f10k_063010-0128.htm



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

FORM 10-K
(Mark One)
[X]
ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the Fiscal Year Ended June 30, 2010
or
[   ]
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the transition period from _________________ to __________________

Commission File Number: 0-51093
 
 
KEARNY FINANCIAL CORP.
(Exact name of Registrant as specified in its Charter)

United States
 
22-3803741
(State or Other Jurisdiction of
Incorporation or Organization)
 
(I.R.S. Employer
Identification No.)

120 Passaic Avenue, Fairfield, New Jersey
   
07004
 
(Address of Principal Executive Offices)
   
(Zip Code)
 

Registrant’s telephone number, including area code:  (973) 244-4500
 
Securities registered pursuant to Section 12(b) of the Act:

Title of Each Class
 
Name of Each Exchange on Which Registered
Common Stock, $0.10 par value
 
The NASDAQ Stock Market LLC

Securities registered pursuant to Section 12(g) of the Act: None

Indicate by check mark if the registrant is a well-known seasoned issuer, as defined in Rule 405 of the Securities Act. [  ] YES    [X]   NO
 
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. [  ] YES    [X]   NO
 
Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. [X] YES [  ] NO
 
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Website, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§229.405 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
 
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein and will not be contained, to the best of registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. [X]
 
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company. See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
 
 
Large accelerated filer o
 
Accelerated filer x
 
Non-accelerated filer o
(Do not check if a smaller reporting company)
 
Smaller reporting company o

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Act).  [  ] YES   [X] NO
 
The aggregate market value of the voting and non-voting common equity held by non-affiliates of the Registrant on December 31, 2009 (the last business day of the Registrant’s most recently completed second fiscal quarter) was $152.1 million.   Solely for purposes of this calculation, shares held by directors, executive officers and greater than 10% stockholders are treated as shares held by affiliates.
 
As of September 3, 2010 there were outstanding 68,000,777 shares of the Registrant’s Common Stock.
 
DOCUMENTS INCORPORATED BY REFERENCE

1.           Portions of the definitive Proxy Statement for the Registrant’s 2010 Annual Meeting of Stockholders. (Part III)
 
 



 
 

 

KEARNY FINANCIAL CORP.
ANNUAL REPORT ON FORM 10-K
For the Fiscal Year Ended June 30, 2010

INDEX


PART I
       
Page
Item 1.
 
Business
 
3
Item 1A.
 
Risk Factors
 
48
Item 1B.
 
Unresolved Staff Comments
 
54
Item 2.
 
Properties
 
54
Item 3.
 
Legal Proceedings
 
56
Item 4.
 
[Removed and Reserved]
 
56
         
PART II
         
Item 5.
 
Market for  Registrant’s Common Equity, Related Stockholder Matters
   and Issuer Purchases of Equity Securities
 
57
Item 6.
 
Selected Financial Data
 
60
Item 7.
 
Management’s Discussion and Analysis of Financial Condition
   and Results of Operations
 
62
Item 7A.
 
Quantitative and Qualitative Disclosures About Market Risk
 
90
Item 8.
 
Financial Statements and Supplementary Data
 
96
Item 9.
 
Changes in and Disagreements with Accountants on Accounting and
   Financial Disclosure
 
97
Item 9A.
 
Controls and Procedures
 
97
Item 9B.
 
Other Information
 
98
         
PART III
         
Item 10.
 
Directors, Executive Officers and Corporate Governance
 
99
Item 11.
 
Executive Compensation
 
99
Item 12.
 
Security Ownership of Certain Beneficial Owners and Management and
   Related Stockholder Matters
 
99
Item 13.
 
Certain Relationships and Related Transactions, and Director Independence
 
100
Item 14.
 
Principal Accounting Fees and Services
 
100
         
PART IV
         
Item 15.
 
Exhibits, Financial Statement Schedules
 
101
         
SIGNATURES
       


 
 

 

Forward-Looking Statements

Kearny Financial Corp. (the “Company” or the “Registrant”) may from time to time make written or oral “forward-looking statements”, including statements contained in the Company’s filings with the Securities and Exchange Commission (including this Annual Report on Form 10-K and the exhibits thereto), in its reports to stockholders and in other communications by the Company, which are made in good faith by the Company pursuant to the “safe harbor” provisions of the Private Securities Litigation Reform Act of 1995.

These forward-looking statements involve risks and uncertainties, such as statements of the Company’s plans, objectives, expectations, estimates and intentions that are subject to change based on various important factors (some of which are beyond the Company’s control).  In addition to the factors described under Item 1A. Risk Factors, the following factors, among others, could cause the Company’s financial performance to differ materially from the plans, objectives, expectations, estimates and intentions expressed in such forward-looking statements:

·  
the strength of the United States economy in general and the strength of the local economy in which the Company conducts operations,
·  
the effects of and changes in, trade, monetary and fiscal policies and laws, including interest rate policies of the Board of Governors of the Federal Reserve System, inflation, interest rates, market and monetary fluctuations,
·  
the impact of changes in financial services laws and regulations (including laws concerning taxation, banking, securities and insurance),
·  
changes in accounting policies and practices, as may be adopted by regulatory agencies, the Financial Accounting Standards Board (“FASB”) or the Public Company Accounting Oversight Board,
·  
technological changes.
·  
competition among financial services providers and,
·  
the success of the Company at managing the risks involved in the foregoing and managing its business.

The Company cautions that the foregoing list of important factors is not exclusive. The Company does not undertake to update any forward-looking statement, whether written or oral, that may be made from time to time by or on behalf of the Company.
















 
2

 

PART I

Item 1. Business

General

The Company is a federally-chartered corporation that was organized on March 30, 2001 for the purpose of being a holding company for Kearny Federal Savings Bank (the “Bank”), a federally-chartered stock savings bank.  On February 23, 2005, the Company completed a minority stock offering in which it sold 21,821,250 shares, representing 30% of its outstanding common stock upon completion of the offering.  The remaining 70% of the outstanding common stock, totaling 50,916,250 shares, were retained by Kearny MHC (the “MHC”). The MHC is a federally-chartered mutual holding company and so long as the MHC is in existence, it will at all time own a majority of the outstanding common stock of the Company.  The stock repurchase programs conducted by the Company since the offering have reduced the total number of shares outstanding.  The 50,916,250 shares held by the MHC represented 74.5% of the 68,344,277 total shares outstanding as of the Company’s June 30, 2010 fiscal year end.  The MHC and the Company are chartered and regulated by the Office of Thrift Supervision (“OTS”).

The Company is a unitary savings and loan holding company and conducts no significant business or operations of its own.  References in this Annual Report on Form 10-K to the Company or Registrant generally refer to the Company and the Bank, unless the context indicates otherwise. References to “we”, “us”, or “our” refer to the Bank or Company, or both, as the context indicates.

The Bank was originally founded in 1884 as a New Jersey mutual building and loan association. It obtained federal insurance of accounts in 1939 and received a federal charter in 1941.  The Bank’s deposits are federally insured by the Deposit Insurance Fund as administered by the Federal Deposit Insurance Corporation (“the FDIC”) and the Bank is regulated by the OTS and the FDIC.

The Company’s primary business is the ownership and operation of the Bank.  The Bank is principally engaged in the business of attracting deposits from the general public in New Jersey and using these deposits, together with other funds, to originate or purchase loans for its portfolio and invest in securities.  Loans originated or purchased by the Bank generally include loans collateralized by residential and commercial real estate augmented by secured and unsecured loans to businesses and consumers.  The investment securities purchased by the Bank generally include U.S. agency mortgage-backed securities, U.S. government and agency debentures and bank-qualified municipal obligations.  The Bank maintains a small balance of single issuer trust preferred securities and non-agency mortgage-backed securities which were acquired through the Company’s purchase of other institutions and does not actively purchase such securities.  At June 30, 2010, net loans receivable comprised 43.0% of our total assets while investment securities, including mortgage-backed and non-mortgage-backed securities, comprised 42.3% of our total assets.   By comparison, at June 30, 2009, net loans receivable comprised 48.9% of our total assets while securities comprised 33.7% of our total assets.
 
The loan portfolio’s decline on both a dollar and percentage of total assets basis during fiscal 2010 reflected an accelerated level of loan prepayments compared to fiscal 2009 that outpaced the year-over-year increase in the Company’s volume of new loan acquisitions.  The increase in loan acquisitions during fiscal 2010 included an increase in internally originated loans partially offset by declines in purchased loans.  Despite the year-to-year increase in loan acquisition volume, the level of loan originations and purchases during fiscal 2010 continued to reflect the challenges of declining real estate values and high levels of unemployment that have characterized the regional and national economy since the financial crisis of 2008-2009.  Notwithstanding these near-term challenges, our strategic business plan
 

 
3

 

continues to call for increasing the balance of our loan portfolio relative to the size of our securities portfolio over the next several years.
 
We operate from an administrative headquarters in Fairfield, New Jersey and had 27 branch offices as of June 30, 2010.  We also operate an Internet website at www.kearnyfederalsavings.com through which copies of our periodic reports are available free of charge as soon as reasonably practicable after they are filed with the Securities and Exchange Commission.

Market Area.  At June 30, 2010, our primary market area consists of the New Jersey counties in which we currently operate branches: Bergen, Essex, Hudson, Middlesex, Morris, Ocean, Passaic and Union Counties.  While we have also considered Monmouth County, New Jersey to be part of our market area in the past, we expect this market to grow in strategic significance due to our proposed acquisition of Central Jersey Bancorp (NASDAQ: CJBK), headquartered in Monmouth County, NJ, as discussed below.   Our lending is concentrated in these nine counties and our predominant sources of deposits are the communities in which our offices are located as well as the neighboring communities.

Our primary market area is largely urban and suburban with a broad economic base as is typical within the New York metropolitan area.  Service jobs represent the largest employment sector followed by wholesale/retail trade. Our business of attracting deposits and making loans is generally conducted within our primary market area.  A downturn in the local economy could reduce the amount of funds available for deposit and the ability of borrowers to repay their loans which would adversely affect our profitability.

Competition.  We operate in a market area with a high concentration of banking and financial institutions and we face substantial competition in attracting deposits and in originating loans. A number of our competitors are significantly larger institutions with greater financial and managerial resources and lending limits.  Our ability to compete successfully is a significant factor affecting our growth potential and profitability.

Our competition for deposits and loans historically has come from other insured financial institutions such as local and regional commercial banks, savings institutions and credit unions located in our primary market area.  We also compete with mortgage banking and finance companies for real estate loans and with commercial banks and savings institutions for consumer loans.  We also face competition for attracting funds from providers of alternative investment products such as equity and fixed income investments such as corporate, agency and government securities as well as the mutual funds that invest in these instruments.

There are large retail banking competitors operating throughout our primary market area, including Bank of America, Citibank, Hudson City Savings Bank, JP Morgan Chase Bank, PNC Bank, TD Bank, and Wells Fargo Bank and we face strong competition from other community-based financial institutions.  Based on data compiled by the FDIC as of June 30, 2009, the latest date for which such data is available, Kearny Federal Savings Bank was ranked 17th of 115 depository institutions operating in the eight counties in which it has branches with 0.92% of total FDIC-insured deposits.

Proposed Acquisition of Central Jersey Bancorp.  On May 25, 2010, the Company and the Bank entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Central Jersey Bancorp (“Central Jersey”) and its wholly owned subsidiary, Central Jersey Bank, National Association (“Central Jersey Bank”), pursuant to which Central Jersey will merge with a to-be-formed subsidiary of the Company and thereby become a wholly owned subsidiary of Company (the “Merger”). Immediately thereafter, Central Jersey Bank will merge with and into the Bank (the “Bank Merger”).  Central Jersey Bank will operate as a division of the Bank for at least 18 months after closing.  At June 30, 2010, Central
 

 
4

 

Jersey Bank had $576.8 million in assets and 13 branch offices in Monmouth and Ocean Counties, New Jersey.
 
Under the terms of the Merger Agreement, shareholders of Central Jersey will receive $7.50 in cash (the “Merger Consideration”) for each share of Central Jersey common stock held.  The Merger Agreement also provides that all options to purchase Central Jersey stock that are outstanding and unexercised immediately prior to the closing under Central Jersey’s various stock option plans will be cancelled in exchange for a cash payment equal to the positive difference between $7.50 and the exercise price. The estimated aggregate value of the transaction is $72.3 million.
 
