities available for sale
  $ (1,241 )   $ 2,643  
Transfer of loans to other real estate owned, net
  $ 2,439     $ 3,885  
.
The accompanying notes are an integral part of these consolidated financial statements.

 
6

 

FRANKLIN FINANCIAL CORPORATION MHC AND SUBSIDIARIES
Notes to Unaudited Consolidated Financial Statements
March 31, 2011

Note 1.
Nature of Business and Summary of Significant Accounting Policies

Organization and Description of Business — Franklin Financial Corporation (the “Holding Company”), a Virginia corporation, succeeded Franklin Financial Corporation MHC (the “MHC” or the “Parent”) as the holding company for Franklin Federal Savings Bank (the “Bank”) after the completion of the MHC’s conversion into the stock holding company form of organization on April 27, 2011 (see note 2).  Because the MHC’s conversion and the Holding Company’s stock offering were consummated on April 27, 2011, the Holding Company was not an operating company and had no assets at March 31, 2011.  The interim financial statements presented in this report include only the unaudited financial information of the Parent and subsidiaries on a consolidated basis.

At March 31, 2011, the Bank was the wholly owned subsidiary of FFC, Inc., a federally chartered mid-tier holding company.  FFC, Inc. was the wholly owned subsidiary of the MHC, a federally chartered mutual holding company. FFC, Inc. and the MHC ceased to exist after completion of the MHC’s conversion into the stock holding company form of organization on April 27, 2011, and the Holding Company became the sole parent company of the Bank.  The Bank has two wholly owned subsidiaries, Franklin Service Corporation, which provides trustee services on loans originated by the Bank, and Reality Holdings LLC, which, through its subsidiaries, holds and manages foreclosed properties purchased from the Bank. The Bank is a federally chartered capital stock savings bank engaged in the business of attracting retail deposits from the general public and originating both owner and non-owner-occupied one-to four-family loans as well as multi-family loans, nonresidential real estate loans, construction loans, land and land development loans, and non-mortgage commercial loans. The Company (as defined below) operates as one segment.

These interim financial statements do not contain all necessary disclosures required by accounting principles generally accepted in the United States of America (“GAAP”) for complete financial statements and, therefore, should be read in conjunction with the audited consolidated financial statements and the notes thereto included in the Holding Company’s Prospectus filed pursuant to Rule 424(b)(3) of the Securities Act of 1933, as amended, on February 22, 2011.  These financial statements include all normal and recurring adjustments that management believes are necessary in order to conform to GAAP.  The results for the three and six months ended March 31, 2011 are not necessarily indicative of the results that may be expected for the year ending September 30, 2011 or any other future period.
 
Principles of Consolidation — The consolidated financial statements include the accounts of the Parent, FFC, Inc., the Bank, Franklin Service Corporation, and Reality Holdings LLC and its subsidiaries (collectively, the “Company”). All significant intercompany transactions and balances have been eliminated in consolidation. The accounting and reporting policies of the Company conform to GAAP.

Use of Estimates — Management of the Company has made a number of estimates and assumptions relating to the reporting of assets and liabilities and the disclosure of contingent assets and liabilities to prepare these consolidated financial statements in conformity with GAAP. Actual results could differ from those estimates. Material estimates that are particularly susceptible to significant change in the near term relate to the allowance for loan losses, the projected benefit obligation for the defined benefit pension plan, the valuation of deferred taxes, and the analysis of securities for other-than-temporary impairment.

Loans — Loans that management has the intent and ability to hold for the foreseeable future or until maturity or pay-off are reported at their outstanding principal balance adjusted for any charge-offs and net of the allowance for loan losses and any deferred fees or costs. Loan origination fees and certain direct loan origination costs are deferred and recognized over the contractual lives of the related loans as an adjustment of the loans’ yields using the level-yield method on a loan-by-loan basis.
 
 
7

 

Loans are placed on nonaccrual status when they are three monthly payments or more past due unless management believes, based on individual facts, that the delay in payment is temporary and that the borrower will be able to bring past due amounts current and remain current. All interest accrued but not collected for loans that are placed on non-accrual status is reversed against interest income. Any payments made on these loans while on non-accrual status are accounted for on a cash-basis until the loan qualifies for return to accrual status or is subsequently charged-off. Loans are returned to accrual status when the principal and interest amounts due are brought current and management believes that the borrowers will be able to continue to make required contractual payments.

Allowance for Loan Losses — The allowance for loan losses is maintained at an amount estimated to be sufficient to absorb probable principal losses, net of principal recoveries (including recovery of collateral), inherent in the existing loan portfolio. Loan losses are charged against the allowance when management believes the uncollectibility of a loan balance is confirmed. The allowance for loan losses consists of specific and general components.

The specific component relates to loans identified as impaired. The Company determines and recognizes impairment of certain loans when, based on current information and events, it is probable that the Company will be unable to collect all amounts due according to the contractual terms of the loan agreement. Loans that experience insignificant delays and payment shortfalls generally are not classified as impaired. An impaired loan is measured at net realizable value, which is equal to present value less estimated costs to sell. The present value is estimated using expected future cash flows discounted at the loan’s effective interest rate, the loan’s observable market price, or the fair value of the collateral, if the loan is collateral dependent.

The general component covers loans not identified for specific allowances and is based on historical loss experience adjusted for various qualitative factors. The allowance for loan losses is increased by provisions for loan losses and decreased by charge-offs (net of recoveries). In estimating the allowance, management segregates its portfolio by loan type and credit grading. Management’s periodic determination of the allowance for loan losses is based on consideration of various factors, including the Company’s past loan loss experience, current delinquency status and loan performance statistics, industry loan loss statistics, periodic loan evaluations, real estate value trends in the Company’s primary lending areas, and current economic conditions. The delinquency status of loans is computed based on the contractual terms of the loans. Management believes that the current allowance for loan losses is a reasonable estimate of known and inherent losses in the loan portfolio.

Income Taxes — Income taxes are accounted for under the asset and liability method. Deferred tax assets and liabilities are recognized for the estimated future tax consequences attributable to differences between the financial statement carrying amounts of existing assets and liabilities and their respective tax bases and operating loss, capital loss, and tax credit carryforwards. Deferred tax assets and liabilities are measured using enacted tax rates expected to be in effect for the year in which those temporary differences are expected to be recovered or settled. The effect on deferred tax assets and liabilities of a change in tax rates is recognized in earnings in the period that includes the enactment date. Valuation allowances are established when necessary to reduce deferred tax assets to the amount deemed more likely than not to be realized in future periods. It is the Company’s policy to provide for uncertain tax positions and the related interest and penalties based upon management’s assessment of whether a tax benefit is more likely than not to be sustained upon examination by tax authorities. Any interest and penalties assessed on tax positions are recognized in income tax expense.

Reclassifications — Certain reclassifications have been made to the financial statements of prior periods to conform to the current period presentation. Net income and net worth previously reported were not affected by these reclassifications.

Concentrations of Credit Risk — Most of the Company’s activities are with customers in Virginia with primary geographic focus in the Richmond metropolitan area, which includes the city of Richmond and surrounding counties. Securities and loans also represent concentrations of credit risk and are discussed in note 3 “Securities” and note 4 “Loans” in the notes to the unaudited consolidated financial statements. Although the Company believes its underwriting standards are conservative, the nature of the Company’s portfolio of construction loans, land and land development loans, and income-producing nonresidential real estate loans and multi-family loans results in a smaller number of higher-balance loans. As a result, the default of loans in these portfolio segments may result in more significant losses to the Company.
 
 
8

 

Recent Accounting Pronouncements

In January 2010, the FASB issued ASU No. 2010-06, Fair Value Measurements and Disclosures (Topic 820): Improving Disclosures about Fair Value Measurements. This ASU requires some new disclosures and clarifies some existing disclosure requirements about fair value measurement as set forth in Codification Subtopic 820-10. The FASB’s objective is to improve these disclosures and, thus, increase the transparency in financial reporting. ASU 2010-06 is effective for interim and annual reporting periods beginning after December 15, 2009, except for the disclosures about purchases, sales, issuances, and settlements in the roll forward of activity in Level 3 fair value measurements. Those disclosures are effective for fiscal years beginning after December 15, 2010, and for interim periods within those fiscal years. Early application is permitted.   See note 9 for the Company’s discussion of fair value measurements for the quarter ended March 31, 2011.

In July 2010, the FASB issued Accounting Standards Update No. 2010-20, Receivables (Topic 310): Disclosure about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. The objective of this ASU is for an entity to provide disclosures that facilitate financial statement users’ evaluation of the nature of credit risk inherent in the entity’s portfolio of financing receivables; how that risk is analyzed and assessed in arriving at the allowance for credit losses; and the changes and reasons for those changes in the allowance for credit losses. To achieve these objectives, an entity should provide disclosures on a disaggregated basis on two defined levels: (1) portfolio segment; and (2) class of financing receivable. The ASU makes changes to existing disclosure requirements and includes additional disclosure requirements about financing receivables, including credit quality indicators of financing receivables at the end of the reporting period by class of financing receivables; the aging of past due financing receivables at the end of the reporting period by class of financing receivables; and the nature and extent of troubled debt restructurings that occurred during the period by class of financing receivables and their effect on the allowance for credit losses. For public entities, the disclosures as of the end of a reporting period are effective for interim and annual reporting periods ending on or after December 15, 2010. The disclosures about activity that occurs during a reporting period are effective for interim and annual reporting periods beginning on or after December 15, 2010. See note 5 for the Company’s discussion of the allowance for loan losses for the quarter ended March 31, 2011.
 
In April 2011, the FASB issued Accounting Standards Update No. 2011-02, Receivables (Topic 310): A Creditor’s Determination of Whether a Restructuring Is a Troubled Debt Restructuring. The FASB believes the guidance in this ASU will improve financial reporting by creating greater consistency in the way GAAP is applied for various types of debt restructurings.  The ASU clarifies which loan modifications constitute troubled debt restructurings. It is intended to assist creditors in determining whether a modification of the terms of a receivable meets the criteria to be considered a troubled debt restructuring, both for purposes of recording an impairment loss and for disclosure of troubled debt restructurings.  In evaluating whether a restructuring constitutes a troubled debt restructuring, a creditor must separately conclude that both of the following exist: (a) the restructuring constitutes a concession; and (b) the debtor is experiencing financial difficulties. The amendments to FASB ASC Topic 310, Receivables, clarify the guidance on a creditor’s evaluation of whether it has granted a concession and whether a debtor is experiencing financial difficulties.  For public companies, the new guidance is effective for interim and annual periods beginning on or after June 15, 2011, and applies retrospectively to restructurings occurring on or after the beginning of the fiscal year of adoption.  The Company is evaluating the impact of ASU 2011-02 on its consolidated financial statements.
 
Note 2.
Stock Conversion
 
The Holding Company completed its initial public stock offering in connection with the MHC’s conversion from the mutual to the stock form of organization on April 27, 2011. The Holding Company sold a total of 13,886,250 shares of its common stock at an offering price of $10.00 per share.  This included 1,144,227 shares purchased by the Franklin Federal Savings Bank Employee Stock Ownership Plan (“ESOP”) funded by a loan from the Holding Company.  In addition, the Holding Company contributed $1.39 million in cash and 416,588 shares of common stock to its charitable foundation, resulting in total shares outstanding of 14,302,838. Trading of the Holding Company’s common stock commenced on the Nasdaq Global Market on April 28, 2011 under the symbol “FRNK”.

 
9

 

During February 2011, the Holding Company began receiving cash for subscriptions to purchase shares of the Holding Company’s common stock.  As of March 31, 2011, the Holding Company had received $242.4 million in cash for stock orders as shown on the consolidated statement of financial condition and, pursuant to subscription orders, had designated an additional $11.4 million in deposit account funds to be used to fill stock orders. Funds received in excess of the net proceeds of the offering of $131.0 million were returned to subscribers whose orders were not filled on April, 28, 2011.  The net proceeds of $135.0 million received in the offering will be reflected in the stockholders’ equity of the Holding Company and subsidiaries in the Holding Company’s June 30, 2011 consolidated statement of financial condition.

Conversion costs were deferred at March 31, 2011 and deducted from the proceeds of the shares sold in the offering upon closing. Through March 31, 2011, conversion costs in the amount of $1.3 million were deferred and included in prepaid expenses and other assets in the consolidated statement of financial condition compared to $227,000 at September 30, 2010.

On April 27, 2011, liquidation accounts were established by the Holding Company and the Bank for the benefit of eligible account holders and supplemental eligible account holders (collectively, “eligible depositors”) of the Bank as defined in the Amended and Restated Plan of Conversion. Each eligible depositor will have a pro rata interest in the liquidation accounts for each of his or her deposit accounts based upon the proportion that the balance of each such account bears to the balance of all deposit accounts of the Bank as of the dates defined in the Amended and Restated Plan of Conversion. The liquidation accounts will be maintained for the benefit of eligible depositors who continue to maintain their deposit accounts in the Bank after the conversion. The liquidation accounts will be reduced annually to the extent that eligible depositors have reduced their qualifying deposits.  In the event of a complete liquidation of the Bank or the Holding Company or both (and only in such event), eligible depositors who continue to maintain accounts will be entitled to receive a distribution from the liquidation accounts before any liquidation may be made with respect to common stock. Neither the Holding Company nor the Bank may declare or pay a cash dividend if the effect thereof would cause its equity to be reduced below either the amount required for the liquidation accounts or the regulatory capital requirements imposed by the OTS.

