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Table of Contents

 

 

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 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

Commission File Number: 000-23667

 

 

HOPFED BANCORP, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Delaware   61-1322555

(State or other jurisdiction of

incorporation or organization)

 

(I.R.S. Employer

Identification No.)

4155 Lafayette Road,

Hopkinsville, Kentucky

  42240
(Address of principal executive offices)   (Zip Code)

Registrant’s telephone number, including area code: (270) 885-1171

 

 

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 ninety days.    Yes  x    No  ¨

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated file or a non-accelerated filer. See definition of “accelerated filer”, “large accelerated filer” and “smaller reporting company” in Rule12b-2 of the Exchange Act: (Check one)

 

Large accelerated filer   ¨    Accelerated filer   ¨
Non-accelerated filer   ¨    Smaller reporting company filer   x

Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act).    Yes  ¨    No  x.

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Date File required and posted pursuant to Rule 405 of Regulation S-T (subsection 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    YES  ¨    No  ¨

As of May 10, 2011, the Registrant had outstanding 7,336,493 shares of the Registrant’s Common Stock.

 

 

 


Table of Contents

CONTENTS

HOPFED BANCORP, INC.

 

     PAGE  

PART I. FINANCIAL INFORMATION

  
The unaudited consolidated condensed financial statements of the Registrant and its wholly owned subsidiaries are as follows:   

Item 1.

  

Financial Statements

  
  

Consolidated Condensed Statements of Financial Condition as of March 31, 2011 (unaudited) and December 31, 2010

     2   
  

Consolidated Condensed Statements of Income (Loss) for the Three-Month Periods Ended March 31, 2011, and March 31, 2010 (unaudited)

     4   
  

Consolidated Condensed Statements of Comprehensive Income (Loss) for the Three-Month Periods Ended March 31, 2011, and March 31, 2010 (unaudited)

     6   
  

Consolidated Condensed Statement of Stockholders’ Equity for the Three-Month Period Ended March 31, 2011 (unaudited)

     7   
  

Consolidated Condensed Statements of Cash Flows for the Three-Month Periods Ended March 31, 2011, and March 31, 2010 (unaudited)

     8   
  

Notes to Unaudited Consolidated Condensed Financial Statements

     9   

Item 2.

  

Management’s Discussion and Analysis of Financial Condition and Results of Operations

     36   

Item 3.

  

Quantitative and Qualitative Disclosures About Market Risk

     46   

Item 4.

  

Controls and Procedures

     46   

PART II OTHER INFORMATION

  

Item 1.

   Legal Proceedings      47   

Item 1A.

   Risk Factors      47   

Item 2.

   Unregistered Sales of Equity Securities and Use of Proceeds      47   

Item 3.

   Defaults Upon Senior Securities      48   

Item 4.

   Removed and Reserved      48   

Item 5.

   Other Information      48   

Item 6.

   Exhibits      48   

SIGNATURES

     48   

 

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Table of Contents

PART I. FINANCIAL INFORMATION

 

Item 1. Financial Statements

HOPFED BANCORP, INC.

Consolidated Condensed Statements of Financial Condition

(Dollars in Thousands)

 

     March 31, 2011      December 31, 2010  
     (Unaudited)         
Assets      

Cash and due from banks

   $ 53,586         54,042   

Interest-earning deposits in Federal Home Loan Bank

     20,583         6,942   
                 

Cash and cash equivalents

     74,169         60,984   

Federal Home Loan Bank stock, at cost

     4,378         4,378   

Securities available for sale

     356,117         357,738   

Loans receivable, net of allowance for loan losses of $13,944 at March 31, 2011, and $9,830 at December 31, 2010

     580,729         600,215   

Accrued interest receivable

     5,790         6,670   

Real estate and other assets owned

     9,008         9,812   

Bank owned life insurance

     8,908         8,819   

Premises and equipment, net

     23,874         24,289   

Deferred tax assets

     5,497         3,788   

Intangible asset

     730         810   

Other assets

     4,843         5,088   
                 

Total assets

   $ 1,074,043       $ 1,082,591   
                 
Liabilities and Stockholders’ Equity      

Liabilities:

     

Deposits:

     

Non-interest-bearing accounts:

   $ 72,503       $ 69,139   

Interest-bearing accounts:

     

NOW accounts

     135,785         138,936   

Savings and money market accounts

     67,012         63,848   

Other time deposits

     558,603         555,006   
                 

Total deposits

     833,903         826,929   

Advances from Federal Home Loan Bank

     70,933         81,905   

Repurchase agreements

     44,055         45,110   

Subordinated debentures

     10,310         10,310   

Advances from borrowers for taxes and insurance

     348         239   

Dividends payable

     613         613   

Accrued expenses and other liabilities

     5,587         6,041   
                 

Total liabilities

     965,749         971,147   
                 

See accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

 

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HOPFED BANCORP, INC.

Consolidated Condensed Statements of Financial Condition, Continued

(Dollars in Thousands)

 

     March 31, 2011     December 31, 2010  
     (Unaudited)        

Stockholders’ equity:

    

Preferred stock, par value $0.01 per share; authorized - 500,000 shares; 18,400 shares issued and outstanding with a liquidation preference of $18,400,000 at March 31, 2011, and December 31, 2010

     —          —     

Common stock, par value $.01 per share; authorized 15,000,000 shares; 7,738,643 issued and 7,335,727 outstanding at March 31, 2011, and 7,737,879 issued and 7,334,963 outstanding at December 31, 2010

     77        77   

Common stock warrants

     556        556   

Additional paid-in-capital

     74,978        74,920   

Retained earnings-substantially restricted

     37,306        39,994   

Treasury stock (at cost, 402,916 shares at March 31, 2011, and December 31, 2010)

     (5,076     (5,076

Accumulated other comprehensive income, net of taxes

     453        973   
                

Total stockholder’s equity

     108,294        111,444   
                

Total liabilities and stockholders’ equity

   $ 1,074,043        1,082,591   
                

The consolidated condensed statement of financial condition at December 31, 2010, has been derived from the audited financial statements of that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements.

See accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

 

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Table of Contents

HOPFED BANCORP, INC.

Consolidated Condensed Statements of Income (Loss)

(Dollars in Thousands)

(Unaudited)

 

     For the Three Month Periods
Ended March 31,
 
     2011     2010  

Interest and dividend income:

    

Loans receivable

   $ 8,482        9,621   

Investment in securities, taxable

     2,690        2,922   

Nontaxable securities available for sale

     611        563   

Interest-earning deposits

     4        —     
                

Total interest and dividend income

     11,787        13,106   
                

Interest expense:

    

Deposits

     3,905        4,591   

Advances from Federal Home Loan Bank

     694        856   

Repurchase agreements

     205        202   

Subordinated debentures

     185        183   
                

Total interest expense

     4,989        5,832   
                

Net interest income

     6,798        7,274   

Provision for loan losses

     4,518        611   
                

Net interest income after provision for loan losses

     2,280        6,663   
                

Non-interest income:

    

Service charges

     856        985   

Merchant card income

     182        160   

Gain on sale of loans

     72        84   

Gain on sale of securities

     721        494   

Other than temporarily impairment on available for sale securities

     (14     —     

Income from bank owned life insurance

     89        89   

Financial services commission

     187        197   

Other operating income

     272        300   
                

Total non-interest income

     2,365        2,309   
                

See accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

 

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HOPFED BANCORP, INC.

Consolidated Condensed Statements of Income (Loss), Continued

(Dollars in Thousands, Except Per Share Amounts)

(Unaudited)

 

     For the Three Month Periods
Ended March 31,
 
     2011     2010  

Non-interest expenses:

    

Salaries and benefits

   $ 3,326        3,230   

Occupancy expense

     788        789   

Data processing expense

     687        689   

State deposit tax

     168        157   

Intangible amortization expense

     81        97   

Professional services expense

     315        252   

Deposit insurance and examination expense

     592        381   

Advertising expense

     279        241   

Postage and communications expense

     148        135   

Supplies expense

     96        93   

Loss on disposal of equipment

     138        —     

Loss on real estate owned

     509        (25

Expenses related to real estate owned

     73        120   

Other operating expenses

     249        227   
                

Total non-interest expense

     7,449        6,386   
                

Income (loss) before income tax expense

     (2,804     2,586   

Income tax expense (benefit)

     (960     726   
                

Net income (loss)

     (1,844     1,860   
                

Less:

    

Dividend on preferred shares

     227        227   

Accretion dividend on preferred shares

     27        27   
                

Net income (loss) available (attributable) to common stockholders

     ($2,098   $ 1,606   
                

Net income (loss) available (attributable) to common stockholders

    

Per share, basic

     ($0.29   $ 0.44   
                

Per share, diluted

     ($0.29   $ 0.44   
                

Dividend per share

     $0.08      $ 0.12   
                

Weighted average shares outstanding - basic

     7,318,703        3,649,634   
                

Weighted average shares outstanding - diluted

     7,318,703        3,649,634   
                

Share and per share data for March 31, 2010, adjusted to reflect 2% common stock dividend paid to shareholders of record as of September 30, 2010.

See accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

 

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HOPFED BANCORP, INC.

Consolidated Condensed Statements of Comprehensive Income (Loss)

(Dollars in Thousands)

(Unaudited)

 

     For the Three Month  Periods
Ended March 31,
 
     2011     2010  

Net income (loss)

     ($1,844     1,860   

Other comprehensive income (loss), net of tax:

    

Unrealized gain (loss) on investment securities available for sale, net of tax effect of $64 and ($656) for the three months ended March 31, 2011, and March 31, 2010, respectively

     (123     1,273   

Unrealized gain on derivatives, net of tax effect of ($42) and $50 for the three month periods ending March 31, 2011 and March 31, 2010, respectively.

     79        (97

Reclassification adjustment for gains included in net income (loss), net of tax effect of $245 and $168 for the three month periods ended March 31, 2011 and March 31, 2010, respectively.

     (476     (326
                

Comprehensive income (loss)

     ($2,364     2,710   
                

See accompanying Notes to Unaudited Consolidated Condensed Financial Statements.

 

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HOPFED BANCORP, INC.

Consolidated Condensed Statement of Stockholders’ Equity

For the Three Month Period Ended March 31, 2011

(Dollars in Thousands, Except Share Amounts)

(Unaudited)

 

                                                    Accumulated        
     Shares             Common      Additional                  Other     Total  
     Common
Stock
     Preferred
Stock
     Common
Stock
     Stock
Warrants
     Capital
Surplus
     Retained
Earnings
    Treasury
Stock
    Comprehensive
Income
    Stockholders
Equity
 

Balance at December 31, 2010

     7,334,963         18,400       $ 77         556         74,920         39,994        (5,076     973        111,444   

Restricted stock awards

     764         —           —           —           —           —          —          —          —     

Consolidated net income

     —           —           —           —           —           (1,844     —          —          (1,844

Compensation expense, restricted stock awards

     —           —           —           —           31         —          —          —          31   

Net change in unrealized gain on securities available for sale, net of income taxes of $309

     —           —           —           —           —           —          —          (599     (599

Net change in unrealized gain (loss) on derivatives, net of income taxes of $42

     —           —           —           —           —           —          —          79        79   

Dividend to preferred stockholder

     —           —           —           —           —           (230     —          —          (230

Accretion of preferred stock discount

     —           —           —           —           27         (27     —          —          —     

Dividend to common stockholders

     —           —           —           —           —           (587     —          —          (587
                                                                             

Balance March 31, 2011

     7,335,727         18,400       $ 77         556         74,978         37,306        (5,076     453        108,294   
                                                                             

See accompanying Notes to Unaudited Consolidated Condensed Financial Statements

 

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HOPFED BANCORP, INC.