Central Jersey will use its best efforts to redeem the 11,300 shares of Fixed Rate Cumulative Perpetual Preferred Stock, Series A previously issued to the U.S. Department of Treasury under the TARP Capital Purchase Plan immediately before or contemporaneously with closing.  The warrant issued to the U.S. Treasury in connection with Treasury’s preferred stock investment will be converted into the right to receive the difference between $7.50 and the warrant exercise price times the number of shares covered by the warrant.
 
The Merger Agreement contains (a) customary representations and warranties of Central Jersey and the Company, including, among others, with respect to corporate organization, capitalization, corporate authority, third party and governmental consents and approvals, financial statements, and compliance with applicable laws, (b) covenants of Central Jersey to conduct its business in the ordinary course until the Merger is completed; (c) covenants of Central Jersey not to take certain actions during such period.  Central Jersey has also agreed not to (i) solicit proposals relating to alternative business combination transactions or (ii) subject to certain exceptions, enter into discussions concerning, or provide confidential information in connection with, any proposals for alternative business combination transactions.
 
Consummation of the Merger is subject to certain conditions, including, among others, approval of the Merger by shareholders of Central Jersey, governmental filings and regulatory approvals and expiration of applicable waiting periods, absence of litigation, accuracy of specified representations and warranties of the other party, and obtaining material permits and authorizations for the lawful consummation of the Merger and the Bank Merger.  The Merger is also conditioned upon Central Jersey’s nonperforming assets, as defined in the Merger Agreement, not exceeding $20.0 million between March 31, 2010 and the Closing Date.
 
The Merger Agreement also contains certain termination rights for the Company and Central Jersey, as the case may be, applicable upon the occurrence or non-occurrence of certain events, including: final, non-appealable denial of required regulatory approvals required for consummation of the Merger; failure of Central Jersey shareholders to approve the Merger; if, subject to certain conditions, the Merger has not been completed by March 31, 2011; a breach by the other party that is not or cannot be cured within 30 days after written notice if such breach would result in a failure of the conditions to closing set forth in the Merger Agreement; entry by the Board of Directors of Central Jersey into an alternative business combination transaction; or the failure by the Board of Directors of Central Jersey to hold the meeting of shareholders to vote on the Merger Agreement or to recommend the Merger to its shareholders. If the Merger is not consummated under certain circumstances, Central Jersey has agreed to pay the Company a termination fee of up to $2.8 million.
 
The representations and warranties of each party set forth in the Merger Agreement have been made solely for the benefit of the other party to the Merger Agreement. In addition, such representations and warranties (a) are subject to materiality qualifications contained in the Merger Agreement which may differ from what may be viewed as material by investors, (b) were made only as of the date of the Merger

 
5

 

Agreement or such other date as is specified in the Merger Agreement, and (c) may have been included in the Merger Agreement for the purpose of allocating risk between the Company and Central Jersey rather than establishing matters as facts. Accordingly, the Merger Agreement is included with this filing only to provide investors with information regarding the terms of the Merger Agreement, and not to provide investors with any other factual information regarding the parties or their respective businesses.

Lending Activities

General.  We have traditionally focused on the origination of one-to-four family first mortgage loans, which comprise a significant majority of our total loan portfolio. Our next largest category of loans comprises commercial mortgages, including loans secured by multi-family, mixed-use and nonresidential properties. Our commercial loan offerings also include secured and unsecured business loans most of which are secured by real estate.  Our consumer loan offerings primarily include home equity loans and home equity lines of credit as well as account loans and overdraft lines of credit.  We also offer construction loans to builders/developers as well as individual homeowners.  Substantially all of our borrowers are residents of our primary market area and would be expected to be similarly affected by economic and other conditions in that area.  Since May 2007, we have been purchasing out-of-state one-to-four family first mortgage loans to supplement our in-house originations, as discussed on Page 13.


 
At June 30,
 
2010
 
2009
 
2008
 
2007
 
2006
 
Amount
   
Percent
 
Amount
   
Percent
 
Amount
   
Percent
 
Amount
   
Percent
 
Amount
   
Percent
 
(Dollars in Thousands)
Real estate mortgage:
                                                                   
    One-to-four family
$
663,850
   
65.52
%
 
$
689,317
   
65.97
%
 
$
687,679
   
66.99
%
 
$
559,306
   
64.66
%
 
$
465,822
   
65.80
%
Multi-family and nonresidential
 
203,013
   
20.04
     
197,379
   
18.89
     
178,588
   
17.40
     
159,147
   
18.40
     
107,111
   
15.13
 
Commercial business
 
14,352
   
1.42
     
14,812
   
1.42
     
8,735
   
0.85
     
4,205
   
0.48
     
3,208
   
0.45
 
Consumer:
                                                                   
    Home equity loans
 
101,659
   
10.03
     
113,387
   
10.85
     
123,978
   
12.08
     
113,624
   
13.14
     
93,639
   
13.23
 
Home equity lines of credit
 
11,320
   
1.12
     
12,116
   
1.16
     
11,478
   
1.12
     
12,748
   
1.47
     
12,988
   
1.83
 
Passbook or certificate
 
2,703
   
0.27
     
2,922
   
0.28
     
2,662
   
0.26
     
3,250
   
0.38
     
2,884
   
0.41
 
Other
 
1,545
   
0.15
     
1,585
   
0.15
     
1,332
   
0.13
     
1,391
   
0.16
     
247
   
0.03
 
Construction
 
14,707
   
1.45
     
13,367
   
1.28
     
12,062
   
1.17
     
11,360
   
1.31
     
22,078
   
 3.12
 
Total loans
 
1,013,149
   
100.00
%
   
1,044,885
   
100.00
%
   
1,026,514
   
100.00
%
   
865,031
   
100.00
%
   
707,977
   
100.00
%
Less:
                                                                   
Allowance for loan losses
 
8,561
           
6,434
           
6,104
           
6,049
           
5,451
       
Unamortized yield adjustments including net premiums on purchased loans and net deferred loans costs and fees
 
(564
         
(962
         
(1,276
)
         
(1,511
)
         
 (1,087
)
     
   
7,997
           
5,472
           
4,828
           
4,538
           
4,364
       
                                                                     
Total loans, net
$
1,005,152
         
$
1,039,413
         
$
1,021,686
         
$
860,493
         
$
703,613
       
                                                                     


 
6

 

Loan Maturity Schedule.  The following table sets forth the maturities of our loan portfolio at June 30, 2010. Demand loans, loans having no stated maturity and overdrafts are shown as due in one year or less.  Loans are stated in the following table at contractual maturity and actual maturities could differ due to prepayments.

   
Real estate mortgage:
One-to-four
family
 
Real estate
mortgage:
Multi-family and
commercial
 
 
 
Commercial
business
 
 
Home
equity
loans
   
Home
equity
lines of
credit
 
 
Passbook or
certificate
 
 
 
 
Other
   
 
 
 
Construction
   
 
 
 
Total
   
(In Thousands)
Amounts Due:
                                                           
Within 1 Year
 
$
285
 
$
385
 
$
6,886
 
$
162
   
$
4
 
$
1,287
 
$
103
   
$
11,985
   
$
21,097
                                                             
After 1 year:
                                                           
1 to 3 years
   
2,548
   
626
   
   
2,124
     
14
   
46
   
1
     
2,722
     
8,081
3 to 5 years
   
6,613
   
504
   
   
5,402
     
142
   
16
   
8
     
     
12,685
5 to 10 years
   
72,078
   
10,321
   
84
   
28,163
     
4,549
   
   
     
     
115,195
10 to 15 years
   
140,772
   
31,836
   
1,427
   
31,615
     
5,941
   
   
     
     
211,591
Over 15 years
   
441,554
   
159,341
   
5,955
   
34,193
     
670
   
1,354
   
1,433
     
     
644,500
                                                             
Total due after one year
   
663,565
   
202,628
   
7,466
   
101,497
     
11,316
   
1,416
   
1,442
     
2,722
     
992,052
                                                             
Total amount due
 
$
663,850
 
$
203,013
 
$
14,352
 
$
101,659
   
$
11,320
 
$
2,703
 
$
1,545
   
$
14,707
   
$
1,013,149
                                                             
 


 
7

 

The following table shows the dollar amount of loans as of June 30, 2010 due after June 30, 2011 according to rate type and loan category.

       
 
 
Fixed Rates
     
Floating or
Adjustable
Rates
     
 
 
Total
 
       
(In Thousands)
 
Real estate mortgage:
                               
One-to-four family
     
$
604,612
     
$
58,953
     
$
663,565
 
Multi-family and commercial
       
172,428
       
30,200
       
202,628
 
Commercial business
       
4,527
       
2,939
       
7,466
 
Consumer:
                               
Home equity loans
       
101,497
       
       
101,497
 
Home equity lines of credit
       
2,650
       
8,666
       
11,316
 
Passbook or certificate
       
       
1,416
       
1,416
 
Other
       
297
       
1,145
       
1,442
 
Construction
       
       
2,722
       
2,722
 
                                 
Total
     
$
886,011
     
$
106,041
     
$
992,052
 
                                 

One-to-Four Family Mortgage Loans.   Our primary lending activity has traditionally consisted of the origination of one-to-four family first mortgage loans, of which approximately $570.7 million or 86.0% are secured by properties located within New Jersey as of June 30, 2010.  By comparison, at June 30, 2009 approximately $583.5 million or 84.7% of loans were secured by New Jersey properties.  During the year ended June 30, 2010, the Bank originated $102.1 million of one-to-four family first mortgage loans within New Jersey compared to $79.4 million in the year ended June 30, 2009.  Despite the year-to-year increase in loan origination volume, the overall level of loan originations during fiscal 2010 continued to reflect the challenges of declining real estate values and high levels of unemployment that have characterized the regional and national economy since the financial crisis of 2008-2009.  The volume of loan originations for fiscal 2010 also reflected management’s decision to maintain its conservative underwriting standards coupled with a disciplined pricing policy which may have caused some potential borrowers to seek financing with more aggressive lenders.  To supplement originations, we also purchased one-to-four family first mortgages totaling $31.2 million during the year ended June 30, 2010, compared to $67.7 million during the year ended June 30, 2009.  An acceleration of one-to-four family mortgage loan prepayments during fiscal 2010 outpaced the corresponding increase in loan acquisition volume resulting in the reported decline in the outstanding balance of this segment of the loan portfolio for fiscal 2010.

We will originate a one-to-four family mortgage loan on an owner-occupied property with a principal amount of up to 95% of the lesser of the appraised value or the purchase price of the property, with private mortgage insurance required if the loan-to-value ratio exceeds 80%. Our loan-to-value limit on a non-owner-occupied property is 75%.  Loans in excess of $1.0 million are handled on a case-by-case basis and are subject to lower loan-to-value limits, generally no more than 50%.

Our fixed-rate and adjustable-rate residential mortgage loans on owner-occupied properties have terms of ten to 30 years.  Residential mortgage loans on non-owner-occupied properties have terms of up to 15 years for fixed-rate loans and terms of up to 20 years for adjustable-rate loans.  We also offer ten-year balloon mortgages with a thirty-year amortization schedule on owner-occupied properties and a twenty-year amortization schedule on non-owner-occupied properties.

 
8

 


Our adjustable-rate loan products provide for an interest rate that is tied to the one-year Constant Maturity U.S. Treasury index and have terms of up to 30 years with initial fixed-rate periods of one, three, five, seven, or ten years according to the terms of the loan and annual rate adjustment thereafter. We also offer an adjustable-rate loan with a term of up to 30 years with a rate that adjusts every five years to the five-year Constant Maturity U.S. Treasury index.  There is a 200 basis point limit on the rate adjustment in any adjustment period and the rate adjustment limit over the life of the loan is 600 basis points.