Note 3.
Securities

The amortized cost, gross unrealized gains and losses, and estimated fair value of securities at March 31, 2011 and September 30, 2010 are summarized as follows:

   
March 31, 2011
 
 (Dollars in thousands)
 
Adjusted
amortized
cost
   
OTTI
recognized
in AOCI
   
Amortized
cost
   
Gross
unrealized
gains
   
Gross
unrealized
losses
   
Estimated
fair value
 
Available for sale:
                                   
U.S. government and federal agencies
  $ 12,500     $ -     $ 12,500     $ -     $ 158     $ 12,342  
States and political subdivisions
    18,904       -       18,904       88       862       18,130  
Agency mortgage-backed securities
    22,756       -       22,756       1,343       -       24,099  
Agency collateralized mortgage
                                               
obligations
    144,759       -       144,759       1,837       571       146,025  
Corporate equity securities
    23,251       -       23,251       1,626       1,220       23,657  
Corporate debt securities
    112,041       1,821       113,862       4,990       705       118,147  
Total
  $ 334,211     $ 1,821     $ 336,032     $ 9,884     $ 3,516     $ 342,400  
  
       
   
September 30, 2010
 
(Dollars in thousands)
 
Adjusted
amortized
cost
   
OTTI
recognized
in AOCI
   
Amortized
cost
   
Gross
unrealized
gains
   
Gross
unrealized
losses
   
Estimated
fair value
 
Available for sale:
     
States and political subdivisions
  $ 20,066     $ -     $ 20,066     $ 774     $ -     $ 20,840  
Agency mortgage-backed securities
    27,017       -       27,017       1,655       -       28,672  
Agency collateralized mortgage obligations
    83,520       -       83,520       2,120       573       85,067  
Corporate equity securities
    23,846       -       23,846       603       1,636       22,813  
Corporate debt securities
    112,077       2,508       114,585       5,846       1,180       119,251  
Total
  $ 266,526     $ 2,508     $ 269,034     $ 10,998     $ 3,389     $ 276,643  
 
 
10

 

   
March 31, 2011
 
 (Dollars in thousands)
 
Adjusted
amortized
cost
   
OTTI
recognized
in AOCI
   
Amortized
cost
   
Gross
unrealized
gains
   
Gross
unrealized
losses
   
Estimated
fair value
 
Held to maturity:
                                   
Agency mortgage-backed securities
  $ 5,919     $ -     $ 5,919     $ 174     $ -     $ 6,093  
Agency collateralized mortgage obligations
    7,214       -       7,214       549       1       7,762  
Non-agency collateralized mortgage obligations
     17,995        948        18,943        1,064        4,621        15,386  
Total
  $ 31,128     $ 948     $ 32,076     $ 1,787     $ 4,622     $ 29,241  

   
September 30, 2010
 
(Dollars in thousands)
 
Adjusted
amortized
cost
   
OTTI
recognized
in AOCI
   
Amortized
cost
   
Gross
unrealized
gains
   
Gross
unrealized
losses
   
Estimated
fair value
 
Held to maturity:
     
Agency mortgage-backed securities
  $ 6,343     $ -     $ 6,343     $ 154     $ 4     $ 6,493  
Agency collateralized mortgage obligations
    8,271       -       8,271       883       1       9,153  
Non-agency collateralized mortgage obligations
     20,904        988        21,892        1,450        5,491        17,851  
Total
  $ 35,518     $ 988     $ 36,506     $ 2,487     $ 5,496     $ 33,497  

The amortized cost and estimated fair value of securities at March 31, 2011, by contractual maturity, are shown below.  Expected maturities may differ from contractual maturities because borrowers may have the right to prepay obligations with or without prepayment penalties.

   
Available for sale
   
Held to maturity
 
   
Amortized
   
Estimated fair
   
Amortized
   
Estimated fair
 
(Dollars in thousands)
 
cost
   
value
   
cost
   
value
 
Non-mortgage debt securities:
                       
Due in one year or less
  $ 5,000     $ 5,000     $ -     $ -  
Due after one year through five years
    57,644       60,004       -       -  
Due after five years through ten years
    34,204       35,887       -       -  
Due after ten years
    48,418       47,728       -       -  
                                 
Total non-mortgage debt securities
    145,266       148,619       -       -  
                                 
Mortgage-backed securities
    22,756       24,099       5,919       6,093  
Collateralized mortgage obligations
    144,759       146,025       26,157       23,148  
Corporate equity securities
    23,251       23,657       -       -  
                                 
Total securities
  $ 336,032     $ 342,400     $ 32,076     $ 29,241  
 
 
11

 

The following tables present information regarding temporarily impaired securities as of March 31, 2011 and September 30, 2010:
 
   
March 31, 2011
 
   
Less Than 12 Months
   
12 Months or Longer
   
Total
 
   
Estimated
   
Gross
   
Estimated
   
Gross
   
Estimated
   
Gross
 
   
fair
   
unrealized
   
fair
   
unrealized
   
fair
   
unrealized
 
 (Dollars in thousands)
 
value
   
losses
   
value
   
losses
   
value
   
losses
 
Available for sale:
                                   
U.S. government and federal agencies
  $ 12,342     $ 158     $ -     $ -     $ 12,342     $ 158  
States and political subdivisions
    5,578       862       -       -       5,578       862  
Agency collateralized mortgage obligations
    43,217       570       417       1       43,634       571  
Corporate equity securities
    12,682       1,220       -       -       12,682       1,220  
Corporate debt securities
    14,771       359       11,654       346       26,425       705  
Total available for sale
    88,590       3,169       12,071       347       100,661       3,516  
                                                 
Held to maturity:
                                               
Agency collateralized mortgage obligations
    -       -       126       1       126       1  
Non-agency collateralized mortgage obligations
    1,149       348       10,807       4,273       11,956       4,621  
Total held to maturity
    1,149       348       10,933       4,274       12,082       4,622  
                                                 
Total temporarily impaired securities
  $ 89,739     $ 3,517     $ 23,004     $ 4,621     $ 112,743     $ 8,138  
 
   
September 30, 2010
 
   
Less Than 12 Months
   
12 Months or Longer
   
Total
 
   
Estimated
   
Gross
   
Estimated
   
Gross
   
Estimated
   
Gross
 
   
fair
   
unrealized
   
fair
   
unrealized
   
fair
   
unrealized
 
(Dollars in thousands)
 
value
   
losses
   
value
   
losses
   
value
   
losses
 
Available for sale:
     
Agency collateralized mortgage obligations
  $ 26,492     $ 573     $ -     $ -     $ 26,492     $ 573  
Corporate equity securities
    15,366       1,617       3,512       19       18,878       1,636  
Corporate debt securities
    -       -       27,820       1,180       27,820       1,180  
Total available for sale
    41,858       2,190       31,332       1,199       73,190       3,389  
                                                 
Held to maturity:
                                               
Agency mortgage-backed securities
    592       4       -       -       592       4  
Agency collateralized mortgage obligations
    -       -       138       1       138       1  
Non-agency collateralized mortgage obligations
    5,448       2,607       8,686       2,884       14,134       5,491  
Total held to maturity
    6,040       2,611       8,824       2,885       14,864       5,496  
                                                 
Total temporarily impaired securities
  $ 47,898     $ 4,801     $ 40,156     $ 4,084     $ 88,054     $ 8,885  

The Company’s securities portfolio consists of investments in various debt and equity securities as permitted by OTS regulations, including mortgage-backed securities, collateralized mortgage obligations, government agency bonds, state and local government obligations, corporate debt obligations, and common stock of various companies.

During the three months ended March 31, 2011 and 2011, the Company recognized gross gains on sales of securities available for sale of $605,000 and $0 and gross losses of $241,000 and $2,000, respectively.  During the six months ended March 31, 2011 and 2010, the Company recognized gross gains on sales of securities available for sale of $705,000 and $2.0 million and gross losses of $441,000 and $0, respectively.
 
 
12

 

The Company performs an other-than-temporary impairment analysis of the securities portfolio on a quarterly basis. The determination of whether a security is other-than-temporarily impaired is highly subjective and requires a significant amount of judgment. In evaluating for other-than-temporary impairment, management considers the duration and severity of declines in fair value, the financial condition of the issuers of each security, as well as whether it is more likely than not that the Company will be required to sell these securities prior to recovery, which may be maturity, based on market conditions and cash flow requirements. In performing its analysis for debt securities, the Company’s consideration of the financial condition of the issuer of each security was focused on the issuer’s ability to continue to perform on its debt obligations, including any concerns about the issuer’s ability to continue as a going concern. In performing its analysis for equity securities, the Company’s analysis of the financial condition of the issuers of each security included the issuer’s economic outlook, distressed capital raises, large write-downs causing dilution of capital, distressed dividend cuts, discontinuation of significant segments, replacement of key executives, and the existence of a pattern of significant operating losses. In addition to the financial condition of each issuer, the Company considered the severity and duration of impairments and the likelihood that the fair value of securities would recover over a reasonable time horizon.

The Company recognized total impairment charges in earnings of $382,000 and $1.3 million during the three months ended March 31, 2011 and 2010, respectively, and $681,000 and $2.5 million during the six months ended March 31, 2011 and 2010, respectively, on debt and equity securities.

The table below provides a cumulative rollforward of credit losses recognized in earnings for debt securities for which a portion of OTTI is recognized in AOCI:

(Dollars in thousands)
     
Balance of credit losses at September 30, 2010
  $ 526  
Additions for credit losses on securities not previously recognized
    84  
Reductions for increases in expected cash flows
    (181 )
Balance of credit losses at March 31, 2011
  $ 429  

To determine the amount of other-than-temporary impairment losses that are related to credit versus the portion related to other factors, management compares the current period estimate of future cash flows to the prior period estimated future cash flows, both discounted at each security’s yield at purchase.  Any other-than-temporary impairment recognized in excess of the difference of these two values is deemed to be related to factors other than credit.

Unrealized losses in the remainder of the Company’s portfolio of collateralized mortgage obligations, mortgage-backed securities, securities of states and political subdivisions, and corporate debt securities were related to eighty-five securities and were caused by increases in market interest rates, spread volatility, or other factors that management deems to be temporary, and because management believes that it is not more likely than not that the Company will be required to sell these securities prior to maturity or a full recovery of the amortized cost, the Company does not consider these securities to be other-than-temporarily impaired.

Unrealized losses in the remainder of the Company’s portfolio of equity securities were related to twelve securities and were considered temporary. Each of these securities has been in an unrealized loss position for fewer than twelve months, and because management believes that it is not more likely than not that the Company will be required to sell these equity positions for a reasonable period of time sufficient for a recovery of fair value, the Company does not consider these equity securities to be other-than-temporarily impaired.

The Company’s pledges certain securities as collateral for its FHLB borrowings.  Securities collateralizing FHLB borrowings had a carrying value of $193.4 million at March 31, 2011.
 
 
13

 

Note 4.
Loans

Loans held for investment at March 31, 2011 and September 30, 2010 are summarized as follows:
 
   
March 31,
   
September 30,
 
(Dollars in thousands)
 
2011
   
2010
 
Loans
           
One-to four-family
  $ 120,819     $ 128,696  
Multi-family
    79,729       78,183  
Nonresidential
    183,460       173,403  
Construction
    40,889       40,294  
Land and land development
    68,631       70,482  
Other
    684       2,997  
Total loans
    494,212       494,055  
                 
Deferred loan fees
    3,497       3,601  
Loans, net of deferred loan fees
    490,715       490,454  
                 
Allowance for loan losses
    11,922       13,419  
Net loans
  $ 478,793     $ 477,035  

The Company’s pledges certain loans as collateral for its FHLB borrowings.  Loans collateralizing FHLB borrowings had a carrying value of $238.7 million at March 31, 2011.

Note 5.
Allowance for Loan Losses

The allowance for loan losses is maintained at a level considered adequate to provide for our estimate of probable credit losses inherent in the loan portfolio. The allowance is increased by provisions charged to operating expense and reduced by net charge-offs. While the Company uses the best information available to make its evaluation, future adjustments may be necessary if there are significant changes in conditions.

The allowance is comprised of two components: (1) a general allowance related to loans both collectively and individually evaluated and (2) a specific allowance related to loans individually evaluated and identified as impaired. A summary of the methodology the Company employs on a quarterly basis related to each of these components to estimate the allowance for loan losses is as follows.

Credit Rating Process

As discussed in note 1 above, the Company's methodology for estimating the allowance for loan losses incorporates the results of periodic loan evaluations for certain non-homogeneous loans, including non-homogenous loans in lending relationships greater than $2.0 million and any individual loan greater than $1.0 million.  The Company's loan grading system analyzes various risk characteristics of each loan type when considering loan quality, including loan-to-value ratios, current real estate market conditions, location and appearance of properties, income and net worth of any guarantors, and rental stability and cash flows of income-producing nonresidential real estate loans and multi-family loans.  The credit rating process results in one of the following classifications for each loan in order of increasingly adverse classification: Excellent, Good, Satisfactory, Watch List, Special Mention, Substandard, and Impaired.  The Company continually monitors the credit quality of loans in the portfolio through communications with borrowers as well as review of delinquency and other reports that provide information about credit quality.  Credit ratings are updated at least annually with more frequent updates performed for problem loans or when management becomes aware of circumstances related to a particular loan that could materially impact the loan’s credit rating.  Management maintains a classified loan list consisting of watch list loans along with loans rated special mention or lower that is reviewed on a monthly basis by the Company’s Internal Asset Review Committee.
 
 
14

 

General Allowance

To determine the general allowance, the Company segregates loans by portfolio segment as defined by loan type.  Loans within each segment are then further segregated by credit rating.  The Company determines a base reserve rate for each portfolio segment by calculating the average charge-off rate for each segment over a historical time period determined by management, typically one to three years.  The base reserve rate is then adjusted based on qualitative factors that management believes could result in future loan losses differing from historical experience.  Such qualitative factors can include delinquency rates, loan-to-value ratios, and local economic and real estate conditions.  The base reserve rate plus these qualitative adjustments results in a total reserve rate for each portfolio segment.  A multiple of the total reserve rate for each segment is then applied to the balance of the loans in each segment based on credit rating.  Loans rated Excellent have no associated allowance.  No loans were rated Excellent at March 31, 2011 or September 30, 2010.  Loans rated Good are multiplied by 10% of the total reserve rate, Satisfactory loans are multiplied by 100% of the total reserve rate, and loans rated Watch List, Special Mention, and Substandard are multiplied by 150%, 200%, and 300% of the total reserve rate, respectively.  This tiered structure is used by the Company to account for a higher probability of loss for loans with increasingly adverse credit ratings.

Specific Allowance for Impaired Loans

Impaired loans include loans identified as impaired through our credit rating system as well as loans modified in a troubled debt restructuring.  Loans are identified as impaired when management believes, based on current information and events, it is probable that the Company will be unable to collect all amounts due in accordance with the contractual terms of the underlying loan agreement.  Once a loan is identified as impaired, management determines a specific allowance by comparing the outstanding loan balance to net realizable value, which is equal to fair value less estimated costs to sell.  The amount of any allowance recognized is the amount by which the loan balance exceeds the net realizable value.  If the net realizable value exceeds the loan balance, no allowance is recorded.  The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value and discounted cash flows.  Of the $41.0 million of loans classified as impaired at March 31, 2011, $39.4 million were considered “collateral dependent” and evaluated using the fair value of collateral method and $1.6 million were evaluated using discounted estimated cash flows.  See note 9 for further discussion of the Company's method for estimating fair value on impaired loans.
 