Consolidated Condensed Statements of Cash Flows

(Dollars in Thousands)

(Unaudited)

 

     For the Three Month Period
Ended March 31,
 
     2011     2010  

Cash flows from operating activities:

    

Net cash provided by operating activities

   $ 3,028        3,657   
                

Cash flows from investing activities

    

Proceeds from sales, calls and maturities of securities available for sale

     46,006        24,037   

Purchase of securities available for sale

     (45,225     (58,723

Net (increase) decrease in loans

     14,474        (3,565

Purchase of Federal Home Loan Bank stock

     —          (98

Proceeds from sale of foreclosed assets

     789        1,322   

Purchase of premises and equipment

     (126     (40
                

Net cash provided by (used in) investing activities

     15,918        (37,067
                

Cash flows from financing activities:

    

Net increase (decrease) in demand deposits

     3,377        (1,761

Net increase in time and other deposits

     3,597        25,156   

Increase (decrease) in advances from borrowers for taxes and insurance

     109        (13

Advances from Federal Home Loan Bank

     —          5,000   

Repayment of advances from Federal Home Loan Bank

     (10,972     (10,003

Net increase (decrease) in repurchase agreements

     (1,055     2,285   

Dividend paid on preferred stock

     (230     (230

Dividends paid on common stock

     (587     (432
                

Net cash provided by (used in) financing activities

     (5,761     20,002   
                

Increase (decrease) in cash and cash equivalents

     13,185        (13,408

Cash and cash equivalents, beginning of period

     60,984        41,111   
                

Cash and cash equivalents, end of period

   $ 74,169        27,703   
                

Supplemental disclosures of Cash Flow Information:

    

Interest paid

     2,376        3,017   
                

Income taxes paid

     445        1,345   
                

Supplemental disclosures of non-cash investing and financing activities:

    
                

Loans charged off

     602        956   
                

Foreclosures and in substance foreclosures of loans during period

     494        2,047   
                

Net unrealized gains (losses) on investment securities classified as available for sale

     (908     1,435   
                

(Increase) decrease in deferred tax asset related to unrealized gains on investments

     309        (488
                

Dividends declared and payable

     613        432   
                

Issue of unearned restricted stock

     7        5   
                

See accompanying Notes to Unaudited Consolidated Condensed Financial Statements

 

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NOTES TO UNAUDITED CONSOLIDATED CONDENSED FINANCIAL STATEMENTS

 

(1) BASIS OF PRESENTATION

HopFed Bancorp, Inc. (the “Company”) was formed at the direction of Heritage Bank, formerly Hopkinsville Federal Savings Bank (the “Bank”), to become the holding company of the Bank upon the conversion of the Bank from a federally chartered mutual savings bank to a federally chartered stock savings bank. The conversion was consummated on February 6, 1998. The Company’s primary assets are the outstanding capital stock of the converted Bank, and its sole business is that of the converted Bank. The Bank owns 100% of the stock of Fall and Fall Insurance Agency (Fall & Fall) of Fulton, Kentucky. Fall & Fall sells life and casualty insurance to both individuals and businesses. The majority of Fall & Fall’s customer base is within the geographic footprint of the Bank.

The Bank operates a mortgage division, Heritage Mortgage Services, in Clarksville, Tennessee with agents located in several of its markets. The Bank has a financial services division, Heritage Solutions, with offices in Murray, Kentucky, Kingston Springs, Tennessee and Pleasant View, Tennessee. Heritage Solutions agents travel throughout western Kentucky and middle Tennessee offering fixed and variable annuities, mutual funds and brokerage services.

The accompanying unaudited financial statements have been prepared in accordance with accounting principles generally accepted (“GAAP”) in the United States of America for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by U.S. GAAP for complete financial statements. In the opinion of management, all adjustments (consisting of only normal recurring accruals) necessary for fair representation have been included. The results of operations and other data for the three month period ended March 31, 2011, are not necessarily indicative of results that may be expected for the entire fiscal year ending December 31, 2011.

The accompanying unaudited financial statements should be read in conjunction with the Consolidated Financial Statements and the Notes thereto included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2010. The accounting policies followed by the Company are set forth in the Summary of Significant Accounting Policies in the Company’s December 31, 2010, Consolidated Financial Statements.

 

(2) INCOME PER SHARE

The following schedule reconciles the numerators and denominators of the basic and diluted income per share (“IPS”) computations for the three month periods ended March 31, 2011, and March 31, 2010. Diluted common shares arise from the potentially dilutive effect of the Company’s stock options and warrants outstanding. Outstanding share amounts for the three month period ended March 31, 2010, were adjusted to reflect a 2% common stock dividend paid to shareholders of record as of September 30, 2010.

 

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     Three Month Periods Ended  
     2011     2010  

Basic IPS:

    

Net income (loss) available (attributable) to common stockholders

     ($2,098,000   $ 1,606,000   

Average common shares outstanding

     7,318,703        3,649,634   
                

Net income (loss) per share available (attributable) to common shareholders, basic

     ($0.29   $ 0.44   
                

Diluted IPS

    

Net income (loss) available (attributable) to common stockholders

     ($2,098,000   $ 1,606,000   

Average common shares outstanding

     7,318,703        3,649,634   

Dilutive effect of stock options

     —          —     
                

Average diluted shares outstanding

     7,318,703        3,649,634   
                

Net income (loss) per share available (attributable) to common shareholders, diluted

     ($0.29   $ 0.44   
                

 

(3) STOCK COMPENSATION

The Company incurred compensation cost related to the HopFed Bancorp, Inc. 2004 Long Term Incentive Plan of $31,000 and $36,000 for the three month periods ended March 31, 2011, and March 31, 2010, respectively. The Company issued 764 shares of restricted stock during the three month period ended March 31, 2011. The table below provides a detail of the Company’s future compensation expense related to restricted stock vesting at March 31, 2011:

 

      Future
Expense
 

Year Ending December 31,

  

2011

   $ 75,379   

2012

     67,974   

2013

     35,185   

2014

     11,933   

2015

     117   
        

Total

   $ 190,588   
        

The compensation committee may make additional awards of restricted stock, thereby increasing the future expense related to this plan. In addition, award vesting may be accelerated due to certain events as outlined in the restricted stock award agreement. Any acceleration of vesting will change the timing of, but not the aggregate amount of, compensation expense incurred.

 

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(4) SECURITIES

Management evaluates securities for other-than-temporary impairment at least on a quarterly basis, and more frequently when economic or market concerns warrant such evaluations. Consideration is given to (1) the length of time and the extent to which the fair value has been less than cost, (2) the financial condition and near-term prospects of the issuer, and (3) the intent and ability of the Company to retain its investment in the issuer for a period of time sufficient to allow for any anticipated recovery in fair value.

After conducting a review of the Company’s Non-Agency CMO portfolio, we determined that one security had potential credit losses not previously indentified. As such, we determined that a $14,000 other than temporary impairment charge was necessary.

At March 31, 2011, the Company has 100 securities with unrealized losses. The carrying amount of securities and their estimated fair values at March 31, 2011, is as follows:

 

     March 31, 2011  
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Estimated
Fair
Value
 
     (Dollars in Thousands)  

Restricted:

          

FHLB stock

   $ 4,378         —           —          4,378   
                                  

Unrestricted:

          

U.S. government and agency securities:

          

Agency debt securities

   $ 158,324         2,207         (1,918     158,613   

Taxable municipal bonds

     18,770         145         (284     18,631   

Tax free municipal bonds

     67,985         1,080         (755     68,310   

Trust preferred securities

     2,000         —           (761     1,239   

Mortgage-backed securities:

          

GNMA

     27,578         624         (267     27,935   

FNMA

     41,320         1,110         (65     42,365   

FHLMC

     16,759         354         (39     17,074   

NON-AGENCY CMOs

     2,531         10         (205     2,336   

AGENCY CMOs

     19,196         496         (78     19,614   
                                  
   $ 354,463         6,026         (4,372     356,117   
                                  

 

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The carrying amount of securities and their estimated fair values at December 31, 2010, is as follows:

 

     December 31, 2010  
     Amortized
Cost
     Gross
Unrealized
Gains
     Gross
Unrealized
Losses
    Estimated
Fair
Value
 
     (Dollars in Thousands)  

Restricted:

          

FHLB stock

   $ 4,378         —           —          4,378   
                                  

Unrestricted:

          

U.S. government and agency securities:

   $ 163,365         2,921         (1,882     164,404   

Tax free municipal bonds

     64,967         481         (1,055     64,393   

Taxable municipal bonds

     17,037         105         (350     16,792   

Trust preferred securities

     2,000         —           (723     1,277   

Mortgage-backed securities:

          

GNMA

     30,325         873         (184     31,014   

FNMA

     27,324         1,247         (23     28,548   

FHLMC

     19,059         413         (29     19,443   

NON-AGENCY CMOs

     3,711         38         (205     3,544   

AGENCY CMOs

     27,388         1,039         (104     28,323   
                                  
   $ 355,176         7,117         (4,555     357,738   
                                  

 

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The scheduled maturities of debt securities available for sale at March 31, 2011, were as follows:

 

March 31, 2011

   Amortized
Cost
     Estimated
Fair
Value
 
     (Dollars in Thousands)  

Due within one year

   $ 635         630   

Due in one to five years

     13,418         13,505   

Due in five to ten years

     24,821         24,999   

Due after ten years

     95,303         94,757   
                 
     134,177         133,891   

Amortizing agency bonds

     112,902         112,902   

Mortgage-backed securities

     107,384         109,324   
                 

Total unrestricted securities available for sale

   $ 354,463         356,117   
                 

The scheduled maturities of debt securities available for sale at December 31, 2010, were as follows:

 

December 31, 2010

   Amortized
Cost
     Estimated
Fair
Value
 
     (Dollars in Thousands)  

Due within one year

   $ 778         773   

Due in one to five years

     6,699         6,772   

Due in five to ten years

     21,825         22,069   

Due after ten years

     88,180         86,836   
                 
     117,482         116,450   

Amortizing agency bonds

     129,887         130,416   

Mortgage-backed securities

     107,807         110,872   
                 

Total unrestricted securities available for sale

   $ 355,176         357,738   
                 

 

 

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The estimated fair value and unrealized loss amounts of temporarily impaired investments as of March 31, 2011, are as follows:

 

     Less than 12 months     12 months or longer     Total  
     Estimated
Fair Value
     Unrealized
Losses
    Estimated
Fair Value
     Unrealized
Losses
    Estimated
Fair Value
     Unrealized
Losses
 