We offer a first-time homebuyer program for persons who have not previously owned real estate and are purchasing a one-to-four family property in Bergen, Passaic, Morris, Essex, Hudson, Middlesex, Monmouth, Ocean and Union Counties, New Jersey for use as a primary residence.  This program is also available outside these areas, but only to persons who are existing deposit or loan customers of Kearny Federal Savings Bank and/or members of their immediate families.  The financial incentives offered under this program are a one-eighth of one percentage point rate reduction on all first mortgage loan types and the refund of the application fee at closing.

The fixed-rate mortgage loans that we originate generally meet the secondary mortgage market standards of the Federal Home Loan Mortgage Corporation (“Freddie Mac”).  However, as our business plan continues to call for increasing loans on both a dollar and percentage of assets basis, we generally do not sell loans in the secondary market and do not currently expect to do so in any large capacity in the near future.  Toward that end, there were no residential mortgage loan sales in the secondary market during the last three fiscal years.

Substantially all of our residential mortgages include “due on sale” clauses, which give  us the right to declare a loan immediately payable if the borrower sells or otherwise transfers an interest in the property to a third party.  Property appraisals on real estate securing our one-to-four family first mortgage loans are made by state certified or licensed independent appraisers approved by the Bank’s Board of Directors.  Appraisals are performed in accordance with applicable regulations and policies.  We require title insurance policies on all first mortgage real estate loans originated.  Homeowners, liability and fire insurance and, if applicable, flood insurance, are also required.

Multi-Family and Nonresidential Real Estate Mortgage Loans.  We also originate commercial mortgage loans on multi-family and nonresidential properties, including loans on apartment buildings, retail/service properties and other income-producing properties, such as mixed-use properties combining residential and commercial space.  The factors noted above that impacted residential loan origination volume during fiscal 2010 also adversely impacted the origination volume of commercial mortgages.  Consequently, the Bank originated $31.0 million of multi-family and commercial real estate mortgages during the year ended June 30, 2010, compared to $36.7 million during the year ended June 30, 2009.  Despite the year-over-year decrease in loan origination volume, the outstanding balance of the portfolio grew modestly during fiscal 2010.  The Company’s business plan continues to call for growing strategic emphasis on the origination of commercial mortgages and increasing that portfolio on both a dollar and percentage of assets basis.

We generally require no less than a 25% down payment or equity position for mortgage loans on multi-family and nonresidential properties.  For such loans, we generally require personal guarantees.  Currently, these loans are made with a maturity of up to 25 years.  We also offer a five-year balloon loan with a twenty five-year amortization schedule.  Our commercial mortgage loans are secured by properties located in New Jersey.

Commercial mortgage loans generally are considered to entail significantly greater risk than that which is involved with one-to-four family, owner-occupied real estate lending.  The repayment of these

 
9

 

loans typically is dependent on the successful operations and income stream of the borrower and the real estate securing the loan as collateral.  These risks can be significantly affected by economic conditions.  In addition, commercial mortgage loans generally carry larger balances to single borrowers or related groups of borrowers than one-to-four family mortgage loans.  Consequently, such loans typically require substantially greater evaluation and oversight efforts compared to residential real estate lending.

Commercial Business Loans.  We also originate commercial term loans and lines of credit to a variety of professionals, sole proprietorships and small businesses in our market area.  As above, the factors noted earlier that impacted mortgage loan origination volume during fiscal 2010 also adversely impacted the origination volume of commercial business loans.  Consequently, during the year ended June 30, 2010, the Bank originated $3.5 million of commercial business loans compared to $8.0 million during the year ended June 30, 2009.  Despite the year-over-year decrease in loan origination volume, the outstanding balance of the portfolio declined only modestly during fiscal 2010.  The Company’s business plan continues to calls for increased emphasis on originating commercial business loans as part of its strategic focus on commercial lending.

Our commercial business loans are normally secured by real estate and we require personal guarantees on all commercial loans.  Approximately $9.2 million or 63.9% of our commercial business loans are secured by one-to-four family properties and approximately $5.2 million or 36.0% are secured by commercial real estate and other forms of collateral.  Only $18,000 or less than one percent of the loans are unsecured.  Marketable securities may also be accepted as collateral on lines of credit, but with a loan to value limit of 50%.  The loan to value limit on secured commercial lines of credit and term loans is otherwise generally limited to 70%. We also make unsecured commercial loans in the form of overdraft checking authorization up to $25,000 and unsecured lines of credit up to $25,000.

Our commercial term loans generally have terms of up to 20 years and are mostly fixed-rate loans.  Our commercial lines of credit have terms of up to two years and are generally adjustable-rate loans.  We also offer a one-year, interest-only commercial line of credit with a balloon payment.

Unlike single-family, owner-occupied residential mortgage loans, which generally are made on the basis of the borrower’s ability to make repayment from his or her employment and other income and which are secured by real property whose value tends to be more easily ascertainable, commercial business loans typically are made on the basis of the borrower’s ability to make repayment from the cash flow of the borrower’s business.  As a result, the availability of funds for the repayment of commercial business loans may be substantially dependent on the success of the business itself and the general economic environment.  Commercial business loans, therefore, have greater credit risk than residential mortgage loans.  In addition, commercial loans may carry larger balances to single borrowers or related groups of borrowers than one-to-four family first mortgage loans.  As such, commercial business lending requires substantially greater evaluation and oversight efforts compared to residential or commercial real estate lending.

Home Equity Loans and Lines of Credit.  Our home equity loans are fixed-rate loans for terms of generally up to 20 years.  We also offer fixed-rate and adjustable-rate home equity lines of credit with terms of up to 15 years.  The factors noted above that impacted one-to-four family loan origination volume during fiscal 2010 also adversely impacted the origination volume of home equity loans and lines of credit.  During the year ended June 30, 2010, the Bank originated $30.6 million of home equity loans and home equity lines of credit compared to $31.0 million in the year ended June 30, 2009.  Consistent with the one-to-four family first mortgage loans, prepayment activity on home equity loans and lines of credit outpaced loan origination volume resulting in the reported decline in the outstanding balance of this segment of the loan portfolio for fiscal 2010.

 
10

 

Collateral value is determined through an automated valuation module, specifically, Freddie Mac’s Home Valuation Explorer, or property value analysis report provided by a state certified or licensed independent appraiser.  In some cases, we determine collateral value by a full appraisal performed by a state certified or licensed independent appraiser.  Home equity loans and lines of credit do not require title insurance but do require homeowner, liability and fire insurance and, if applicable, flood insurance.

Home equity loans and fixed-rate home equity lines of credit are generally originated in our market area and are generally made in amounts of up to 80% of value on term loans and of up to 75% of value on home equity adjustable-rate lines of credit.  We originate home equity loans secured by either a first lien or a second lien on the property.

Other Consumer Loans.  In addition to home equity loans and lines of credit, our consumer loan portfolio primarily includes loans secured by savings accounts and certificates of deposit on deposit with the Bank and unsecured personal overdraft loans.  We will generally lend up to 90% of the account balance on a loan secured by a savings account or certificate of deposit.

Consumer loans entail greater risks than residential mortgage loans, particularly consumer loans that are unsecured.  Consumer loan repayment is dependent on the borrower’s continuing financial stability and is more likely to be adversely affected by job loss, divorce, illness or personal bankruptcy. The application of various federal laws, including federal and state bankruptcy and insolvency laws, may limit the amount that can be recovered on consumer loans in the event of a default.

Our underwriting standards for consumer loans include a determination of the applicant’s credit history and an assessment of the applicant’s ability to meet existing obligations and payments on the proposed loan.  The stability of the applicant’s monthly income may be determined by verification of gross monthly income from primary employment and any additional verifiable secondary income.

Construction Lending.  Our construction lending includes loans to individuals for construction of one-to-four family residences or for major renovations or improvements to an existing dwelling.  Our construction lending also includes loans to builders and developers for multi-unit buildings or multi-house projects. All of our construction lending is in New Jersey.  During the year ended June 30, 2010, construction loan disbursements were $7.1 million compared to $5.4 million during the year ended June 30, 2009.  The level of construction loan disbursements continues to reflect reduced origination volume attributable to many of the same factors that have adversely impacted the origination volume of other loan categories during fiscal 2010.
 
Construction borrowers must hold title to the land free and clear of any liens. Financing for construction loans is limited to 80% of the anticipated appraised value of the completed property. Disbursements are made in accordance with inspection reports by our approved appraisal firms.  Terms of financing are limited to one year with an interest rate tied to the prime rate published in the Wall Street Journal and may include a premium of one or more points.  In some cases, we convert a construction loan to a permanent mortgage loan upon completion of construction.
 
We have no formal limits as to the number of projects a builder has under construction or development and make a case-by-case determination on loans to builders and developers who have multiple projects under development.  The Board of Directors reviews the Bank’s business relationship with a builder or developer prior to accepting a loan application for processing.  We generally do not make construction loans to builders on a speculative basis.  There must be a contract for sale in place. Financing is provided for up to two houses at a time in a multi-house project, requiring a contract on one of the two houses before financing for the next house may be obtained.

 
11

 


Construction lending is generally considered to involve a higher degree of credit risk than mortgage lending. If the initial estimate of construction cost proves to be inaccurate, we may be compelled to advance additional funds to complete the construction with repayment dependent, in part, on the success of the ultimate project rather than the ability of a borrower or guarantor to repay the loan. If we are forced to foreclose on a project prior to completion, there is no assurance that we will be able to recover the entire unpaid portion of the loan.  In addition, we may be required to fund additional amounts to complete a project and may have to hold the property for an indeterminate period.

Loans to One Borrower.  Federal law generally limits the amount that a savings institution may lend to one borrower to the greater of $500,000 or 15% of the institution’s unimpaired capital and surplus. Accordingly, as of June 30, 2010, our loans-to-one-borrower limit was approximately $54.7 million.
 
At June 30, 2010, our largest single borrower had an aggregate loan balance of approximately $14.1 million, representing four mortgage loans secured by commercial real estate.  Our second largest single borrower had an aggregate loan balance of approximately $10.0 million, representing ten loans secured by commercial real estate, two residential construction loans and one residential loan.  Our third largest borrower had an aggregate loan balance of approximately $9.7 million, representing two loans secured by commercial real estate.  At June 30, 2010, all of these lending relationships were current and performing in accordance with the terms of their loan agreements.  By comparison, at June 30, 2009, loans outstanding to the Bank’s three largest borrowers totaled approximately $14.0 million, $11.0 million and $10.0 million, respectively.

Loan Originations, Purchases, Sales, Solicitation and Processing.  The following table shows total loans originated, purchased and repaid during the periods indicated.

   
For the Years Ended June 30,
 
   
2010
   
2009
   
2008
 
   
(In Thousands)
 
Loan originations and purchases:
                       
Loan originations:
                       
Real estate mortgage:
                       
One-to-four family
 
$
102,116
   
$
79,413
   
$
99,113
 
Multi-family and commercial
   
31,002
     
36,700
     
44,854
 
Commercial business
   
3,457
     
8,002
     
7,622
 
Construction
   
7,081
     
5,374
     
5,569
 
Consumer:
                       
Home equity loans and lines of credit
   
30,622
     
31,034
     
44,992
 
Passbook or certificate
   
843
     
1,506
     
1,504
 
Other
   
469
     
792
     
334
 
Total loan originations
   
175,590
     
162,821
     
203,988
 
Loan purchases:
                       
Real estate mortgage:
                       
One-to-four family
   
31,216
     
67,698
     
102,228
 
Total loan purchases
   
31,216
     
67,698
     
102,228
 
Loan principal repayments
   
(239,697
   
(213,131
   
(145,959
)
(Decrease) increase due to other items
   
(1,370
   
339
     
936
 
                         
Net (decrease) increase in loan portfolio
 
$
(34,261
 
$
17,727
   
$
161,193
 


 
12

 

    Our customary sources of loan applications include loan originated by our commercial and residential loan officers, repeat customers, referrals from realtors and other professionals and “walk-in” customers.  These sources are supported in varying degrees by our newspaper and electronic advertising and marketing strategies.