Changes to the Allowance for Loan Losses Methodology
 
As part of the calculation of the allowance for loan losses at March 31, 2011, management modified the Company’s methodology to classify non-owner-occupied one- to four-family loans as non-homogenous loans.  Previously, non-owner-occupied one-to four-family loans were classified as homogenous and, as a result, credit ratings on such loans were not used in the determination of the amount of allowance provided for such loans.  Loan pools are typically considered homogeneous when they consist of a high number of smaller-balance loans.  Due to the significant size and higher risk profile of certain non-owner-occupied one-to four-family loans, management believes that these loans are more appropriately classified as non-homogeneous and that credit ratings should be used as a factor in determining the allowance for loan losses on such loans.  The change in methodology resulted in an $111,000 increase in the allowance for loan losses at March 31, 2011 over that which would have been calculated if there had been no change to the methodology.
 
Activity in the allowance for loan losses by portfolio segment is summarized as follows:
 
(Dollars in thousands)
 
One-to
four-family
   
Multi-
family
   
Non-
residential
   
Construction
   
Land and land
development
   
Other
   
Total
 
                                           
Balance, September 30, 2010
  $ 1,260     $ 1,177     $ 2,888     $ 2,700     $ 5,372     $ 22     $ 13,419  
                                                         
Provision
    454       977       583       236       (1,526 )     (12 )     712  
Recoveries
    1       -       -       23       -       -       24  
Charge-offs
    (464 )     -       -       (933 )     (836 )     -       (2,233 )
                                                         
Balance, March 31, 2011
  $ 1,251     $ 2,154     $ 3,471     $ 2,026     $ 3,010     $ 10     $ 11,922  

 
15

 

(Dollars in thousands)
 
One-to
four-family
   
Multi-
family
   
Non-
residential
   
Construction
   
Land and land
development
   
Other
   
Total
 
                                           
Balance, September 30, 2009
  $ 1,046     $ 620     $ 1,306     $ 2,729     $ 2,781     $ 42     $ 8,524  
                                                         
Provision
    (85 )     126       748       532       795       (15 )     2,101  
Recoveries
    3       -       -       127       -       76       206  
Charge-offs
    (151 )     -       -       (294 )     (812 )     -       (1,257 )
                                                         
Balance, March 31, 2010
  $ 813     $ 746     $ 2,054     $ 3,094     $ 2,764     $ 103     $ 9,574  

Details of the allowance for loan losses by portfolio segment and impairment methodology at March 31, 2011 and September 30, 2010 are as follows:
 
   
March 31, 2011
 
   
General Allowance
   
Specific Allowance
                     
Allowance as
 
(Dollars in thousands)
 
Balance
   
Allowance
   
Balance
   
Allowance
   
Total
Balance
   
Total
Allowance
   
Coverage
   
% of total
allowance
 
One-to four-family
  $ 115,447     $ 1,227     $ 5,372     $ 24     $ 120,819     $ 1,251       1.04 %     10.5 %
Multi-family
    79,729       2,154       -       -       79,729       2,154       2.70 %     18.1  
Nonresidential
    172,385       3,053       11,075       418       183,460       3,471       1.89 %     29.1  
Construction
    40,799       1,999       90       27       40,889       2,026       4.96 %     17.0  
Land and land development
    44,135       2,840       24,496       170       68,631       3,010       4.39 %     25.2  
Other
    684       10       -       -       684       10       1.40 %     0.1  
Total allowance
  $ 453,179     $ 11,283     $ 41,033     $ 639     $ 494,212     $ 11,922       2.41 %     100.0 %
 
   
September 30, 2010
 
   
General Allowance
   
Specific Allowance
                     
Allowance as
 
(Dollars in thousands)
 
Balance
   
Allowance
   
Balance
   
Allowance
   
Total
Balance
   
Total
Allowance
   
Coverage
   
% of total
allowance
 
One-to four-family
  $ 127,378     $ 799     $ 1,318     $ 461     $ 128,696     $ 1,260       0.98 %     9.4 %
Multi-family
    78,183       1,177       -       -       78,183       1,177       1.51 %     8.8  
Nonresidential
    171,143       2,673       2,260       215       173,403       2,888       1.67 %     21.5  
Construction
    37,770       1,818       2,524       882       40,294       2,700       6.70 %     20.1  
Land and land development
    53,921       4,458       16,561       914       70,482       5,372       7.62 %     40.0  
Other
    2,997       22       -       -       2,997       22       0.72 %     0.2  
Total allowance
  $ 471,392     $ 10,947     $ 22,663     $ 2,472     $ 494,055     $ 13,419       2.72 %     100.0 %

Details regarding classified loans and impaired loans at March 31, 2011 and September 30, 2010 are as follows:
 
   
March 31,
   
September 30,
 
(Dollars in thousands)
 
2011
   
2010
 
Special mention
           
One-to four-family
  $ 4,293     $ 7,189  
Nonresidential
    5,362       6,579  
Construction
    1,675       422  
Land and land development
    7,950       7,875  
Total special mention loans
    19,280       22,065  
                 
Substandard
               
One-to four-family
    5,914       3,823  
Multi-family
    12,807       13,539  
Nonresidential
    442       6,018  
Construction
    166       166  
Land and land development
    627       10,270  
Total substandard loans
    19,956       33,816  
                 
Impaired
               
One-to four-family
    5,372       1,318  
Nonresidential
    11,075       2,260  
Construction
    90       2,524  
Land and land development
    24,496       16,561  
Total impaired loans
    41,033       22,663  
                 
Total rated loans
  $ 80,269     $ 78,544  
 
 
16

 

Included in impaired loans are troubled debt restructurings of $10.6 million and $4.3 million at March 31, 2011 and September 30, 2010, respectively, that had related allowance balances of $220,000 and $281,000, respectively.

During the six months ended March 31, 2011, the Company modified three loans in troubled debt restructurings, including one land and land development loan with an outstanding balance of $760,000, one construction loan with an outstanding balance of $90,000, and one nonresidential loan with a balance of $5.5 million.  The restructuring of the land and land development loan consisted of a reduction in the monthly principal payment requirement to accommodate cash flow difficulties being experienced by the borrower.  This loan had previously been identified as impaired and is considered collateral dependent; therefore, there was no effect on the consolidated financial statements as a result of this modification.  This loan remained on accrual status as the borrower was current at March 31, 2011.  All other loans modified in troubled debt restructurings were classified as non-accrual at March 31, 2011.  The construction loan was previously classified as impaired and considered collateral-dependent, and the restructuring consisted of forgiving past-due principal amounts and eliminating a monthly principal payment requirement.  Since the loan was already classified as impaired, there was no effect on the consolidated financial statements as a result of this modification.  The nonresidential loan was already on nonaccrual status at the time of modification, and the restructuring consisted of a reduction in near-term principal payment requirements as well as forgiving unpaid late charges. Interest recognized on a cash basis on restructured loans was not material.

During the six months ended March 31, 2010, the Company modified one land and land development loan in a troubled debt restructuring.  The restructuring consisted of a reduction in the stated interest rate and capitalization of past-due amounts to accommodate cash flow difficulties being experienced by the borrower.  As a result of the restructuring, the loan was classified as impaired and has since had a specific allowance established using the present value of estimated cash flows.

During the six months ended March 31, 2011, one nonresidential loan with a balance of $2.3 million modified in a troubled debt restructuring in the previous twelve months, which was classified as impaired and on nonaccrual status, remained in default on its restructured payments.

Loans and the related allowance for loan losses summarized by loan type and credit rating at March 31, 2011 are as follows:

 (Dollars in thousands)
 
Total
   
Good
   
Satisfactory
   
Watch
List
   
Special
Mention
   
Substandard
   
Impaired
   
Not Rated
 
Loans
                                               
One-to four-family
  $ 120,819     $ -     $ 23,750     $ 3,112     $ 3,756     $ 648     $ 5,372     $ 84,181  
Multi-family
    79,729       10,721       47,223       -       -       12,807       -       8,978  
Nonresidential
    183,460       63,276       82,655       2,720       5,362       442       11,075       17,930  
Construction
    40,889       8,560       16,067       -       684       166       90       15,322  
Land and land development
    68,631       -       34,351       -       7,950       359       24,496       1,475  
Other
    684       -       -       -       -       -       -       684  
Total loans
  $ 494,212     $ 82,557     $ 204,046     $ 5,832     $ 17,752     $ 14,422     $ 41,033     $ 128,570  
 
 
17

 

(Dollars in thousands)
 
Total
   
Good
   
Satisfactory
   
Watch
List
   
Special
Mention
   
Substandard
   
Impaired
   
Not Rated
 
Allowance for loan losses
                                               
One-to four-family
  $ 1,251     $ -     $ 351     $ 69     $ 111     $ 29     $ 24     $ 667  
Multi-family
    2,154       25       1,063       -       -       864       -       202  
Nonresidential
    3,471       158       2,050       101       266       33       418       445  
Construction
    2,026       50       942       -       80       29       27       898  
Land and land development
    3,010       -       1,848       -       855       58       170       79  
Other
    10       -       -       -       -       -       -       10  
Total allowance for
loans losses
  $ 11,922     $ 233     $ 6,254     $ 170     $ 1,312     $ 1,013     $ 639     $ 2,301  
 
Details regarding the delinquency status of the Company’s loan portfolio at March 31, 2011 are as follows:
 
 (Dollars in thousands)
 
Total
   
Current
   
31-60
Days
   
61-90
Days
   
91-120
Days
   
121-150
Days
   
151-180
Days
   
180+
Days
 
One-to four-family
  $ 120,819     $ 113,730     $ 5,627     $ -     $ 129     $ 697     $ 286     $ 350  
Multi-family
    79,729       77,229       -       2,500       -       -       -       -  
Nonresidential
    183,460       171,725       5,535       3,940       -       -       -       2,260  
Construction
    40,889       40,633       -       90       -       -       -       166  
Land and land development
    68,631       57,497       18       -       31       9,925       20       1,140  
Other
    684       684       -       -       -       -       -       -  
Total
  $ 494,212     $ 461,498     $ 11,180     $ 6,530     $ 160     $ 10,622     $ 306     $ 3,916  
 
The following is a summary of information pertaining to impaired and non-accrual loans at March 31, 2011 and September 30, 2010:
 
   
March 31, 2011
   
September 30, 2010
 
(Dollars in thousands)
 
Amount
   
Allowance
   
Amount
   
Allowance
 
Impaired loans with a specific allowance
                       
One-to four-family
  $ 410     $ 24     $ 907     $ 461  
Nonresidential
    1,221       418       2,260       215  
Construction
    90       27       2,324       882  
Land and land development
    2,319       170       4,259       914  
Total impaired loans with a specific allowance
  $ 4,040     $ 639     $ 9,750     $ 2,472  
                                 
Impaired loans for which no specific allowance
                               
is necessary
                               
One-to four-family
  $ 4,962     $ -     $ 410     $ -  
Nonresidential
    9,854       -       -       -  
Construction
    -       -       201       -  
Land and land development
    22,177       -       12,302       -  
Total impaired loans for which no specific
                               
allowance is necessary
  $ 36,993     $ -     $ 12,913     $ -  

(Dollars in thousands)
 
March 31,
2011
   
September 30,
2010
 
Nonaccrual loans
           
One-to four-family
  $ 11,421     $ 4,576  
Nonresidential
    11,075       7,830  
Construction
    255       1,470  
Land and land development
    12,693       14,667  
Total non-accrual loans
  $ 35,444     $ 28,543  
                 
Loans past due ninety days or more and still accruing
               
Construction
  $ -     $ 90  
Land and land development
    -       1,140  
Total loans past due ninety days or more and still accruing
  $ -     $ 1,230  
 
 
18

 

The weighted average balance of impaired loans was $29.4 million and $17.6 million for the six months ended March 31, 2011 and 2010, respectively.  Accrued interest on impaired loans was not material at March 31, 2011 or September 30, 2010.  Interest recognized on a cash basis on impaired loans was $229,000 and $584,000 for the three months ended March 31, 2011 and 2010, respectively, and $398,000 and $722,000 for the six months ended March 31, 2011 and 2010, respectively.   Interest recognized on a cash basis on all nonaccrual loans was $423,000 and $898,000 for the three months ended March 31, 2011 and 2010, respectively, and $788,000 and $1.1 million for the six months ended March 31, 2011 and 2010, respectively.

Note 6.
Real Estate Owned

Real estate owned at March 31, 2011 and September 30, 2010 is summarized as follows:

   
March 31,
   
September 30,
 
(Dollars in thousands)
 
2011
   
2010
 
Real estate owned
           
Real estate held for sale
  $ 3,717     $ 3,240  
Real estate held for development and sale
    7,919       8,341  
Total real estate owned
  $ 11,636     $ 11,581  

During the six months ended March 31, 2011, the Company foreclosed on several properties securing loans that had been classified as impaired.  These foreclosures resulted in additions of $2.2 million to real estate owned, including $629,000 classified as held-for-sale comprised of six non-owner-occupied single-family homes and one speculative home, and $1.6 million classified as held-for-development and sale consisting of 23 developed lots for construction of single-family homes and undeveloped land intended for residential development.  These foreclosures were partially offset by sales of real estate owned totaling $1.4 million.  In addition, the Company recognized impairment charges on real estate owned of $781,000 for the six months ended March 31, 2011 as a result of a new appraisal on one piece of undeveloped land as well as a change to the use of an “as-is” appraised value on a retail shopping center from the “upon stabilization” value due to lease-up difficulties.  No impairment charges were recognized in the six months ended March 31, 2010.

Note 7.
Employee Benefit Plans
 
The Bank has a noncontributory defined benefit pension plan (the Pension Plan) for substantially all of the Bank’s employees. Retirement benefits under this plan are generally based on the employee’s years of service and compensation during the five years of highest compensation in the ten years immediately preceding retirement.
 