     (Dollar in Thousands)  

Available for sale

               

U.S. government and agency securities:

               

Agency debt securities

   $ 92,693         (1,918     —           —          92,693         (1,918

Taxable municipals

     10,478         (284     —           —          10,478         (284

Tax free municipals

     25,408         (752     198         (3     25,606         (755

Trust preferred securities

     —           —          1,239         (761     1,239         (761

Mortgage-backed securities:

               

GNMA

     11,432         (267     —           —          11,432         (267

FNMA

     9,806         (63     83         (2     9,889         (65

FHLMC

     6,610         (39     —           —          6,610         (39

NON-AGENCY CMOs

     —           —          1,948         (205     1,948         (205

AGENCY CMOs

     4,935         (78     —           —          4,935         (78
                                                   

Total Available for Sale

   $ 161,362         (3,401     3,468         (971     164,830         (4,372
                                                   

The estimated fair value and unrealized loss amounts of temporarily impaired investments as of December 31, 2010, are as follows:

 

     Less than 12 months     12 months or longer     Total  
     Estimated
Fair Value
     Unrealized
Losses
    Estimated
Fair Value
     Unrealized
Losses
    Estimated
Fair Value
     Unrealized
Losses
 
     (Dollars in Thousands)  

Available for sale

               

U.S. government and agency securities:

               

Agency debt securities

   $ 90,716         (1,882     —           —          90,716         (1,882

Taxable municipal bonds

     10,207         (345     445         (5     10,652         (350

Tax free municipal bonds

     31,411         (885     5,225         (170     36,636         (1,055

Trust preferred securities

     —           —          1,277         (723     1,277         (723

Mortgage-backed securities:

               

GNMA

     11,871         (184     —           —          11,871         (184

FNMA

     3,104         (22     85         (1     3,189         (23

FHLMC

     8,316         (29     —           —          8,316         (29

NON-AGENCY CMOs

     —           —          2,149         (205     2,149         (205

AGENCY CMOs

     5,028         (104     —           —          5,028         (104
                                                   

Total Available for Sale

   $ 160,653         (3,451     9,181         (1,104     169,834         (4,555
                                                   

 

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Table of Contents

At March 31, 2011, securities with a book value of approximately $131.3 million and a market value of approximately $132.9 million were pledged to various municipalities for deposits in excess of FDIC limits as required by law. In addition, securities with a book value of $10.6 million and a market value of $11.3 million are pledged as collateral to the Federal Home Loan Bank of Cincinnati. The Federal Home Loan Bank of Cincinnati has issued letters of credit in the Bank’s name totaling $29.3 million secured by the Bank’s loan portfolio to secure additional municipal deposits.

At March 31, 2011, securities with a book and market value of approximately $28.1 million were sold under agreements to repurchase from various customers. Furthermore, the Company has two wholesale repurchase agreements with third parties secured by investments with a combined book value of $18.7 million and a market value of $18.6 million. One repurchase agreement is in the amount of $6.0 million and has a maturity of September 18, 2016 and is currently callable on a quarterly basis and has a fixed rate of interest of 4.36%. The second repurchase agreement, in the amount of $10.0 million, has a maturity of September 5, 2014, is currently callable quarterly and has a fixed rate of interest of 4.28%.

 

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Table of Contents
(5) LOANS

Set forth below is selected data relating to the composition of the loan portfolio by type of loan at March 31, 2011, and December 31, 2010. At March 31, 2011, and December 31, 2010, there were no concentrations of loans exceeding 10% of total loans other than as disclosed below:

 

     March 31, 2011
Amount
    March 31, 2011
Percent
    December 31, 2010
Amount
    December 31, 2010
Percent
 
     (Dollars in Thousands)  

Real estate loans:

        

One-to-four family (closed end) first mortgages

   $ 181,065        30.5   $ 182,671        30.0

Second mortgages (closed end)

     6,865        1.2     6,196        1.0

Home equity lines of credit

     39,207        6.6     40,191        6.6

Multi-family

     28,664        4.8     29,416        4.8

Construction

     20,164        3.4     23,361        3.8

Land

     59,414        10.0     60,063        9.9

Non-residential real estate

     191,673        32.2     195,285        32.0
                                

Total mortgage loans

     527,052        88.7     537,183        88.1

Consumer loans

     17,218        2.9     18,060        3.0

Commercial loans

     50,076        8.4     54,439        8.9
                                

Total other loans

     67,294        11.3     72,499        11.9
                                

Total loans, gross

     594,346        100.0     609,682        100.0
                    

Deferred loan cost, net of income

     327          363     

Less allowance for loan losses

     (13,944       (9,830  
                    

Total loans

   $ 580,729        $ 600,215     
                    

 

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The Bank assigns an industry standard NAICS code to each loan in the Bank’s portfolio. By assigning a standard code to each type of loan, management can more readily determine concentrations in risk by industry, location and loan type. This information is most useful when analyzing the Bank’s non-residential real estate loan portfolio. At March 31, 2011, and December 31, 2010, the Bank’s non-residential real estate loan portfolio was made up of the following loan types:

 

     Balance
March 31, 2011
     Balance
December 31, 2010
 
     (Dollars in Thousands)  

Land & development

   $ 59,414         60,063   

Construction

     5,511         5,179   

Manufacturing

     5,023         5,358   

Professional and Technical

     2,272         2,440   

Retail Trade

     12,341         12,664   

Other Services

     18,930         20,200   

Finance & Insurance

     140         144   

Agricultural, Forestry, Fishing & Hunting

     35,525         40,655   

Real Estate and Rental and Leasing

     49,945         49,017   

Wholesale Trade

     9,761         7,779   

Arts, Entertainment & Recreation

     5,766         5,981   

Accomodations / Food Service

     26,219         26,439   

Healthcare and Social Assistance

     10,430         10,588   

Educational Services

     36         38   

Transportation & Warehousing

     1,739         1,771   

Information

     3,042         3,099   

Public Administration

     323         119   

Non-industry

     3,380         3,426   

Admin Support / Waste Mgmt

     1,290         388   
                 

Total

     251,087         255,348   
                 

The allowance for loan losses totaled $13.9 million at March 31, 2011, $9.8 million at December 31, 2010, and $8.6 million at March 31, 2010. The ratio of the allowance for loan losses to total loans was 2.34% at March 31, 2011, 1.61% at December 31, 2010, and 1.33% at March 31, 2010. The following table indicates the type and level of non-accrual loans at the periods indicated below:

 

     March 31, 2011     December 31, 2010     March 31, 2010  
     (Dollars in Thousands)  

One-to-four family first mortgages

   $ 2,178        1,559        1,536   

Home equity lines of credit

     190        103        10   

Multi-family

     300        301        3,363   

Construction

     1,483        1,541        535   

Land

     851        363        3,522   

Non-residential real estate

     626        1,043        1,386   

Consumer loans

     114        23        51   

Commercial loans

     347        97        392   
                        

Total non-accrual loans

   $ 6,089        5,030        10,795   
                        

Non-accrual loans to total loans

     1.02     0.82     1.66
                        

 

 

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The table below presents past due and non-accrual balances at March 31, 2011, by loan classification allocated between performing and non-performing:

 

     Currently
Performing
     30 -  89
Days
Past Due
     Non-accrual
Loans
     Special
Mention
     Impaired Loans
Currently Performing
        
                 Substandard      Doubful      Total  
     (Dollars in Thousands)  

One-to-four family mortgages

     160,777         1,756         2,178         8,574         7,780         —           181,065   

Home equity line of credit

     36,960         196         190         1,179         490         192         39,207   

Junior liens

     5,426         —           —           405         1,034         —           6,865   

Multi-family

     22,023         —           300         4,124         2,217         —           28,664   

Construction

     9,730         —           1,483         5,303         3,648         —           20,164   

Land

     15,227         1,305         851         24,371         17,660         —           59,414   

Non-residential real estate

     157,542         241         626         10,111         22,997         156         191,673   

Consumer assets owned by bank

     16,436         69         114         251         348         —           17,218   

Commercial loans

     41,588         315         347         3,207         4,603         16         50,076   
                                                              

Total

     465,709         3,882         6,089         57,525         60,777         364         594,346   
                                                              

All loans listed as 30-89 days past due and non-accrual are not performing as agreed. Loans listed as special mentioned, substandard and doubtful are paying as agreed. However, the customer’s financial statements may indicate weaknesses in their current cash flow, the customer’s industry may be in decline due to current economic conditions, collateral values used to secure the loan may be declining, or the Company may be concerned about the customer’s future business prospects.

The Bank does not originate loans it considers sub-prime and is not aware of any exposure to the additional credit concerns associated with sub-prime lending in either the Company’s loan or investment portfolios. The Company does have a significant amount of construction and land development loans. Management reports to the Company’s Board of Directors on the status of the Company’s specific construction and development loans as well as the market trends in those markets in which the Company actively participates.

 

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Table of Contents

The Company’s annualized net charge off ratios for three month periods ended March 31, 2011, March 31, 2010, and the year ended December 31, 2010, was 0.27%, 0.50% and 0.78%, respectively. The ratios of allowance for loan losses to non-accrual loans at March 31, 2011, March 31, 2010, and December 31, 2010, were 228.96%, 80.03%, and 195.43% respectively. The following table sets forth an analysis of the Bank’s allowance for loan losses for the periods ended:

 

     March 31, 2011     December 31, 2010     March 31, 2010  
     (Dollars in Thousands, Except Percentages)  

Beginning balance, allowance for loan loss

   $ 9,830        8,851        8,851   

Charge offs:

      

One-to-four family mortgages

     (227     (403     (87

Home equity line of credit

     —          (61     —     

Junior liens

     —          —          —     

Multi-family

     —          (1,605     (366

Construction

     (60     (751     (255

Land

     (148     (265     (25

Non-residential real estate

     (67     (1,252     (77

Consumer loans

     (100     (472     (123

Commercial loans

     —          (481     (23
                        

Total charge offs

     (602     (5,290     (956
                        

Recoveries:

      

One-to-four family mortgages

     82        10        —     

Home equity line of credit

     —          1        —     

Junior liens

     —          5        5   

Multi-family

     —          85        —     

Construction

     —          —          —     

Land

     —          3        —     

Non-residential real estate

     84        —          32   

Consumer loans

     32        184        70   

Commercial loans

     —          11        26   
                        

Total recoveries

     198        299        133   
                        

Net charge offs

     (404     (4,991     (823
                        

Provision for loan losses

     4,518        5,970        611   
                        

Ending balance

   $ 13,944        9,830        8,639   
                        

Average loan balance, gross

   $ 592,517        638,378        642,615   
                        

Ratio of net charge offs to average outstanding loans during the period

     0.27     0.78     0.50
                        

The determination of the allowance for loan losses is based on management’s analysis, performed on a quarterly basis. Various factors are considered, including the market value of the underlying collateral, growth and composition of the loan portfolio, the relationship of the allowance for loan losses to outstanding loans, historical loss experience, delinquency trends and prevailing economic conditions. Although management believes its allowance for loan losses is adequate, there can be no assurance that additional allowances will not be required or that losses on loans will not be incurred.