The Bank maintains loan purchase and servicing agreements with three large nationwide lenders, in order to supplement the Bank’s loan production pipeline.  The original agreements called for the purchase of loan pools that contain mortgages on residential properties in our lending area.  Subsequently, we expanded our loan purchase and servicing agreements with the same nationwide lenders to include mortgage loans secured by residential real estate located outside of New Jersey.  We have procedures in place for purchasing these mortgages such that the underwriting guidelines are consistent with those used in our in-house loan origination process.  The evaluation and approval process ensures that the purchased loans generally conform to our normal underwriting guidelines.  Our due diligence process includes full credit reviews and an examination of the title policy and associated legal instruments.  We recalculate debt service and loan-to-value ratios for accuracy and review appraisals for reasonableness.  All loan packages presented to the Bank must meet the Bank’s underwriting requirements as outlined in the purchase and servicing agreements and are subject to the same review process outlined above.  Furthermore, there are stricter underwriting guidelines in place for out-of-state mortgages, including higher minimum credit scores.  During the year ended June 30, 2010, we purchased a total of $11.0 million and $3.9 million of fixed-rate and adjustable rate loans, respectively, from these sellers.

Once we purchase the loans, we continually monitor the seller’s performance by thoroughly reviewing portfolio balancing reports, remittance reports, delinquency reports and other data supplied to us on a monthly basis.  We also review the seller’s financial statements and documentation as to their compliance with the servicing standards established by the Mortgage Bankers Association of America.

Since May 2007, we have occasionally purchased out-of-state one-to-four family first mortgage loans to supplement our in-house originations.  As of June 30, 2010, our portfolio of out-of-state loans included mortgages in 28 states and totaled $93.2 million.  The states with the two largest concentrations of loans at June 30, 2010 were Texas and Washington with outstanding principal balances totaling $9.7 million and $9.5 million, respectively.  The aggregate outstanding balances of loans in each of the remaining 26 states comprise less than 10% of the total balance of out-of-state loans.
 
The Bank also enters into purchase agreements with a limited number of mortgage originators to supplement the Bank’s loan production pipeline.  These agreements call for the purchase, on a flow basis, of one-to-four family first mortgage loans with servicing released to the Bank.  During the year ended June 30, 2010, we purchased a total of $15.6 million and $661,000 of fixed-rate and adjustable rate loans, respectively, from these sellers.

In addition to purchasing one-to-four family loans, we also occasionally purchase participations in loans originated by other banks and through the Thrift Institutions Community Investment Corporation of New Jersey (“TICIC”), a subsidiary of the New Jersey Bankers Association.  Our TICIC participations generally include multi-family and commercial real estate properties. The aggregate balance of TICIC participations at June 30, 2010 was $7.4 million and the average balance of a single participation was approximately $246,000.  Both were virtually unchanged from June 30 2009, with additional loan disbursements generally offset by principal repayments.  At June 30, 2010, we had four non-TICIC participations with an aggregate balance of $8.6 million, consisting of loans on commercial real estate properties, including a medical center, a self-storage facility, a shopping plaza and commercial buildings with a combination of retail and office space and a construction loan to build townhouses.   By comparison, at June 30, 2009 non-TICIC participations totaled $11.3 million.  During the year ended June 30, 2010, the Bank did not purchase any loan participations originated by other banks.

 
13

 


Loan Approval Procedures and Authority.  Senior management recommends and the Board of Directors approves our lending policies and loan approval limits.  Our Chief Lending Officer may approve loans up to $750,000.  Loan department personnel of the Bank serving in the following positions may approve loans as follows: mortgage loan managers, mortgage loans up to $500,000; mortgage loan underwriters, mortgage loans up to $250,000; consumer loan managers, consumer loans up to $250,000; and consumer loan underwriters, consumer loans up to $150,000.  In addition to these principal amount limits, there are established limits for different levels of approval authority as to minimum credit scores and maximum loan to value ratios and debt ratios.  Our Chief Executive Officer, Chief Financial Officer and Chief Investment Officer have authorization to countersign loans for amounts that exceed $750,000 up to a limit of $1.0 million.  Our Chief Lending Officer must approve loans between $750,000 and $1.0 million along with one of these designated officers.  Non-conforming mortgage loans and loans over $1.0 million require the approval of the Board of Directors.

Asset Quality

Loan Delinquencies and Collection Procedures.  The Company regularly monitors the payment status of all loans within its portfolio and promptly initiates collections efforts on past due loans in accordance with applicable policies and procedures.  Delinquent borrowers are notified by both mail and telephone when a loan is 30 days past due. If the delinquency continues, subsequent efforts are made to contact the delinquent borrower and additional collection notices and letters are sent.  All reasonable attempts are made to collect from borrowers prior to referral to an attorney for collection.  However, when a loan is 90 days delinquent, it is our general practice to refer it to an attorney for repossession, foreclosure or other form of collection action, as appropriate. In certain instances, we may modify the loan or grant a limited moratorium on loan payments to enable the borrower to reorganize his or her financial affairs and we attempt to work with the borrower to establish a repayment schedule to cure the delinquency.

As to mortgage loans, if a foreclosure action is taken and the loan is not reinstated, paid in full or refinanced, the property is sold at judicial sale at which we may be the buyer if there are no adequate offers to satisfy the debt. Any property acquired as the result of foreclosure or by deed in lieu of foreclosure is classified as real estate owned until it is sold or otherwise disposed of. When real estate owned is acquired, it is recorded at its fair market value less estimated selling costs. The initial write-down of the property, if necessary, is charged to the allowance for loan losses. Adjustments to the carrying value of the properties that result from subsequent declines in value are charged to operations in the period in which the declines are identified. At June 30, 2010, we held real estate owned totaling $146,000, consisting of two properties acquire through foreclosure.

Loans are generally placed on non-accrual status when they are more than 90 days delinquent, with the exception of passbook loans.  When a passbook loan becomes 120 days delinquent, we collect the outstanding balance of the loan from the related passbook account along with accrued interest (and a penalty is charged if the account securing the loan is a certificate of deposit).  Loans may be placed on a non-accrual status at any time if, in the opinion of management, repayment of the loan in accordance with its stated terms is doubtful.  Interest accrued and unpaid at the time a loan is placed on non-accrual status is charged against interest income.  Subsequent payments are applied in accordance with the promissory note.  At June 30, 2010, we had approximately $9.2 million of loans that were held on a non-accrual basis compared to $8.1 million at June 30, 2009.




 
14

 

Non-Performing Assets.  The following table provides information regarding the Bank’s non-performing loans and real estate owned.

   
At June 30,
   
2010
   
2009
   
2008
   
2007
   
2006
   
(Dollars in Thousands)
                                                 
Loans accounted for on a non-accrual basis:
                                               
Real estate mortgage:
                                               
One- to four-family
 
$
1,867
     
$
2,120
     
$
530
     
$
472
     
$
329
 
Multi-family and nonresidential
   
4,358
       
5,626
       
1,012
       
1,017
       
592
 
Commercial business
   
2,298
       
       
       
       
 
Consumer:
                                               
Home equity loans
   
250
       
27
       
31
       
       
21
 
Home equity lines of credit
   
       
       
       
       
 
Other
   
1
       
       
       
       
 
Construction
   
468
       
362
       
       
 —
       
 —
 
Total
   
9,242
       
8,135
       
1,573
       
1,489
       
942
 
Accruing loans which are contractually
past due 90 days or more:
                                               
Real estate mortgage:
                                               
One- to four-family
   
12,321
       
5,017
       
       
       
 
Multi-family and commercial
   
       
       
       
       
 
Commercial business
   
       
       
       
       
 
Consumer:
   
       
                               
Home equity loans and lines of credit
   
       
       
       
       
 
Passbook or certificate
   
       
       
       
       
 
Other
   
       
       
       
       
 
Construction
   
       
       
 —
       
 —
       
 —
 
Total
   
12,321
       
5,017
       
 —
       
 —
       
 —
 
                                                 
Total non-performing loans
 
$
21,563
     
$
13,152
     
$
1,573
     
$
1,489
     
$
942
 
Real estate owned
 
$
146
     
$
109
     
$
109
     
$
109
     
$
109
 
Other non-performing assets
 
$
     
$
     
$
     
$
     
$
 
Total non-performing assets
 
$
21,709
     
$
13,261
     
$
1,682
     
$
1,598
     
$
1,051
 
Total non-performing loans to total loans
   
2.13
%
     
1.26
%
     
0.15
%
     
 0.17
%
     
0.13
%
Total non-performing loans to total assets
   
0.92
%
     
0.62
%
     
0.08
%
     
 0.08
%
     
0.05
%
Total non-performing assets to total assets
   
0.93
%
     
0.62
%
     
0.08
%
     
 0.08
%
     
0.05
%

Non-performing assets increased by $8.4 million to $21.7 million at June 30, 2010 from $13.3 million at June 30, 2009.  The increase comprised a net increase in non-accrual loans of $1.1 million plus the addition of $7.3 million of loans 90 days or more past due and still accruing.  For those same comparative periods, the number of nonaccrual loans increased from 21 to 26 loans while the number of loans 90 days or more past due and still accruing increased from 12 to 28 loans.

 
15

 
The $2,117,000 of nonaccrual one-to-four family mortgage loans and home equity loans include a total of 11 originated loans with outstanding principal balances ranging from $7,000 to $470,000 at June 30, 2010.  The loans are in various stages of collection, workout or foreclosure and are secured by New Jersey properties whose values at June 30, 2010 are estimated to equal or exceed the outstanding balances of the loans at that date.

The $4,358,000 of nonaccrual multifamily and nonresidential mortgage loans includes a total of seven loans with outstanding principal balances ranging from $70,000 to $2.7 million at June 30, 2010.  Five of the seven loans with combined balances of $1,632,000 were acquired through TICIC.  Based upon updated collateral valuations, the Bank has established specific valuation allowances of $1,551,000 for the identified impairment attributable to four of these five loans at June 30, 2010.  The remaining loans represent two originated nonresidential mortgage loans with combined balances of $2,726,000.  The loans are secured by New Jersey properties whose values at June 30, 2010 are estimated to equal or exceed the outstanding balances of the loans at that date.

The $2,298,000 of nonaccrual commercial business loans include a total of three loans with outstanding principal balances ranging from $4,800 to $2.2 million at June 30, 2010.  The largest of these three loans represents one loan with an outstanding balance of $2.2 million loan which is secured by land with approvals for residential development.  The loan was placed on nonaccrual at June 30, 2010 based upon its past due status.  However, no specific valuation allowance for impairment was required to be established against the loan as of that date based upon the adequacy of the Bank’s collateral as well as an existing contract for the sale of the underlying property which is expected to close in the quarter ending September 30, 2010.  The remaining two nonaccrual commercial business loans have combined balances of $99,600 with a specific valuation allowance of $4,800 established in the allowance for loan loss for the identified impairment attributable to one of these two loans.

The balance of nonaccrual loans also includes $468,000 attributable to three construction loans secured by properties in New Jersey with outstanding principal balances ranging from $106,000 to $213,000 at June 30, 2010.  Based upon updated collateral valuations, the Bank has established a specific valuation allowance of $106,000 at June 30, 2010 for the identified impairment attributable to one of the three loans while the values of the collateral securing the remaining two properties are estimated to equal or exceed the outstanding balances of the loans at that date.

Nonperforming loans also include 28 accruing loans totaling $12,321,000 reported as 90 days or more past due.  Of these 28 loans, 27 represent residential mortgage loans secured by New Jersey properties while one loan is secured by a residential property located in Alabama.  The loans were purchased from nationwide mortgage loan originators and continue to be serviced by those organizations.  In accordance with our agreements, the servicers advance scheduled principal and interest payments to the Bank when such payments are not made by the borrower.  The timely receipt of principal and interest from the servicer ensures the continued accrual status of the Bank’s loan.  However, the delinquency status reported for these nonperforming loans reflects the borrower’s actual delinquency irrespective of the Bank’s receipt of advances which will be recouped by the servicer from the Bank in the event the borrower does not reinstate the loan.  Based upon updated collateral valuations, the Bank has established specific valuation allowances of $2,433,000 for the identified impairment attributable to 22 of these 28 loans at June 30, 2010.