The Pension Plan assets are held in a trust fund by the plan trustee. The trust agreement under which assets of the Pension Plan are held is a part of the Virginia Bankers Association Master Defined Benefit Pension Plan (the Plan). The Plan’s administrative trustee is appointed by the board of directors of the Virginia Bankers Association Benefits Corporation. At March 31, 2011, Reliance Trust Company was investment manager for the Plan. Contributions are made to the Pension Plan, at management’s discretion, subject to meeting minimum funding requirements, up to the maximum amount allowed under the Employee Retirement Income Security Act of 1974 (ERISA), based upon the actuarially determined amount necessary for meeting plan obligations. Contributions are intended to provide not only for benefits attributed to service to date, but also for benefits expected to be earned by employees in the future.
 
The Company uses a September 30 measurement date for the Pension Plan.
 
 
19

 

Components of net periodic benefit cost for the three and six months ended March 31, 2011 and 2010 are as follows:

   
Three months ended March 31,
   
Six months ended March 31,
 
(Dollars in thousands)
 
2011
   
2010
   
2011
   
2010
 
Service cost
  $ 143     $ 224     $ 286     $ 351  
Interest cost
    162       279       324       437  
Expected return on plan assets
    (218 )     (365 )     (435 )     (572 )
Recognized net actuarial loss
    16       35       32       54  
Net periodic benefit cost
  $ 103     $ 173     $ 207     $ 270  

The net periodic benefit cost is included in personnel expense in the consolidated statements of earnings.

Note 8.
Financial Instruments with Off-Balance-Sheet Risk

The Company is a party to financial instruments with off-balance-sheet risk in the normal course of business to meet its investment and funding needs and the financing needs of its customers. These financial instruments include commitments to extend credit, commitments to sell loans, and standby letters of credit. Those instruments involve, to varying degrees, elements of credit and interest rate risk in excess of the amount recognized or disclosed in the consolidated financial statements. The contractual or notional amounts of those instruments reflect the extent of involvement the Company has in particular classes of financial instruments.

The Company’s exposure to credit loss in the event of nonperformance by the other party to the financial instrument for commitments to extend credit and standby letters of credit is represented by the contractual or notional amount of those instruments. The Company uses the same credit and collateral policies in making commitments to extend credit and standby letters of credit as it does for on-balance-sheet instruments.

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 by the customer. Since some commitments may expire without being funded, the commitment amounts do not necessarily represent future cash requirements. The Company evaluates each customer’s creditworthiness on a case-by-case basis. The total amount of loan commitments was $94.4 million and $130.8 million at March 31, 2011 and September 30, 2010, respectively.  At March 31, 2011, this included $15.1 million of commitments to fund fixed-rate loans with a weighted-average interest rate of 6.1%.

Standby letters of credit written are conditional commitments issued by the Company to guarantee the performance of a customer to a third party. The credit risk and recourse provisions involved in issuing letters of credit are essentially the same as those involved in extending loans to customers, and the estimated fair value of these letters of credit, which is included in accrued expenses and other liabilities, was not material at March 31, 2011 and September 30, 2010, respectively. The amount of standby letters of credit was $1.1 million at March 31, 2011 and September 30, 2010. The Company believes it is reasonably possible that it will have to perform on four standby letters of credit totaling $698,000 due to the default of one borrower. The letters of credit are related to a residential development in the Richmond MSA. However, the Company expects that any amounts funded on these letters of credit will add to the value of the related projects and will ultimately be recovered from sale of the development. The Company believes that the likelihood of having to perform on additional standby letters of credit is remote based on the financial condition of the guarantors and the Company’s historical experience.

At March 31, 2011, the Company had rate lock commitments to originate mortgage loans amounting to $2.8 million and mortgage loans held for sale of $249,000 compared to $5.5 million and $2.8 million at September 30, 2010, respectively. At March 31, 2011, the Company had corresponding commitments outstanding of $3.1 million to sell loans on a best-efforts basis compared to $8.3 million at September 30, 2010. These commitments to sell loans are designed to eliminate the Company’s exposure to fluctuations in interest rates in connection with rate lock commitments and loans held for sale.

 
20

 

Note 9.
Fair Value Measurements

The fair value of a financial instrument is the current amount that would be exchanged between willing parties in an orderly market, other than in a forced liquidation. Fair value is best determined based on quoted market prices. In cases where quoted market prices are not available or quoted prices are reflective of a disorderly market, 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. Accordingly, the fair value estimates may not be realized in an immediate settlement of the instruments. The Codification (Section 825-10-50) excludes certain financial instruments and all non-financial instruments from its disclosure requirements. Accordingly, the aggregate fair value amounts presented may not necessarily represent the underlying fair value of the Company.

Under current fair value guidance, the Company groups assets and liabilities at fair value in three levels, based on the markets in which the assets and liabilities are traded and the reliability of the assumptions used to determine fair value. An adjustment to the pricing method used within either Level 1 or Level 2 inputs could generate a fair value measurement that effectively falls in a lower level in the hierarchy. These levels are:
  
 
Level 1: Quoted prices (unadjusted) for identical assets or liabilities in active markets that the entity has the ability to access as of the measurement date.
 
 
 
Level 2: Significant other observable inputs other than Level 1 prices, such as quoted prices for similar assets or liabilities, quoted prices in markets that are not active, and other inputs that are observable or can be corroborated by observable market data.

 
Level 3: Valuations for assets and liabilities that are derived from other valuation methodologies, including option pricing models, discounted cash flow models and similar techniques, and not based on market exchange, dealer, or broker traded transactions. Level 3 valuations incorporate certain assumptions and projections in determining the fair value assigned to such assets or liabilities.
 
 
The following is a description of valuation methodologies used for assets and liabilities recorded at fair value. The determination of where an asset or liability falls in the hierarchy requires significant judgment. The Company evaluates its hierarchy disclosures each quarter and, based on various factors, it is possible that an asset or liability may be classified differently from quarter to quarter. However, the Company expects changes in classifications between levels will be rare.

Securities available for sale: Securities available-for-sale are recorded at fair value on a recurring basis. Fair value measurement is based upon quoted prices, if available. If quoted prices are not available, fair values are measured using a combination of methods, including model pricing based on spreads obtained from new market issues of similar securities, dealer quotes, and trade prices. Level 1 securities include common equity securities traded on nationally recognized securities exchanges. Level 2 securities include mortgage-backed securities and collateralized mortgage obligations issued by government sponsored entities, municipal bonds, and corporate debt securities.

Securities held to maturity: Securities held-to-maturity are recorded at fair value on a non-recurring basis. A held-to-maturity security’s amortized cost is adjusted only in the event that a decline in fair value is deemed to be other-than-temporary. At March 31, 2011, certain held-to-maturity securities were deemed to be other-than-temporarily impaired. These securities are classified as Level 3 securities and were written down to fair value at the balance sheet date determined by discounting estimated future cash flows. Management believes that classification and valuation of these securities, consisting of private-label asset-backed securities, as Level 3 assets was necessary as the market for such securities severely contracted beginning in 2008 and became and has remained inactive since that time. While the market for highly-rated private-label securities with low delinquency levels and high subordination saw significant price improvement in the second half of fiscal 2010, the market for securities similar to those recognized as other-than-temporarily impaired, which had low ratings, high delinquency levels, and low subordination levels, remained inactive. As a result, management does not believe that quoted prices on similar assets were representative of fair value as there were few transactions, and transactions were often executed at distressed prices. Management estimates and discounts future cash flows based on a combination of observable and unobservable inputs, including a security’s subordination percentage, projected delinquency rates, and estimated loss severity given default. These estimates are discounted using observable current market rates for securities with similar credit quality.

 
21

 
 
Derivative instruments: The Company’s portfolio of derivative instruments consists of call options to purchase or sell common stock of publicly traded companies. These instruments are valued on a recurring basis using quoted market prices at each date that financial statements are prepared. The instruments trade on various nationally recognized options exchanges, and as a result are classified as Level 1 assets.

Loans held for sale: The fair value of loans held for sale is determined using quoted secondary-market prices. If the fair value of a loan is below its carrying value, a lower-of-cost-or-market adjustment is made to reduce the basis of the loan. If fair value exceeds carrying value, no adjustment is made. As such, the Company classifies loans held for sale as Level 2 assets and makes fair value adjustments on a non-recurring basis.

Impaired loans: The Company does not record loans at fair value on a recurring basis. However, from time to time, a loan is considered impaired and, if necessary, a specific allowance for loan losses is established. Loans for which it is probable that payment of principal and interest will not be made in accordance with the contractual terms of the loan agreement are considered impaired. Once a loan is identified as individually impaired, management writes the loan down to net realizable value, which is equal to fair value less estimated costs to sell, if the loan balance exceeds net realizable value. The fair value of impaired loans is estimated using one of several methods, including collateral value, market value of similar debt, enterprise value, liquidation value, or discounted cash flows. Those impaired loans not requiring a specific allowance represent loans for which the fair value of the expected repayments or collateral exceed the recorded investments in such loans. For loans deemed to be “collateral dependent,” fair value is estimated using the appraised value of the related collateral. At the time the loan is identified as impaired, the Company determines if an updated appraisal is needed and orders an appraisal if necessary. Subsequent to the initial measurement of impairment, management considers the need to order updated appraisals each quarter if changes in market conditions lead management to believe that the value of the collateral may have changed materially. Impaired loans where a specific allowance is established based on the fair value of collateral require classification in the fair value hierarchy. When the fair value of the collateral is based on an observable market price or an appraised value less than one year old estimated utilizing information gathered from an active market, the Company classifies the impaired loan as a Level 2 asset. When an appraised value is not available, is greater than one year old, or if management determines the fair value of the collateral is further impaired below the appraised value and there is no observable market price, the Company classifies the impaired loan as a Level 3 asset. Additionally, if the fair value of an impaired loan is determined using an appraisal less than one year old that utilizes information gathered from an inactive market or contains material adjustments based upon unobservable market data, the Company classifies the impaired loan as a Level 3 asset. Impaired loans evaluated using discounted estimated cash flows are classified as Level 3 assets.

Real estate owned: Real estate owned (“REO”) is adjusted to net realizable value, which is equal to fair value less costs to sell, upon foreclosure. Subsequently, REO is adjusted on a non-recurring basis to the lower of carrying value or net realizable value. Fair value is based upon independent market prices, appraised values of the collateral, or management’s estimation of the value of the REO. When the fair value of REO is based on an observable market price or an appraised value less than one year old estimated utilizing information gathered from an active market, the Company classifies the REO as a Level 2 asset. When an appraised value is not available, is greater than one year old, or if management determines the fair value of the REO is further impaired below the appraised value and there is no observable market price, the Company classifies the REO as a Level 3 asset. Additionally, if the fair value of the REO is determined using an appraisal less than one year old that utilizes information gathered from an inactive market or contains material adjustments based upon unobservable market data, the Company classifies the REO as a Level 3 asset.
 
 
22

 
 
Assets and liabilities measured at fair value on a recurring basis as of March 31, 2011 are summarized below:

   
Total
   
Level 1
   
Level 2
   
Level 3
 
Securities available for sale
                       
U.S. government and federal agencies
  $ 12,342     $ -     $ 12,342     $ -  
States and political subdivisions
    18,130       -       16,162       1,968  
Agency mortgage-backed securities
    24,099       -       24,099       -  
Agency collateralized mortgage obligations
    146,025       -       146,025       -  
Corporate equity securities
    23,657       23,657       -       -  
Corporate debt securities
    118,147       -       113,123       5,024  
Total assets at fair value
  $ 342,400     $ 23,657     $ 311,751     $ 6,992  

A rollforward of securities classified as Level 3 measured at fair value on a recurring basis from the prior quarter end is as follows:

Balance of Level 3 assets measured on a recurring basis at December 31, 2010
  $ 6,989  
Principal payments in period
    (50 )
Accretion (amortization) of premiums or discounts
    (7 )
Increase (decrease) in unrealized gains or losses included in accumulated other comprehensive income
    60  
Balance of Level 3 assets measured on a recurring basis at March 31, 2011
  $ 6,992  

Level 3 securities measured at fair value on a recurring basis at March 31, 2011 consist of one municipal bond and one corporate debt security for which the Company was not able to obtain dealer quotes due to lack of trading activity.  These two securities are measured at fair value based on the observable market price of similar securities adjusted for certain unobservable inputs necessary to account for aspects specific to the securities owned by the Company.

The Company may be required, from time to time, to measure certain assets at fair value on a non-recurring basis in accordance with GAAP. These include assets that are measured at the lower of cost or market that were recognized at fair value below cost at the end of the period. Assets measured at fair value on a non-recurring basis as of March 31, 2011 are included in the table below:

   
Total
   
Level 1
   
Level 2
   
Level 3
 
Non-agency collateralized mortgage obligations
  $ 1,846       -       -       1,846  
Impaired loans
                               
One-to-four-family
    387       -       -       387  
Nonresidential
    3,062       -       -       3,062  
Construction
    63       -       -       63  
Land and land development
    2,150       -       -       2,150  
Real estate owned
    3,344       -       -       3,344  
Total assets at fair value
  $ 10,852       -       -       10,852  

The following methods and assumptions were used to estimate fair value of other classes of financial instruments:

Cash and cash equivalents: The carrying amount is a reasonable estimate of fair value.

Loans held for investment: The fair value of loans held for investment is determined by discounting the future cash flows using the rates currently offered for loans of similar remaining maturities. Estimates of future cash flows are based upon current account balances, contractual maturities, prepayment assumptions, and repricing schedules.

Federal Home Loan Bank of Atlanta stock: The carrying amount of restricted stock approximates the fair value based on the redemption provisions.

Accrued interest receivable: The carrying amount is a reasonable estimate of fair value.

 
23

 
 
Savings deposits: The carrying values of passbook savings, money market savings, and money market checking accounts are reasonable estimates of fair value. The fair value of fixed-maturity certificates of deposit is determined by discounting the future cash flows using the rates currently offered for deposits of similar remaining maturities.

Stock order funds: Due to the short-term nature of these funds, the carrying amount is a reasonable estimate of fair value.

FHLB borrowings: The fair values of FHLB borrowings are determined by discounting the future cash flows using rates currently offered for borrowings with similar terms.

Accrued interest payable: The carrying amount is a reasonable estimate of fair value.

Advance payments by borrowers for property taxes and insurance: The carrying amount is a reasonable estimate of fair value.