 

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Table of Contents

The Company conducts annual reviews on all loan relationships above $1.0 million to ascertain the borrowers continued ability to service their debt as agreed. In addition to the credit relationships mentioned above, management may classify any credit relationship once we become aware of adverse credit trends for that customer. Typically, the annual review consists of updated financial statements for both the borrowers and any guarantors, a review of the borrower’s credit history with the Company and other creditors, and current income tax information.

As a result of this review, management will classify loans based on their credit risk. Additionally, the Company provides a risk grade for all loans past due more than sixty days. The Company uses the following risk definitions for risk grades:

Satisfactory loans of average strength having some deficiency or vulnerability to changing economic or industry conditions. These customers should have reasonable amount of capital and operating ratios. Secured loans may lack in margin or liquidity. Loans to individuals, perhaps supported in dollars of net worth, but with supporting assets may be difficult to liquidate.

Watch loans are acceptable credits: (1) that need continual monitoring, such as out-of territory or asset-based loans (since the bank does not have an asset-based lending department), or (2) with a marginal risk level to business concerns and individuals that; (a) have exhibited favorable performance in the past, though currently experiencing negative trends; (b) are in an industry that is experiencing volatility or is declining, and their performance is less than industry norms; and (c) are experiencing unfavorable trends in their financial position, such as one-time net losses or declines in asset values. These marginal borrowers may have early warning signs of problems such as occasional overdrafts and minor delinquency. If considered marginal, a loan would be a “watch” until financial data demonstrated improved performance or further deterioration to a “substandard” grade usually within a 12-month period. In the table on page 22, Watch loans are included with Satisfactory loans and classified as Pass.

Other Loans Especially Mentioned are currently protected but are potentially weak. These loans constitute an undue and unwarranted credit risk but not to the point of justifying a substandard classification. The credit risk may be relatively minor yet constitutes an unwarranted risk in light of the circumstances surrounding a specific loan. These credit weaknesses, if not checked or corrected, will weaken the loan or inadequately protect the bank’s credit position at some future date.

 

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Table of Contents

A Substandard loan is inadequately protected by the current sound worth and paying capacity of the obligor or of the collateral pledged. Loans so classified have a well-defined weakness or weaknesses that jeopardize the liquidation of the debt. The loans are characterized by the distinct possibility that the bank will sustain some loss if the deficiencies are not corrected. This does not imply ultimate loss of the principal, but may involve burdensome administrative expenses and the accompanying cost to carry the credit. Examples of substandard loans include those to borrowers with insufficient or negative cash flow, negative net worth coupled with inadequate guarantor support, inadequate working capital, and/or significantly past-due loans and overdrafts.

A loan classified Doubtful has all the weaknesses inherent in a substandard credit except that the weaknesses make collection or liquidation in full (on the basis of currently existing facts, conditions, and values) highly questionable and improbable. The possibility of loss is extremely high, but because of certain pending factors charge-off is deferred until its more exact status may be determined. Pending factors include proposed merger, acquisition, or liquidation procedures, capital injection, perfecting liens on additional collateral, and refinancing plans. The doubtful classification is applied to that portion of the credit in which the full collection of principal and interest is questionable.

A loan is considered to be impaired when management determines that it is possible that the Company will be unable to collect all principal and interest payments due in accordance with the contractual terms of the loan agreement. The value of individually impaired loans is measured based on the present value of expected payments using the fair value of the collateral if the loan is collateral dependent. Currently, it is management’s practice to classify all substandard or doubtful loans as impaired. At March 31, 2011, December 31, 2010 and March 31, 2010, the Company’s impaired loans totaled $67.2 million, $58.6 million and $35.4 million, respectively. At March 31, 2011, December 31, 2010, and March 31, 2010, the Company’s reserve for impaired loans totaled $6.6 million, $4.3 million and $1.7 million, respectively.

 

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A summary of the Company’s impaired loans, including their respective regulatory classification and their respective specific reserve at March 31, 2011, were as follows:

March 31, 2011

   Pass      Special
Mention
     Impaired Loans      Total      Specific
Reserve
for
Impairment
     Reserve
for
Performing
Loans
 
         Substandard      Doubful           
                   (Dollars in Thousands)                       

One-to-four family mortgages

   $ 162,533         8,574         9,849         109         181,065         366         958   

Home equity line of credit

     37,156         1,179         611         261         39,207         201         276   

Junior liens

     5,426         405         1,034         —           6,865         276         191   

Multi-family

     22,023         4,124         2,217         300         28,664         461         335   

Construction

     9,730         5,303         5,131         —           20,164         280         439   

Land

     16,532         24,371         18,511         —           59,414         1,124         1,072   

Non-residential real estate

     157,783         10,111         23,326         453         191,673         3,248         3,346   

Consumer assets owned by bank

     16,505         251         462         —           17,218         108         631   

Commercial loans

     41,903         3,207         4,935         31         50,076         486         146   
                                                        

Total

   $ 469,591         57,525         66,076         1,154         594,346         6,550         7,394   
                                                              

A summary of the Company’s impaired loans and their respective reserve at December 31, 2010, were as follows:

 

December 31, 2010

   Pass      Special
Mention
     Impaired Loans      Total      Specific
Reserve
for
Impairment
     Reserve
for
Performing
Loans
 
         Substandard      Doubful           
                   (Dollars in Thousands)                       

One-to-four family mortgages

   $ 165,864         8,121         8,388         298         182,671         350         746   

Home equity line of credit

     39,129         499         333         230         40,191         105         69   

Junior liens

     5,514         495         187         —           6,196         77         107   

Multi-family

     26,098         —           3,017         301         29,416         178         1,843   

Construction

     16,164         3,292         3,702         203         23,361         108         549   

Land

     29,858         16,930         13,275         —           60,063         588         276   

Non-residential real estate

     160,995         11,089         22,780         421         195,285         2,540         1,489   

Consumer assets owned by bank

     17,492         205         363         —           18,060         85         22   

Commercial loans

     47,016         2,314         5,092         17         54,439         255         443   
                                                              

Total

   $ 508,130         42,945         57,137         1,470         609,682         4,286         5,544   
                                                              

 

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Table of Contents

Impaired loans by classification type and the related valuation allowance amounts at March 31, 2011, were as follows:

 

     At March 31, 2011      For the three-month period
ended March 31, 2011
 
Impaired loans with no recorded reserve    Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment
     Interest
Income
Recognized
 

One-to-four family mortgages

     6,896         6,896         —           6,997         95   

Home equity line of credit

     352         352         —           386         6   

Junior liens

     160         160         —           80         3   

Multi-family

     666         666         —           1,061         14   

Construction

     2,404         2,404         —           1,821         —     

Land

     15,137         15,137         —           13,156         196   

Non-residential real estate

     11,325         11,325         —           12,260         189   

Consumer assets owned by bank

     99         99         —           75         3   

Commercial loans

     4,077         4,077         —           4,327         7   
                                            

Total

     41,116         41,116         —           40,163         513   
                                            
     At March 31, 2011      For the three-month period
ended March 31, 2011
 
Impaired loans with recorded reserve    Recorded
Investment
     Unpaid
Principal
Balance
     Related
Allowance
     Average
Recorded
Investment
     Interest
Income
Recognized
 

One-to-four family mortgages

     3,062         3,062         366         2,326         28   

Home equity line of credit

     520         520         201         332         5   

Junior liens

     874         874         276         531         9   

Multi-family

     1,851         1,851         461         1,857         26   

Construction

     2,727         2,727         280         2,697         39   

Land

     3,374         3,374         1,124         2,737         36   

Non-residential real estate

     12,454         12,454         3,248         11,231         428   

Consumer assets owned by bank

     363         363         108         340         2   

Commercial loans

     889         889         486         711         6   
                                            

Total

     26,114         26,114         6,550         22,762         579   
                                            

Total impaired loans

     67,230         67,230         6,550         62,925         1,092   
                                            

 

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On a periodic basis, Heritage Bank may chose to modify the terms of certain loans. These modifications may originate from a borrower who is having a difficult time meeting their financial obligations. The Bank may chose to temporarily or permanently modify the terms of the loan to assist the borrower and avoid foreclosure. The Bank’s decision to modify lending terms is dependent on whether we deem the customer’s financial situation correctable, the likelihood that the loan’s collateral may decline in value and/or its condition may deteriorate during the term of the modification and that the modification is likely to assist both the customer and Bank avoid future collection issues, including foreclosure:

A summary of the Company’s loans classified as Troubled Debt Restructurings (TDR’s) that are reported as performing at March 31, 2011, and December 31, 2010, is below:

 

     March 31, 2011     December 31, 2010  
     (Dollars in Thousands)  

One-to-four family mortgages

   $ 3,844        3,932   

Home equity line of credit

     522        114   

Multi-family

     244        246   

Construction

     1,482        1,541   

Land

     1,415        512   

Non-residential real estate

     3,617        3,915   

Consumer loans

     51        69   

Commercial loans

     712        700   
                

Total TDR

     11,887        11,029   
                

Less:

    

TDR in non-accrual status

    

One-to-four family mortgages

     (1,445     (1,181

Home equity line of credit

     —          —     

Multi-family

     —          —     

Construction

     (1,482     (1,338

Land

     (512     (512

Non-residential real estate

     —          —     

Consumer loans

     —          —     

Commercial loans

     (230     —     
                

Total performing TDR

   $ 8,218        7,998   
                

 

(6) REAL ESTATE AND OTHER ASSETS OWNED

The Company’s other real estate and other assets owned represent properties and personal collateral acquired through customer loan defaults. The property is recorded at the lower of cost or fair value less estimated cost of to sell and carrying cost at the date acquired. Any difference between the book value and estimated market value is recognized as a charge off through the allowance for loan loss account. Additional other real estate owned and other asset losses may be determined on individual properties at specific intervals or at the time of disposal. Additional losses are recognized as a non-interest expense.

 

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At March 31, 2011, December 31, 2010, and March 31, 2010, the Company had balances in other real estate and other assets owned consisting of the following:

 

     March 31, 2011     December 31, 2010     March 31, 2010  
     (Dollars in Thousands)  

One-to-four family mortgages

   $ 303        534        611   

Multi-family

     6,823        7,266        1,384   

Construction

     460        624        47   

Land

     555        482        650   

Non-residential real estate

     865        900        34   

Consumer assets owned by bank

     2        6        2   

Commercial loans

     —          —          —     
                        

Total

   $ 9,008        9,812        2,728   
                        

Total non-accrual loans

     6,089        5,030        10,795   
                        

Total non-performing assets

   $ 15,097        14,842        13,523   
                        

Non-performing asset / Total assets

     1.41     1.37     1.29
                        

The following is a summary of the activity in the Company’s other real estate owned and other asset accounts for the three month period ending March 31, 2011:

 

     Balance
December 31, 2010
     Activity During 2011     Repairs and
Reduction
in Values
    Balance
March 31, 2011
     Gain
(Loss)
on Sale
 
        Foreclosures      Sales         
     (Dollars in Thousands)  

One-to-four family mortgages

   $ 534         303         (534     —          303         (2

Multi-family

     7,266         —           —          (443     6,823         —     

Construction

     624         —           (164     —          460         (8

Land

     482         160         (62     (25     555         —     

Non-residential real estate

     900         —           —          (35     865         —     

Consumer assets owned by bank

     6         31         (35     —          2         4   
                                                   

Total

   $ 9,812         494         (795     (503     9,008         (6
                                                   

 

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Table of Contents
(7) INVESTMENTS IN AFFILIATED COMPANIES

Investments in affiliated companies accounted for under the equity method consist of 100% of the common stock of HopFed Capital Trust 1 (“Trust”), a wholly-owned statutory business trust. The Trust was formed on September 25, 2003. Summary financial information for the Trust follows (dollars in thousands):

 

Summary Statements of Financial Condition    At
March 31, 2011
     At
December 31, 2010
 

Asset - investment in subordinated debentures issued by HopFed Bancorp, Inc.