During the years ended June 30, 2010, 2009 and 2008, gross interest income of $629,000, $591,000 and $105,000, respectively, would have been recognized on loans accounted for on a non-accrual basis if those loans had been current. Interest income recognized on such loans of $233,000, $134,000 and $47,000 was included in income for the years ended June 30, 2010, 2009 and 2008, respectively.

 
16

 

In addition to the non-performing assets included in the table above, the Bank had two loans with combined outstanding balances totaling $945,000 reported as troubled debt restructurings at June 30, 2010.  No loans were reported as troubled debt restructurings at June 30, 2009, 2008, 2007 or 2006.

During the year ended June 30, 2010, gross interest income of $63,000 would have been recognized on loans reported as troubled debt restructurings under their original terms prior to restructuring.  Actual interest income of $46,000 was recognized on such loans for the year ended June 30, 2010 reflecting the interest received under the revised terms of those restructured loans.

Loan Review System.  The Company maintains a loan review system consisting of several related functions including, but not limited to, classification of assets, calculation of the allowance for loan losses, independent credit file review as well as internal audit and lending compliance reviews.  The Company utilizes both internal and external resources, where appropriate, to perform the various loan review functions.  For example, the Company has engaged the services of a third party firm specializing in loan review and analysis to perform several loan review functions.  This firm reviews the loan portfolio in accordance with the scope and frequency determined by senior management and the Asset Quality Committee of the Board of Directors.  The third party loan review firm assists senior management and the board of directors in identifying potential credit weaknesses; in appropriately grading or adversely classifying loans; in identifying relevant trends that affect the collectability of the portfolio and identify segments of the portfolio that are potential problem areas; in verifying the appropriateness of the allowance for loan losses; in evaluating the activities of lending personnel including compliance with lending policies and the quality of their loan approval, monitoring and risk assessment; and by providing an objective assessment of the overall quality of the loan portfolio. Currently, independent loan reviews are being conducted quarterly and include non-performing loans as well as samples of performing loans of varying types within the Company’s portfolio.

The Company’s loan review system also includes the internal audit and compliance functions, which operate in accordance with a scope determined by the Audit and Compliance Committees of the Board of Directors.  Internal audit resources assess the adequacy of, and adherence to, internal credit policies and loan administration procedures.  Similarly, the Company’s compliance resources monitor adherence to relevant lending-related and consumer protection-related laws and regulations.  The loan review system is structured in such a way that the internal audit function maintains the ability to independently audit other risk monitoring functions without impairing its independence with respect to these other functions.

As noted, the loan review system also comprises the Company’s policies and procedures relating to the regulatory classification of assets and the allowance for loan loss functions each of which are described in greater detail below.
 
Classification of Assets.  In compliance with the OTS guidelines, management maintains an internal loan review program, whereby certain loans exhibiting adverse credit quality characteristics are classified “Special Mention”, “Substandard”, “Doubtful” or “Loss”.  It is our policy to review the loan portfolio in accordance with regulatory classification procedures, generally on a monthly basis.  Management evaluates loans classified as substandard or doubtful for impairment in accordance with applicable accounting requirements.  Management classifies the impaired portion of a loan as “Loss” through which a specific valuation allowance equal to 100% of the impairment is established.

An asset is classified as “Substandard” if it is inadequately protected by the paying capacity and net worth of the obligor or the collateral pledged, if any.  Substandard assets include those characterized by the distinct possibility that the insured institution will sustain some loss if the deficiencies are not

 
17

 
 
corrected. Assets classified as “Doubtful” have all of the weaknesses inherent in those classified as “Substandard”, with the added characteristic that the weaknesses present make collection or liquidation in full highly questionable and improbable, on the basis of currently existing facts, conditions and values. Assets, or portions thereof, classified as “Loss” are considered uncollectible or of so little value that their continuance as assets is not warranted.  Assets classified as “Loss” are either charged off directly against the allowance for loan loss or a specific valuation allowance equal to 100% of the loss is established as noted above.

Assets which do not currently expose the Company to a sufficient degree of risk to warrant an adverse classification but have some credit deficiencies or other potential weaknesses are designated as “Special Mention” by management.  Adversely classified assets, together with those rated as “Special Mention”, are generally referred to as “Classified Assets”.  Non-classified assets are rated as either “Pass” or “Watch” with the latter denoting a potential deficiency or concern that warrants increased oversight or tracking by management until remediated.

Management performs a classification of assets review, including the regulatory classification of assets, generally on a monthly basis.  The results of the classification of assets review are validated by the Company’s third party loan review firm during their quarterly, independent review.  In the event of a difference in rating or classification between those assigned by the internal and external resources, the Company will generally utilize the more critical or conservative rating or classification.  Final loan ratings and regulatory classifications are presented monthly to the Board of Directors and are reviewed by regulators during the examination process.

The following table discloses our designation of certain loans as special mention or adversely classified during each of the five years presented.  See Page 32 for a discussion on classified securities.

   
At June 30,
   
2010
     
2009
     
2008
     
2007
     
2006
   
(In Thousands)
                                               
Special Mention
 
$
10,353
     
$
3,506
     
$
     
$
736
     
$
236
Substandard
   
18,697
       
14,891
       
749
       
1,470
       
1,448
Doubtful
   
       
817
       
1,871
       
1,881
       
2,001
Loss
   
       
       
       
       
                                               
Total
 
$
29,050
     
$
19,214
     
$
2,620
     
$
4,087
     
$
3,685

The balance of “Special Mention” loans at June 30, 2010 included a total of 19 loans whose entire outstanding balances were classified in that manner.  The balance of “Substandard” loans included a total of 52 loans at June 30, 2010.  Of these “Substandard” loans, the entire balances of 29 loans totaling $8,915,000 were classified in that manner.  The remaining 23 loans had total outstanding balances of $12,434,000 of which $9,782,000 was classified as “Substandard” with the remaining $2,652,000 classified as “Loss”.

In addition to the 23 “Substandard” loans with portions of their balances classified as “Loss”, the entire balances of six additional loans totaling $1,663,000 were fully classified as “Loss”.  In total, the outstanding balance of loans, or portions thereof, classified as “Loss” totaled $4,315,000 at June 30, 2010.  As seen on Page 25, specific valuation allowances have been established against 100% of these estimated losses in accordance with the Company’s allowance for loan loss methodology.  Consistent with regulatory reporting requirements, the balance of classified assets are reported in the table above net of

 
18

 

any applicable specific valuation allowances resulting in the zero net balance for assets classified as “Loss”.

Allowance for Loan Losses.  The allowance for loan losses is a valuation account that reflects the Company’s estimation of the losses in its loan portfolio to the extent they are both probable and reasonable to estimate. The balance of the allowance is generally maintained through provisions for loan losses that are charged to income in the period that estimated losses on loans are identified by the Company’s loan review system.  The Company charges losses on loans against the allowance as such losses are actually incurred.  Recoveries on loans previously charged-off are added back to the allowance.

In accordance with generally accepted accounting principles and supporting regulatory guidelines, the balance of our allowance for loan losses generally comprises two components.  The first represents specific valuation allowances that we have established for identified losses on certain loans that have been individually reviewed for impairment.  The second component represents the general valuation allowances that we have established for estimated losses on homogenous groups of loans sharing similar risk characteristics.  The following narrative describes the specific manner in which the Company calculates and records its allowance for loan losses within the framework of its integrated loan review system.

The Company’s allowance for loan loss calculation methodology utilizes a “two-tier” loss measurement process that is performed monthly.  Based upon the results of the classification of assets and credit file review processes described earlier, the Company first identifies the loans that must be reviewed individually for impairment.  Loans eligible for individual impairment review generally represent the Company’s larger and/or more complex loans including commercial mortgage loans, comprising multi-family, nonresidential real estate and construction loans, as well as the Company’s commercial business loans.  However, the Company may also evaluate certain individual one-to-four family mortgage loans, home equity loans and home equity lines of credit for impairment based upon certain risk factors.  Factors considered in identifying individual loans to be reviewed include, but may not be limited to, delinquency status, size of loan, type and condition of collateral and the financial condition of the borrower.

A reviewed loan is deemed to be impaired when, based on current information and events, it is probable that we will be unable to collect all amounts due according to the contractual terms of the loan agreement.  Once a loan is determined to be impaired, management measures the amount of impairment associated with that loan.  Impairment is generally defined as the difference between the carrying value and fair value of a loan where former exceeds the latter.  For the collateral dependent mortgage loans that comprise the large majority of the Company’s portfolio, the fair value of the real estate collateralizing the loan serves as a practical expedient for that of the impaired loan itself.  Such values are generally determined based upon a discounted market value obtained through an automated valuation module or prepared by a qualified, independent real estate appraiser.  As supported by the accounting and regulatory guidance, the fair value of the collateral is further reduced by estimated selling costs when such costs are expected to reduce the cash flows available to repay the loan.

The Company establishes specific valuation allowances in the fiscal period during which the loan impairments are identified.  The results of management’s specific loan impairment evaluation are validated by the Company’s third party loan review firm during their quarterly, independent review.  Such valuation allowances are adjusted in subsequent fiscal periods, where appropriate, to reflect any changes in carrying value or fair value identified during subsequent impairment evaluations which are updated monthly by management.

The second tier of the loss measurement process involves estimating the probable and estimable losses which addresses loans not otherwise reviewed individually for impairment.  Such loans generally

 
19

 

comprise large groups of smaller-balance homogeneous loans, such as one-to-four family mortgage loans, home equity loans and home equity lines of credit and consumer loans, that may generally be excluded from individual impairment analysis and instead collectively evaluated for impairment.  Such loans also include the remaining non-impaired loans of the larger and/or more complex types, such as the Company’s commercial mortgage and business loans, which were not individually reviewed for impairment.

Valuation allowances established through the second tier of the loss measurement process utilize historical and environmental loss factors to collectively estimate the level of probable losses within defined segments of the Company’s loan portfolio.  These segments aggregate homogeneous subsets of loans with similar risk characteristics based upon loan type.  For allowance for loan loss calculation and reporting purposes, the Company currently stratifies its loan portfolio into six primary categories: residential mortgage loans, multi-family mortgage loans, nonresidential mortgage loans, construction loans, commercial business loans and consumer loans.  Within these broad categories, the Company defines certain segments.  For example, the residential mortgage loan category comprises four primary segments including one-to-four family originated mortgage loans, one-to-four family purchased loans, home equity loans and home equity lines of credit.  Commercial real estate loans, comprising the multi-family and nonresidential mortgage loan categories are each grouped into TICIC participations and other (non-TICIC) loans.  Construction loans segments also differentiate between TICIC participations and other (non-TICIC) loans while also grouping loans by underlying property types such as one-to-four family, multi-family and nonresidential construction loans.  Commercial business loans are generally grouped by collateral type while consumer loans are broken into segments based on both collateral type and/or purpose.

In regard to historical loss factors, the Company’s allowance for loan loss calculation calls for an analysis of historical charge-offs and recoveries for each of the defined segments within the loan portfolio.  The Company currently utilizes a two-year moving average of annual net charge-off rates (charge-offs net of recoveries) by loan segment, where available, to calculate its actual, historical loss experience.  During earlier fiscal years, the Company had generally utilized a five-year “look-back” period to determine the average charge-off history used in the calculation of historical loss factors.  The Company reduced that “look-back” period to two years during fiscal 2010 to better reflect the level of actual losses incurred during the current credit cycle in the calculation of its historical loss factors.  The outstanding principal balance of each loan segment is multiplied by the applicable historical loss factor to estimate the level of probable losses based upon the Company’s historical loss experience.

As noted, the Company’s allowance for loan loss calculation also utilizes environment loss factors to estimate the probable losses within the loan portfolio.  Environmental loss factors are based upon specific qualitative criteria representing key sources of risk within the loan portfolio.  Such risk criteria includes the level of and trends in delinquencies and non-accrual loans; the effects of changes in credit policy; the experience, ability and depth of the lending function’s management and staff; national and local economic trends and conditions; credit risk concentrations and changes in local and regional real estate values. For each segment of the loan portfolio, a level of risk, developed from a number of internal and external resources, is assigned to each of the qualitative criteria utilizing a scale ranging from zero (negligible risk) to 15 (high risk).  The sum of the risk values, expressed as a whole number, is multiplied by .01% to arrive at an overall environmental loss factor, expressed in basis points, for each segment.  The outstanding principal balance of each loan segment is multiplied by the applicable environmental loss factor to estimate the level of probable losses based upon the qualitative risk criteria.