Commitments to extend credit: The fair value of commitments is estimated using the fees currently charged to enter into similar agreements, taking into account the remaining terms of the agreements and the present creditworthiness of the counterparties. For loan commitments, fair value also considers the difference between current levels of interest rates and the committed rates. The majority of the Company’s commitments to extend credit carry current interest rates if converted to loans.

Standby letters of credit: The fair value of standby letters of credit is based on fees the Company would have to pay to have another entity assume its obligation under the outstanding arrangement.

The estimated fair values of the Company’s financial instruments at March 31, 2011 and September 30, 2010 are as follows:

   
March 31, 2011
   
September 30, 2010
 
         
Estimated
         
Estimated
 
   
Carrying
   
Fair
   
Carrying
   
Fair
 
(Dollars in thousands)
 
Value
   
Value
   
Value
   
Value
 
Financial assets:
                       
Cash and cash equivalents
  $ 312,438     $ 312,438     $ 97,909     $ 97,909  
Securities available for sale
    342,400       342,400       276,643       276,643  
Securities held to maturity
    31,128       29,241       35,518       33,497  
Net loans
    478,793       484,820       477,035       478,892  
Loans held for sale
    249       249       2,781       2,781  
FHLB stock
    12,071       12,071       12,542       12,542  
Accrued interest receivable
    5,013       5,013       4,722       4,722  
                                 
Financial liabilities:
                               
Deposits
    679,110       657,579       647,127       636,612  
Stock order funds
    242,377       242,377       -       -  
FHLB borrowings
    190,000       210,836       190,000       221,776  
Accrued interest payable
    926       926       926       926  
Advance payments by borrowers for taxes and insurance
    2,448       2,448       2,340       2,340  
                                 
Off-balance-sheet financial instruments:
                               
Commitments to extend credit
    94,380       -       130,815       -  
Standby letters of credit
    1,063       6       1,063       9  
 
 
24

 
 
Note 10.  Supplemental Disclosure for Earning Per Share

When presented, basic earnings per share are computed by dividing income available to common stockholders by the weighted average number of common shares outstanding for the period. Diluted earnings per share reflect the potential dilution that could occur if securities or other contracts to issue common stock were exercised or converted into common stock or resulted in the issuance of common stock that then shared in the earnings of the entity. Because the mutual to stock conversion was not completed as of March 31, 2011, per share earnings data is not meaningful for this quarter or prior comparative periods and is therefore not presented.

 
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Item 2.   Management’s Discussion and Analysis of Financial Condition and Results of Operations

Safe Harbor Statement for Forward-Looking Statements

This report may contain forward-looking statements within the meaning of the federal securities laws. These statements are not historical facts; rather they are statements based on our current expectations regarding our business strategies and their intended results and our future performance. Forward-looking statements are preceded by terms such as “expects,” “believes,” “anticipates,” “intends” and similar expressions.  Forward-looking statements are not guarantees of future performance. Numerous risks and uncertainties could cause or contribute to our actual results, performance and achievements being materially different from those expressed or implied by the forward-looking statements. These forward-looking statements are subject to significant risks and uncertainties. Actual results may differ materially from those contemplated by the forward-looking statements due to, among others, the following factors:
 
 
general economic conditions, either internationally, nationally, or in our primary market area, that are worse than expected;
 
a continued decline in real estate values;
 
changes in the interest rate environment that reduce our interest margins or reduce the fair value of financial instruments;
 
increased competitive pressures among financial services companies;
 
changes in consumer spending, borrowing and savings habits;
 
legislative, regulatory or supervisory changes that adversely affect our business;
 
adverse changes in the securities markets; and
 
changes in accounting policies and practices, as may be adopted by the bank regulatory agencies, the  Financial Accounting Standards Board or the Public Company Accounting Oversight Board.

Additional factors that may affect our results are discussed beginning on page 12 of the Company’s prospectus, dated February 11, 2011 under the section titled “Risk Factors.” These factors should be considered in evaluating the forward-looking statements and undue reliance should not be placed on such statements. Except as required by applicable law or regulation, we assume no obligation and disclaim any obligation to update any forward-looking statements.

Critical Accounting Policies

We consider accounting policies involving significant judgments and assumptions by management that have, or could have, a material impact on the carrying value of certain assets or on income to be critical accounting policies.

Allowance for Loan Losses. The allowance for loan losses is the amount estimated by management as necessary to cover losses inherent in the loan portfolio at the balance sheet date. The allowance is established through the provision for loan losses, which is charged to income. Determining the amount of the allowance for loan losses necessarily involves a high degree of judgment. Among the material estimates required to establish the allowance are: the likelihood of default; the loss exposure at default; the amount and timing of future cash flows on impaired loans; the value of collateral; and the determination of loss factors to be applied to the various elements of the portfolio. All of these estimates are susceptible to significant change. Management reviews the level of the allowance at least quarterly and establishes the provision for loan losses based upon an evaluation of the portfolio, past loss experience, current economic conditions and other factors related to the collectibility of the loan portfolio. Although we believe that we use the best information available to establish the allowance for loan losses, future adjustments to the allowance may be necessary if economic or other conditions differ substantially from the assumptions used in making the evaluation. In addition, the OTS, as an integral part of its examination process, periodically reviews our allowance for loan losses and may require us to recognize adjustments to the allowance based on its judgments about information available to it at the time of its examination. A large loss could deplete the allowance and require increased provisions to replenish the allowance, which would adversely affect earnings. See note 5 of the notes to the unaudited consolidated financial statements.

 
26

 
 
Other-Than-Temporary Impairment. Investment securities are reviewed at each quarter-end reporting period to determine whether the fair value is below the current amortized cost. When the fair value of any of our investment securities has declined below its amortized cost, management is required to assess whether the decline is other than temporary. In making this assessment, we consider such factors as the type of investment, the length of time and extent to which the fair value has been below the carrying value, the financial condition and near-term prospects of the issuer, and our intent and ability to hold the investment long enough to allow for any anticipated recovery. The decision to record a write-down, its amount and the period in which it is recorded could change if management’s assessment of the above factors were different. We do not record impairment write-downs on debt securities when impairment is due to changes in interest rates, since we have the intent and ability to realize the full value of the investments by holding them to maturity. Quoted market value is considered to be fair value for actively traded securities. For privately issued securities, and for thinly traded securities where market quotes are not available, we use estimation techniques to determine fair value. Estimation techniques used include discounted cash flows for debt securities. Additional information regarding our accounting for investment securities is included in note 3 to the notes to the unaudited consolidated financial statements.
 
Income Taxes. Management makes estimates and judgments to calculate certain tax liabilities and to determine the recoverability of certain deferred tax assets, which arise from temporary differences between the tax and financial statement recognition of revenues and expenses. The Company also estimates a valuation allowance for deferred tax assets if, based on the available evidence, it is more likely than not that some portion or all of the recorded deferred tax assets will not be realized in future periods. These estimates and judgments are inherently subjective.

In evaluating the recoverability of deferred tax assets, management considers all available positive and negative evidence, including past operating results, recent cumulative losses – both capital and operating – and the forecast of future taxable income – also both capital and operating. In determining future taxable income, management makes assumptions for the amount of taxable income, the reversal of temporary differences and the implementation of feasible and prudent tax planning strategies. These assumptions require judgments about future taxable income and are consistent with the plans and estimates to manage the Company’s business. Any reduction in estimated future taxable income may require the Company to record a valuation allowance against deferred tax assets. An increase in the valuation allowance would result in additional income tax expense in the period and could have a significant impact on future earnings.

Pension Plan. The Company has a noncontributory, defined benefit pension plan. This plan is accounted for under the provisions of ASC Topic 715: Compensation-Retirement Benefits, which requires an employer to recognize the overfunded or underfunded status of a defined benefit postretirement plan as an asset or liability in its statement of financial position and to recognize changes in that funded status in the year in which the changes occur through comprehensive income. The funded status of a benefit plan is measured as the difference between plan assets at fair value and the benefit obligation. For a pension plan, the benefit obligation is the projected benefit obligation. ASC Topic 715 also requires an employer to measure the funded status of a plan as of the date of its year-end statement of financial position. Management must make certain estimates and assumptions when determining the projected benefit obligation. These estimates and assumptions include the expected return on plan assets, the rate of compensation increases over time, and the appropriate discount rate to be used in determining the present value of the obligation.

Comparison of Financial Condition at March 31, 2011 and September 30, 2010

Assets. Total assets at March 31, 2011 were $1.2 billion, an increase of $278.9 million, or 28.7%, from total assets of $971.1 million at September 30, 2010.

Cash and cash equivalents increased $214.5 million to $312.4 million at March 31, 2011 compared to $97.9 million at September 30, 2010, an increase of 219.1%. The increase in cash and cash equivalents was due to the receipt of $242.4 million of stock order funds related to our mutual to stock conversion plus an increase in deposits of $32.0 million, or 4.9%, of which $11.4 million related to the conversion.  On April 28, 2011, $131.0 million of cash was refunded to subscribers whose stock orders were not filled as part of the conversion, $127.5 million of which had been received by March 31, 2011 and is included in the consolidated statements of financial condition.  The foregoing increases in cash and cash equivalents were partially offset by the purchase of agency CMOs for the purpose of meeting qualified thrift lender requirements.

 
27

 
 
Securities increased $61.4 million, or 19.7%, to $373.5 million at March 31, 2011 compared to $312.2 million at September 30, 2010. The increase was primarily the result of the purchase of $98.5 million of CMOs, $12.5 million of agency bonds and $20.1 million of corporate bonds, partially offset by $44.8 million of normal principal payments on mortgage-backed securities (“MBSs”) and CMOs, $8.2 million of sales of corporate bonds, $4.0 million of sales of corporate equity securities, and $12.2 million of corporate bond maturities.

Total loans, excluding loans held for sale, increased $157,000, less than 1%, to $494.2 million at March 31, 2011 compared to $494.1 million at September 30, 2010. The increase was the net result of new loan originations mostly offset by charge-offs of $2.2 million along with the repayment and refinancing of several loans due to the low interest rate environment. One- to four-family loans declined $7.9 million, land and land development loans declined $1.9 million, and other loans declined $2.3 million. Partially offsetting these decreases were net increases in nonresidential loans of $10.1 million, multi-family loans of $1.5 million, and construction loans of $600,000 primarily relating to predominately pre-leased commercial construction projects that will convert to nonresidential loans upon completion of construction.

Liabilities. Total liabilities at March 31, 2011 were $1.1 billion compared to $844.3 million at September 30, 2010, an increase of $275.3 million, or 32.6%, almost exclusively due to conversion-related funds held in escrow or in deposit accounts pending closing of the conversion.  As noted above, $127.5 million of these funds were returned to subscribers whose stock orders were not filled and $135.0 million was converted to common stock and additional paid-in capital in April 2011.

Total deposits increased $32.0 million, or 4.9%, to $679.1 million at March 31, 2011 compared to $647.1 million at September 30, 2010. The increase in deposits was due to a $12.1 million increase in money market savings and money market checking accounts and a $21.2 million increase in certificates of deposit, both primarily related to the conversion.  This increase was partially offset by the elimination of our traditional passbook savings product, which had a balance of $1.3 million at September 30, 2010.

FHLB borrowings were $190.0 million at March 31, 2011, unchanged from September 30, 2010.

Net worth. Net worth was $130.3 million at March 31, 2011, an increase of $3.6 million from September 30, 2010. The increase was the net result of earnings of $3.8 million and a $197,000 decrease in accumulated other comprehensive income. The components of the decrease in accumulated other comprehensive income include a $516,000 decrease in net unrealized gains on securities available for sale, net of the impact of deferred taxes, a $451,000 decrease in other-than-temporary impairment charges recorded in accumulated other comprehensive income, net of the impact of deferred taxes, and $132,000 of previously unrealized gains on securities available for sale recognized in earnings as the result of sales of securities, net of the impact of deferred taxes.

Comparison of Operating Results for the Three Months Ended March 31, 2011 and March 31, 2010

General. We had net income of $1.7 million for the three months ended March 31, 2011, an increase of $177,000, or 11.3%, from the $1.6 million earned in the quarter ended March 31, 2010. The increase was the net result of a $41,000 decrease in net interest income, a $134,000 increase in the provision for loan losses, a $931,000 decrease in other-than-temporary impairment charges on securities included in earnings, a $241,000 decrease in other service charges and fees, a $366,000 increase in gains on sales of securities, a $32,000 increase in the change in value of call options on equity securities, a $55,000 decrease in other noninterest income, and a $701,000 increase in other noninterest expenses.  Income tax expense was comparable in both periods.

Net Interest Income. Net interest income decreased $41,000, or 0.7%, to $6.2 million in the quarter ended March 31, 2011 from $6.3 million in the quarter ended March 31, 2010. The decrease in net interest income resulted from a decline in total interest and dividend income that exceeded a decline in interest expense on savings deposits and FHLB borrowings.

 
28

 
 
Total interest and dividend income decreased $1.4 million, or 11.2%, to $11.2 million for the quarter ended March 31, 2011 from $12.6 million for the quarter ended March 31, 2010. Interest income on loans decreased $582,000, or 6.9%, for the quarter ended March 31, 2011 as a result of a 32 basis point decrease in the yield on loans and an $11.3 million decline in the average balance of loans for the quarter ended March 31, 2011 compared to the quarter ended March 31, 2010. The yield on loans was negatively impacted by our level of nonaccrual loans during the three months ended March 31, 2011 as well as a lower overall interest rate environment.  Additionally, interest and dividend income on investment securities declined $821,000, or 20.2%, primarily due to a decline in the yield on MBSs and CMOs. These securities continue to prepay at accelerated rates due to the efforts of the Federal Reserve to keep home mortgage interest rates low. We expect to continue to purchase shorter-term MBSs and CMOs with significantly lower yields than those MBSs and CMOs that are prepaying in order to meet regulatory qualified thrift lender requirements.  Additionally, interest income on corporate debt securities declined $196,000 primarily due to the maturity of several high-yielding bonds.