   $ 10,310         10,310   
                 

Liabilities

     —           —     

Stockholder’s equity – trust preferred securities

     10,000         10,000   

Common stock (100% Owned by HopFed Bancorp, Inc.)

     310         310   
                 

Total stockholders’ equity

   $ 10,310         10,310   
                 

 

     Three Month Periods  
     Ended March 31,  
Summary Income Statements    2011      2010  

Income – interest income from subordinated debentures issued by HopFed Bancorp, Inc.

   $ 88         86   
                 

Net income

   $ 88         86   
                 

 

Summary Statement of Stockholders’ Equity    Trust
Preferred
Securities
     Common
Stock
     Retained
Earnings
    Total
Stockholders’
Equity
 

Beginning balances, December 31, 2010

   $ 10,000         310         —          10,310   

Net income

     —           —           88        88   

Dividends:

          

Trust preferred securities

     —           —           (86     (86

Common paid to HopFed Bancorp, Inc.

     —           —           (2     (2
                                  

Ending balances, March 31, 2011

   $ 10,000         310         —          10,310   
                                  

 

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Table of Contents
(8) FAIR VALUE OF ASSETS AND LIABILITIES

In September 2006, the FASB issued ASC 820-10, Fair Value Measurements. This Statement defines fair value, establishes a framework for measuring fair value and expands disclosure about fair value. The statement was effective for fiscal years beginning after November 15, 2007. The statement establishes a fair value hierarchy which requires an entity to maximize the use of observable input and minimize the use of unobservable inputs when measuring fair value. The standard describes three levels of inputs that may be used to measure fair value.

 

   

Level 1 is for assets and liabilities that management has obtained quoted prices (unadjusted for transaction cost) or identical assets or liabilities in active markets that the Company has the ability to access as of the measurement date.

 

   

Level 2 is for assets and liabilities in which significant unobservable inputs other than Level 1 prices such as quoted prices for similar assets and liabilities; quoted prices in markets that are not active; or other inputs that are observable or can be corroborated by observable market data.

 

   

Level 3 is for assets and liabilities in which significant unobservable inputs that reflect a reporting entity’s own assumptions about the assumptions that market participants would use in pricing an asset or liability.

The fair values of securities available for sale are determined by a matrix pricing, which is a mathematical technique that is widely used in the industry to value debt securities without exclusively using quoted prices for the individual securities in the Company’s portfolio but rather by relying on the securities relationship to other benchmark quoted securities. Impaired loans are valued at the net present value of expected payments using the fair value of any assigned collateral. The values for bank owned life insurance are obtained from stated values from the respective insurance companies. The liability associated with the Company’s derivative is obtained from a quoted value supplied by our correspondent banker.

Assets and Liabilities Measured on a Recurring Basis

The assets and liabilities measured at fair value on a recurring basis are summarized below:

 

March 31, 2011

Description

   Total carrying value in
the consolidated
condensed Statement of
Financial Position at
March 31, 2011
     Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
Assets            

Available for sale securities

   $ 356,117         —           354,878       $ 1,239   

Bank owned life insurance

     8,908         —           8,908         —     
Liabilities            

Interest rate swap

     967         —           967         —     

 

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December 31, 2010
Description

   Total carrying value
in the consolidated
condensed Statement of
Financial Position at
December 31, 2010
     Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
Assets            

Available for sale securities

   $ 357,738         —           356,461       $ 1,277   

Bank owned life insurance

     8,819         —           8,819         —     
Liabilities            

Interest rate swap

     1,088         —           1,088         —     

The assets and liabilities measured at fair value on a non-recurring basis are summarized below for March 31, 2011:

 

March 31, 2011
Description

   Total carrying value
in the consolidated
condensed Statement of
Financial Condition at
March 31, 2011
     Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
Assets            

Other real estate owned

   $ 9,006         —           —         $ 9,006   

Other assets owned

     2         —           —           2   

Impaired loans, net of reserve of $6,550

     60,680         —           —           60,680   

The assets and liabilities measured at fair value on a non-recurring basis are summarized below for December 31, 2010:

 

December 31, 2010
Description

   Total carrying value
in the consolidated
condensed Statement of
Financial Condition at
December 31, 2010
     Quoted Prices
In Active
Markets for
Identical Assets
(Level 1)
     Significant
Other
Observable
Inputs
(Level 2)
     Significant
Unobservable
Inputs
(Level 3)
 
Assets            

Other real estate owned

   $ 9,806         —           —         $ 9,806   

Other assets owned

     6         —           —           6   

Impaired loans, net of reserve of $4,286

     54,321         —           —           54,321   

 

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The table below includes a roll-forward of the consolidated condensed statement of financial condition items for the three-month periods ended March 31, 2011, and March 31, 2010, (including the change in fair value) for assets and liabilities classified by HopFed Bancorp, Inc. within level 3 of the valuation hierarchy for assets and liabilities measured at fair value on a recurring basis. When a determination is made to classify an asset or liability within level 3 of the valuation hierarchy, the determination is based upon the significance of the unobservable factors to the overall fair value measurement. However, since level 3 assets and liabilities typically include, in addition to the unobservable or level 3 components, observable components (that is components that are actively quoted and can be validated to external sources), the gains and losses in the table below include changes in fair value due in part to observable factors that are part of the valuation methodology.

 

     2011      2010  

Three month period ended March 31,

   Other Assets     Other Liabilities      Other Assets      Other Liabilities  
     (Dollars in Thousands)  

Fair value, January 1,

   $ 1,277        —           1,426         —     

Change in unrealized gains (losses) included in other comprehensive income for assets and liabilities still held at March 31,

     (38     —           —           —     

Purchases, issuances and settlements, net

     —          —           —           —     

Transfers in and/or out of Level 3

     —          —           —           —     
                                  

Fair value, March 31,

   $ 1,239        —           1,426         —     
                                  

 

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The estimated fair values of financial instruments were as follows at March 31, 2011:

 

     Carrying
Amount
     Estimated
Fair
Value
 
     (Dollars in Thousands)  

Financial assets:

  

Cash and due from banks

   $ 53,586         53,586   

Interest-earning deposits in Federal Home Loan Bank

     20,583         20,583   

Securities available for sale

     356,117         356,117   

Federal Home Loan Bank stock

     4,378         4,378   

Loans receivable

     580,729         592,747   

Bank owned life insurance

     8,908         8,908   

Financial liabilities:

     

Deposits

     833,903         843,904   

Advances from borrowers for taxes and insurance

     348         348   

Advances from Federal Home Loan Bank

     70,933         74,102   

Repurchase agreements

     44,055         45,023   

Subordinated debentures

     10,310         10,092   

Market value of interest rate swap

     967         967   

Off-balance-sheet liabilities:

     

Commitments to extend credit

     —           —     

Commercial letters of credit

     —           —     

 

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Table of Contents

The estimated fair values of financial instruments were as follows at December 31, 2010:

 

     Carrying
Amount
     Estimated
Fair
Value
 
     (Dollars in Thousands)  

Financial assets:

  

Cash and due from banks

   $ 54,042         54,042   

Interest-earning deposits in Federal Home Loan Bank

     6,942         6,942   

Securities available for sale

     357,738         357,738   

Federal Home Loan Bank stock

     4,378         4,378   

Loans receivable

     600,215         612,694   

Bank owned life insurance

     8,819         8,819   

Financial liabilities:

     

Deposits

     826,929         835,465   

Advances from borrowers for taxes and insurance

     239         239   

Advances from Federal Home Loan Bank

     81,905         85,209   

Repurchase agreements

     45,110         46,273   

Subordinated debentures

     10,310         10,092   

Market value of interest rate swap

     1,088         1,088   

Off-balance-sheet liabilities:

     

Commitments to extend credit

     —           —     

Commercial letters of credit

     —           —     

 

(9) ISSUANCE OF PREFERRED SHARES

On December 12, 2008, HopFed Bancorp issued and sold 18,400 shares of preferred stock to the United States Treasury (Treasury) for $18,400,000 pursuant to the Capital Purchase Program. The Company also issued 243,816 common stock warrants to the Treasury as a condition to its participation in the Capital Purchase Program. The warrants have an exercise price of $11.32 each and are immediately exercisable. The warrants expire in ten years from the date of issuance. The preferred stock has no stated maturity and is non-voting, other than having class voting rights on certain matters, and pays cumulative dividends quarterly at a rate of 5% per year for the first five years and 9% thereafter.

On September 22, 2010, the Board of Directors declared a 2% common stock dividend to be paid to shareholders of record on September 30, 2010. As a result of the common stock dividend, total shares outstanding increased by 143,458. In addition, the Company is obligated to adjust the number and strike price of warrants issued to the United States Treasury under the Capital Purchase Program. The new warrant balance is 248,692.32 shares and the new strike price is $11.098.

 

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Table of Contents
(10) STOCK OPTIONS

At March 31, 2011, all stock options outstanding were issued under the HopFed Bancorp, Inc. 1999 Stock Option Plan. At March 31, 2011, the Company can no longer issue options under this plan. The remaining 81,600 options are fully vested and outstanding until their maturity date. At March 31, 2011, the strike price of all options outstanding exceed the current market price of HopFed Bancorp, Inc. stock.

The following is a summary of stock options outstanding at March 31, 2011:

 

Exercise
Price

     Average
Remaining
Life (Years)
     Outstanding
Options
 
$ 12.08         1.4         10,200   
  12.08         0.2         51,000   
  17.00         3.2         20,400   
                       
$ 13.31         1.1         81,600   
                       

 

(11) DERIVATIVE INSTRUMENTS

Under guidelines of FASB ASC 815, Derivative and Hedging Activities, as amended, all derivative instruments are required to be carried at fair value on the consolidated statement of financial position. ASC 815 provides special hedge accounting provisions, which permit the change in fair value of the hedge item related to the risk being hedged to be recognized in earnings in the same period and in the same income statement line as the change in the fair value of the derivative.