The sum of the probable and estimable loan losses calculated through the first and second tiers of the loss measurement processes as described above, represents the total targeted balance for the Company’s allowance for loan losses at the end of a fiscal period.  As noted earlier, the Company

 
20

 

establishes all additional specific valuation allowances in the fiscal period during which additional loan impairments are identified.  This step is generally performed by transferring the required additions to specific valuation allowances on impaired loans from the balance of Company’s general valuation allowances.  After establishing all specific valuation allowances relating to impaired loans, the Company then compares the remaining actual balance of its general valuation allowance to the targeted balance calculated at the end of the fiscal period.  The Company adjusts its balance of general valuation allowances through the provision for loan losses as required to ensure that the balance of the allowance for loan losses reflects all probable and estimable loans losses at the close of the fiscal period.  Any balance of general valuation allowances in excess of the targeted balance is reported as unallocated with such balances attributable to probable losses within the loan portfolio relating to environmental factors within one or more non-specified loan segments.  Notwithstanding calculation methodology and the noted distinction between specific and general valuation allowances, the Company’s entire allowance for loan losses is available to cover all charge-offs that arise from the loan portfolio.

Finally, the labels “specific” and “general” used herein to define and distinguish the Company’s valuation allowances have substantially the same meaning as those used in the regulatory nomenclature applicable to the valuation allowances of insured financial institutions.  As such, the portion of the allowance for loan losses categorized herein as “general valuation allowance” is considered “supplemental capital” for the regulatory capital calculations applicable to the Company and its wholly owned bank subsidiary.  By contrast, the Company’s “specific valuation allowance” maintained against impaired loans is excluded from all forms of regulatory capital and is instead netted against the balance of the applicable assets for regulatory reporting purposes.

Our focus has consistently been to maintain an allowance for loan losses that represents our best estimate of probable losses within the Company’s loan portfolio given current facts and economic circumstances as of the evaluation date.  For fiscal years ended June 30, 2007 and prior, the Company had utilized a loan classification-based methodology to estimate the allowance for loan losses.  The loan classification methodology utilized benchmarks to establish the allowance for loan losses based upon their classification within the Company’s classification of assets process described earlier.  For example, the prior methodology generally required that the Company maintain a minimum level of general valuation allowances ranging from 0.30% to 1.00% of the outstanding principal balance of loans graded as “Pass” or “Watch”.  Similarly, general valuation allowances of 5%, 25% and 50%, respectively, were also established and maintained against the outstanding balance of all classified loans rated as “Special Mention”, “Substandard” and “Doubtful”.  Where appropriate, additional general valuation allowance percentages were established and maintained against certain categories of commercial loans.  The prior methodology also required that the Company maintain a specific valuation allowance in the amount of 100% of the outstanding balance of all loans, or portions thereof, classified as Loss which is consistent with the current allowance calculation methodology and regulatory requirements.

Like the current allowance for loan loss calculation methodology, the Company’s prior practice also allowed for the balance of the allowance to be maintained within a reasonable threshold of the balance targeted by the calculation methodology in place at that time.  Calculation methodology notwithstanding, the Company consistently determined that the overall balance of the allowance for loan losses at the close of each reporting period was being maintained within a range consistent with that required by GAAP.

 During the fiscal year ended June 30, 2008, the Company revised its allowance for loan loss calculation methodology to that described in the preceding discussion.  Doing so resulted in a more precise measurement of estimated probable losses consistent with the Interagency Policy Statement on the Allowance for Loan and Lease Losses that had been recently updated by bank regulators.  Through this policy statement, bank regulators clarified the applicable regulatory guidance regarding the allowance for

 
21

 

loan loss and emphasized the requirement that insured institutions adhere to the applicable accounting standards in calculating the appropriate level for the allowance for loan loss.

As discussed in greater detail below, the use of this new methodology did not result in a material change in the overall level of the allowance for loan losses.  Moreover, the provision recorded during the year ended June 30, 2008, which was determined based on the newly implemented methodology, was not materially different, on an overall basis, from what would have been required under the prior methodology.  However, the change in methodology did increase the precision of the calculation supporting the component balances of the Company’s allowance for loan losses while resulting in a noteworthy reallocation between loan segments and the general and specific valuation allowances applicable to each.  In particular, eliminating the use of loan classification benchmarks to estimate the allowance for loan losses corrected a tendency to overweight the allocation towards multi-family and commercial mortgages during prior periods in favor of a greater allocation toward one-to-four family mortgage loans.  Moreover, the change in underlying methodology converted what had been general valuation allowances, previously established and maintained on certain TICIC participations based upon their adverse loan classification, into more precisely defined specific and general valuation allowances attributable to those same loans, albeit in a lesser aggregate amount.  The remainder was largely reallocated toward the general valuation allowances required by the historical and environmental loss factors utilized in the revised calculation.


 
22

 

The following table sets forth information with respect to activity in the allowance for loan losses for the periods indicated.
 
 
For the Years Ended June 30,
 
 
2010
   
2009
   
2008
   
2007
 
2006
 
 
(Dollars in Thousands)
 
                                     
Allowance balance (at beginning of period)
$
6,434
   
$
6,104
   
$
6,049
   
$
5,451
 
$
5,416
 
Provision for loan losses
 
2,616
     
317
     
94
     
571
   
72
 
Charge-offs:
                                   
One-to-four family mortgage
 
202
     
2
     
30
     
   
 
Home equity loan
 
16
     
     
     
   
 
Commercial mortgage
 
322
     
     
     
   
 
Commercial business
 
     
     
     
   
30
 
Other
 
1
     
3
     
9
     
   
12
 
Total charge-offs
 
541
     
5
     
39
     
   
42
 
Recoveries:
                                   
One-to-four family mortgage
 
10
     
     
     
   
 
Commercial mortgage
 
42
     
     
     
   
 
Commercial business
 
     
18
     
     
27
   
5
 
Total recoveries
 
52
     
18
     
     
27
   
5
 
Net (charge-offs) recoveries
 
(489
   
13
     
(39
)
   
27
   
(37
                                     
Allowance balance (at end of period)
$
8,561
   
$
6,434
   
$
6,104
   
$
6,049
 
$
5,451
 
Total loans outstanding
$
1,013,149
   
$
1,044,885
   
$
1,026,514
   
$
865,031
 
$
707,977
 
Average loans outstanding
$
1,030,287
   
$
1,064,019
   
$
951,019
   
$
785,210
 
$
633,758
 
Allowance for loan losses as a percent
  of total loans outstanding
 
0.84
%
   
0.62
%
   
0.59
%
   
 0.70
%
 
 0.77
%
Net loan charge-offs as a percent
  of average loans outstanding
 
0.05
%
   
0.00
%
   
0.00
%
   
 0.00
%
 
 0.01
%
Allowance for loan losses to non-performing loans
 
39.70
%
   
48.92
%
   
388.05
%
   
406.25
%
 
578.66
%

 
23

 

Allocation of Allowance for Loan Losses.  The following table sets forth the allocation of the total allowance for loan losses by loan category and segment and the percent of loans in each category’s segment to total net loans receivable at the dates indicated.  The portion of the loan loss allowance allocated to each loan segment does not represent the total available for future losses which may occur within a particular loan segment since the total loan loss allowance is a valuation reserve applicable to the entire loan portfolio.

 
 
   
At June 30,
   
2010
 
2009
 
2008
 
2007
 
2006
       
Percent of
     
Percent of
     
Percent of
     
Percent of
     
Percent of
       
Loans to
     
Loans to
     
Loans to
     
Loans to
     
Loans to
   
Amount
 
Total Loans
 
Amount
 
Total Loans
 
Amount
 
Total Loans
 
Amount
 
Total Loans
 
Amount
 
Total Loans
At end of period allocated to:
                                                           
Real estate mortgage:
                                                           
One-to-four family
 
$
4,302
 
65.52
%
 
$
3,254
 
65.97
%
 
$
2,979
 
66.99
%
 
$
1,854
 
64.66
%
 
$
1,582
 
65.80
%
Multi-family and  commercial
   
3,315
 
20.04
     
2,181
 
18.89
     
1,841
 
17.40
     
3,602
 
18.40
     
3,133
 
15.13
 
Commercial business
   
108
 
1.42
     
73
 
1.42
     
44
 
0.85
     
27
 
0.48
     
34
 
0.45
 
Consumer:
                                                           
Home equity loans
   
313
 
10.03
     
510
 
10.85
     
719
 
12.08
     
356
 
13.14
     
286
 
13.23
 
Home equity lines of credit
   
34
 
1.12
     
55
 
1.16
     
67
 
1.12
     
46
 
1.47
     
39
 
1.83
 
Passbook or certificate
   
7
 
0.27
     
 
0.28
     
 
0.26
     
 
0.38
     
 
0.41
 
Other
   
6
 
0.15
     
24
 
0.15
     
41
 
0.13
     
34
 
0.16
     
27
 
0.03
 
Construction
   
245
 
1.45
     
106
 
1.28
     
118
 
1.17
     
 130
 
 1.31
     
 350
 
 3.12
 
     
8,330
         
6,203
         
5,809
         
6,049
         
5,451
     
Unallocated
   
231
         
231
         
295
         
         
     
                                                             
Total
 
$
8,561
 
100.00
%
 
$
6,434
 
100.00
%
 
$
6,104
 
100.00
%
 
$
6,049
 
100.00
%
 
$
5,451
 
100.00
%
 
 

 
24

 

The following table sets forth the allocation of the allowance for loan losses by loan category and segment within each valuation allowance category at the dates indicated.  The valuation allowance categories presented reflect the allowance for loan loss calculation methodology in effect at the time.
 
   
At June 30,
   
2010
     
2009
     
2008
     
2007
     
2006
   
(Dollars in Thousands)
Specific valuation allowance:
                                             
Real estate mortgage:
                                             
One-to-four family
 
$
2,433
     
$
150
     
$
     
$
     
$
Multi-family and  commercial (TICIC Participations)
   
1,551
       
1,046
       
1,160
       
       
Multi-family and  commercial (Non-TICIC)
   
220
       
232
       
       
       
Commercial business
   
5
       
2
       
3
       
       
Construction
   
106
       
       
       
       
Total specific valuation allowance
   
4,315
       
1,430
       
1,163
       
       
                                               
General valuation allowance (Factors based):
                                             
  Historical loss factors
   
199
       
30
       
33
       
       
  Environmental loss factors:
                                             
    Real estate mortgage:
                                             
One-to-four family
   
1,784
       
3,098
       
2,972
       
       
Multi-family and  commercial
   
1,443
       
901
       
679
       
       
    Commercial business
   
103
       
71
       
41
                   
    Consumer:
                                             
Home equity loans
   
305
       
510
       
719
       
       
Home equity lines of credit
   
34
       
55
       
67
       
       
Other
   
8
       
8
       
23
       
       
    Construction
   
139
       
100
       
112
       
       
Total environmental loss factors
   
3,816
       
4,743
       
4,613
       
       
                                               
          Total (Factors based)
   
4,015
       
4,773
       
4,646
       
       
                                               
General valuation allowance (Loan classifications based):
                                             
    Real estate mortgage:
                                             
One-to-four family
   
       
       
       
1,854
       
1,582
Multi-family and  commercial (TICIC Participations)
   
       
       
       
2,014
       
2,105
Multi-family and  commercial (Non-TICIC)
   
       
       
       
1,588
       
1,028
Commercial business
   
       
       
       
27
       
34
    Consumer:
                                             
Home equity loans
   
       
       
       
356
       
286
Home equity lines of credit
   
       
       
       
46
       
39
Other
   
       
       
       
34
       
27
    Construction
   
       
       
       
130
       
350
Total (Loan classifications based)
   
       
       
       
6,049
       
5,451
                                               
Unallocated general valuation allowance
   
231
       
231
       
295
       
       
                                               
Total allowance for loan losses
 
$
8,561
     
$
6,434
     
$
6,104
     
$
6,049
     
$
5,451


 
25

 

As reported in the tables above, the balance of the allowance for loan losses increased by approximately $2.1 million to $8.6 million at June 30, 2010 from $6.4 million at June 30, 2009.  The increase resulted from additional provisions of $2.6 million combined with net charge offs of $489,000 during fiscal 2010.  The increase reflects net additions to specific valuation allowances of approximately $2.9 million relating to impaired loans partially offset by net reductions of general valuation allowances, including unallocated amounts, of approximately $758,000 arising from the application of the historical and environmental loss factors to the outstanding balance of the remaining, non-impaired loans within the Company’s portfolio which declined during the year.