Total interest expense decreased $1.4 million, or 21.7%, to $4.9 million for the quarter ended March 31, 2011 from $6.3 million for the quarter ended March 31, 2010. Deposit costs declined $918,000, or 25.6 %, and FHLB borrowing costs declined $455,000, or 16.7%. The average balance of interest-bearing deposits increased $9.8 million, or 1.5%, for the quarter ended March 31, 2011 compared to the quarter ended March 31, 2010 because growth in the average balance of money market savings and money market checking accounts more than offset a decline in the average balance of certificates of deposit. The average interest rate paid on deposits decreased 60 basis points as a result of the lower interest rate environment for deposits in the quarter ended March 31, 2011. Interest paid on FHLB borrowings decreased in 2011 due to a decrease in the average balance of higher-rate borrowings of $30.0 million, resulting in a lower average interest rate paid of 18 basis points.

Provision for Loan Losses. The provision for loan losses increased $134,000 to $290,000 for the quarter ended March 31, 2011 from $156,000 for the quarter ended March 31, 2010. The increase in the provision reflects higher nonperforming loans as well as higher reserve rates resulting from higher historical charge-offs. The increase in the provision reflects an increase in the overall reserve rate of 4 basis points at March 31, 2011 from December 31, 2010 and a $2.6 million increase in total loans compared to an increase in the overall reserve rate of 1 basis point at March 31, 2010 from December 31, 2009 and a $1.2 million increase in total loans.  Net loan charge-offs were $14,000 for the quarter ended March 31, 2011 compared to $86,000 for the quarter ended March 31, 2010.  See note 5 of the notes to the unaudited consolidated financial statements for a discussion of our methodology for estimating the allowance for loan losses.

Gains, Losses, and Impairment Charges on Securities. Other-than-temporary-impairment charges on securities reflected in earnings decreased $931,000 to $382,000 for the quarter ended March 31, 2011 compared to $1.3 million for the quarter ended March 31, 2010. The decrease in impairment charges reflects a current stabilization in the delinquency and loss rates for mortgages underlying our portfolio of non-agency CMOs. Delinquency and loss rates could increase in the future depending on market conditions. Sales of securities resulted in net gains of $364,000 for the quarter ended March 31, 2011 compared to a $2,000 loss for the quarter ended March 31, 2010.

Noninterest Income, Excluding Gains, Losses, and Impairment Charges on Securities. Total other noninterest income decreased $246,000, or 29.4%, for the quarter ended March 31, 2011 compared to the quarter ended March 31, 2010, primarily as a result of a $241,000 decrease in other service charges and fees, which was primarily related to late fees received on construction loans, and a $55,000 decrease in gains on the sale of other real estate owned.  These declines were partially offset by a $32,000 increase in the change in fair value of call options on equity securities.

Noninterest Expense. Total noninterest expenses increased $701,000, or 20.2%, to $4.2 million for the quarter ended March 31, 2011 compared to $3.5 million for the quarter ended March 31, 2010. The increase in noninterest expenses was due to a $142,000 increase in personnel expense and a $641,000 increase in other operating expenses.  Other operating expenses for the three months ended March 31, 2011 included a decrease of $82,000 in foreclosure expenses compared to the three months ended March 31, 2010 as well as $781,000 in impairment charges on real estate owned compared to no impairment charges on real estate owned in the three months ended March 31, 2010. The impairment charges were the result of obtaining an updated appraisal on one property consisting of undeveloped land as well as changing to the use of an “as-is” appraisal value rather than the “upon stabilization” value for a shopping center that we have had more difficulty than anticipated in leasing-up.  These increases were partially offset by a decrease of $47,000 in advertising expense and a $24,000 decrease in occupancy expense resulting from lower real estate and personal property taxes.

 
29

 
 
Income Tax Expense. Income tax expense was $597,000 for the quarter ended March 31, 2011 compared to $599,000 for the quarter ended March 31, 2010. The effective income tax expense rate for the quarter ended March 31, 2011 was 25.6% compared to 27.8% for the quarter ended March 31, 2010.

Comparison of Operating Results for the Six Months Ended March 31, 2011 and March 31, 2010

General. We had net income of $3.8 million for the six months ended March 31, 2011, an increase of $1.2 million, or 45.7%, from the $2.6 million earned in the six months ended March 31, 2010. The increase was the net result of a $992,000 increase in net interest income, a $1.4 million decrease in the provision for loan losses, a $1.8 million decrease in other-than-temporary impairment charges on securities included in earnings, a $284,000 decrease in other service charges and fees, a $1.7 million decrease in gains on sales of securities, a $35,000 increase in the change in value of call options on equity securities, a $39,000 increase in other noninterest income, a $499,000 increase in other noninterest expenses, and a $664,000 increase in income tax expense.

Net Interest Income. Net interest income increased $992,000, or 8.5%, to $12.7 million in the six months ended March 31, 2011 from $11.7 million in the six months ended March 31, 2010. The increase in net interest income resulted from a decline in total interest and dividend income that was more than offset by lower interest expense on savings deposits and FHLB borrowings.

Total interest and dividend income decreased $2.0 million, or 8.1%, to $22.7 million for the six months ended March 31, 2011 from $24.7 million for the six months ended March 31, 2010. Interest income on loans decreased $443,000, or 2.7%, for the six months ended March 31, 2011 compared to the six months ended March 31, 2010 as a result of a $14.8 million decline in the average balance of loans. The interest income on loans was also negatively impacted by our level of nonaccrual loans during the six months ended March 31, 2011.  Additionally, interest and dividend income on investment securities declined $1.6 million, or 19.3%, primarily due to a decline in the yield on MBSs and CMOs. These securities continue to prepay at accelerated rates due to the efforts of the Federal Reserve to keep home mortgage interest rates low. For the purpose of meeting the regulatory qualified thrift lender requirements, we expect to continue to purchase shorter-term MBSs and CMOs with significantly lower yields than those MBSs and CMOs that are pre-paying.  Additionally, interest income on corporate debt securities declined $221,000 primarily due to the maturity of several high-yielding bonds.

Total interest expense decreased $3.0 million, or 23.0%, to $10.0 million for the six months ended March 31, 2011 from $13.0 million for the six months ended March 31, 2010. Deposit costs declined $2.1 million, or 27.6 %, and FHLB borrowing costs declined $927,000, or 16.8%. The average balance of interest-bearing deposits increased $3.4 million, or 0.5%, for the six months ended March 31, 2011 compared to the six months ended March 31, 2010 because growth in money market savings and money market checking accounts more than offset a decline in certificates of deposit. The average interest rate paid on deposits decreased 65 basis points as a result of the lower interest rate environment for deposits in the six months ended March 31, 2011.  Interest paid on FHLB borrowings decreased in 2011 due to a decrease in the average balance of higher-rate borrowings of $30.7 million, resulting in a lower average interest rate paid of 17 basis points.

Provision for Loan Losses. The provision for loan losses decreased $1.4 million to $712,000 for the six months ended March 31, 2011 from $2.1 million for the six months ended March 31, 2010. The decrease in the provision reflects a decrease in the overall reserve rate of 31 basis points at March 31, 2011 from September 30, 2010 and a $157,000 increase in total loans compared to an increase in the overall reserve rate of 24 basis points at March 31, 2010 from September 30, 2009 offset by a $9.5 million decrease in total loans.  Changes in reserve rates reflected changes in loan ratings.  Total classified loans decreased $1.7 million in the six months ended March 31, 2011 compared to an increase in classified loans of $17.7 million in the six months ended March 31, 2010.  Net loan charge-offs were $2.2 million for the six months ended March 31, 2011 compared to $1.1 million for the six months ended March 31, 2010.  See note 5 of the notes to the unaudited consolidated financial statements for a discussion of our methodology for estimating the allowance for loan losses.

 
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Gains, Losses, and Impairment Charges on Securities. Other-than-temporary-impairment charges on securities reflected in earnings decreased $1.8 million to $681,000 for the six months ended March 31, 2011 compared to $2.5 million for the six months ended March 31, 2010. The decrease in impairment charges reflects a current stabilization in the delinquency and loss rates for mortgages underlying our portfolio of non-agency CMOs. Delinquency and loss rates could increase in the future depending on market conditions. Sales of securities resulted in gains of $265,000 for the six months ended March 31, 2011 compared to $2.0 million for the six months ended March 31, 2010.

Noninterest Income, Excluding Gains, Losses, and Impairment Charges on Securities. Total other noninterest income decreased $147,000, or 9.8%, for the six months ended March 31, 2011 compared to the six months ended March 31, 2010, primarily as a result of a $285,000 decrease in other service charges and fees, which was primarily related to late fees received on construction loans, partially offset by a $74,000 increase in gains on sales of loans, a $45,000 increase in gains on the sale of other real estate owned, and a $35,000 increase in the change in fair value of call options on equity securities.

Noninterest Expense. Total noninterest expenses increased $499,000, or 7.0%, to $7.6 million for the six months ended March 31, 2011 compared to $7.1 million for the six months ended March 31, 2010. The increase in noninterest expenses was due to a $142,000 increase in personnel expense and a $795,000 increase in other operating expenses.  Other operating expenses for the six months ended March 31, 2011 included $781,000 in impairment charges on real estate owned compared to no impairment charges on real estate owned in the six months ended March 31, 2010. The impairment charges were the result of obtaining an updated appraisal on one property consisting of undeveloped land as well as changing to the use of an “as-is” appraisal value rather than an “upon stabilization” value for a shopping center that we have had more difficulty than anticipated leasing-up.  These increases were partially offset by a decrease of $48,000 in advertising expense, a $33,000 decrease in FDIC premiums, and a $48,000 decrease in occupancy expense resulting from lower real estate and personal property taxes as well as lower repairs and maintenance expenses.

Income Tax Expense. Income tax expense was $1.5 million for the six months ended March 31, 2011 compared to $840,000 for the six months ended March 31, 2010. The effective income tax expense rate for the six months ended March 31, 2011 was 28.5% compared to 24.5% for the six months ended March 31, 2010.

 
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Average Balances, Income and Expenses, Yields and Rates

The following table presents information regarding average balances of assets and liabilities, the total dollar amounts of interest income and dividends from average interest-earning assets, the total dollar amounts of interest expense on average interest-bearing liabilities, and the resulting average yields and costs. The yields and costs for the periods indicated are derived by dividing income or expense by the average daily balances of assets or liabilities, respectively, for the periods presented. Non-accrual loans are included in average loan balances only. Loan fees are included in interest income on loans and are not material.

   
For the Three Months Ended March 31,
 
   
2011
   
2010
 
(Dollars in thousands)
 
Average
Balance
   
Interest
and
Dividends
   
Yield/
Cost
   
Average
Balance
   
Interest
and
Dividends
   
Yield/
Cost
 
Assets:
                                   
Interest-earning assets:
                                   
Loans:
                                   
One- to four-family
  $ 121,089     $ 2,072       6.94 %   $ 135,976     $ 2,365       7.05 %
Multi-family
    77,756       1,337       6.97 %     79,114       1,304       6.68 %
Nonresidential
    183,264       3,080       6.82 %     143,713       2,420       6.83 %
Construction
    41,572       523       5.10 %     68,132       735       4.38 %
Land and land development
    68,624       773       4.57 %     74,420       1,529       8.33 %
Other
    809       15       7.52 %     3,017       29       3.90 %
Total loans
    493,114       7,800       6.42 %     504,372       8,382       6.74 %
Securities:
                                               
Collateralized mortgage obligations
    153,237       1,165       3.08 %     128,089       1,648       5.22 %
Mortgage-backed securities
    31,651       295       3.78 %     42,692       446       4.24 %
States and political subdivisions
    18,738       210       4.55 %     21,228       232       4.43 %
U. S. government agencies
    10,303       25       0.98 %     -       -       -  
Corporate equity securities
    24,829       72       1.18 %     22,610       81       1.45 %
Corporate debt securities
    122,884       1,538       5.07 %     136,588       1,734       5.15 %
Total securities
    361,642       3,305       3.71 %     351,207       4,141       4.78 %
Investment in FHLB stock
    12,071       24       0.81 %     13,510       9       0.27 %
Other interest-earning assets
    66,642       33       0.21 %     79,739       44       0.22 %
Total interest-earning assets
    933,469       11,162       4.85 %     948,828       12,576       5.38 %
Allowance for loan losses
    (12,098 )                     (10,083 )                
Noninterest-earning assets
    91,999                       69,947                  
Total assets
  $ 1,013,370                     $ 1,008,692                  
Liabilities and equity:
                                               
Interest-bearing liabilities:
                                               
Deposits:
                                               
Passbook savings
  $ -       -             $ 2,732       7       1.04 %
Money market savings
    227,218       515       0.92 %     209,552       740       1.43 %
Money market checking
    46,586       108       0.94 %     31,509       114       1.47 %
Certificates of deposit
    390,036       2,049       2.13 %     410,295       2,729       2.70 %
Total interest-bearing deposits
    663,840       2,672       1.63 %     654,088       3,590       2.23 %
FHLB borrowings
    190,000       2,266       4.84 %     220,000       2,721       5.02 %
Total interest-bearing liabilities
    853,840       4,938       2.35 %     874,088       6,311       2.93 %
Noninterest bearing liabilities
    28,178                       10,296                  
Total liabilities
    882,018                       884,384                  
Retained earnings
    127,967                       127,354                  
Accumulated other comprehensive income  (loss)
    3,385                       (3,046 )                
Total net worth
    131,352                       124,308                  
Total liabilities and net worth
  $ 1,013,370                     $ 1,008,692                  
Net interest income
          $ 6,224                     $ 6,265          
Interest rate spread (1)
                    2.50 %                     2.45 %
Net interest margin (2)
                    2.70 %                     2.68 %
Average interest-earning assets to average interest-bearing liabilities
                    109.33 %                     108.55 %

(1)
Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(2)
Net interest margin represents net interest income as a percentage of average interest-earning assets.