A derivative instrument designated in a hedge relationship to mitigate exposure to changes in the fair value of an asset, liability or firm commitment attributable to a particular risk, such as interest rate risk, are considered fair value hedges under ASC 815. Derivative instruments designated in a hedge relationship to mitigate exposure to variability in expected future cash flows, or other types of forecasted transactions, are considered cash flow hedges. Cash value hedges are accounted for by recording the fair value of the derivative instrument and the fair value related to the risk being hedged of the hedged asset or liability on the consolidated statement of financial position with corresponding offsets recorded in the consolidated statement of financial position.

The adjustment to the hedged asset or liability is included in the basis of the hedged item, while the fair value of the derivative is recorded as a freestanding asset or liability. Actual cash receipts or payments and related amounts accrued during the period on derivatives included in a fair value hedge relationship are recorded as adjustments to the income or expense recorded on the hedged asset or liability.

 

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Under both the fair value and cash flow hedge methods, derivative gains and losses not effective in hedging the change in fair value or expected cash flows of the hedged item are recognized immediately in the income statement. At the hedge’s inception and at least quarterly thereafter, a formal assessment is performed to determine whether changes in the fair values or cash flows of the derivative instrument has been highly effective in offsetting changes in the fair values or cash flows of the hedged items and whether they are expected to be highly effective in the future. If it is determined a derivative instrument has not been, or will not continue to be highly effective as a hedge, hedged accounting is discontinued. ASC 815 basis adjustments recorded on hedged assets and liabilities are amortized over the remaining life of the hedged item beginning no later than when hedge accounting ceases. There were no fair value hedging gains or losses, as a result of hedge ineffectiveness, recognized for the three-month period ended March 31, 2011, or the year ended December 31, 2010.

In October of 2008, the Bank entered into an interest rate swap agreement for a term of seven years and an amount of $10.0 million. The Bank will pay a fixed rate of 7.27% for seven years and receive an amount equal to the three-month London Interbank Lending Rate (LIBOR) plus 3.10%. The interest rate swap is classified as a cash flow hedge by the Bank and will be tested quarterly for effectiveness. At March 31, 2011, and December 31, 2010, the cost of the Bank to terminate the cash flow hedge was approximately $967,000 and $1,088,000, respectively.

 

(12) REGULATORY AGREEMENT

On April 30, 2010, the Company and its wholly owned subsidiary, Heritage Bank, each entered into an informal Memorandum of Understanding (MOU) with its primary regulator, the Office of Thrift Supervision (OTS). The agreement requires the Company to obtain prior written approval prior to the declaration of a common stock dividend or to receive a cash dividend from its Bank subsidiary. The Company may continue to pay other normal operating expenses, and may pay interest on HopFed Capital Trust 1 and dividends on preferred stock held by the United States Department of Treasury without regulatory approval if the Bank maintains a Tier 1 Capital Ratio of 8.00% and a Total Risk Based Capital Ratio of 12.00%. At March 31, 2011, the Bank’s Tier 1 Ratio was 9.28% and its Total Risk Based Capital was 16.38%.

Under the Bank MOU, among other things, the Bank has agreed to the following: (1) the Bank will not declare or pay any dividends or make other capital distributions, or commit to pay dividends or make other capital distributions, without prior OTS approval; (2) the Bank will adopt a concentration risk reduction plan to reduce the outstanding balance of commercial real estate loans relative to core capital and the allowance for loan losses; and (3) the Bank will not increase brokered deposits without prior OTS approval.

In addition, the MOUs identify actions, policies and procedures to be taken and adopted by the Board of Directors and management of the Company and the Bank, as appropriate, to ensure maintenance of adequate liquidity, monitor and report compliance with the MOUs and certain applicable regulations, reduce the level of classified assets, and correct certain deficiencies and weaknesses identified by the OTS.

 

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The MOUs will remain in effect until modified or terminated by the OTS. The Company and the Bank do not expect the actions and limitations required by the MOUs to change their business strategy in any material respect.

The Board of Directors and management of each of the Company and the Bank have taken various actions to comply with the terms and conditions of the MOUs, and will continue to take all actions believed to be necessary for compliance. The Board and management will continue to work closely with the OTS in order to comply with the terms and conditions of the MOUs and are committed to addressing and resolving any and all issues presented in the MOUs.

 

(13) EFFECT OF NEW ACCOUNTING PRONOUNCEMENTS

In January 2010, the FASB issued Accounting Standards Update No. 201-06, Improving Disclosures about Fair Value Measurements. The new guidance clarifies two existing disclosure requirements and requires two new disclosures as follows: (1) a “gross” presentation of activities (purchases, sales, and settlements) within the Level 3 roll-forward reconciliation, which will replace the “net” presentation format; and (2) detailed disclosures about the transfers in and out of Level 1 and 2 measurements. This guidance is effective for the first interim or annual reporting period beginning after December 15, 2009, except for the gross presentation of the Level 3 roll-forward information, which is required for annual reporting periods beginning after December 15, 2010, and for interim reporting periods within those years. The Company adopted the fair value disclosures guidance on January 1, 2010, except for the gross presentation of the Level 3 roll-forward information which was adopted by the Company on January 1, 2011. The adoption of this pronouncement did not have a material impact on the Company’s financial statements.

On January 1, 2010, the FASB amended Accounting Standards Update No. 810 by issuing Update 2010-10 to change how a company determines when an entity that is insufficiently capitalized or is not controlled through voting (or similar rights) should be consolidated. The determination of whether a company is required to consolidate an entity is based on, among other things, an entity’s purpose and design and a company’s ability to direct the activities of the entity that most significantly impact the entity’s economic performance. The new authoritative accounting guidance requires additional disclosures about the reporting entity’s involvement with variable-interest entities and any significant changes in risk exposure due to that involvement as well as its affect on the entity’s financial statements. The new authoritative accounting guidance under ASC 810 was effective January 1, 2010, and did not have a significant impact on the Company’s financial statements.

In July 2010, the Financial Accounting Standards Board (FASB) issued Accounting Standards Update (ASU) 2010-20, Disclosures about the Credit Quality of Financing Receivables and the Allowance for Credit Losses. ASU 2010-20 provides enhanced disclosures related to the credit quality of financing receivables and the allowance for credit losses, and provides that new and existing disclosures should be disaggregated based on how an entity develops its allowance for credit losses and how it manages credit exposures.

 

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Under the provisions of ASU 2010-20, additional disclosures required for financing receivables include information regarding the aging of past due receivables, credit quality indicators, and modifications of financing receivables. The provisions of ASU 2010-20 were effective for periods ending after December 15, 2010, with the exception of the amendments to the roll-forward of the allowance for credit losses which are effective for periods beginning after December 15, 2010. Comparative disclosures are required only for periods ending subsequent to initial adoption. HopFed Bancorp adopted the provisions of ASU 2010-20 and has provided the required disclosures in the consolidated financial statements provided herein.

In 2010, the FASB issued ASU 2010-11, Scope Exception Related to Embedded Credit Derivatives. ASU 2010-11 amends ASC 815 to provide clarifying language regarding when embedded credit derivative features are not considered embedded derivatives subject to potential bifurcation and separate accounting. The provisions of ASU 2010-11 are effective for periods beginning after June 15, 2010, and require re-evaluation of certain preexisting contracts to determine whether the accounting for such contracts is consistent with the amended guidance in ASU 2010-11. If the fair value option is elected for an instrument upon adoption of the amendments to ASC 815, re-evaluation of such preexisting contracts is not required. The adoption of this standard did not impact the operating results of the Company.

In January 2011, the FASB issued ASU 2011-01, Deferral of the Effective Date of Disclosures about Troubled Debt Restructurings in ASU 2010-20 which temporarily delays the effective date of the disclosures about troubled debt restructuring in ASU 2010-20. This delay was intended to allow the FASB time to complete its deliberations on what constitutes a troubled debt restructuring.

In April 2011, the FASB issued ASU 2011-02, A Creditor’s Determination of Whether a Restructuring is a Troubled Debt Restructuring.” The provisions of ASU 2011-02 provide additional guidance related to determining whether a creditor has granted a concession, including factors and examples for creditors to consider in evaluating when a credit restructuring results in a delay in payment that is insignificant, prohibits creditors from using the borrowers interest cost as a factor in determining whether the lender has granted a concession to the borrower, and added factors for creditors to use in determining whether a borrower is experiencing financial difficulties. A provision in ASU 2011-02 ends the FASB’s deferral of additional disclosures about troubled debt restructuring as required by ASU 2010-20. The provisions of ASU 2011-02 are effective for the Company’s reporting period ending September 30, 2011. The adoption of ASU 2011-02 is not expected to have a material impact on the Company’s consolidated financial statements of income, condition and cash flow.

Other accounting standards that have been issued or proposed by the FASB or other standards-setting bodies are not expected to have a material impact on the Company’s financial position, results of operations or cash flows.

 

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

Critical Accounting Policies

The consolidated condensed financial statements as of March 31, 2011, and December 31, 2010, and for the three month periods ended March 31, 2011, and March 31, 2010, included herein have been prepared by the Company, without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in interim financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed or omitted pursuant to such rules and regulations. These financial statements should be read in conjunction with the financial statements and notes thereon included in the Company’s 2010 Annual Report to Stockholders on Form 10-K.

Certain of the Company’s accounting policies are important to the portrayal of the Company’s financial condition, since they require management to make difficult, complex or subjective judgments, some of which may relate to matters that are inherently uncertain. Estimates associated with these policies are susceptible to material changes as a result of changes in facts and circumstances. Facts and circumstances, which could affect these material judgments, include, but without limitation, changes in interest rates, in the performance of the economy or in the financial condition of borrowers. Management believes that its critical accounting policies include determining the allowance for loan losses, determining the fair value of securities and other financial instruments, and assessing other than temporary impairments of securities.

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

Total assets declined from $1.08 billion at December 31, 2010, to $1.07 billion at March 31, 2011. Securities available for sale decreased from $357.7 million at December 31, 2010, to $356.1 million at March 31, 2011. At March 31, 2011, and December 31, 2010, securities classified as “available for sale” had an amortized cost of $354.5 million and $355.2 million, respectively.

The Company’s holdings of Federal Home Loan Bank of Cincinnati (FHLB) stock, at cost was $4.4 million at December 31, 2010, and March 31, 2011. Total Federal Home Loan Bank “FHLB” borrowings declined $11.0 million, from $81.9 million at December 31, 2010, to $70.9 million at March 31, 2011. Total repurchase balances declined from $45.1 million at December 31, 2010, to $44.1 million at March 31, 2011.

Net loans totaled $580.7 million and $600.2 million at March 31, 2011, and December 31, 2010, respectively. Loan demand is weak for consumer, agricultural and commercial loan products. Given the current weakness in the economy, the Company remains highly selective in both its underwriting standards and types of loans being originated. The Company’s net loan balances are also adversely affected by the presence of a Memorandum of Understanding and Agreement between the Office of Thrift Supervision “OTS”, the Company and our Bank subsidiary.