With regard to the reported net additions to specific valuation allowances at June 30, 2010, the Company reported a total of 39 impaired loans with a total outstanding balance of $20.5 million compared to a total of 19 impaired loans with a total outstanding balance of $11.1 million at June 30, 2009.  As of June 30, 2010, the portion of the total allowance for loan losses specifically attributable to impaired loans totaled $4.3 million representing the specific valuation allowances on 29 impaired loans with a total outstanding balance of $14.1 million.  The remaining 10 impaired loans with a total outstanding balance of $6.4 million did not require specific impairment allowances at June 30, 2010.  By comparison, as of June 30, 2009, the portion of the total allowance for loan losses specifically attributable to impaired loans totaled approximately $1.4 million representing specific valuation allowances attributable to ten impaired loans with a total outstanding balance of $5.4 million.  The remaining nine impaired loans with a total outstanding balance of $5.7 million did not require specific impairment allowances at June 30, 2009.  The increases in specific valuation allowances reported in fiscal 2010 generally resulted from reductions in the fair value of the real estate securing the collateral dependent loans that were individually evaluated for impairment in accordance with the Company’s allowance for loan loss calculation methodology described earlier.

The balance of the Company’s general valuation allowances, including unallocated amounts, decreased $758,000 from $5.0 million at June 30, 2009 to $4.2 million at June 30, 2010.  The reported net change in general valuation allowances during fiscal 2010 was attributable to the application of the Company’s historical and environment loss factors to the “non-impaired” portion of the loan portfolio during the year.

With regard to historical loss factors, the Company’s loan portfolio experienced a net annual charge-off rate of 5 basis points during fiscal 2010 while such losses were limited to one basis point or less during fiscal 2006-2009.  As a result, the Company’s general valuation allowances are derived largely from environmental loss factors with a significantly lesser portion of the allowance attributable to historical loss factors.  Of the balance of general valuation allowances reported at June 30, 2010 and June 30, 2009, $199,000 and $30,000, respectively, were attributable to historical loss factors.  Notwithstanding its low level of historical charge-offs, however, there can be no assurance that the Company’s net charge-off rate will remain at these levels given the current downturn in the economy and its potential effect on the future performance of the Company’s loan portfolio.  In particular, the Company has established specific valuation allowances of approximately $4.3 million at June 30, 2010 that represent identified impairments on nonperforming loans which are ultimately expected to result in additional charge offs in future periods as such loans work through the resolution process.

At June 30, 2010 and June 30, 2009, the portion of the Company’s general valuation allowances attributable to environmental factors totaled $3.8 million and $4.7 million, respectively.  The net decrease in this portion of the general valuation allowance reflects the level of environmental loss factors applied to the Company’s “non-impaired” loan portfolio whose outstanding balances declined during the year.    Specifically, loans receivable, excluding the allowance for loan loss, decreased $32.1 million from $1.05 billion at June 30, 2009 to $1.01 billion at June 30, 2010.  Along with this decline, impaired loans increased $9.4 million from $11.1 million at June 30, 2009 to $20.5 million at June 30, 2010.  Therefore,

 
26

 

the net decline in the “non-impaired” loan portfolio totaled approximately $41.5 million for the year ended June 30, 2010.  Additionally, management’s review and update of the historical and environmental loss factors during fiscal 2010 also resulted in modifications to the Company’s environmental factors from June 30, 2009 to June 30, 2010.  The result of such modifications increased the environmental loss factors applied to the Company’s riskier assets while reducing those factors applicable to those loans that are generally characterized by less credit risk.  The net result of these changes, in conjunction with the overall declines in the outstanding balance of the “non-impaired” loan portfolio, resulted in an overall reduction in the level of general valuation allowances attributable to environmental factors during the year.

Finally, the general valuation allowances included a balance of the unallocated allowance totaling $231,000 at both June 30, 2010 and June 30, 2009.  As noted earlier, the balance of the unallocated general allowance represents the amount established and maintained for probable losses attributable to environmental factors within one or more non-specified segments within the loan portfolio.  In accordance with the Company’s allowance for loan loss methodology, changes in the targeted balance of general valuation allowances attributable to modifications in environmental loss factors may, in whole or in part, be transferred to and from the unallocated allowance subject to the thresholds outlined in the earlier discussion concerning allowance for loan loss calculation methodology.

The balance of the allowance for loan losses included in the tables above for the two years ended June 30, 2006 and June 30, 2007 reflect the Company’s prior calculation methodology described in the earlier section.  As noted in that discussion, prior to the fiscal year ended June 30, 2008, the Company had utilized a loan classification-based methodology to estimate the allowance for loan losses.  This prior methodology utilized benchmarks to establish the allowance for loan losses based upon the Company’s classification of assets process.

During those two fiscal years, the balance of the Company’s allowance for loan losses comprised general valuation allowances only.  The Company maintained no specific valuation allowances on loans, or portions thereof, resulting from its classification of assets process.  This was consistent with the Company’s reporting of no impaired loans during those same years.

As noted earlier, loan classification-based methodology in use by the Company during that time resulted in a total balance of the allowance that was within a range consistent with that required by GAAP.  However, the balance of the Company’s allowance fluctuated within that acceptable range based upon the methodology and its application given certain corporate events affecting the loan portfolio.

Specifically, the Company acquired two banks, one in October 2002 and the other in July 2003. The Bank’s allowance for loan losses, when combined with the allowance for loan losses from each of the acquisitions, as required by GAAP at the time, resulted in an allowance for loan losses that generally reflected a margin for imprecision and uncertainty that is inherent in estimates of probable credit losses. Included in the loan portfolios of both acquired institutions were several loan participations of questionable credit quality originated by TICIC. TICIC enables financial institutions to pool their individual resources into a single facility designed to provide long-term financing for affordable and senior housing in New Jersey while supporting the participating institutions’ Community Reinvestment Act (“CRA”) lending objectives.  Based upon the Company’s understanding of the facts, economic circumstances and probable loss exposure relating to the TICIC loans following the acquisitions, the Company increased the applicable general valuation allowances to approximately $2.0 million in accordance with the loan classification-based allowance methodology in use during that time.  As described in the table above, the Company maintained the balance of the general valuation allowances attributable to the TICIC loans within a range of $2.0 million to $2.1 million during the two years ended June 30, 2006 and June 30, 2007 based upon their adverse classification during those years.

 
27

 


Loan loss provisions were minimal during the fiscal year ended June 30, 2006 due largely to targeted additions to valuation allowances attributable to net loan growth during those periods being largely offset by reductions in required valuation allowances on diminishing balances of classified assets.  Specifically, total loans outstanding increased $145.4 million from $562.6 million at June 30, 2005 to $708.0 million at June 30, 2006.  During that same timeframe, total classified assets declined by $3.7 million from $7.4 million to $3.7 million, respectively.  Based upon the allowance calculation methodology in use during that time, the balance of the Company’s valuation allowances was $5.4 million at both June 30, 2005 and June 20, 2006 reflecting the partially offsetting effects of net loan growth and net reductions in classified assets.  In total, net growth in the Company’s loan portfolio outpaced that of the allowance for loan losses during those periods.  Consequently, the ratio of allowance for loan losses to total loans decreased from 0.96% at June 30, 2005 to 0.77% at June 30, 2006.

By the fiscal year ended June 30, 2007, net growth in the loan portfolio necessitated a comparatively larger provision of $571,000 to increase the allowance to the level targeted by the Company’s allowance calculation methodology.  The net growth in the allowance during fiscal 2007 also reflected a modest increase in the balance of classified assets.  Specifically, total loans outstanding increased by $157.0 million from $708.0 million at June 30, 2006 to $865.0 million at June 30, 2007.  During that same timeframe, total classified assets increased by $402,000 from $3.7 million to $4.1 million, respectively.  Based upon the allowance calculation methodology in use during that time, the balance of the Company’s valuation allowances increased by $598,000 from $5.4 million at June 30, 2006 to $6.0 million at June 30, 2007 reflecting the combined effects of net loan growth and an increase in the balance of classified assets.  As in prior years, the overall growth in the loan portfolio during fiscal 2007 outpaced that of the allowance.  Consequently, the ratio of the allowance for loan losses to total loans continued to decline to 0.70% at June 30, 2007.

As noted earlier, during the fiscal year ended June 30, 2008, the Company revised its allowance for loan loss calculation to the methodology currently in use.  Doing so resulted in a more precise measurement of estimated probable losses that was consistent with the Interagency Policy Statement on the Allowance for Loan and Lease Losses updated by bank regulators and more closely aligned the Company’s calculation methodology to that required by the applicable accounting standards.

As supported by the tables above, the change in underlying calculation methodology did not result in a material change in the overall level of the allowance for loan losses from year to year.  Rather, the implementation of the revised methodology largely reallocated what had been the Company’s balance of general valuation allowances, calculated in accordance with the prior loan classification-based methodology at June 30, 2007, into more precisely defined specific valuation allowances for individually identified loan impairments and general valuation allowances based upon historical and environmental loss factors, as reported at June 30, 2008.

In total, the balance of the allowance for loan losses increased $55,000 from $6.0 million at June 30, 2007 to $6.1 million at June 30, 2008 reflecting additional provisions of $94,000 partially offset by net charge-offs of $39,000 during fiscal 2008.  This net provision for fiscal 2008 reflected the Company’s implementation of the new allowance for loan loss calculation methodology coupled with the effects of continued net loan growth and a further reduction in the balance of total classified assets.  Specifically, total loans outstanding increased $161.5 million from $865.0 million at June 30, 2007 to $1.03 billion at June 30, 2008.  The additions to general valuation allowances attributable to this net growth in loans, as calculated by the revised methodology, were largely offset by decreases in the required level of valuation allowances attributable to the TICIC loan participations discussed earlier.  Specifically, reviewing the individual TICIC loans for impairment, in accordance with the Company’s revised allowance calculation methodology, resulted in a lower, albeit more precise, estimate of probable losses associated with those

 
28

 

loans than had been calculated based upon the Company’s prior allowance calculation methodology.  At June 30, 2007, the outstanding balance of the Company’s TICIC participations totaled $9.0 million against which the Company maintained general valuation allowances of $2.0 million based upon the allowance calculation methodology in use by the Company at that time.  By comparison, at June 30, 2008, the outstanding balance of the Company’s TICIC participations totaled $8.5 million against which the Company maintained total valuation allowances of $1.19 million.

The total amount of valuation allowances attributable to the TICIC participations at June 30, 2008 included $1.16 million of specific valuation allowances attributable to impairments identified on loans that were individually reviewed in accordance with revised allowance calculation methodology implemented by the Company during fiscal 2008.  This amount was effectively reallocated from the general valuation allowances that had previously been established and maintained against the TICIC loans in accordance with the prior allowance calculation methodology.  The remaining $33,000 of TICIC valuation allowances at June 30, 2008 represented general valuation allowances arising from the identification of probable losses using the applicable historical and environmental loss factors on the “non-impaired” TICIC participations.  This amount was similarly reallocated within the balance of general valuation allowances attributable to the TICIC loan participations.

Having established the required level of specific and general valuation allowances against the TICIC loan participations in accordance with its revised allowance calculation methodology, the Company reallocated the remaining $821,000 of general valuation allowances previously attributable to the TICIC loan participations to other probable losses identified by that revised methodology including, but not limited to, that required by the net growth in the loan portfolio during fiscal 2008.