 
32

 
 
   
For the Six Months Ended March 31,
 
   
2011
   
2010
 
(Dollars in thousands)
 
Average
Balance
   
Interest
and
Dividends
   
Yield/ 
Cost
   
Average
Balance
   
Interest
and
Dividends
   
Yield/
Cost
 
Assets:
                                   
Interest-earning assets:
                                   
Loans:
                                   
One- to four-family
  $ 123,798     $ 4,384       7.10 %   $ 122,254     $ 4,340       7.12 %
Multi-family
    77,179       2,624       6.82 %     95,139       3,156       6.65 %
Nonresidential
    178,427       6,082       6.84 %     139,164       4,645       6.69 %
Construction
    41,815       1,100       5.28 %     70,212       1,536       4.39 %
Land and land development
    69,323       1,736       5.02 %     76,440       2,667       7.00 %
Other
    1,925       57       5.94 %     4,068       82       4.04 %
Total loans
    492,467       15,983       6.51 %     507,277       16,426       6.49 %
Securities:
                                               
Collateralized mortgage obligations
    140,972       2,293       3.26 %     126,583       3,307       5.24 %
Mortgage-backed securities
    33,059       641       3.89 %     44,148       947       4.30 %
States and political subdivisions
    19,598       429       4.39 %     22,180       479       4.33 %
U. S. government agencies
    8,630       38       0.88 %     -       -       -  
Corporate equity securities
    23,382       155       1.33 %     23,939       177       1.48 %
Corporate debt securities
    123,192       3,038       4.94 %     135,963       3,259       4.81 %
Total securities
    348,833       6,594       3.79 %     352,813       8,169       4.64 %
Investment in FHLB stock
    12,197       37       0.61 %     13,510       23       0.34 %
Other interest-earning assets
    68,250       77       0.23 %     71,811       75       0.21 %
Total interest-earning assets
    921,747       22,691       4.94 %     945,411       24,693       5.24 %
Allowance for loan losses
    (12,457 )                     (9,528 )                
Noninterest-earning assets
    83,122                       68,561                  
Total assets
  $ 992,412                     $ 1,004,444                  
Liabilities and equity:
                                               
Interest-bearing liabilities:
                                               
Deposits:
                                               
Passbook savings
  $ 22       -             $ 3,349       17       1.02 %
Money market savings
    226,055       1,026       0.91 %     203,392       1,474       1.45 %
Money market checking
    45,066       212       0.94 %     27,928       208       1.49 %
Certificates of deposit
    381,872       4,199       2.21 %     414,931       5,805       2.81 %
Total interest-bearing deposits
    653,015       5,437       1.67 %     649,600       7,504       2.32 %
FHLB borrowings
    190,000       4,582       4.84 %     220,714       5,509       5.01 %
Total interest-bearing liabilities
    843,015       10,019       2.38 %     870,314       13,013       3.00 %
Noninterest bearing liabilities
    19,803                       9,707                  
Total liabilities
    862,818                       880,021                  
Retained earnings
    126,767                       127,571                  
Accumulated other comprehensive income  (loss)
    2,827                       (3,148 )                
Total net worth
    129,594                       124,423                  
Total liabilities and net worth
  $ 992,412                     $ 1,004,444                  
Net interest income
          $ 12,672                     $ 11,680          
Interest rate spread (1)
                    2.56 %                     2.24 %
Net interest margin (2)
                    2.76 %                     2.48 %
Average interest-earning assets to average interest-bearing liabilities
                    109.34 %                     108.63 %

(1)
Interest rate spread represents the difference between the average yield on interest-earning assets and the average cost of interest-bearing liabilities.
(2)
Net interest margin represents net interest income as a percentage of average interest-earning assets.
 
 
33

 
 
Rate/Volume Analysis

The following table sets forth the effects of changing rates and volumes on our net interest income. 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. The net changes attributable to the combined impact of both rate and volume have been allocated proportionately to the changes due to volume and the changes due to rate.

   
Three Months Ended March 31, 2011
Compared to Three Months Ended
March 31, 2010
   
Six Months Ended March 31, 2011
Compared to Six Months Ended
March 31, 2010
 
   
Increase (Decrease)
Due to:
         
Increase (Decrease)
Due to:
       
(Dollars in thousands)
 
Volume
   
Rate
   
Net
   
Volume
   
Rate
   
Net
 
Interest income:
                                   
Loans
  $ (185 )   $ (397 )   $ (582 )   $ (584 )   $ 141     $ (443 )
Securities
    337       (1,173 )     (836 )     (92 )     (1,483 )     (1,575 )
Investment in FHLB stock
    (3 )     18       15       (6 )     20       14  
Other interest earning assets
    (6 )     (5 )     (11 )     (9 )     11       2  
Total
    143       (1,557 )     (1,414 )     (691 )     (1,311 )     (2,002 )
Interest expense:
                                               
Deposits:
                                               
Passbook savings
    (4 )     (3 )     (7 )     (9 )     (8 )     (17 )
Money market savings
    161       (386 )     (225 )     403       (851 )     (448 )
Money market checking
    93       (99 )     (6 )     195       (191 )     4  
Certificates of deposit
    (129 )     (551 )     (680 )     (436 )     (1,170 )     (1,606 )
FHLB borrowings
    (359 )     (96 )     (455 )     (745 )     (182 )     (927 )
Total
    (238 )     (1,135 )     (1,373 )     (592 )     (2,402 )     (2,994 )
Increase (decrease) in net interest income
  $ 381     $ (422 )   $ (41 )   $ (99 )   $ 1,091     $ 992  

Asset Quality

Nonperforming Assets (NPAs)

At March 31, 2011, nonperforming assets totaled $47.1 million, an increase of $5.7 million from $41.4 million at September 30, 2010. Our level of NPAs remains elevated over historical experience as a result of stresses in the real estate market, which are largely a result of the broader and extended economic slowdown. While we intend to actively work to reduce our NPAs, these levels of nonperforming assets are likely to remain elevated in the near term as problem loans work to resolution, which may be foreclosure.

Nonperforming assets at March 31, 2011 included $35.4 million in nonperforming loans (NPLs) as summarized in the table below. The following table reflects the balances and changes from the prior quarter:

(Dollars in thousands)
 
March 31,
2011
   
December 31,
2010
   
Change
 
Nonaccrual loans:
                 
One-to four-family
  $ 11,421     $ 4,444     $ 6,977  
Nonresidential
    11,075       7,807       3,268  
Construction
    255       166       89  
Land and land development
    12,693       12,938       (245 )
Total
    35,444       25,355       10,089  
                         
Accruing loans past due 90 days or more:
                       
Construction
    -       290       (290 )
Land and land development
    -       1,140       (1,140 )
Total
    -       1,430       (1,430 )
Total non-performing loans
  $ 35,444     $ 26,785     $ 8,659  
 
 
34

 
 
At March 31, 2011, the allowance for loan losses as a percentage of total loans was 2.41% compared to 2.37% at December 31, 2010 and 2.72% at September 30, 2010 while total loans increased $2.6 million and $157,000 for the three months ended March 31, 2011 and December 31, 2010, respectively.  Management notes that while the level of nonperforming loans increased significantly at March 31, 2011 compared to December 31, 2010, many of the Company’s loans, once identified as impaired, have resulted in little or no specific allowance due to sufficient collateral values.  This has resulted in decreases to the allowance for loan losses as these loans were more heavily provided for when evaluated collectively than when evaluated individually.  As a result, the allowance for loan losses did not increase in proportion to the increase in nonperforming or classified loans.  See note 5 of the notes to the unaudited consolidated financial statements for further analysis of the allowance for loan losses.

The following table sets forth selected asset quality data and ratios for the dates indicated:

(Dollars in thousands)
 
March 31,
2011
   
September 30,
2010
 
Nonperforming loans
  $ 35,444     $ 29,773  
Real estate owned
    11,636       11,581  
Total non-performing assets
  $ 47,080     $ 41,354  
                 
Allowance for loan losses
  $ 11,922     $ 13,419  
Total loans
  $ 494,212     $ 494,055  
                 
Ratios
               
Allowance as a percentage of total loans
    2.41 %     2.72 %
Allowance as a percentage of nonperforming loans
    33.64 %     45.07 %
Total non-performing loans to total loans
    7.17 %     6.03 %
Total non-performing loans to total assets, excluding stock order funds
    3.52 %     3.07 %
Total non-performing assets to total assets, excluding stock order funds
    4.67 %     4.26 %
 
At March 31, 2011, nonaccrual loans were primarily comprised of the following:
 
Land and land development loans:
 
 
-
One loan on 305 acres of undeveloped land in central Virginia proposed for a multi-use development within a planned unit development. This loan had a balance of $4.9 million and was rated substandard at March 31, 2011. The collateral was valued at $12.2 million based upon a December 2010 appraisal, and a specific allowance calculation on this loan resulted in no allowance at March 31, 2011 due to sufficient collateral.
 
 
-
One loan on 314 acres of undeveloped land in central Virginia proposed for multi-use development within a planned unit development. This loan is a participation loan with two other banks, each having a one-third interest. The balance of the Bank’s portion of this loan was $4.9 million and was rated substandard at March 31, 2011. The collateral was valued at $37.1 million (of which $12.4 million is attributable to the Bank) based upon a November 2010 appraisal, and a specific allowance calculation on this loan resulted in no allowance at March 31, 2011 due to sufficient collateral.
 
 
-
One loan on 71 single-family lots and 58 acres of developed land in central Virginia. As of March 31, 2011, nine single-family lots had been sold. The loan is a participation with another bank and was current at March 31, 2011. Our participation interest is 62%, and our balance on this loan was $1.6 million at March 31, 2011. This loan was modified in a troubled debt restructuring during the year ended September 30, 2010 and had a related specific allowance of $133,000 at March 31, 2011.
 
 
 -
One loan on 18 developed residential lots plus approximately 16 acres of land zoned for residential development in central Virginia.  This loan had a balance of $943,000 and was rated substandard at March 31, 2011.  The collateral was valued at $1.1 million based upon a September 2010 appraisal, and a specific allowance calculation on this loan resulted in no allowance at March 31, 2011 due to sufficient collateral.
 
 
35

 
 
Nonresidential real estate loans:
 
 
-
One loan on a 37,880 square foot strip shopping center in northern Virginia with four available out-parcel sites, two of which have contingent ground leases in negotiation that, if consummated, will improve the cash flow of the property. The shopping center, which is 29% leased, is within one mile of a major regional shopping center. The loan is a participation with two other banks, and our participation portion is approximately 32%. Our balance at March 31, 2011 was $2.3 million. This loan was modified in a troubled debt restructuring during the year ended September 30, 2010.  Based upon an April 2011 appraisal valuing the collateral at $8.3 million (of which $2.7 million is attributable to the Bank), no specific allowance was necessary at March 31, 2011 due to sufficient collateral. While the loan was over 180 days delinquent and on nonaccrual status at March 31, 2011, the lenders have not taken any action on this loan pending the results of the contingent ground lease negotiations.
 
 
-
One loan on two shopping centers in North Carolina under one deed of trust with 84,000 total leasable square feet. The shopping centers do not generate sufficient cash flow to service the loan debt. The loan balance was $5.5 million at March 31, 2011. The loan was 31-60 days delinquent and on nonaccrual status at March 31, 2011. The two shopping centers have a combined appraised value of $7.4 million based upon a December 2010 appraisal.  A specific allowance calculation on this loan resulted in no allowance at March 31, 2011 due to sufficient collateral.
 
 
-
One loan secured by a day care center and twenty-six developed lots in central Virginia.  This loan had a balance of $2.1 million and was fewer than 30 days delinquent at March 31, 2011.  The collateral for this loan was valued at $3.6 million based on a March 2010 appraisal of the day care center and the estimated value of the lots.  We have three other loans to entities controlled by the guarantor on this loan as described below in the section regarding nonaccrual one-to four-family loans.  A specific allowance calculation on this loan resulted in no allowance at March 31, 2011 due to sufficient collateral.
 
 
-
One loan on a 21,600 square foot shopping center in central Virginia with two outparcels.  The shopping center was 83% leased but was not generating sufficient cash flow to service the loan debt at March 31, 2011.  This loan is a participation with three other banks, and our participation is approximately 22%.  Our balance at March 31, 2011 was $1.2 million.  Based upon a February 2011 appraisal valuing the collateral at $4.0 million (of which $890,000 was attributable to the Bank), a specific allowance calculation resulted in an allowance of $419,000 at March 31, 2011.
 
One-to four-family
 
 
-
Fifty-one loans on one-to four-family residential properties in central Virginia to multiple borrowers with an aggregate balance of $6.5 million at March 31, 2011.
 
 
 -
Three loans outstanding to separate entities controlled by the same guarantor totaling $4.9 million secured by twenty-five one-to four-family homes, twenty-three of which are currently leased. These loans were 31-60 days delinquent at March 31, 2011.  A specific allowance calculation on this loan resulted in no allowance at March 31, 2011 due to sufficient collateral.
 
The following table shows the aggregate amounts of our classified and criticized assets at the dates indicated in accordance with OTS loan classification definitions.
 
(Dollars in thousands)
 
March 31,
2011
   
September 30,
2010
 
Loans:
           
Special mention loans
  $ 19,280     $ 22,065  
Substandard loans
    60,989       56,479  
Total criticized and classified loans
    80,269       78,544  
Securities:
               
Substandard
    21,948       29,414  
Doubtful
    2,446       3,063  
Total classified securities
    24,394       32,477  
Total criticized and classified assets
  $ 104,663     $ 111,021  

 
36

 
 
At March 31, 2011, substandard loans, other than nonperforming loans, were comprised primarily of the following:
 
 
-
One loan on a mixed use development on 257 acres in central Virginia that, as proposed, will contain 80,000 square feet of retail space, a 280 unit apartment complex and more than 300 attached and detached single family lots. Construction of the apartment complex is expected to begin by mid-2011. As of March 31, 2011, 64 single-family lots had been sold. Payments of principal and interest are made as lots are sold. This loan had a balance of $11.3 million at March 31, 2011 and was identified as impaired. During the three months ended March 31, 2011, this loan was returned to accrual status after it was brought current and had multiple non-contingent contracts for the sale of single-family lots scheduled to close by December 31, 2011.  At March 31, 2011, the loan was under 30 days delinquent. The development has an appraised value of $19.6 million based on a December 2010 appraisal.
 
 
-
Three loans on an apartment complex in central Virginia totaling $11.6 million. The project has approximately 600 units, of which approximately 250 units were rented at March 31, 2011. Based upon current occupancy, the apartment complex does not generate enough cash to service the debt and requires support from the guarantor. The apartment complex is valued at $15.0 million based upon a January 2011 appraisal.
 
 
 -
One loan on a 64-unit apartment complex in central Virginia with a balance of $1.3 million at March 31, 2011. The apartment complex was approximately 25% leased at March 31, 2011 and does not generate enough cash to service the debt and requires support from the guarantor.

Liquidity and Capital Resources

Liquidity

Liquidity is the ability to meet current and future financial obligations of a short-term and long-term nature. Our primary sources of funds consist of deposit inflows, loan repayments, maturities and sales of securities and borrowings from the FHLB. While maturities and scheduled amortization of loans and securities are predictable sources of funds, deposit flows, calls of investment securities and borrowed funds, and prepayments on loans and mortgage-backed securities and collateralized mortgage obligations are greatly influenced by general interest rates, economic conditions and competition.

Our most liquid assets are cash and cash equivalents, interest-bearing deposits in other banks, and corporate bonds. The levels of these assets depend on our operating, financing, lending and investing activities during any given period. At March 31, 2011, cash and cash equivalents totaled $312.4 million. Cash and cash equivalents at March 31, 2011 included cash received for stock subscriptions as part of the conversion of the MHC as discussed above in the “Comparison of Financial Condition at March 31, 2011 and September 30, 2010.”  Securities classified as available-for-sale, whose aggregate market value exceeds cost, provide additional sources of liquidity and had a market value of $249.1 million at March 31, 2011. In addition, at March 31, 2011, we had the ability to borrow a total of approximately $128.1 million in additional funds from the FHLB. Additionally, we established a borrowing arrangement with the Federal Reserve Bank of Richmond, although no borrowings have occurred and no assets have been pledged to date. We intend to use corporate bonds as collateral for this arrangement and had unpledged corporate bonds with an estimated fair value of $118.1 million at March 31, 2011.

At March 31, 2011, we had $94.4 million in loan commitments outstanding, which included $78.3 million in undisbursed loans. Certificates of deposit due within one year of March 31, 2011 totaled $261.6 million. The large percentage of certificates of deposit that mature within one year reflects customers’ hesitancy to invest their funds for long periods. If these maturing deposits are not renewed, we will be required to seek other sources of funds, including other certificates of deposit and borrowings. Depending on market conditions, we may be required to pay higher rates on such deposits or other borrowings than we currently pay on the certificates of deposit. Management believes, however, based on past experience that a significant portion of our certificates of deposit will be renewed. We have the ability to attract and retain deposits by adjusting the interest rates offered.

In addition, we believe that our branch network, which is presently comprised of eight full-service retail banking offices located throughout our primary market area, and the general cash flows from our existing lending and investment activities, will afford us sufficient long-term liquidity.
 
 
37

 
 
Regulatory Capital

The Bank is subject to various regulatory capital requirements administered by the OTS. Failure to meet minimum capital requirements can initiate certain mandatory and possible discretionary actions by regulators that, if undertaken, could have a direct material effect on the Company's consolidated 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 classification are also subject to qualitative judgments by the regulators about components, risk weightings, and other factors. In addition, the Bank is required to notify the OTS before paying dividends to the Parent.

The regulations require that savings institutions meet three capital requirements: a core capital requirement, a tangible capital requirement, and a risk-based capital requirement. The Tier 1 capital regulations require a savings institution to maintain Tier 1 capital of not less than 4% of adjusted total assets. The tangible capital regulations require savings institutions to maintain tangible capital of not less than 1.5% of adjusted total assets. The risk-based capital regulations require savings institutions to maintain capital of not less than 8% of risk-weighted assets.

At March 31, 2011, the Bank had regulatory capital in excess of that required under each requirement and was classified as a “well capitalized” institution as determined by the OTS.  There are no conditions or events that management believes have changed the Bank’s classification.  The following table reflects the level of required capital and actual capital of the Bank at March 31, 2011 and September 30, 2010:

   
Actual
   
Amount required to be
"adequately capitalized"
   
Amount required to be
"well capitalized"
 
(Dollars in thousands)
 
Amount
   
Percentage
   
Amount
   
Percentage
   
Amount
   
Percentage
 
As of March 31, 2011
                                   
Tier 1 capital
  $ 103,575       8.49 %   $ 48,795       4.00 %   $ 61,352       5.00 %
(to adjusted tangible assets)
                                               
                                                 
Tier 1 risk-based capital
    103,575       14.27       29,042       4.00       43,563       6.00  
(to risk weighted assets)
                                               
                                                 
Tangible capital
    103,575       8.49       18,298       1.50       18,298       1.50  
(to adjusted tangible assets)
                                               
                                                 
Risk-based capital
    112,678       15.52       58,084       8.00       72,605       10.00  
(to risk weighted assets)
                                               
                                                 
As of September 30, 2010
                                               
Tier 1 capital
  $ 103,183       10.90 %   $ 37,877       4.00 %   $ 47,616       5.00 %
(to adjusted tangible assets)
                                               
                                                 
Tier 1 risk-based capital
    103,183       14.12       29,234       4.00       43,850       6.00  
(to risk weighted assets)
                                               
                                                 
Tangible capital
    103,183       10.90       14,204       1.50       14,204       1.50  
(to adjusted tangible assets)
                                               
                                                 
Risk-based capital
    112,341       15.37       58,467       8.00       73,084       10.00  
(to risk weighted assets)
                                               

There were no dividends declared by the Bank to the Parent in the three or six months ended March 31, 2011.  Additionally, no contributions were made by the Parent to the Bank in the three or six months ended March 31, 2011.

The tangible capital percentages at March 31, 2011 were temporarily reduced by the cash received for stock subscriptions as part of the conversion of the MHC.  At March 31, 2011, these amounts were included as liabilities of the Bank and temporarily inflated the Bank’s assets and liabilities.
 
 
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The following is a reconciliation of the Bank’s GAAP capital to regulatory capital at March 31, 2011 and September 30, 2010 (dollars in thousands):

   
March 31, 2011
 
(Dollars in thousands)
 
Tier 1
capital
   
Tier 1 risk-
based capital
   
Tangible
capital
   
Risk-based
capital
 
GAAP capital
  $ 109,453     $ 109,453     $ 109,453     $ 109,453  
Accumulated gains on certain available- for-sale securities
    (3,108 )     (3,108 )     (3,108 )     (3,108 )
Disallowed deferred tax assets
    (4,052 )     (4,052 )     (4,052 )     (4,052 )
Pension plan
    1,282       1,282       1,282       1,282  
General allowance for loan losses
    -       -       -       9,103  
Regulatory capital – computed
  $ 103,575     $ 103,575     $ 103,575     $ 112,678  

   
September 30, 2010
 
(Dollars in thousands)
 
Tier 1
capital
   
Tier 1 risk-
based capital
   
Tangible
capital
   
Risk-based
capital
 
GAAP capital
  $ 107,305     $ 107,305     $ 107,305     $ 107,305  
Accumulated gains on certain available- for-sale securities
    (4,745 )     (4,745 )     (4,745 )     (4,745 )
Disallowed deferred tax assets
    (659 )     (659 )     (659 )     (659 )
Pension plan
    1,282       1,282       1,282       1,282  
General allowance for loan losses
    -       -       -       9,158  
Regulatory capital – computed
  $ 103,183     $ 103,183     $ 103,183     $ 112,341  

Off-Balance Sheet Arrangements

In the normal course of operations, we engage in a variety of financial transactions that, in accordance with generally accepted accounting principles are not recorded in our financial statements.  These transactions involve, to varying degrees, elements of credit, interest rate and liquidity risk.  Such transactions are used primarily to manage customers’ requests for funding and take the form of loan commitments and lines of credit.

For the year ended September 30, 2010 and the six months ended March 31, 2011, we engaged in no off-balance sheet transactions reasonably likely to have a material effect on our consolidated financial condition, results of operations or cash flows.

Item 3.    Quantitative and Qualitative Disclosures About Market Risk

Interest Rate Sensitivity Analysis

Management uses an interest rate sensitivity analysis to review our level of interest rate risk. This analysis measures interest rate risk by computing changes in the present value of our cash flows from assets, liabilities and off-balance sheet items in the event of a range of assumed changes in market interest rates. The present value of equity is equal to the market value of assets minus the market value of liabilities, with adjustments made for off-balance sheet items. This analysis assesses the risk of loss in market risk sensitive instruments in the event of a sudden and sustained 50 to 300 basis point increase or a 50 to 100 basis point decrease in market interest rates with no effect given to any future steps that management might take to counter the impact of that interest rate movement. The following table presents the change in the present value of Franklin Federal’s equity at March 31, 2011 that would occur in the event of an immediate change in interest rates based on management assumptions. The table does not include the effect of approximately $30.1 million of investable assets held by Franklin Financial Corporation MHC at March 31, 2011.
 
 
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Present Value of Equity
 
Change in
 
Market
             
Basis Points
 
Value
   
$ Change
   
% Change
 
   
(Dollars in thousands)
 
-100
  $ 114,999     $ (2,978 )     (2.5 )%
-50
    116,892       (1,085 )     (0.9 )
0
    117,977       -       -  
50
    113,507       (4,470 )     (3.8 )
100
    108,842       (9,135 )     (7.7 )
200
    96,156       (21,821 )     (18.5 )
300
    85,052       (32,925 )     (27.9 )

Using the same assumptions as above, the sensitivity of our projected net interest income for the twelve months ending March 31, 2012 is as follows:

   
Projected Net Interest Income
 
Change in
 
Net Interest
             
Basis Points
 
Income
   
$ Change
   
% Change
 
   
(Dollars in thousands)
 
-100
  $ 25,212     $ (2,264 )     (8.2 )%
-50
    26,683       (793 )     (2.9 )
0
    27,476       -       -  
50
    27,368       (108 )     (0.4 )
100
    27,196       (280 )     (1.0 )
200
    26,834       (642 )     (2.3 )
300
    26,093       (1,383 )     (5.0 )

Assumptions made by management relate to interest rates, loan prepayment rates, deposit decay rates, and the market values of certain assets under differing interest rate scenarios, among others. As with any method of measuring interest rate risk, certain shortcomings are inherent in the method of analysis presented in the foregoing table. For example, although certain assets and liabilities may have similar maturities or periods to repricing, they may react in different degrees to changes in market interest rates. Also, the interest rates on certain types of assets and liabilities may fluctuate in advance of changes in market interest rates, while interest rates on other types may lag behind changes in market rates. Additionally, certain assets have features, such as rate caps or floors, that restrict changes in interest rates on a short-term basis and over the life of the asset. Further, in the event of a change in interest rates, expected rates of prepayments on loans and early withdrawals from certificates could deviate significantly from those assumed in calculating the table.

Item 4.   Controls and Procedures

The Company’s management has carried out an evaluation, under the supervision and with the participation of the Company’s principal executive officer and principal financial officer, of the effectiveness of the Company’s “disclosure controls and procedures,” as such term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934, as amended (the “Exchange Act”).  Based on this evaluation, the Company’s principal executive officer and principal financial officer concluded that, as of the end of the period covered by this report, the Company’s disclosure controls and procedures were effective for the purpose of ensuring that information required to be disclosed by the Company in reports that it files or submits under the Exchange Act (1) is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms, and (2) is accumulated and communicated to the Company’s management, including its principal executive and principal financial officers, as appropriate, to allow timely decisions regarding required disclosure.

In addition, based on that evaluation, there has been no change in the Company’s internal control over financial reporting that occurred during the Company’s last fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.
 
 
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PART II.  OTHER INFORMATION

Item 1.    Legal Proceedings

We are not involved in any pending legal proceedings other than routine legal proceedings occurring in the ordinary course of business. Our management believes that such routine legal proceedings, in the aggregate, are immaterial to our consolidated financial condition and results of operations.

Item 1A.  Risk Factors

For information regarding the Company’s risk factors, see “Risk Factors” in the Company’s prospectus, filed with the Securities and Exchange Commission pursuant to Rule 424(b)(3) on February 22, 2011.  As of March 31, 2011, the risk factors of the Company have not changed materially from those disclosed in the prospectus.

Item 2.    Unregistered Sales of Equity Securities and Use of Proceeds

The effective date of the Company’s Registration Statement on Form S-1 (File No. 333-171108) was February 11, 2011. The offering was consummated on April 27, 2011 with the sale of 13,886,250 shares of  common stock registered pursuant to the Registration Statement. Sandler O’Neill + Partners, L.P. acted as financial advisor and managed the subscription offering. The class of securities registered was common stock, par value $0.01 per share. The aggregate amount of such securities registered was 14,302,838, of which 416,588 shares were contributed to The Franklin Federal Foundation and 13,886,250 shares were sold to certain members of the MHC and the Bank’s employee stock ownership plan for aggregate proceeds of $138.9 million. As of April 30, 2011, the expenses incurred in connection with the stock offering were $3.9 million, including expenses paid to Sandler O’Neill + Partners, L.P. of $907,000, attorney and accounting fees of $1.0 million and other expenses of $2.0 million, including a contribution of $1.4 million to The Franklin Federal Foundation. The net proceeds resulting from the offering after deducting expenses were $135.0 million. The net proceeds have initially been invested in securities and cash and cash equivalents.

Item 3.    Defaults Upon Senior Securities

Not applicable.

Item 4.    [Removed and Reserved]

Item 5.    Other Information

Not applicable.

Item 6.    Exhibits
 
3.1
Articles of Incorporation of Franklin Financial Corporation (1)
3.2
Bylaws of Franklin Financial Corporation (2)
4.0
Form of Common Stock Certificate of Franklin Financial Corporation (3)
31.1
Rule 13a-14(a) Certification of Chief Executive Officer
31.2
Rule 13a-14(a) Certification of Chief Financial Officer
32
Section 1350 Certifications
 

 
 
41

 
 
(1)
Incorporated herein by reference to Exhibit 3.1 of pre-effective amendment No. 1 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), filed with the Securities and Exchange Commission on January 28, 2011.
(2)
Incorporated herein by reference to Exhibit 3.2 of pre-effective amendment No. 1 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), filed with the Securities and Exchange Commission on January 28, 2011.
(3)
Incorporated herein by reference to Exhibit 4.0 to the Company’s Registration Statement on Form S-1 (File No. 333-171108), as amended, initially filed with the Securities and Exchange Commission on December 10, 2010.
 
 
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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

 
FRANKLIN FINANCIAL CORPORATION
 
 
Registrant
 
       
May 13, 2011
By:
/s/ Richard T. Wheeler, Jr.
 
   
Richard T. Wheeler, Jr.
 
   
Chairman, President and Chief Executive Officer
 
   
(Principal Executive Officer)
 
       
May 13, 2011
By:
/s/ Donald F. Marker
 
   
Donald F. Marker
 
   
Treasurer and Corporate Secretary
 
   
(Principal Financial and Accounting Officer)
 
 
 
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