 

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The Company has made significant increases to its allowance for loan loss account, increasing the allowance to $13.9 million at March 31, 2011, as compared to $9.8 million at December 31, 2010. The first quarter provision expense was necessary due to a number of localized factors, including recent flooding and other weather related events that have resulted in poor growing conditions for local farmers, many of whom will lose their crops due to flooded fields. Weather events both here and Japan have affected local manufacturers, as companies that supply Japanese automakers have been impacted by lower demand in Japan as well as tornadoes locally which have affected manufacturing production. These factors, as well as a poor economy nationally, continue to have negative consequences for business in our region.

At March 31, 2011, deposits increased to $833.9 million from $826.9 million at December 31, 2010. The average cost of all deposits during the three month periods ended March 31, 2011, March 31, 2010, and December 31, 2010, was 1.86%, 2.27% and 1.92%, respectively. Management continually evaluates the investment alternatives available to customers and adjusts the pricing on its deposit products to more actively manage its funding costs while remaining competitive in its market area. Given weak loan demand and poor investment alternatives, the Company has chosen to reduce its balances of higher costing time deposits. The Company anticipates a further reduction in both FHLB borrowing balances and brokered deposits in the first half of 2011.

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

Net Income. The Company incurred a $2.1 million loss attributable to common shareholders for the three month period ended March 31, 2011, as compared to net income available to common shareholders of $1.6 million for the three month period ended March 31, 2010. As discussed previously in this report, the Company’s results of operations for the three month period ended March 31, 2011, were adversely affected by a $4.5 million provision for loan loss expense as compared to a $611,000 provision for loan loss expense in the three month period ended March 31, 2010. The need for the additional provision expense is the result of weather related factors both locally and in Japan and is discussed further in the provision for loan loss section of this narrative.

Net Interest Income. Net interest income for the three month period ended March 31, 2011, was $6.8 million, compared to $7.3 million for the three month period ended March 31, 2010. The decline in net interest income for the three months ended March 31, 2011, as compared to March 31, 2010, was largely due to a $50.1 million decline in the average balance of loans outstanding. For the three months ended March 31, 2011, the average yield on loans was 5.73%, as compared to 6.00% for the three month period ended March 31, 2010.

For the three month period ended March 31, 2011, income on taxable securities declined to $2.7 million, from $2.9 million for the three month period ended March 31, 2010, despite a $48.9 million increase in the average balance on taxable securities during the same periods. The decline in income on taxable securities is the result of declining yields on those assets. For the three month period ending March 31, 2011, the yield on taxable securities was 3.62%, compared to 4.70% for the three-month period ended March 31, 2010.

 

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For the three month periods ended March 31, 2011, and March 31, 2010, the Company’s cost of interest bearing liabilities was 2.22% and 2.62%, respectively. The lower cost of interest bearing liabilities was the result of lower short term interest rates. However, the decline in yields on interest earnings assets exceeded the decline in the Company’s cost of interest bearing liabilities, resulting in a reduced net interest margin. At March 31, 2011, and March 31, 2010, the Company’s net yield on interest earning assets was 2.94% and 3.19%, respectively.

Average Balances, Yields and Interest Expenses. The table below summarizes the overall effect of changes in both interest rates and the average balances of interest earning assets and liabilities for the three-month periods ended March 31, 2011, and March 31, 2010. Yields on assets and cost of liabilities are derived by dividing income or expense by the average daily balances of interest earning assets and liabilities for the appropriate three-month periods.

 

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Average balances for loans include loans classified as non-accrual, net of the allowance for loan losses. The table adjusts tax-free investment income by $284,000 for March 31, 2011, and $256,000 for March 31, 2010, for a tax equivalent rate using a cost of funds rate of 2.25% for March 31, 2011, and 2.62% for March 31, 2010. The table adjusts tax-free loan income by $9,000 for March 31, 2011, and $17,000 for March 31, 2010, for a tax equivalent rate using the same cost of funds rate:

 

     Average
Balance
3/31/2011
     Income and
Expense
3/31/2011
    Average
Rates
3/31/2011
    Average
Balance
3/31/2010
     Income and
Expense
3/31/2010
    Average
Rates
3/31/2010
 
     (Table Amounts in Thousands, Except Percentages)  

Loans

   $ 592,517         8,491        5.73   $ 642,615         9,638        6.00

Investments AFS taxable

     297,358         2,690        3.62     248,453         2,922        4.70

Investment AFS tax free

     67,368         895        5.32     55,399         819        5.91

Federal funds

     6,771         4        0.24     —           —          —     
                                

Total interest earning assets

     964,014         12,080        5.01     946,467         13,379        5.65
                                      

Other assets

     121,659             97,855        
                          

Total assets

   $ 1,085,673           $ 1,044,322        
                          

Interest bearing retail deposits

     677,548         3,389        2.00     657,999         4,035        2.45

Brokered deposits

     92,406         516        2.23     85,254         556        2.61

FHLB borrowings

     76,566         694        3.63     99,183         856        3.45

Repurchase agreements

     40,631         205        2.02     38,058         202        2.12

Subordinated debentures

     10,310         185        7.18     10,310         183        7.10
                                                  

Total interest bearing liabilities

     897,461         4,989        2.22     890,804         5,832        2.62
                                      

Non-interest bearing deposits

     70,150             66,456        

Other liabilities

     6,004             4,745        

Stockholders’ equity

     112,058             82,317        
                          

Total liabilities and stockholders’ equity

   $ 1,085,673           $ 1,044,322        
                          

Net change in interest earning assets and interest bearing liabilities

        7,091        2.79        7,547        3.03
                                      

Net yield on interest earning assets

        2.94          3.19  
                          

Interest Income. For the three month periods ended March 31, 2011, and March 31, 2010, the Company’s total interest income was $11.8 million and $13.1 million, respectively. As the Company’s loan demand has slowed down, we continue to have a greater dependency on investment income. The average balance of loans receivable declined from $642.6 million for the three months ended March 31, 2010, to $592.5 million for the three month period ended March 31, 2011. The ratio of average interest-earning assets to average interest-bearing liabilities increased from 106.25% for the three months ended March 31, 2010, to 107.42% for the three months ended March 31, 2011.

 

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Interest Expense. Interest expense declined approximately $800,000 for the three months ended March 31, 2011, as compared to March 31, 2010. The decline was attributable to lower market interest rates and the re-pricing of higher costing deposits, offsetting a $6.7 million increase in the average balance of total interest bearing liabilities as compared to March 31, 2010. The average cost of interest-bearing retail deposits declined from 2.45% for the three month period ended March 31, 2010, to 2.00% for the three months ended March 31, 2011. Over the same period, the average balance of interest bearing retail deposits increased $19.5 million, from $658.0 million for the three months ended March 31, 2010 to $677.5 million for the three months ended March 31, 2011.

The average balance cost of brokered deposits declined from 2.61% for the three months ended March 31, 2010, to 2.23% for the three months ended March 31, 2011. Over the same period, the average balance of brokered deposits increased $7.1 million, from $85.3 million for the three months March 31, 2010, to $92.4 million for the three month period ended March 31, 2011.

The average balance of funds borrowed from the FHLB declined $22.6 million, from $99.2 million for the three months ended March 31, 2010, to $76.6 million for the three month period ended March 31, 2011. The average cost of borrowed funds from the FHLB increased from 3.45% for the three months ended March 31, 2010, to 3.63% for the three months ended March 31, 2011. The average balance of repurchase agreements increased from $38.1 million for the three months ended March 31, 2010, to $40.6 million for the three months ended March 31, 2011. The average cost of repurchase agreements declined from 2.12% for the three months ended March 31, 2010, to 2.02% for the three months ended March 31, 2011.

Provision for Loan Losses. The allowance for loan losses is established through a provision for loan losses based on management’s evaluation of the risk inherent in its loan portfolio and the general economy. Such evaluation considers numerous factors including general economic conditions, loan portfolio composition and prior loss experience, the estimated fair value of the underlying collateral and other factors that warrant recognition in providing for an adequate loan loss allowance. The Company determined that an additional $4.5 million in provision for loan loss was required for the three months ended March 31, 2011, compared to a $611,000 in provision for loan loss expense for the three months ended March 31, 2010.

The increase in provision expense is largely the result of an increase in loans classified as impaired. At March 31, 2010, the Company’s impaired loans totaled $35.4 million, as compared to $58.6 million at December 31, 2010, and $67.2 million at March 31, 2011. The increase in impaired loans is due to the continued weakness in both the local and national economies as well as impact of weather related events occurring both locally and internationally.

As discussed earlier in this report, our area has experienced a significant amount of flooding in 2011. The current flood is the second in two years for many of our communities. The Company’s losses related to both the May 2010 flood and the drought that followed were severe. It remains difficult for the Company to estimate losses related to the 2011 flood. However, management does have last year as a point of reference as well as information on the flood’s agricultural impact from the United States Department of Agriculture.

 

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Of the areas affected by flooding, the western parts of Kentucky and Tennessee have experienced the highest average rainfall in their respective states. In addition, the Mississippi, Ohio, Tennessee, and Cumberland rivers all flow through our market area and converge within a short distance at the northern edge of our market area, with the Mississippi River traveling the western boundary of our marketplace. We anticipate that commerce along both the Mississippi and Ohio rivers will be negatively impacted for an extended period of time due to high water conditions.

In addition to the yet undetermined damage to personal and real property, we anticipate that the flood will cause significant agricultural damages. The May 9, 2011, USDA Kentucky Crop and Weather Report provided by the University of Kentucky Agricultural Extension Office indicates that only 19% of expected corn production has been planted, a decline of 69% from the previous year and 52% from the five year average. Corn emergence was 11%, down 63% from the prior year and 41% percent from the five year average. In addition, the Company anticipates that many farmers who successfully planted corn must re-plant due to flooding. With wet conditions not expected to abate for an extended period of time, the spring planting season may be delayed by more than six weeks. In 2010, the delay in spring planting resulted in local yield losses of up to 50 bushels per acre for corn, or a 30% reduction of gross revenue with no offsetting reduction in operating expenses.

In addition to the corn crop, the local wheat crop has also been damaged. The damage has occurred as a result of direct flooding and an overabundance of moisture at the end of the growing season. The Company is not able to accurately estimate wheat losses due to flooding and flood related disease at this time. However, we are aware that a significant percentage of wheat has been damaged. The wet conditions affecting the wheat crop will delay the planting of soybeans, which are typically planted on the same ground immediately after wheat is harvested. The USDA reports no plantings of soybeans at this time. At this time last year, 10% of the soybean crop was in the ground. As with the corn crop, a late soybean planting is detrimental to yields. The reduction in yields is due to the lower moisture levels that typically occur in middle to late summer as compared to early and late spring. In our market area, 2010 soybean yields were far below normal with many farmers relying on crop insurance to help cover their cost.

Local manufacturers have been affected by weather events both locally and in Japan. The same weather pattern that produced our local flooding also produced numerous tornadoes, one of which directly affected an automobile parts manufacturer in our home market. In addition to the local weather events, weather related issues in Japan will continue to affect many employers in our area that either produce parts for Japanese cars or rely on suppliers based in Japan.

As the Company continues to review the financial results of our customers, we note that more customers are facing a decline in their income levels. As a result, the Company may downgrade these relationships and complete an impairment test on the collateral used to secure the loan. Despite the increase in impaired loans, non-performing assets and loans classified as TDR’s have not experienced a sharp increase in the last year. Management’s decision to fund the allowance for loan loss account at current levels is based on conservative financial management.

 

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Non-Interest Income. There was a $56,000 increase in non-interest income in the three months ended March 31, 2011, as compared to the same period in 2010. For the three month period ended March 31, 2011, the Company’s service charge income was $856,000, a decline of $129,000 over the same period in 2010. For the three-month period ended March 31, 2011, the Company recognized $721,000 in gains on the sale of investments as compared to $494,000 for the three-month period ended March 31, 2010.

Non-Interest Expenses. There was a $1.1 million increase in total non-interest expenses in the three-month period ended March 31, 2011, as compared to the same period in 2010. The most significant change in non-interest expenses was $509,000 in loss on other real estate as compared to a $25,000 gain experienced during the three-month period ended March 31, 2010. Approximately $503,000 of the loss on other real estate was the result of reductions in the value of properties owned by the Company and obtained through foreclosure. Appraisals obtained on these properties in April 2011 indicated that the property values of these properties had declined due to the reduction in income produced by these properties. The Company is in the process of making necessary repairs to these properties, making them attractive to renters. The Company intends to sell the units after they are rented, improving the marketability of the units. For the three months ended March 31, 2011, other expenses items with significant increases as compared to the same period in 2010 include salaries and benefits increasing by $96,000 and expenses for deposit insurance and examination fees increasing by $211,000.

Income Taxes. The effective tax rate for the three-month March 31, 2010, was 28.1%, or $726,000. For the three-month period ended March 31, 2011, the Company’s tax benefit was $960,000, or 34% of the Company’s net loss before income taxes.

Liquidity and Capital Resources. The Company has no business other than that of the Bank. Management believes that dividends that may be paid by the Bank to the Company will provide sufficient funds for its current needs. However, no assurance can be given that the Company will not have a need for additional funds in the future. The Bank is subject to certain regulatory limitations with respect to the payment of dividends to the Company. The Company is required to seek approval from the Office of Thrift Supervision prior to the declaration of a dividend to common shareholders.

 

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As discussed in Note 12 of Notes to Unaudited Consolidated Condensed Financial Statements section of this report, the Bank may not increase the amount of brokered deposits outstanding without prior written approval from the OTS Regional Director. The Bank uses brokered deposits to supplement its asset liability need for longer term deposits at reasonable prices. In addition to the coupon rate listed below, brokered deposits carry an additional 0.25% that includes the cost of selling and servicing the deposits. The Company includes this cost as interest expense on its income statement.

At March 31, 2011, the Bank’s brokered deposits consisted of the following:

 

Issue Date

     Interest Rate     Current Balance      Maturity Date  
  9/29/2010         0.20   $ 2,088,000         6/29/2011   
  10/23/2009         1.65     2,020,000         10/24/2011   
  2/16/2010         1.00     4,000,000         11/16/2011   
  2/16/2010         1.00     2,000,000         12/16/2011   
  9/22/2009         2.00     5,077,000         3/22/2012   
  9/29/2010         0.60     2,076,000         6/30/2012   
  10/16/2009         2.30     3,011,000         10/16/2012   
  3/3/2010         1.75     2,032,000         3/4/2013   
  1/22/2010         2.20     3,092,000         7/22/2013   
  3/2/2010         2.00     3,204,000         9/2/2013   
  10/26/2009         2.00     5,215,000         10/28/2013   
  9/22/2010         1.15     2,144,000         3/22/2014 (1) 
  7/1/2009         2.75     9,802,000         7/1/2014   
  8/11/2009         3.00     5,095,000         8/11/2014 (1) 
  9/22/2009         2.00     7,003,000         9/22/2014   
  3/9/2010         2.00     5,078,000         3/9/2015   
  7/26/2010         1.25     4,093,000         7/26/2015 (1) 
  12/21/2010         1.70     805,000         12/21/2015   
  1/3/2011         1.00     1,874,000         1/3/2016 (1) 
  3/17/2011         2.25     1,500,000         3/17/2016 (1) 
  9/22/2010         1.25     2,372,000         9/22/2020 (1) 
  10/6/2010         1.25     540,000         10/6/2020 (1) 
             
     $ 74,121,000      
             

 

(1) 

Denotes brokered deposit with rising rate feature in which the Company has a call option.

 

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The Bank must satisfy three capital standards: a ratio of core capital to adjusted total assets of 4.0%, a tangible capital standard expressed as 1.5% of total adjusted assets, and a combination of core and “supplementary” capital equal to 8.0% of risk-weighted assets. At March 31, 2011, the Bank exceeded all regulatory capital requirements.

The table below presents certain information relating to the Company’s and Bank’s capital compliance at March 31, 2011:

 

     Company     Bank  
     Amount      Percent     Amount      Bank  
     (Dollars in Thousands)  

Tangible Capital

   $ 117,422         10.94   $ 97,575         9.28

Core Capital

   $ 117,422         10.94   $ 97,575         9.28

Risk Based Capital

   $ 124,816         19.27   $ 104,969         16.38

At March 31, 2011, the Bank had outstanding commitments to originate loans totaling $3.8 million and undisbursed commitments on loans outstanding of $32.0 million. Management believes that the Bank’s sources of funds are sufficient to fund all of its outstanding commitments. Certificates of deposits scheduled to mature in one year or less from March 31, 2011, totaled $295.7 million. Management believes that a significant percentage of such deposits will remain with the Bank.

The Bank’s FHLB borrowings are secured by a blanket security agreement pledging the Bank’s 1-4 family first mortgage loans and non-residential real estate loans. At March 31, 2011, the Bank has pledged all eligible 1-4 family first mortgages, home equity lines of credit and non-residential real estate loans that may be pledged under this agreement.

 

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At March 31, 2011, the Bank has outstanding borrowings of $70.9 million from the FHLB with maturities ranging nine months to eight years. A schedule of FHLB borrowings at March 31, 2011, is provided below:

 

Outstanding
Balance

     Rate     Maturity      Note  
(Dollars in thousands)  
  5,000         2.56     12/09/11      
  5,000         1.82     12/16/12      
  2,945         3.30     06/01/13         Monthly Principal Payments   
  5,000         2.32     12/30/13      
  959         3.19     04/14/14         Monthly Principal Payments   
  5,000         3.15     12/11/14      
  4,000         5.34     03/17/16      
  7,000         4.25     05/01/17         Quarterly callable   
  10,000         4.56     06/28/17         Quarterly callable   
  10,000         4.26     08/17/17         Quarterly callable   
  16,029         3.13     01/01/19         Monthly Principal Payments   
                         
$ 70,933         3.55     5.2 years      
                   

At March 31, 2011, the Bank had $70.7 million in additional borrowing capacity with the FHLB which includes an overnight line of credit and $8 million in overnight borrowing capacity from the Company’s correspondent bank.

The Bank’s exposure to credit loss in the event of non-performance by the other party to the financial instrument for commitments to extend credit and standby letters of credit and financial guarantees written is represented by the contractual notional amount of those instruments. The Bank uses the same credit policies in making these commitments and conditional obligations as it does for on-balance-sheet instruments.

At March 31, 2011, the Company had the following off-balance sheet commitments (in thousands):

 

Standby letters of credit

   $ 1,247   

Unused home equity lines of credit

   $ 29,445   

Unused commercial lines of credit

   $ 11,217   

 

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Forward-Looking Statements

This Quarterly Report on Form 10-Q contains forward-looking statements. Additional written or oral forward-looking statements may be made by the Company from time to time in filings with the Securities and Exchange Commission or otherwise. The words “believe,” “expect,” “seek,” and “intend” and similar expressions identify forward-looking statements, which speak only as of the date the statement is made. Such forward-looking statements are within the meaning of that term in Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Such statements may include, but are not limited to, projections of income or loss, expenditures, acquisitions, plans for future operations, financing needs or plans relating to services of the Company, as well as assumptions relating to the foregoing.

Forward-looking statements are inherently subject to risks and uncertainties, some of which cannot be predicted or quantified. Future events and actual results could differ materially from those set forth in, contemplated by or underlying the forward-looking statements. The Company does not undertake, and specifically disclaims, any obligation to publicly release the results of revisions, which may be made to forward-looking statements to reflect the occurrence of anticipated or unanticipated events or circumstances after the date of such statements.

 

Item 3. Quantitative and Qualitative Disclosures About Market Risk

The actual results of the Company’s asset liability management analysis are highly dependent on the prepayment speed of mortgage backed securities and collateralized mortgage obligations. The United States Treasury’s policy of purchasing longer dated Treasury bonds has the result of lowering mortgage loan rates, allowing more consumers to refinance their mortgages and pay-off their current mortgage, resulting in higher prepayment speeds on mortgage investment products.

The effects of rising interest rates are discussed throughout Item 2, “Management’s Discussion and Analysis of Financial Condition and Results of Operations.” Actual results for the year ending December 31, 2011, will differ from simulations due to timing, magnitude, and the frequency or interest rate changes, market conditions, management strategies, and the timing of the Company’s cash receipts and disbursements.

 

Item 4. Controls and Procedures

Evaluation of Disclosure Controls and Procedures.

In accordance with Rule 13a-15(b) under the Securities Exchange Act of 1934 (the “Exchange Act”), an evaluation was carried out with the participation of the Company’s management, including the Company’s Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of the Company’s disclosure controls and procedures (as defined in Rule 13a-14(c) and 15 d-14(c) under the Exchange Act) as of the end of the quarter ended March 31, 2011.

 

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Based upon their evaluation of these disclosure controls and procedures, the Chief Executive Officer and Chief Financial Officer concluded that the disclosure controls and procedures were effective as of the end of the three months ended March 31, 2011, to ensure that material information relating to the Company, including its consolidated subsidiaries, was made known to them by others within those entities, particularly during the period in which this quarterly report on Form 10-Q was being prepared.

Any control system, no matter how well conceived and operated, can provide only reasonable assurance that its objectives are achieved. The design of a control system inherently has limitations, including the controls cost relative to their benefits. Additionally, controls can be circumvented. No cost-effective control system can provide absolute assurance that all control issues and instances of fraud will be detected.

The Company is subject to Section 404 of The Sarbanes-Oxley Act of 2002. Section 404 requires management to assess and report on the effectiveness of the Company’s internal controls over financial reporting.

Changes in Internal Control over Financial Reporting

There were no changes in the Company’s internal control over financial reporting during the Company’s fiscal quarter ended March 31, 2011, that have materially affected, or are reasonable likely to materially affect, the Company’s internal control over financial reporting.

PART II. OTHER INFORMATION

 

Item 1. Legal Proceedings

No material pending proceedings

 

Item 1A. Risk Factors

No changes

 

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

 

  (a) None

 

  (b) None

 

  (c) None

 

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Item 3. Defaults Upon Senior Securities

None

 

Item 4. Removed and Reserved

 

Item 5. Other Information

None

 

Item 6. Exhibits

 

31.1    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 for John E. Peck, Chief Executive Officer.
31.2    Certification Pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 for Billy C. Duvall, Chie