The Company’s historical loss experience throughout the past twenty years has generally reflected a period of unprecedented and sustained economic expansion that continued through fiscal 2007. The strong economic and real estate market conditions during that time resulted in minimal loan charge-offs through the current year ended June 30, 2010.  Accordingly, the Company did not consider the formal validation of the current allowance for loan loss methodology via comparison to our actual charge-off history through June 30, 2010 as necessary or useful.  Notwithstanding the Company’s low historical charge-off rates, however, economic and market conditions deteriorated significantly from fiscal 2008 through fiscal 2010.  As such, the Company expects that probable loan losses estimated by its current allowance for loan loss methodology, particularly those attributable to specific impairments, will be realized through actual charge-offs in the foreseeable future.  As such, the Company intends to validate the results of its allowance for loan loss calculations based upon historical data as such data builds in the future.  Notwithstanding this future analysis, the Company will continue to regularly update the historical loss factors used to estimate probable losses within its portfolio based upon its actual charge-offs.

Finally, the calculation of probable losses within a loan portfolio and the resulting allowance for loan losses is subject to estimates and assumptions that are susceptible to significant revisions as more information becomes available and as events or conditions effecting individual borrowers and the marketplace as a whole change over time.  Future additions to the allowance for loan losses will likely be necessary if economic and market conditions do not improve in the future from those currently prevalent in the marketplace.  In addition, the OTS, as an integral part of its examination process, periodically reviews our loan and foreclosed real estate portfolios and the related allowance for loan losses and valuation allowance for foreclosed real estate.  The OTS may require the allowance for loan losses or the valuation allowance for foreclosed real estate to be increased based on its review of information available at the time of the examination, which may negatively affect our earnings.



 
29

 

Securities Portfolio

Our deposits and borrowings have traditionally exceeded our outstanding balance of loans receivable.  We generally invest excess funds into investment securities with an emphasis on agency mortgage-backed securities. At June 30, 2010, our securities portfolio totaled $989.7 million and comprised 42.3% of our total assets.  By comparison, at June 30, 2009, our securities portfolio totaled $716.1 million and comprised 33.7% of our total assets.

In the recent years preceding fiscal 2010, we had increased the balance of our loan portfolio relative to the size of our securities portfolio in order to improve earnings as contemplated in our strategic business plan.  However, that trend reversed during fiscal 2010 during which the balance of the securities portfolio grew while aggregate loan balances declined.  The increase in the securities portfolio reflected the reinvestment of excess liquidity from deposit growth coupled with additional cash flows attributable to net declines in the loan portfolio as reviewed earlier.  Notwithstanding the growth in securities during fiscal 2010, our strategic business plan continues to call for shifting the mix of our earning assets toward greater balances of loans and lesser balances of investment securities over the longer term.

Our investment policy, which is approved by the Board of Directors, is designed to foster earnings and manage cash flows within prudent interest rate risk and credit risk guidelines.  Generally, our investment policy is to invest funds in various categories of securities and maturities based upon our liquidity needs, asset/liability management policies, investment quality, and marketability and performance objectives.  Our Chief Executive Officer, Chief Financial Officer and Chief Investment Officer are designated by the Board of Directors as the officers responsible for securities investment transactions and all transactions require the approval of at least two of these designated officers. The Interest Rate Risk Management Committee, currently composed of Directors Hopkins, Regan, Aanensen, Mazza and Parow, with our Chief Investment Officer and Chief Financial Officer participating as management’s liaison to the committee, is responsible for oversight of the securities portfolio. This committee meets quarterly to review the securities portfolio. The results of the committee’s quarterly review are reported to the full Board, which adjusts the investment policy and strategies, as it considers necessary and appropriate.

Federally chartered savings banks have the authority to invest in various types of liquid assets. The investments authorized under the investment policy approved by our Board of Directors include U.S. government and government agency obligations, municipal securities (consisting of bank qualified municipal bond obligations of state and local governments) and mortgage-backed securities of various U.S. government agencies or government-sponsored entities.  On a short-term basis, our investment policy authorizes investment in securities purchased under agreements to resell, federal funds, certificates of deposits of insured banks and savings institutions and FHLB term deposits.

As of June 30, 2010, mortgage-backed securities represented approximately 71.3% of our total investment in securities, compared to 96.1% as of June 30, 2009.  Mortgage-backed securities generally include mortgage pass-through securities and collateralized mortgage obligations which are typically issued with stated principal amounts and backed by pools of mortgage loans.  Collateralized mortgage obligations represented less than 1.0% of total mortgage-backed securities at both June 30, 2010 and 2009.  Mortgage originators use intermediaries (generally government agencies and government-sponsored enterprises, but also a variety of non-agency corporate issuers) to pool and package mortgage loans into mortgage-backed securities.  The cash flow and re-pricing characteristics of a mortgage pass-through security generally approximate those of the underlying mortgages.  By comparison, the cash flow and re-pricing characteristics of collateralized mortgage obligations are determined by those assigned to an individual security, or “tranche”, within the terms of a larger investment vehicle which allocates cash

 
30

 

flows to its component tranches based upon a predetermined structure as payments are received from the underlying mortgagors.

We generally invest in mortgage-backed securities issued by U.S. government agencies or government-sponsored entities, such as the Government National Mortgage Association (“Ginnie Mae”), Freddie Mac and the Federal National Mortgage Association (“Fannie Mae”).  Mortgage-backed securities issued or sponsored by U.S. government agencies and government-sponsored entities are guaranteed as to the payment of principal and interest to investors.  Mortgage-backed securities generally yield less than the mortgage loans underlying such securities because of the costs of servicing and of their payment guarantees or credit enhancements which minimize the level of credit risk to the security holder.

In addition to our investments in agency mortgage-backed securities, we formerly had an investment in the AMF Ultra Short Mortgage Fund (“AMF Fund”), a mutual fund acquired during 2002 as the result of a merger, which invested primarily in agency and non-agency mortgage-backed securities of short duration.  The housing and credit crises negatively impacted the market value of certain securities in the fund’s portfolio resulting in a continuing decline in the net asset value of this fund.  In addition, the fund’s manager instituted a temporary prohibition against cash redemptions to protect shareholders against the possibility that the fund might be forced to liquidate securities at distressed price levels to satisfy redemption requests.  In light of these factors, the Company recognized an impairment charge of $659,000 during the fiscal year ended June 30, 2008 due to other-than-temporary declines in the fund’s net asset value.

Due to a continuing decline in the net asset value of the AMF Fund, the Company elected to withdraw its investment in the fund by invoking a redemption-in-kind option during the first quarter of fiscal 2009 in lieu of cash.  The shares redeemed for cash and the shares redeemed for the underlying securities were written down to fair value as of the trade date resulting in an additional pre-tax charge to operations of $415,000 during the quarter ended September 30, 2008.  Through March 31, 2009, the Company recognized an additional $570,000 of other-than-temporary impairments through earnings attributable to further declines in the value of the non-agency collateralized mortgage obligations acquired through the AMF Fund redemption-in-kind.  Effective April 1, 2009, the Company adopted updated guidance relating to the accounting for impairment of investment securities.  As a result, that impairment was bifurcated into credit-related and noncredit-related components of $290,000 and $280,000, respectively.  Further credit-related and noncredit-related other-than-temporary impairments relating to these securities totaling $144,000 and $274,000, respectively, were recognized during the fourth quarter of fiscal 2009.

Through the first three quarters of fiscal 2010, the Company recorded additional credit-related and noncredit-related other-than-temporary impairments relating to these securities totaling $206,000 and $240,000, respectively.  During the fourth quarter ended June 30, 2010, the Company sold the remaining outstanding balance of its non-investment grade, non-agency collateralized mortgage obligations, most of which had been identified as other-than-temporarily impaired (“OTTI”) triggering the recognition of the impairment charges noted above.  At June 30, 2010, the Company’s remaining portfolio of non-agency collateralized mortgage obligations totaled 20 securities with an aggregate outstanding balance of approximately $310,000.  These securities, all of which were acquired through the AMF Fund redemption and remain in the held-to-maturity portfolio, were not other-than-temporarily impaired and were rated as investment grade as of that date.

Current accounting standards require that securities be categorized as “held to maturity”, “trading securities” or “available for sale”, based on management’s intent as to the ultimate disposition of each security.  These standards allow debt securities to be classified as “held to maturity” and reported in financial statements at amortized cost only if the reporting entity has the positive intent and ability to hold

 
31

 

these securities to maturity.  Securities that might be sold in response to changes in market interest rates, changes in the security’s prepayment risk, increases in loan demand, or other similar factors cannot be classified as “held to maturity”.

We do not currently use or maintain a trading account.  Securities not classified as “held to maturity” are classified as “available for sale”.  These securities are reported at fair value and unrealized gains and losses on the securities are excluded from earnings and reported, net of deferred taxes, as adjustments to Accumulated Other Comprehensive Income, a separate component of equity.  As of June 30, 2010, the $1.7 million remaining balance of all securities originally acquired through the AMF Fund redemption-in-kind, including both agency and non-agency mortgage-backed securities, were classified as held to maturity.  Additionally, the Company has classified $255.0 million of its agency debentures as held-to-maturity.  The remainder of Company’s portfolio, including all other agency mortgage backed securities, agency debentures; municipal obligations and single issuer trust preferred securities were classified as available for sale at June 30, 2010.

Other than mortgage-backed securities issued or guaranteed by the U.S. government or its agencies, we did not hold securities of any one issuer having an aggregate book value in excess of 10% of our equity at June 30, 2010.  All of our securities carry market risk insofar as increases in market rates of interest may cause a decrease in their market value.  Purchases of securities are made based on certain considerations, which include the interest rate, tax considerations, volatility, yield, settlement date and maturity of the security, our liquidity position and anticipated cash needs and sources.  The effect that the proposed security would have on our credit and interest rate risk and risk-based capital is also considered. We do not currently participate in hedging programs, interest rate caps, floors or swaps, or other activities involving the use of off-balance sheet derivative financial instruments.  We do not purchase securities that are rated below investment grade.

During the years ended June 30, 2010, 2009 and 2008, proceeds from sales of securities available for sale totaled $34.2 million, $7.3 million and $48.5 million which resulted in gross gains of $1,545,000, $-0- and $57,000 and gross losses of $-0-, $415,000 and $57,000, respectively.  Proceeds from sale of securities held to maturity during the year ended June 30, 2010 totaled $1.1 million with gross gains and gross losses of $-0- and $1,036,000, respectively.  There were no sales of held to maturity securities during the years ended June 30, 2009 or June 30, 2008.

As of June 30, 2010, two securities with a combined amortized cost $4.9 million were classified as “Substandard” for regulatory reporting purposes.  The securities represent two single issuer, trust preferred securities whose credit-ratings had fallen below investment grade by one of two rating agencies monitored by the Company.


 
32

 

The following table sets forth the carrying value of our securities portfolio at the dates indicated. Mortgage-backed securities include mortgage pass-through securities and collateralized mortgage obligations.

    
At June 30,
   
2010
 
2009
 
2008
 
2007
 
2006
   
(In Thousands)
Securities Available for Sale:
                             
U.S. agency obligations
 
$
3,942
 
$
4,557
 
$
5,513
 
$
6,864
 
$
8,786
Obligations of states and political subdivisions
   
18,955
   
18,340
   
17,757
   
65,333
   
195,661
Mutual funds (1)
   
   
   
7,545
   
7,795
   
7,424
Trust preferred securities
   
6,600
   
5,130
   
7,368
   
8,877
   
10,922
    Total securities available for sale
   
29,497
   
28,027
   
38,183
   
88,869
   
222,793
                               
Securities Held to Maturity:
                             
U.S. agency obligations
   
255,000
   
   
   
   
    Total securities held to maturity
   
255,000
   
   
   
   
                               
Mortgage-Backed Securities Available for Sale:
                             
Government National Mortgage Association
   
15,628
   
18,431
   
21,930
   
29,540
   
42,646
Federal Home Loan Mortgage Corporation
   
273,704
   
289,468
   
317,448
   
252,497
   
256,036
Federal National Mortgage Association
   
414,123
   
375,886
   
386,645
   
361,742
   
371,647
    Total mortgage-backed securities available for 
       sale
   
703,455
   
683,785
   
726,023
   
643,779
   
670,329
                               
Mortgage-Backed Securities Held to Maturity: